Tuesday, December 30, 2008

AIG and credit default swaps: whatever the statistical models, they violated all common sense

This morning, The Washington Post is running a series “The Crash: What Went Wrong” and has a particularly interesting segment Tuesday, Dec. 30 “A Crack in the System” with a detailed story about AIG, American International Group, and how credit default swaps took it down. The front page story is by Brady Dennis and Robert O’Harrow, Jr (the second of three parts) here. The story has some diagrams explaining how credit default swaps “worked.”

Computer models had estimated that AIG had a 99.85% chance of never paying out on the liability it had taken on. But then the collapse of the housing bubble starting around 2006 set in motion a “statistically unlikely chain of events”, which AIG was able to stave off for a year or so.

One basic flaw in the swaps is that they did not follow the usual principle of “insurable interest” normally required in the insurance business. The collapse seems to be a conceptual failure to understand a risk qualitatively and socially. Housing prices have always been exposed to the possibility of downturns. Anyone with common sense should have seen that prices were rising much faster than worker’s wages, and that homeowners would not be able to pay escalated payments that rose in the future. Furthermore, some renters were forced into buying apartments (converted into condos) that they would not be able to afford when rates went up.

This all sounds like a basic failure to understand the difference between right and wrong.

Anderson Cooper – keep on naming names in your “culprits of the collapse” on your CNN 360 show.

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