Someone smart figured out that AIG was mispricing credit risk, and then everyone jumped into the game to trade against AIG.
That may be the case, but my gut feeling is that the first call to go against AIG was also an intuitive, gut call. The formulas were in AIG’s favor — they became a victim of what Naseem Nicholas Taleb’s example of the Turkey Fallacy. And since it’s seasonally appropriate, it’s worth discussing.
The turkey has a wonderful life right up until Thanksgiving. Every time he sees the farmer, the farmer brings him more food. He has shelter, and reliable access to water. From the turkey’s perspective, life on the farm is really good, right up until it isn’t. Turkeys are unable to distinguish a farmer carrying a feed pail from a farmer carrying a hatchet.
AIG (and the rest of the CDS counterparties) started small in the CDS market. They wrote a contract, collected the fee, and all of the sudden their CDS business began to grow and contribute to the bottom line. They had David X. Li’s Gaussian copula formula to allow them to predict their risk, and even if the formula wasn’t foolproof, they had already done X hundred million in business, collected their 2% of X for signing some papers, and nothing bad had happened.
As time went on and they accumulated more and more ‘experience’ with the CDS business, all of their (only positive) experience folded into the copula formula or whatever their in-house quants used told them, with PowerPoint slides and everything, that this was a good business for AIG. There was no feedback to tell them that they were doing anything wrong. By the time the CDS risk became apparent, AIG had become the ‘experts’ in writing CDS contracts by virtue of doing the most business as a counterparty. Who was going to tell them they were foolish or wrong?
The underlying problem with bubbles is that all the data is running one way, and people who stand in the way of that data rapidly become unpopular. Meredith Whitney got death threats for noting that Citibank specifically and the mortgage market in general were badly oversold. You can be reasonably sure that there was someone at AIG-FP who was nervous about the amount of CDS exposure the company had, but knew that to write that down in a message to their superiors was a career death sentence.
It’s sad, but it’s also entirely predictable in hindsight that people working with six years of positive data could forecast nothing other than positive results. The other sad part of it is that had AIG known about the risk and priced accordingly, they could have slowed down the housing bubble significantly. There is no risk that cannot be priced, but a more sober (and informed-of-the-downside) risk pricing would have made the CDOs and their ilk largely unsellable. It would have knocked the market for a loop, and either AIG would have been blamed or other counterparties would have come in to fulfill AIG’s counterparty duties at a slightly lower price, or both. Either way, AIG loses — credibility or business or both — so why does any one particular person want to attempt to be the party pooper? It’s arguable the party would have continued to its eventual end in any case, just with less exposure at AIG and more elsewhere.
The turkey could run for it, but that would mean losing the comforts of regular food delivery, shelter and possibly female companionship. Turkeys would bolt at the first chance if they knew the hatchet was coming, but nothing in their experience leads them to believe the good times will ever come to an end.
