Wednesday, September 17, 2008

AIG and what the Feed All Reserve should do now?

Banking is a war-zone today, a financial war to save the radioactive core of capitalism from meltdown. Commentators may fear the moral hazard of savings firms from their own errors, but these are political-economy concerns that are valid only in more normal times.
The most important statement by Greenspan has been that this is a 1 in a 100 year event; it is not merely sectoral or special, but entirely unique and as extreme as can be. When all counter-party credit risk models are made irrelevant by a system-wide crisis, when disorderly trading, credit defaults, ratings downgrades, recession and bankruptcies have disasterous domino, multiplier and amplification effects, so too are moral hazard concerns made irrelevant for now. No-one, except maybe some among the vulture hedge funds, believes that just because some big safety nets are erected now that they can ever return to the exact same high-wire acts as before.
Insurers take a large portfolio approach to risk, which means that they know the probabilities of defaults and losses and cover this in the risk margin charged to all insurance policies. When all policy holders make claims at the same time the business model of insurance is entirely broken and all risk mitigations are useless, however sensible and practical to cope with normal disasters, of which the worst hitherto conceived by the financial regulators that financial service firms had to plan for was a 1 in 25 year event i.e. nothing like this!.
Moreover, truth is that AIG internally cannot know the full extent of its liability claims. It bought and sold CDS and now it and the Fed have the mother of all headaches to audit claims, reinsurance and monolines risk. In this market all roads lead to AIG. Coming on top of Bear Stearns and Lehmans, it is clear that a regulated exchange to book and clear these derivative instruments is urgently needing to be created. This is what the Fed should do with AIG – turn it into a fully regulated credit and insurance derivatives exchange!

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