Wednesday, September 17, 2008

AIG - what happened and what next?

Credit Default Swaps (CDS) were sold and resold to the extent that the nominal value at $62tn of the CDS outstandings is many times the underlying, something like 10-20 times, reflecting the depth and complexity of the chains to be unraveled – probably by heavily discounted estimated settlements. Deutsche Bank carried over $1 trillion exposure to Lehmans, but estimates that it has closed most of these and has a potential loss remaining of only about $0.3bn.
The CDS market is 60 times what it was 7 years ago! This growth has 3 reasons. 1. four years of fears about insurance and reinsurance risk causing multiple cover. 2. trading of CDS as if truly liquid tradable short term assets. 3. fear of the coming recession that would trigger sharp spikes in defaults in the underlying and arbitraging between those who had economics awareness and those who just traded on static risk grades.
To the extent the investing public knows anything about AIG, the company would be recognized as a property and casualty insurer. It is not general insurance, life, motor or lease finance or credit card backed securities that pose problems at AIG - these can be sold. AIG charged competitive premiums for policies and became a central intermediary like an inter-dealer broker. The policies were cover for loans going bad, but AIG sold these on to reinsurers and the market’s volume exploded. AIG was the closest thing to a central exchange, to an insurer of first and last resort. This seemed great business when defaults were historically low, but that is the quiet before the storm.
The first signs of fear and panic about a coming recession began rumbling in the gut of the markets in 2005. Most players took liver salts, but kept on ordering up more champagne. Now everyone has severe stomach cramps; all have some CDS exposure, and all roads (chain links) lead to AIG.
The market was new, over-the–counter and failed to get properly commoditized. It lacked a system for unwinding positions, and so does AIG itself - why it went begging to the Fed and why it might have been be a major beneficiary of the $75bn fund being set up by JPM and GS until the Fed stepped in sensibly with an $85bn loan facility. The Fed is biting its nails on this. But, its best option would be to use the opportunity of a 79.9% holding to convert AIG into a regulated exchange and clearing house. That would be politically and practically a powerful and positive result.
S&P wanted to cut AIG's rating by 3 notches requiring it to raise at least $13bn extra reserves - probably over $30bn given its falling share price – and maybe $40bn more to refresh its tier 1 capital, hence the $85bn figure. Ratings downgrades would have rippled through the whole financial system beginning with the CDS market. This was the same threat that torpedoed Lehmans and Merrils.
In July a 30% drop in AIG’s share value was forecast for sometime over next 6 months - it took only 2 months to arrive.
AIG wrote super senior (AAA+) CDS protection on $513bn of CDOs etc. via CDS (including $63bn written on CDOs containing sub-prime mortgages). Of the remaining CDS, $141bn was written on European residential mortgages (UK and Spain where prices are down 20% and 30% but negative equity is much less of a threat since borrowers cannot legally walk away from the debt like in the US!) and of the remaining $309bn, its source and quality are unknown, which means that fair value is hard to calculate.
It is hard to fair value all AIG’s CDS exposures (as admitted by AIG) – and this became the subject of a regulatory enquiry. But, given that this is a disorderly market driven by panic not fundamentals, it is a masterstroke of the Federal Reserve to step in and take over.
In my view the best fundamentals analysis is being undertaken by Hedge style Vulture Funds, who were waiting for distress prices sufficiently low to generate double digit profits over 5-6 years after interest and margin cost i.e. very hard-nosed calculations.
Downgrades of 2 big monolines added further downside: AIG holds many AAA bonds - some wrapped by Ambac and MBIA. It purchased CDS (insurance) against subprime exposures (estimated at $5.2bn) from Ambac and MBIA – the value of which now has to be written down. Downgrading of Ambac and MBIA increase % exposure of AIG to its AAA+ insurance as CDOs are down-graded (not helped when Merril sold a super-tranche CDO for 23% of face in July) and attachment points continued to drop.
AIG fell, arguably, far below book value and would have remained there had it not been taken over or shored up by the Fed at least until the CDS spaghetti market can be worked through, or as I recommend, until a fully scoped regulated exchange can be built and launched.

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