The final chapter in the Washington Post's telling of the AIG saga is the most exciting--and the most frustrating. In the end, it is still not clear whether there was anything fundamentally wrong with AIG's portfolio. After all their research, and all of their writing, the reporters have failed to get to the bottom of the story. They end up saying,
It seems that as Financial Products ramped up its credit-default swap business, its leaders assumed that its parent, AIG, would always be as strong as it was the day it backed the firm's first big trade in 1987...they had failed to prepare for the possibility of a downgrade in AIG's credit rating.
If that is the story, then it is possible that the actual losses on the AIG credit default swap portfolio could turn out to be zero. Instead, what did them in was the collateral posting that was required because their credit rating was downgraded. The collateral demands multiplied as their credit default swaps went from being deep out of the money to being slightly out of the money.
If that is the story, then the stern-sheriff metaphor, that I first introduced here and later included in my Congressional testimony, looks really apt. Instead of putting money into AIG, the Treasury and the Fed should have told Goldman Sachs to stop grabbing for collateral. Make Goldman wait for actual losses to occur before they make claims against AIG.
Early in the article, the authors write,
Financial Products made its money by selling credit-default swaps only on the super-senior tier. It seemed a safe bet: Cassano once defined super senior as the portion of the deal that was safe even "under worst-case stresses and worst-case stress" assumptions.
With risk-layered mortgage securities, the super-senior tier is protected from the first X oercent of losses, where I believe that X is usually at least 5 percent, perhaps higher. Part of the reason that it has become difficult to calculate exposure is that when you have a pool of mortgages with, say, 3 percent defaults, you don't know whether what remains in the pool are good loans that have demonstrated an ability to survive or just more bad stuff that has not yet surfaced.
The article says that AIG stopped writing credit default swaps on mortgage-backed securities late in 2005. If so, then: (a) they were certainly a lot wiser than Freddie and Fannie, which plunged in to the subprime market right around that time; and (b) the rate of defaults on the loans in the mortgagte securities ought to be a lot lower than the default rates we are seeing on the 2006 and 2007 books, because the earlier books had less inflated house prices.
But I can only speculate on the extent of actual losses in AIG's credit default swap book. And, in spite of all of their digging, the reporters appear to be in the same position. That makes for a story that is entertaining but not satisfying.
Of course, Roger Lowenstein's entire book on Long Term Capital Management, When Genius Failed, left me feeling the same way. Did LTCM make bad bets, or did they make good bets that just took too long to come in? Maybe I'm just a geek, but that was the main question I was looking for Lowenstein to answer, and he didn't.
Remember that Tyler Cowen thinks that the bailout of LTCM lulled folks into a false sense of security. But it seems to me that at AIG the sense of security came from the fact that the folks there thought they had a safe portfolio. Whether that sense of security was false or not is the question that is still unanswered, in my view.