Gary Gorton and AIG models

Gary Gorton, Professor of Finance at Yale, has written one of the best articles on the panic of 2007. The essential point is that:

The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages...When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks.

It turns out that Gorton was also responsible for producing the risk models that AIG was using to value credit default swaps. This article explains his role and how the models failed to account for the key risks that led to AIG's downfall. As the article notes:

Mr. Gorton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances.

Felix Salmon also links to the article and has a good discussion. He notes:

At heart, here, is an age-old debate over the value of any fixed-income instrument. Let's say you buy a bond at par which makes all its interest and principal payments in full and on time. Then you're happy, and making money. But let's say that a couple of years after issue, that bond is trading at just 10 cents on the dollar. Have you lost money?

The answer of depends on how many such bonds you hold, and what your counterparties think. And AIG got into trouble when it could not come up with sufficient collateral to meet the demands.