Kevin writes here
It also gets interesting if the firms use different valuation approaches from each other. In that case it would be theoretically possible for both parties to post a profit on the transaction or for both parties to post a loss on it.
He is referring to the approaches used to value the embedded put option in the ERM, and the actual put option used to hedge the ERM.
There is a troubling reminder here of what happened to AIG Financial Products in the run-up to the last financial crisis.
AIG Financial Products was a subsidiary of the insurance giant American International Group, operating mainly out of London. In the Spring of 2008 AIGFP suffered catastrophic losses on the credit default insurance it had issued. The insurance was meant to protect investors against default of fixed-income securities. FP wrote the insurance on large scale (half a trillion dollars, according to one report) much of it linked to mortgages.
But all was not well and this paraphrase tells a familiar story.
- AIG knew of potential valuation problems in relation to the insurance contracts that ultimately led to a $123 billion US bailout.
- The whole circus was presided over by a Maxwellian figure, Joe Cassano. ‘He was the law there, the absolute ruler of AIG FP’.
- An auditor blew the whistle on the valuation problem, only to told he was ‘polluting the process’ by Cassano.
- The culture was built on bonus. ‘we were making $250 million in premiums on this stuff and 30 percent [of revenues] went into the bonus – so 30 cents of each dollar in operating profit went into comp – so of course they don’t want to mark to market, they didn’t want any of that to go into bonus calculation’
But that’s another story. One problem, as everyone knows, was not simply AIGFP writing their whole business on one concentrated and undiversified insurance product. Another, not so well known is that they were pricing the insurance wrongly. Or rather, they were treating what is essentially a traded option as an insurance product, thus valuing the option on a ‘real world’ basis. They looked at the history of default on the risks they were underwriting, concluding that the risk was tiny. ‘This thing was written such that the moon would have to crash into the Earth to pay out.’ They monitored their super senior CDS using a Value at Risk model, which isn’t a valuation model at all. Sound familiar?
The misvaluation was well-known on the Street, and many traders made a lifetime’s fortune (and more) by simple arbitrage strategies exploiting it. If a firm is pricing the cost of default on a bond portfolio at say 20bp and the spread on the bond portfolio is 50bp, you can lock in a 30bp instant profit by the right combination of bond positions, credit insurance and market-traded credit default swaps. So everyone was cashing in. The salespeople at FP were making 30 cents on every dollar, the traders were making £10s of millions upfront on the arbitrage, what could possibly go wrong?
The problem of course was that FP could not possibly pay out, and when Goldman made a $2 billion collateral call, things started to go horribly wrong.
Why didn’t the regulators do something? Well, they certainly knew about it. The exposure of monolines such as FP was a massive concern, and FSA made half-hearted attempts to stop the arbitrageurs taking profit upfront. But as to the problem of it being theoretically (indeed actually) possible for both parties to post a profit on the transaction, nothing was done, as far as I know. The regulatory approach at the time was ‘light touch’ (and still is, in my opinion), and the view was that the market should sort out misvaluation issues. If a firm is undervaluing its exposure, well, the usual Darwinian process will sort things out.
Trouble was, any company whose solvency is so essential to the global economy that its failure would be catastrophic could not be sorted out in the Darwinian way, so AIG was bailed out by the US government for nearly $100 billion. Cassano never paid back his total bonus of $315 million, nor as far as I know did the salespeople, and the arbitrageurs were presumably handsomely rewarded.
Are we back for round II?
Idea: write a massive amount of put options under insurance contract regulations, perhaps using a VaR or ‘real world’ model, so the options are nice and cheap. Never mind Black Scholes, if the market is not deep and liquid, the model is not valid. Pay appropriate commission to the sales staff, who will surely sell a lot of this stuff at such prices. Everyone else in the market: go long the underlying, buy the cheap option, and work out a way to take the profit up front.
Sound familiar?