Contrary to what most people believe, the financial crisis didn’t begin in America.
In fact, few people outside the finance industry understand the origins of the great financial crisis.
In the Mayfair section of London, east of Hyde Park, was the unremarkable fifth floor office of an unremarkable insurance company. It was the largest in the world, but unremarkable none the less.
Hidden behind seductive polished stone curves — in a building nicknamed hedge fund hotel — was AIG Financial Products.
And it’s this tiny subsidiary of American Insurance Group that was the cause of the financial crisis that crippled the globe in 2007.
But the story starts way before then.
Like all good tales of exploitation of innocent people, it begins with a bunch of ex traders from a sinister part of the market: junk bonds.
Somehow, in 1987 these blokes from Drexel Burnham Lambert — only a year before the 1988 stock market crash — convinced the then AIG’s chairman Hank Greenberg that there was a new type of insurance in town. The sort of insurance they wanted. The sort of insurance that carried very little risk.
By the early 90s, collateralised debt obligations (CDOs) became seen as a failsafe way to hedge a bank risk.
In banking terms, CDOs are cash flow generating assets pooled together, then repackaged and hedged by selling them to investors.
In the real world we know CDOs are a group of loans a bank has made to consumers and businesses. They could be anything: a mortgage, corporate debt, a business loan, credit card debt.
Basically, a lender takes a select group of debt. Some of its low risk (corporate bonds), some medium risk debt (mortgages, business credit) and consumer debt (credit cards), and dresses them up as an ‘income’ producing assets.
While that’s an exaggeration, I’m trying to get you to picture how varied the debt is.
They’re ‘pooled’ because you don’t know exactly what the ‘assets’ are. Remember, pooled assets are nothing more than different types of debt.
The theory is, the higher risk rating of the debt, the higher income — or coupon as it’s called — received. So a low risk CDO would attract a low coupon payment and vice versa for a riskier CDO.
What it boils down to is this: a bank will sell their debt — the debt they created — to other parties.
The beauty of the product, was that CDOs could be anything. All CDOs were debt that a bank had issued, and now needed to protect itself from default on.
However, the lines of what was risky could be blurred. A few very high risk assets could be mixed in with lots of low risk assets.
Basically, a lender could roll low risk debt and high risk debt into one package, and insure it with a company like AIG Financial Products (AIGFP).
Essentially, the bank now didn’t have to worry about the risk. The risk was all on AIGFP.
Some bean counter at AIGFP worked out that the likelihood of paying out on credit defaults was minimal.
Credit default swaps (CDS) quickly became the only way to insure CDOs.
Suddenly this highly leveraged and highly lucrative business was bringing in the big bucks for AIGFP.
However AIGFP wasn’t alone. Banks and hedge funds decided the credit default swaps were less risk, and easier to use to insure their CDOs.
Why buy and sell bonds when a CDS did what you needed, with less hassle, less cost, and most importantly, less risk to the lender?
You see, credit default swaps aren’t traditionally considered insurance. But as far as the bankers were concerned, the risk — their exposure — was covered. So the technicalities of a name didn’t matter.
It didn’t take long for the credit default swaps to grow. By 2007, they were a $60 trillion global business.
The flaw however, is in their pricing structure.
Credit default swaps are based on historical data. In addition, global wealth was increasing, property prices were rising and shocks to the economic cycles weren’t anticipated.
All those pin striped suits safely tucked away in the Mayfair section of London thought they’d found the cracks in the system.
The former president of AIG financial production division, Tom Savage, said to the Guardian in 2009, ‘The models suggested that the risk was so remote that the fees were almost free money.’
And then history, as we now know it, happened.
The US property market fell to its knees. Suddenly AIG’s clients were loaded up with toxic mortgage related debt. Lender after lender hit up AIG to pay up on the CDS.
However, that ‘free money’ AIG were making wasn’t there. AIG were liable for half a trillion dollars, and they couldn’t pay it.
And from here, is where most people think the subprime story begins…
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AIG was the snowflake
Do you remember what the unravelling of the subprime crisis looked like?
I do. I was 26 and I’d only really just begun working in this industry.
It was my first market crash. Matt Hibbard, editor of Total Income, and I were watching the market during those early days. As our screens furiously flashed red with every tick down, he turned to me and said to me ‘You’ll always remember your first crash.’
The crash didn’t happen over a day or two though. It went on, and on.
Day after day, the news got worse. People queued up outside banks. People dumped any investments they had. The Rudd government handed people back some of their taxes, getting them to spend to save the Aussie economy from a complete collapse. Retirements were delayed.
This is just the local news I remember.
The impact was much more intense overseas.
All because AIG guaranteed a few too many debts it didn’t fully understand. AIG’s simple underestimation and miscalculation of the economy market lead it to place bets it couldn’t back up.
And that misunderstanding and false sense of security that they knew everything, saw AIG become the ‘snowflake’ to cause the avalanche. And it took down the entire global economy.
Half a trillion to a quadrillion
On 17 September 2008, AIG was given a US$85 billion bailout from the US government. To this day estimates on the total ‘loss’ from the crash vary. But most research papers agree that more than US$500 billion written off over 2007/2008.
Today, this entire event is simply referred to as the ‘subprime crisis’.
In two little words we dismiss what was actually a catastrophic banking liquidity crisis.
Sure, investigations were made. The CEOs of banks embroiled in potential wrongdoings were prodded. One or two dodgy bastards went to jail.
But mostly, for a short time, people became aware.
As the subprime crisis unravelled, people were learning about derivatives. Suddenly, ordinary people — those with no inside banking knowledge — understood that one loan didn’t just stay with the bank.
One loan often became two. And sometimes those two loans are spilt, and hedged to other institutions. And suddenly — thanks to derivatives like CDOs and CDSs — two loans became four income producing assets for someone else. Some investor. A hedge fund. Your super. Your own portfolio could have ended up holding this toxic subprime debt.
The point is, you don’t know what the original debt is. You just end up with the responsibility for it somehow.
That’s the funny thing about these products.
They filter through the financial system. The risk doesn’t just stay with one bank, one lender or one business.
Rather the debt that’s issued is multiple, repackaged and resold so many times, that it reaches into each unsuspecting pocket of the financial system.
When AIG brought the global system to its knees, the derivatives market was worth an estimated US$567 trillion dollars.
Today, the derivative market is estimated to be about US$1.2 quadrillion dollars.
Could you imagine the damage to the global economy if a similar situation happened again?
Jim Rickards and I are currently working on a report. We’ve found the next problem. And in the next few weeks, we’ll show you the ‘new AIG’ no one sees coming.
Ed Note: This article first appeared in Money Morning.