Wednesday, September 17, 2008

The boring is biting with a vengeance

(Gillian Tett @ FT.com) Once upon a time, say a whole 18 months ago, policymakers and pundits used to think the most likely candidate to blow up the financial world was a high-rolling hedge fund.

After all, these risk-loving, unregulated entities had form: just remember the 1998 drama around Long-Term Capital Management, when some of the most brilliant minds in finance almost triggered a meltdown.

But if there is one painful lesson that investors have learnt over the past 12 months, it is that it is not just the smartest guy in the room who can blow up the system. The dull, plodding nerds can be lethal too. This week, for example, the markets are being rocked by the woes of AIG, an unglamorous insurance behemoth that was not supposed to be in the business of taking high-rolling risks. However, in earlier chapters of this credit saga it has been the monoline industry, money market funds, commercial paper sector and structured investment vehicles that have shaken the system.

What unifies this seemingly motley list is that these are all sectors of finance that used to look stodgy and safe. In a sense, they were the herbivores of the financial world. Indeed, they were so dull, at least compared with the carnivorous hedge funds, that they were usually ignored by regulators and investors alike.

Now, however, the boring is biting with a vengeance. Take the case of AIG. As its crisis plays out, there is still much about its balance sheet that remains unclear – not for nothing did Citigroup analysts dub it a “black box” last year.

It now appears that a large proportion of AIG’s $41bn in writedowns stem from its exposure to so-called supersenior instruments, or the most senior chunks of pools of debt backed by mortgage and corporate bonds.

Until last summer, these instruments were considered so utterly safe and dull that they carried a triple A rating and rarely moved in price. That was because these instruments sat so high in the capital structure that they only suffer losses if a tsunami of defaults occur – and in the halcyon days before the credit crunch most investors, and rating agencies, found it impossible to imagine such a shock. However, this once-unthinkable scenario is now starting to materialise in relation to some bundles of mortgage-linked debt, causing the price of supersenior debt to fall 30 and 60 per cent, according to different measures. That has created vast mark-to-market losses at the entities holding this stuff, such as Merrill Lynch and UBS. It has also hit AIG, both in terms of securities it holds and those it has insured.

For the AIG directors, this has come as a devastating shock: indeed, the losses were so unforeseen that as recently as late last year, the company was admitting to only $1.5bn of supersenior losses, which has subsequently been revised up numerous times.

But the news is even more startling for investors. After all, if there is one part of the financial system which is supposed to understand risk correlations it should be the insurance world. Yet AIG has stumbled at least twice in that respect. On a micro level, the insurance group apparently failed to see that its models underestimated the dangers of “supersenior” debt – the issue here is technical, but revolves around how models track the correlation of defaults.

On a wider level, AIG also failed to see how the fate of supersenior could be linked to behaviour in other parts of the financial world. For what has made the price falls so vicious this year is that all the institutions that had previously piled this “boring” supersenior on their books have needed to sell at once. Hence the development of a vicious, downward spiral.

All that has taken AIG by surprise. Worse, it has wrongfooted regulators too. That is partly because the group has been supervised by insurance regulators in recent years – some of whom might not recognise a CDO if it hit them on the nose. Moreover, policymakers who did know about CDOs have tended to pay relatively little attention to entities such as AIG: after all, they were mostly watching those hedge funds.

No wonder the current storm has come as such a terrible shock to the markets. And no wonder that trust in the system is unravelling fast. After all, as investors reel from the woes at AIG, the key question on many lips is this: just how many other hitherto boring bits of the financial world could yet unleash new horrors? Answers, please, on a postcard. And better keep watching the CDS market.

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