Another Academic Panel on the Crisis

The Great Moderation implied stationary statistics, but the Great Moderation didn't exist. AIG missed that part.

I'm a little perplexed by this notion about CDS's.

It seems to me that if there is a wide probability swath where they are out of the money, that also suggests that there is a wide swath where naive (hockey-stick) pricing of these options is fairly accurate.

The real advantage of an option pricing formula is around the strike value. So your assertion suggests - to me - that there was a wide range of situations in which simple common sense could probably price these things accurately. That doesn't do a good job of explaining the source of troubles.

David,
Let's assume they were priced right. But at a probability of default of .02 percent (two hundredths of one percent), the requirement to post collateral or margin is trivial. At a probability of default of 2 percent, and with lots of fear that there are other swaps in AIG's portfolio that might be in the money, you start to ask them to post significant collateral. Enough people start doing that and they run out of assets to post.

What happened to AIG is that its counterparties started asking for a lot more collateral.

You make it sound ad-hoc, like the counterparties pleasantly requested more collateral because they felt like it (as if they're words had influence), and AIG said, "can't make me, nannynannybooboo" (as if that was an adequate rejoinder).

I'm guessing that collateral requirements were specified in contracts for the CDS, which would certainly provide a clean way of settling a disagreement about risk. But I'm open to being shown that the contracts actually said, "if default starts to look likely, we'll bicker over what amount of collateral is necessary."

"they're" should be "their". Yowza.

Gary, from the Wall Street Journal article:

The buyers of the swaps -- AIG's "counterparties" or trading partners on the deals -- typically have the right to demand collateral from AIG if the securities being insured by the swaps decline in value, or if AIG's own corporate-debt rating is cut.

...The credit crisis hammered the markets for debt securities, sparking tough negotiations between AIG and its trading partners over how much more collateral AIG should have to post

So the trading partners "have the right to demand collateral" and yet they have to enter into "tough negotiations" with AIG to satisfy their right?

If the contract writers had foresight enough to include terms for collateral, it seems unlikely that they would fail to include terms for quantity of collateral.