AIG, 2008

Protection that could not pay its collateral calls

AIG Financial Products sold credit default swap protection on the super-senior tranches of hundreds of billions of dollars of portfolios, including around $78bn referencing multi-sector CDOs heavy in US subprime mortgages. The trades were modelled as almost riskless because default losses would never reach that high. What reached AIG first was collateral: as the referenced assets fell in value and AIG’s own rating was cut, its credit support annexes demanded cash it did not have. On 16 September 2008 the Federal Reserve lent AIG $85bn, the first part of support that rose to about $182bn.

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What the lesson covers

1. What happened
2. The position
3. Why it broke
4. What it cost
5. What it teaches

Key terms

• Super-senior tranche — The most protected layer of a structured portfolio, losing only after every junior tranche is exhausted.
• Protection seller — The party to a credit default swap that pays out on a credit event, in return for a running premium.
• Collateral call — A demand under a CSA for collateral to cover a change in mark-to-market or a change in thresholds.
• Rating trigger — A clause that lowers a party’s collateral threshold or adds an independent amount when its credit rating falls.
• Wrong-way risk — Exposure that grows as the counterparty’s ability to pay shrinks, because both depend on the same thing.
• Multi-sector CDO — A CDO whose collateral is other securitised debt, such as mortgage-backed securities, rather than loans.

Every key term, A to Z

In practice

Protection sellers are now judged on liquidity under stress as much as on credit: collateral calls are projected under downgrade and market scenarios, rating triggers are negotiated out of CSAs or capped, and uncleared trades carry regulatory initial margin, so a seller posts against a large move before it happens rather than after.

Read next

• Credit Default Swap — Insurance against a borrower defaulting
• Collateral and the CSA — The cash and bonds that back an OTC exposure
• Lehman Brothers, 2008 — Nine hundred thousand trades, closed out at once

In the app, AIG, 2008 carries a five-step lesson, a worked example and a bank of twelve questions drawn differently every sitting.

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