“The models suggested that the risk was so remote that the fees were almost free money. Just put it on your books and enjoy the money.”

–Tom Savage, President, AIG’s Financial Products


The second part of the 3 part series is now posted, A Crack in The System. This section gets into the details as to how AIG got so buried in the credit default swaps (CDS) business.


“For months, several executives at AIG Financial Products had pulled apart the data, looking for flaws in the logic. In phone calls and e-mails, at meetings and on their trading floor, they kept asking themselves in early 1998: Could this be right? What are we missing?

Their debate centered on a consultant’s computer model and a new kind of contract known as a credit-default swap. For a fee, the firm essentially would insure a company’s corporate debt in case of default. The model showed that these swaps could be a moneymaker for the decade-old firm and its parent, insurance giant AIG, with a 99.85 percent chance of never having to pay out.

The computer model was based on years of historical data about the ups and downs of corporate debt, essentially the bonds that corporations sell to finance their operations. As AIG’s top executives and Tom Savage, the 48-year-old Financial Products president, understood the model’s projections, the U.S. economy would have to disintegrate into a full-blown depression to trigger the succession of events that would require Financial Products to cover defaults.

If that happened, the holders of swaps would almost certainly be wiped out, so how could they even collect? Financial Products would receive millions of dollars in fees for taking on infinitesimal risk.

The firm’s chief operating officer, Joseph Cassano, had studied the model and urged Savage to give the swaps a green light. . . .

Initially, the credit-default swaps business would amount to a fraction of the half-billion dollars in Financial Products’ revenue that year. It didn’t seem to them like a major decision and certainly not a turning point.

They were wrong. The firm’s entry into credit-default swaps would evolve into insuring more volatile forms of debt, including the mortgage-backed securities that helped fuel the real estate boom now gone bust. It would expose AIG to more than $500 billion in liabilities and entangle dozens of financial institutions on Wall Street and around the world.

Who ever could have foreseen that “free money” would backfire?

Call it the revenge of the Black Swan . . .


A Crack in The System (part 2 of 3)
Brady Dennis and Robert O’Harrow Jr.
Washington Post, Tuesday, December 30, 2008; Page A01


Category: Bailouts, Credit, Derivatives, Really, really bad calls

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

14 Responses to “Revenge of the Black Swan”

  1. VennData says:

    Your financial products hurt you? Efficient market theory not all it was cracked up to be? All those contacts from the frat can’t buy anymore of your paper? What does a former Master of the Universe who thought there was no end in site for his Croseus-esque salary do when you’re just another out-of-work Wall Streeter, but now the bills keep coming?


  2. phb says:

    BR – Any comment about all of the so-called “super-regional” banks entering into the CDS business? Can’t help but believe that FITB, KEY, HBAN, etc. etc. entered into deals in an effort to temporarily raise revenues that they did not and do not fully understand. Feels like the other shoe is about to drop? Thoughts?

  3. Lars39 says:

    Attack of the Black Swoon.

  4. super_trooper says:

    Any reason why these idiots are still walking on the streets?

  5. leftback says:

    They are not walking the streets, they are in a building in Greenwich, getting retention bonuses, apparently.

  6. RW says:

    What Lars39 said: A Black Swan by definition is an event that can not be foreseen which is hardly an accurate characterization of anything that happened at AIG; they all were too busy swooning with their hands in the till while wanking on each other to care about anything but packing more of it in before the music stopped and that’s just the way it played out, the ownly unpredictable element being how long they could get away with it (longer than most of them suspected I’ll bet).

  7. Andy Tabbo says:

    This is a nice three part series they have there. I love it. I wonder how many egg head “quants” out there are just sitting around mumbling to themselves: “It’s not supposed to be like this…the models said….”

    99.85% chance of default??!!?? Did they really believe that crap? There’s NO TRADER in the world that would say ANYTHING is 99.85% certain….Amazing.

  8. momus says:

    The eminent statistician, George E P Box, once remarked, “all models are false, some are useful.” Mathematicians and scientists know this; some engineers accept it; economists and MBAs do not seem to have a clue. Welcome to the difference between interpolation and extrapolation.

  9. leftback says:

    Good point AT.

    Are we going to break through 900-915 resistance zone in SPX??

  10. Human Powered says:

    momus is exactly right. Models can be exceptionally useful, but you really have to know what you’re doing and the limitations. With the short history available they should have known the model would only be valid within a narrow band of circumstances.

  11. dunnage says:

    Enough of this Black Swan crap.

    Real Estate has always been cyclical, as everybody knows. A house in Riverside, Ca. depreciates and the system collapses — there was no model and there was no blackbird.

    Wage earners do not get a raise in 40 years while the world’s players hybridize $. Nothing is new. We get the same people who done it, possibly trying to undone it by giving money to each other. Nothing new. Wall Street should’ve left a little meat on the bone.

  12. Econophile says:

    Taleb says the Crash of ’08 was not a Black Swan because he and many others saw it coming.

    I would be curious to know if any of the commentators here have read Taleb’s books.

  13. loan shark says:

    Insurance regulations were in place. Change the name of the product from default insurance to swaps and the regs didn’t apply. Can you say regulatory failure?

  14. Hernie says:

    Econophile: I have read a couple of Taleb’s books and I share many of his ideas, they are really great…

    You are right, according to Taleb, ’08 crash was not a Black Swan but a Gray Swan, because it could be partially foreseen due to the huge risks being assumed by agencies such as Fannie and Freddie….

    Here’s more:

    “The Black Swan is a matter of perspective. A turkey is fed for 1,000 days – every day lulling it more and more into the feeling that the human feeders are acting in its best interest. Except that on the 1,001st day, the butcher shows up and there is a surprise. The surprise is for the turkey, not the butcher. Anyone who knows anything about the history of banking (or remembers the 1982 Latin American debt crisis or the 1990s savings and loan collapse) will tell you that the subprime crisis was so bound to happen. Banks are exposed to such blowups. Bankers have been the turkey, historically.”

    “So I call these crises “gray swans.” I’ve been telling anyone willing to listen that banks have a tendency to sit on time bombs while convincing themselves that they are conservative and nonvolatile”