Financial Crisis Update

Commentary

Here is an update pointing to all the blogs in chronological order that related to the financial crisis:

• Feb. 21: Excellent YouTube explaining the credit crisis
• Feb. 24: The academic equation that led to financial ruin
• Feb. 25: FBI sent report to Bush back in 2004 regarding the problem
• Feb. 28: News on Warren Buffet's letter to his shareholders
• Mar. 10: Geithner explains to House Democrats
• Mar. 11: YouTube video of Geithner's interview on Charlie Rose
• Mar. 11: Technical analysis of AIG Exposure to CDO CDS

Excerpt

I remember sitting in on a meeting with an AIG portfolio manager sometime in early 2007 where the topic of conversation was the corporate CDS market. It was a standard chat where we talked about the market environment as well as the most recent product innovations.

Though mostly unmemorable, there was one moment in the meeting that I will never forget. As the marketing guys were pitching mezz tranches to the PM, I threw in a comment that if credit spreads were to widen the delta of the tranche would go up thus increasing the mark-to-market (MTM) sensitivity, and thus net credit exposure, of the trade. This the PM calmly brushed aside responding “we are not MTM sensitive” as he reached for another piece of fruit.

How about them MTM-apples now?

Brief Outline of What Happened

The broad outlines of the story are the following. As part of an effort to expand its insurance underwriting business, AIG (more precisely, London-based AIG Financial Products) began writing protection on supersenior (senior to AAA) ABS CDOs. By the time lax underwriting standards led AIG to get out of this business in 2005, it had sold some $560bn of protection.

By 2007 spreads had widened enough that counterparties started to demand that AIG post collateral on the trades, which by mid 2008 totaled over $16bn. Following its first and second quarterly losses of $5.3bn and $7.8bn, AIG, under pressure, adjusted the valuation methodology for its CDO portfolio (word at the time was the company was not mark-to-marking the trades) - leading to a further $8bn writedown. On September 15th - the Monday following the Lehman default, AIG’s rating was cut, effectively guaranteeing a bankruptcy of the company. Concernerned about the effect on world markets, the government stepped in with a bailout.