How the financial system swept risk under the rug

Last week, Braintruster Henry Liu unpacked the assets value debate. Today, he takes a closer look at how securities brought down the big names — and why once-in-10,000-years odds seemed worth it.

Let’s use AIG as our case study.

AIG Financial Products (AIGFP), based in London where the regulatory regime was less restrictive, took advantage of AIG’s categorization as an insurance company, which freed it from the burdensome rules on capital reserves that banks must follow. AIG did not need to set aside anything but a tiny sliver of capital to insure the super-senior risk tranches of collateralized debt obligations (CDOs) in its holdings. Nor was the insurer likely to face hard questions from its own regulators because AIGFS had largely fallen through the interagency cracks of oversight. It was regulated by the US Office for Thrift Supervision, whose staff had inadequate expertise in the field of cutting-edge structured finance products.

AIGFP-insured banks held super-senior risk CDOs in the broad credit-default swap market. AIG would earn a relatively trifle fee for providing this coverage – just 0.02 cents for each dollar insured per year. For the buyer of such insurance, the cost is insignificant given the critical benefit, particularly the financial advantage associated with a good credit rating, which the buyer receives not because the instruments are “safe” but because the risk was insured by AIGFP. For AIG, 0.02 cents multiplied a few hundred billion times adds up to an appreciable income stream, particularly if no reserves are required to cover the supposedly non-existent risk. Regulators were told by the banks that a way had been found to remove all credit risk from their CDO deals.

How it all worked

There were two dimensions to the cause of the current credit crisis. The first was that unit risk was not eliminated, merely transferred to a larger pool to make it statistically invisible. The second, and more ominous, was that regulatory risks were defined by credit ratings, and the two fed on each other inversely. As credit ratings rose, risk exposure fell; this created an under-pricing of risk. But as risk exposure rose, credit ratings fell, which led to further risk exposure, in a chain reaction that detonated a debt explosion of atomic dimensions.

The Office of the Comptroller of the Currency and the Federal Reserve jointly allowed banks with credit default swaps (CDS) insurance to keep super-senior risk assets on their books without adding capital — because the risk was insured. Normally, if the banks held the super-senior risk on their books, they would need to post capital at 8 percent of the liability. But capital could be reduced to one-fifth the normal amount (20 percent of percent, or $160 for every $10,000 of risk on the books) if two conditions could be fulfilled: first, banks had to prove that the risk of default on the super-senior portion of their deals was truly negligible. Second, banks had to show that the securities issued via a collateral debt obligation (CDO) structure carried a Triple-A credit rating from a “nationally recognized credit rating agency,” such as Standard and Poor’s. AIG, for example, held a Triple-A rating.

Under those rules, banks with CDS insurance could loan up to five times more on the same capital. The CDS-insured CDO deals could then bypass international banking rules on capital. Correcting this bypass was one key reason behind the bank stress tests: The government wanted to see if banks need to raise new capital in a Downward Loss Given Default.

CDS contracts are generally subject to mark-to-market accounting that introduces regular periodic income statements to show balance sheet volatility – something that would not be present in a regulated insurance contract. Further, the buyer of a CDS does not even need to own the underlying security or other form of credit exposure. In fact, the buyer does not even have to suffer an actual loss from the default event, only a virtual loss would suffice for collection of the insured notional amount. So, at 0.02 cents to a dollar (1 to 10,000 odd), speculators could place bets to collect astronomical payouts in billions with affordable losses. A $10, 000 bet on a CDS default could stand to win $100,000,000 within a year. That was exactly what many hedge funds did because they could recoup all their lost bets — even if they only won once in 10,000 years.

Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.