Arnold Kling  

Another Academic Panel on the Crisis

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So many teach-ins. The one at Yale School of Management builds up to an interesting argument in the last half hour over mark-to-market accounting. In all of the teach-ins I've seen, this one generates the most actual debate.

The link to the video can be found in a Wall Street Journal article on Gary Gorton (a participant in the Yale panel) and his role at AIG. An interesting question posed by the article (and ever-so-briefly hinted at during the panel) is what should happen to the seller of a credit default swap as a default becomes more probable. Suppose you have sold a default swap on XYZ corporation, and it has not yet defaulted. But things are looking a lot shakier. What happened to AIG is that its counterparties started asking for a lot more collateral. Presumably, if credit default swaps traded on an organized exchange, the exchange would be doing the same thing with margin calls.

Supposedly, Gorton's models say that AIG is not going to lose much on its default swaps. But the counterparties are worried that it might, so they ask for more collateral, and AIG has a hard time coming up withh that collateral. So what we are seeing, in effect, is a huge disagreement about the probability of XYZ corporation's default, with no clean way to resolve it. If you side with AIG and don't require them to post collateral, then counterparties will be afraid that their protection against XYA's default will not materialize when needed. If you side with the counterparties, then you create a run on AIG that makes it require a bailout, even if none of the defaults occur.

To me, this is just another flaw in the concept of a credit default swap. It is in some sense a deeply out-of-the-money option. There is a huge range of probability shifts (default risk going from, say, 0.2 percent to 0.8 percent, not to mention all the way up to 25 or 30 percent) that change the value of the swap while still keeping it far out of the money. It's not surprising that AIG got gummed up the way it did.


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The author at PrestoPundit in a related article titled "ROCKET SCIENCE" + MORON BOSS = writes:
    HUNDREDS OF BILLIONS LOST AT AIG.The kicker?  The moron boss was retained after retirement as a "consultant" at a rate of $1,000,000 per month.Make sure to read also this and this.... [Tracked on November 3, 2008 4:51 PM]
COMMENTS (7 to date)
MattYoung writes:

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


Dave Tufte writes:

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.

Arnold Kling writes:

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.

Gary writes:

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."

Gary writes:

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

Arnold Kling writes:

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

Gary writes:

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.

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