AIG, 2008

At a glance

What happened

AIG Financial Products sold credit protection on the safest, super-senior layers of loan portfolios, mortgage pools and CDOs, earning small premiums on a book of around $527bn notional backed by its parent's AAA rating. About $78bn of it referenced CDOs full of 2005 to 2007 subprime mortgages. From mid-2007 counterparties called for collateral as those CDOs were marked down, and rating downgrades on 15 September 2008 triggered more calls than AIG could meet. The next day the Federal Reserve lent it $85bn, the start of support that rose to about $182bn.

Why it went wrong

Super-senior tranches only lose money after every junior tranche is wiped out, so default losses looked remote. But AIG's collateral agreements required it to post cash on the market value of the protection, and to post more if its own rating fell. The housing collapse drove both at once: the marks fell long before any loss arrived, and the losses cut AIG's rating. Its securities lending business added a second cash drain. A firm with a huge balance sheet ran out of liquidity, not capital, in days.

What it teaches

Selling protection is a funding business as well as a credit business: you must be able to meet collateral calls long before any default. Rating triggers concentrate those calls at the worst moment. And protection bought from a seller whose health moves with the reference assets is wrong-way risk in its purest form. Initial margin on uncleared derivatives would have required AIG to post up front.

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.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of wrong-way risk, collateral calls and rating triggers. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

Related case studies

• Lehman Brothers, 2008Nine hundred thousand trades, closed out at once

The instruments behind it

OTC Learn lessons on the products this case turns on:

• Credit Default SwapInsurance against a borrower defaulting
• Collateral and the CSAThe cash and bonds that back an OTC exposure