From Real Clear Markets:
Mr. Keller, former head of structured products at UBS, now runs a micro-finance enterprise in Peru. He can be reached at firstname.lastname@example.org
By James Keller
...The typical trade for a large bank would have been something like the following: A large Bank might buy the super-senior tranche of a mortgage CDO. This security would likely have a triple-A rating from two major rating agencies. The security itself was at the time of its pricing considered very low risk. Its spread to Libor in 2006 might have been 30 basis points.
The next leg of the trade is where AIG comes in. The bank or brokerage owning the AAA security then went and bought an additional layer of protection from AIG FP. On the surface, this made the trade even safer, because AIG was also AAA. So the bank owned a AAA asset, protected by a AAA insurance company. A belt and suspenders approach.
Not really, because the likelihood of AIG being able to pay off this claim was low. The risk of losses was then considered miniscule, but they were no further reduced by the purchase of an additional layer of protection from AIG. The reason for this is that AIG, through the process of writing hundreds of billions of this protection, became perfectly correlated with the assets it was insuring.
The analogy of a passenger on the Titanic buying life insurance from another passenger on the Titanic is apt. It doesn’t make much sense, but the Titanic is unsinkable. And home prices never decline.
Why would banks buy protection they knew was unlikely ever to pay off? Because traders had an enormous incentive to do so, even knowing the value of the protection would likely never be realized.
In our example, the bank owns the asset and earns 30 basis points, assuming it funds itself at Libor. On a $1 billion CDO tranche, the trader would earn about $3MM per year on this position. Not bad, but a clever trader can do better.
If the trader pays 10 basis points to AIG FP for protection on the asset, the net spread falls to 20 basis points. But by hedging the asset with AIG he or she could capture the full present value of that 20 basis point stream into current income. So on the same $1 billion CDO tranche, with an average life of 10 years, the trader might recognize close to $20MM immediately. From the bonus-minded trader’s perspective, making $20MM today is far better than making $3MM per year for 10 years.
This explains why a banker might buy insurance from an entity whose very existence is so highly correlated with the risk he is insuring. Not so much greed, or the lack of regulations, but the presence of bizarre regulations. This also explains why firms such as Goldman Sachs and Bank of America found themselves so heavily exposed to AIG.But why was Goldman Sachs first in line at the bailout parade?>>>MORE