WaPo on AIG

Robert Waldmann

read Carol Leonnig’s article which quotes many people arguing that the feds should have let AIG file for chapter 11. The point of the complainers is simple, the takeover has been very (realtively) good for counterparties but not so good for the treasury or, it is alleged, AIG shareholders. I don’t see how people can claim that shareholders would have ended up with something after bankruptcy proceedings, but it is costly to the treasury. Oddly no one mentions that the deal was great for Goldman Sachs, I guess that simple observation is too scurrilous for the Post.

I was interested in the discussion of what AIG did wrong.

AIG’s Financial Products division is the primary villain in the company’s free-fall. It made tens of billions of disastrously bad bets on mortgage investments but may not have carefully hedged those bets or properly estimated its risk.

OK this is simple, there is risk that can’t be hedged by everyone. Someone has to bear aggregate risk. The idea that risk is a problem that can be solved, if one hedges rationally is, uhm, crazy. The idea of an insurance company buying insurance is odd. AIG uhm insures people, helps them hedge, bears risk.

In this case, they took on risk that they shouldn’t have taken on, but there is no reason to think that there was a rational equilibrium in which AIG wrote CDS and then hedged them by shorting the underlying assets.

One can make money by bearing risk or by outsmarting other people. Why would anyone expect an insurance company to be able to outsmart the financial services sector ?

Someone somewhere on the web notes (without naming names) two eminent economists who said that the housing bubble wouldn’t be a huge problem as losses from bad mortgages would only be around $400 billion (similar to the losses when the dot com bubble burst) and the net value of derivatives is zero.

So, assuming people are rational, they will only have an unpleasant surprise similar to 2000.

However, if everyone thinks they are beating the market, because of their clever derivatives trading strategies, the moment of truth for derivatives (bankruptcy in the case of CDSs) will be a very painful shock. The fact that the total supply of derivatives is zero doesn’t mean that the total perceived expected value of derivatives positions is zero.

Similarly if everyone thinks they have hedged aggregate risk by buying and selling derivatives, a mere $400 billion hit which people rated as hedged but it wasn’t can be much more damaging than a $400 billion hit which people knew they might bear.

The argument is that if everyone were rational except for the people writing mortgage contract, then everything will be more or less OK is true, but the hypothesis can’t be reconciled with the volume of trade in derivatives.