Fatal Risk

4 ideas

1. AIG Financial Products' credit default swap collapse

   By the mid-2000s those CDOs were increasingly backed by subprime mortgages. The contracts required AIG to post collateral if the underlying securities fell in market value or if AIG's own credit rating was cut. As housing prices fell in 2007–2008, counterparties made collateral calls totaling tens of billions of dollars, and AIG's downgrade on September 15, 2008 set off more. The next day the Federal Reserve extended an $85 billion rescue loan, although the firm's default models had predicted essentially no losses on the positions.

2. Catastrophic risk was disclosed yet unread

   AIG's filings disclosed the size of the swap book, its link to multi-sector CDOs, and the collateral-posting provisions tied to ratings and market value. A diligent reader could have assembled the exposure from those public documents. The failure was not concealment but inattention: analysts, rating agencies, and investors trusted the AAA franchise and did not do the arithmetic the disclosures invited.

3. Collateral triggers turn solvency into liquidity

   A position can be safe against ultimate default and still be fatal if its contract demands cash when market prices fall or ratings drop. AIG's models measured the probability that super-senior tranches would actually default, which was low. They did not measure the probability of mark-to-market declines and downgrades, which were likely and demanded immediate cash. The firm could be solvent on paper and still unable to meet the calls in time.

4. Danger hides in units labeled conservative

   AIG's securities lending program lent out insurance subsidiaries' bonds and reinvested the cash collateral in long-dated mortgage-backed securities. Borrowers could return the bonds and demand their cash back on short notice. This created a maturity and credit mismatch inside a business treated as a low-risk yield enhancement. When the question shifts from which division is exotic to where short-term obligations fund long-term illiquid assets, exposures appear that org charts and reputations conceal.

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