A top AIG executive’s testimony to the financial crisis panel reveals a profound lack of understanding of the mortgages derivatives business that helped cripple the insurance giant.
Andrew Forster headed up the London office of AIG Financial Products (AIGFP)—the group that sold credit protection on mortgage-backed securities. His group—sometimes called “ground zero of the financial crisis”—agreed with Goldman Sachs to provide credit protection on a mark-to-market basis for various mortgage securities.
Those agreements meant that AIG had to post more collateral when the value of the securities dropped. When the bottom fell out of the market, AIG found itself facing demands for tens of billions in collateral on the credit default swaps.
In an interview with the Financial Crisis Inquiry Commission, Forster claimed that the requirement to post collateral on subprime collateralized debt obligations and mortgage-backed securities was the “market standard.”
The blog Economics of Contempt has provided a transcript of the interview. Go ahead and read it. Here’s EofC’s comment:
OK, to be clear, it's simply not true that the "market standard" was for CDS on asset-backed securities to include full-blown CSAs, which require counterparties to post collateral based on mark-to-market prices.
Apart from AIG, the biggest providers of credit protection in the mortgage market were the monoline insurance companies. As a rule, they refused to agree to post collateral based on mark-to-market pricing. Their rule was that they would pay out only after a credit event. The only exception to this was that they would agree to post collateral if their own credit ratings were downgraded—something they claimed could never realistically happen.
Goldman Sachs decided to deal with AIG rather than the monolines specifically because of this issue of collateral, according to extensive interviews I conducted with people very close to this issue. Goldman was worried about taking on the credit risk of those from whom it was buying protection. It was wary that by the time a ratings agency downgraded an insurer, it would be too late—the insurer would be under such financial stress that it would be unable to meet the collateral demands.
AIG was pretty much alone among triple-A rated insurance companies in its willingness to post collateral. This was the source of their competitive advantage at the time. They could get business from those such as Goldman Sachs that were wary of systemic risk. The uniqueness of these collateral deals was the heart of the business model of AIGFP.
Economics of Contempts basically takes Forster at his word when he claims to have given the uniqueness of this arrangement so little thought. That strikes me as highly implausible. While I cannot read Forster's mind or entirely rule out the possibility that he really was that clueless, I am tempted to believe that Forster must have known that this was the very basis for AIG’s business.
So why would Forster claim ignorance?
In part, I suspect, because it later emerged that the guys at AIGFP never explained to the senior executives at AIG that this was why they were making so much money. They were taking on a market risk that others were avoiding—something that would have made their profits look a lot less enticing to more risk-averse insurance executives. My cynical side says maybe the AIGFP guys decided it was better to never, ever admit that they were concealing this risk.
But people who know AIG far better than I say I'm reading too much intelligence into those London derivatives traders. They just took it on religious faith that they faced no market risk. It never occurred to them that they were acting outside the market standard.
In short, they didn't understand their own business.
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