AIG sub ALICO wrote CDS's

[Guilty Bystander]

From yesterday's NY Times

http://www.nytimes.com/2010/02/01/bu...LICO&st=Search

Risky Trading Wasn’t Just on the Fringe at A.I.G.
...

But the suggestion that A.I.G.’s core insurance business did not dabble in derivatives is not quite true. One of its biggest insurance units, incorporated in Delaware, was also dealing in the derivatives known as credit-default swaps, according to regulatory filings with the state.

...

Even at its peak, in 2007, Alico’s portfolio of credit-default swaps was just a fraction of the one at A.I.G. Financial Products, the London shop whose collapsing business led the United States government to prop up A.I.G., the biggest bailout in American history.

If Alico’s entire portfolio had blown up that year, the maximum possible loss — a little more than $1 billion — would not have wiped out the company’s total reported surplus of $7 billion.

Alico’s executives said they considered their swap program much safer as well. Michael Buthe, the chief investment officer, said that the company had sold protection only on investment-grade bonds, which the company considered unlikely to default.

Alico’s chief financial officer, Christopher J. Swift, added that the bonds were issued by companies in many commercial sectors, which diversified the portfolio. That differed starkly from A.I.G. Financial Products, whose swaps gave A.I.G. a vast, undiversified exposure to the housing markets.

“This isn’t tied to real estate,” Mr. Swift said of his company’s program. “It diversified our holdings and increased yield.”

[A Student]

This is one of those stories that works because people don't understand positive uses of derivatives. They see CDS's and aha, they're bad. Its quite reasonable that the CDS's were a valid trade to get the appropriate risk exposure.

For an example, if you have a portfolio that's exposed to inflation (say pensions with an inflation link, or life insurance where the DB increases with CPI), then you would want inflation adjusted bonds in your portfolio to hedge the risk. The problem is that there are not enough inflation bond issuers to have a diverse inflation protected portfolio (if you have a large liability). So a solution is to buy TIPs, and then add CDS's on an investment grade index so that your total credit risk is similar to what it would be if you held a diverse investment grade portfolio.

[MetsMan]

Agree with the previous poster that this looks worse than reality. Surprising amount of sensationalism from the NY Times.

All insurance companies take corporate bond credit risk. (and often lots of it.) Why does it matter if the credit exposure comes through a bond or through a derivative, so long as the portfolio is diversified?

[freshwoman]

There's a few problems with CDS: (1) liquidity, (2) what if you don't own the underlying, (3) and a lot of it was a reg and accounting arb play for insurance via CLNs which didn't have to be marked to market.

However, FASB woke up and as of 2010 credit risk in no longer clearly and closely related and all those CLNs now have to be bifurcated and MTM. Don't think insurers will be holding that much anymore.

That goes for the inflation play listed above.

[Flavia Flav]

Originally Posted by Guilty Bystander

From yesterday's NY Times

"Alico’s executives said they considered their swap program much safer as well. Michael Buthe, the chief investment officer, said that the company had sold protection only on investment-grade bonds, which the company considered unlikely to default."

Agreed that there's less than meets the eye here, but doing a double-take over this sentence offered a second or so of amusement. Actually, I do sort of enjoy picturing AIG as a real-life Bluth Company, with the beleaguered CIO driving their grounded company jet on the freeway to work every morning...

[Eimon Gnome]

Originally Posted by A Student

This is one of those stories that works because people don't understand positive uses of derivatives. They see CDS's and aha, they're bad. Its quite reasonable that the CDS's were a valid trade to get the appropriate risk exposure.

For an example, if you have a portfolio that's exposed to inflation (say pensions with an inflation link, or life insurance where the DB increases with CPI), then you would want inflation adjusted bonds in your portfolio to hedge the risk. The problem is that there are not enough inflation bond issuers to have a diverse inflation protected portfolio (if you have a large liability). So a solution is to buy TIPs, and then add CDS's on an investment grade index so that your total credit risk is similar to what it would be if you held a diverse investment grade portfolio.

sad. contemplate this:

"The market can remain irrational longer than you can remain liquid"

Now talk to me about diversifying your govvies by issuing CDS and how it is the same thing as buying the underlying. Geez, smell the coffee.

[A Student]

Originally Posted by Eimon Gnome

sad. contemplate this:

"The market can remain irrational longer than you can remain liquid"

Now talk to me about diversifying your govvies by issuing CDS and how it is the same thing as buying the underlying. Geez, smell the coffee.

You clearly don't get it. The theory isn't to diversify govvies, its to add corporate credit risk on top of gov bonds and get paid for taking on that corporate risk.

Are you saying for example, holding 1M in 10yr BOA bonds is perfectly fine for an insurance company, but holding 1M in 10yr governments and 1M in notional on 10yr BOA bonds is not fine for that same insurance company? Now, instead of doing that over one name, do it over an index of investment grade names.

Your quote makes absolutely no sense in this case. The strategy is not trying to take advantage of a mispricing or irrationality in the market - unless you are saying that having a credit spread is irrational, but insurance companies already use that spread and are exposed to that risk.

[Colymbosathon ecplecticos]

If spreads blow out, you could get killed by a mark-to-market call that wouldn't happen if you actually held the underlying.

[Flavia Flav]

Originally Posted by Colymbosathon ecplecticos

If spreads blow out, you could get killed by a mark-to-market call that wouldn't happen if you actually held the underlying.

Yes, you get a mark-to-market adjustment. Whether or not it kills you (or even hurts very much) depends on a number of factors. One rather important such factor is the size of the exposure, which sounds like it was pretty manageable in this instance. For the NY Times to compare this to the disatrously irresponsible programs at AIGFP just because CDS were involved is pure sensationalism.

[Colymbosathon ecplecticos]

Sure, but the point is that if you hold the underlying you can 115 account them, but that isn't available synthetically.