AIG’s Diversity of Horrors

This post originally appeared on The Finance Buff.

Last week the media and political worlds seemed consumed with the approximately $165 million (or was it $218 million?) AIG paid in contractual bonuses to members of its Financial Products subsidiary (AIGFP). (By the way, Zachary Roth and Ben Buchwalter of Talking Points Memo have written a detailed history of AIGFP.)

Relative to the $170 billion in AIG bailout payments to date or the $14.3 trillion U.S. GDP, the AIGFP bonus payments are tiny (0.1% of the former and 0.001% of the latter). In pure economic terms they are insignificant. Ian Bremmer wrote in the Washington Post that “this issue pales in the context of the big picture,” and that “the Obama administration cannot afford the luxury of outrage.” Ignoring the politics, I agree. However, politically and morally the AIG bonuses are bursting with significance. Should the firestorm lead to reform, then there may be economic relevance. But at the moment there is little.

The bonus furor has obscured some of what I think were last week’s more significant revelations about AIG. In particular the insurance giant disclosed collateral payments made to counterparties during the last quarter or so of 2008. The payments included multibillions to major European banks Societe Generale and Deutsche Bank, and other financial institutions around the globe. In addition, $12.1 billion were paid to US municipalities, including over $1 billion each to those in California and Virginia.

When it was said that AIG was too big to let fail, this is what was meant. Those who take that position (and not all do) argue that the failure of AIG would have meant the collapse of unbearably more. Too many banks and municipalities (and, no doubt, other institutional investors) bought vast sums of mortgage backed securities wrapped in AIG credit default swap (CDS) “insurance” or entered into naked CDS contracts with AIG. Many CDS contracts were moves to shed systemic risk, to sell it to another willing to bear it. Ironically, because the same entity was on the other side of so many such transactions it led to a collective concentration of systemic risk at AIG.

As a consequence, AIG received the greatest blow in the staggering implosion of mortgage backed securities and associated CDSs, the modern financial innovations intended to dilute risk by spreading it around the system. As Gillian Tett put it in the Financial Times, “Far from promoting ‘dispersion’ or ‘diversification’, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too.”

It is a truism that systemic risk can be transferred but not eliminated. The only protections against it are avoidance or dilution. AIG went the other way, concentrating enormous risk within its walls. By October 2008 AIGFP’s 450 worldwide employees had amassed $2.7 trillion in CDS contracts from 50,000 outstanding trades with 2,000 different firms (source). Those are now the US taxpayer’s problem.

The injury dealt, the minor insult is that some of those AIGFP employees received large contractual bonuses. The organization that spectacularly misunderstood the limitations of diversification in its portfolio has revealed a diversity of horrors in its collapse. Duly outraged, the nation is indulging in a torch and pitchfork moment, which could cost vastly more than the bonus payments that ignited it.

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