What really happened at AIG

There are certainly indications that the mismangement at the insurance broker AIG far exceeded anything on the scale of Sir Fred Goodwin and this from a credit trader makes that wholly apparent.

1.From comments made by AIG executives it appears that the company fundamentally misunderstood the nature of risks that it was underwriting. Those risks were

a) much more highly correlated than they assumed (due to the nature of bonds in CDO structures as well as the likely performance of super-senior tranches in event of impairment)

b) actually mark-to-market risk, not default risk which made AIG’s business much riskier than it thought. This is because long before super-senior tranches became impaired (the only risk AIG was worried about), AIG will have had to post more collateral than the cash it had on hand effectively guaranteeing its bankruptcy.

2.The logical consequence of the previous point is that buying protection from AIG on ABS CDO’s is horribly wrong-way (discussed below) or, to use an analogy, akin to buying deep out-of-the-money puts from a company on its own stock. In other words, that protection is worthless. The consequences of this point are that

a) internal risk management groups inside investment banks were massively short AIG to compensate for the wrong-wayness of this exposure and

b) investment banks who bought protection from AIG, while fully aware of the zero value of the protection they were buying, were continuing the charade only in order to continue originating CDOs.

ht-andrew sullivan