AIG Financial Products (AIGFP), based in London, where the regulatory regime
was less restrictive than in the US, took advantage of AIG's statute
categorization as an insurance company and therefore not subject to the same
burdensome rules on capital reserves as banks. AIG would not need to set aside
anything but a tiny sliver of capital if it would insure the super-senior risk
tranches of collateralized debt obligations (CDOs) in its holdings. Nor was the
insurer likely to face hard questions from its own regulators because AIGFS had
largely fallen through the interagency cracks of oversight. It was regulated by
the US Office
for Thrift Supervision, whose staff had inadequate expertise in the field of
cutting-edge structured finance products.
AIGFP insured bank-held super-senior risk CDOs in the broad CDS market. AIG
would earn a relatively trifling fee for providing this coverage - just 0.02
cents for each dollar insured per year. For the buyer of such insurance, the
cost is insignificant for the critical benefit, particularly in the financial
advantage associated with a good credit rating, which the buyer receives not
because the instruments are "safe" but because the risk was insured by AIGFP.
For AIG, with 0.02 cents multiplied a few hundred billion times, it adds up to
an appreciable income stream, particularly if no reserves are required to cover
the supposedly non-existent risk. Regulators were told by the banks that a way
had been found to remove all credit risk from their CDO deals.
Systemic risk and credit rating
Thus there were two dimensions to the cause of the current credit crisis. The
first was that unit risk was not eliminated, merely transferred to a larger
pool to make it invisible statistically. The second, and more ominous, was that
regulatory risks were defined by credit ratings, and the two fed on each other
inversely. As credit rating rose, risk exposure fell to create an under-pricing
of risk. But as risk exposure rose, credit rating fell to exacerbate a further
rise of risk exposure in a chain reaction that detonated a debt explosion of
atomic dimension.
The Office of the Comptroller of the Currency and the Federal Reserve jointly
allowed banks with CDS insurance to keep super-senior risk assets on their
books without adding capital because the risk was insured. Normally, if the
banks held the super-senior risk on their books, they would need to post 8%
capital. But capital could be reduced to one-fifth the normal amount (20% of
8%, meaning $160 for every $10,000 of risk on the books) if banks could prove
to the regulators that the risk of default on the super-senior portion of the
deals was truly negligible, and if the securities being issued via a CDO
structure carried a Triple-A credit rating from a "nationally recognized credit
rating agency", such as Standard & Poor's rating on AIG.
With CDS insurance, banks then could cut the normal $800 million capital for
every $10 billion of corporate loans on their books to just $160 million,
meaning banks with CDS insurance could lend up to five times more on the same
capital. The CDS-insured CDO deals could then bypass international banking
rules on capital. To correct this bypass is a key reason why the government
wanted to conduct stress tests on banks in 2009 to see if banks needed to raise
new capital in a downward loss-given default.
CDS contracts are generally subject to mark-to-market accounting that
introduces regular periodic income statements to show balance sheet volatility
that would not be present in a regulated insurance contract. Further, the buyer
of a CDS does not even need to own the underlying security or other form of
credit exposure. In fact, the buyer does not even have to suffer an actual loss
from the default event - only a virtual loss would suffice for collection of
the insured notional amount. So, at 0.02 cents to a dollar (1 to 10,000 odd),
speculators could place bets to collect astronomical payouts in billions with
affordable losses. A $10,000 bet on a CDS default could stand to win
$100,000,000 within a year. That was exactly what many hedge funds did because
they could recoup all their lost bets even if they only won once in 10,000
years.
Default correlation
Modeling the risks involved in credit derivatives revolved around the issue of
"correlation", which is the degree to which defaults within any given pool of
loans might be interconnected vertically. Statisticians know that company debt
defaults can be contagious within and even beyond industry limits. Historical
correlations in corporate default and equity prices are normally used as a
basis to project future correlations. But most of these historical correlation
models do not include that fact that deregulated financial globalization has
magnified correlation to the degree that even a small number of defaults could
mushroom into catastrophic events of too-big-to fail dimension.
Too-big-to-fail then is no longer enterprise specific, but has become systemic.
This is beginning finally to hit on the consciousness of regulators so that
they realize that even small individual mortgage or credit-card holders have in
fact also become too-big-to-fail in a perverse manifestation of debt-driven
financial democracy.
While margin payments do flow periodically between counterparties to rebalance
changing risk exposures, the special conduits that hold CDO contracts insured
by CDS are in effect non-regulated banks, much like hedge funds, with no
requirements to hold reserves against a "Black Swan" event or a Minsky Moment
that might cause a chain reaction.
A Black Swan event is a large-impact, hard-to-predict and rare occurrence that
deviates beyond what is normally expected of a situation. This term was coined
by Nassim Nicholas Taleb and summarized in his 2007 book, The Black Swan.
A Minsky Moment, named after economist Hyman Minsky (1919-1996), is the point
in a credit cycle when investors develop cash flow problems due to spiraling
debt they had been structurally compelled by systemic logic to incur in order
to finance irresistible speculative investments offered by imbalance between
the penalty and reward of risk caused by mis-pricing of risk, usually caused by
excessively low cost of borrowing.
At the point of a Minsky Moment, a major sell-off would begin due to the
inability to find counterparty to bid at the high asking prices previously
quoted, leading to a sudden and precipitous collapse in market-clearing asset
prices and a sudden, sharp drop in liquidity. The term Minsky Moment was coined
by Paul McCulley of PIMCO (Pacific Investment Management Co) in 1998 to
describe the Russian default that led to the collapse of hedge fund Long-Term
Capital Management, as worked out by the late Hyman Minsky decades earlier.
According to the Bank for International Settlements, total outstanding CDS at
year-end 2007 was $43 trillion, more than half the size of the entire asset
base of the global banking system. Total derivatives amounted to over $500
trillion in notional value, spread out in the balance sheets of special
investment vehicles (SIVs), CDOs and other conduits comprising the highly
leveraged shadow banking system. July 2007 was the month the credit market
imploded.
Big payoff for lobbying
During 2008, the financial companies that received bailout money from the Fed
and the Treasury had spent $114 million on lobbying Congress and political
campaign contributions. These companies received $295 billion in bailout money.
Center for Responsive Politics executive director Sheila Krumholz said of this
development: "Even in the best economic times, you won't find an investment
with a greater payoff than what these companies have been getting."
Krumholz was correct that the campaign contribution was a fantastically good
investment for the donors, but it was by far not the best. The regulators'
relaxation on bank capital requirements from CDS insurance beat it by a mile.
But the biggest windfall was from the lifting of leverage limits.
The net capital rule created by the US Securities and Exchange Commission (SEC)
in 1975 required broker-dealers to limit their debt-to-net-capital ratio to
12-to-1. They had to issue early warnings if they began approaching this limit,
and were forced to stop trading if they exceeded it, so broker-dealers often
kept their debt-to-net capital ratios much lower than 12-1. The rule allowed
the SEC to oversee broker-dealers, and required firms to value all of their
tradable assets at market prices. The rule applied a haircut, or a discount, to
account for the assets' market risk. Equities, for example, had a haircut of
15%, while a 30-year Treasury bill, because it is less risky, had a 6% haircut.
But a 2004 SEC exemption - given to only five big firms - allowed them to lever
up 30 and even 40 to 1.
Ever since the Great Depression of the 1930s, the government has tried to limit
the leverage available to the public in the US stock market by maintain margin
requirements. But regulators, led by former chairman of the Federal Reserve
Alan Greenspan, thought financial innovation would be hampered and financial
activity driven to unregulated market overseas if there were any attempts to
impose limits on leverage in the unregulated globalized credit and capital
markets. After all, innovation was viewed as the driving force in US
prosperity. The global financial system embarked on a race to assume more risk
under a mentality of "if I don’t smoke, somebody else will".
This brave new approach, which all five qualifying broker-dealers - Bear
Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley -
voluntarily adopted, altered the way the SEC measured their capital. The five
big firms led the charge for the net capital rule change to promote financial
innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two
years later, in 2006, would leave Goldman to become the Treasury secretary and
a year later had to deal with the global mess created by high leverage from
which three of the five qualifying broker-dealers had collapsed.
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