Dynamic Hedging was all the rage in the summer of 1987. Market participants knew they were taking outsized risks in an attempt to capture outsized gains. The rationalization was "I've got portfolio insurance to hedge what I'm doing"
As The Motley Fool put it on the 10th anniversary of the crash of '87:
The concept of portfolio insurance, indeed the name itself, reflects the ardent wishes of its creators for a utopian investment vehicle capable of minimizing the pain of investment loss.I'm reminded of that when looking at what AIG did to themselves. Market players wanted all the upside and none of the risk. AIG said "We can do that for you" and they started selling Credit Default Swaps as fast as they could print them up so the banks and hedge funds could go play in the debt markets with no downside. Yeah right. "Here at Cloud Cukoo Land we believe...". Sure the CDS's had provisions that if AIG was downgraded, the insurer would post collateral to guarantee their guarantee. AIG was the largest insurer. In 48 hours it will be unrecognizable.
AIG is trading at $3.03 down 36% premarket.