The Fall of AIG

The Washington Post has a three part series on the downfall of AIG, and the role of the Financial Products Group. This is a story of how a subsidiary that was started making hedged transactions in derivatives expanded into credit default swaps. The idea was to leverage AIG's AAA credit rating and provide insurance against what seemed extremely low risks. As AIG's credit rating fell the cost of supporting the swaps increased as counterparties demanded more collateral. And the group's model did not adequately forecast the risks inherent in CDO's built from sub-prime lending.

It is an important story. What we see is that a business that started out limited expanded beyond its original horizons. As the business morhped risks increased in ways that were not recognized.

Justin Fox has some interesting comments on the series.

Porsche Financial Engineering

As a Porsche owner I am convinced of the quality of Porsche's engineering. But now we have more details about Porsche's financial engineering. Apparently, Porsche was able to engineer a short squeeze on VW shares as it moved to become the majority owner of the firm. The squeeze briefly made VW the most valuable company on earth, and it made Porsche, already the most profitable of auto companies a huge return.

Financial Engineering

What role did financial engineering -- complex quantitative financial models -- play in the financial crisis? This article in the New York Times discusses this issue. The article notes:

“Complexity, transparency, liquidity and leverage have all played a huge role in this crisis,” said Leslie Rahl, president of Capital Market Risk Advisors, a risk-management consulting firm. “And these are things that are not generally modeled as a quantifiable risk.”

Math, statistics and computer modeling, it seems, also fell short in calibrating the lending risk on individual mortgage loans. In recent years, the securitization of the mortgage market, with loans sold off and mixed into large pools of mortgage securities, has prompted lenders to move increasingly to automated underwriting systems, relying mainly on computerized credit-scoring models instead of human judgment.

An important point, noted by Andrew Lo is that while academic economists were receptive to his warnings of the risks associated with financial innovation Wall Street was not. The reason is that Wall Street had little incentive to listen as long as profits were high. He points out that we have fire safety regulations even though buildings have little risk of burning down, and financial regulation is needed for the same reason.