From Free Lunch to Black Hole: Credit Default Swaps atAIGcase W04C41August 6, 2015Published by WDI Publishing, a division of the William Davidson Institute (WDI) at the University of Michigan.©2015 Stefan Nagel. This case was written by Stefan Nagel (Michael Stark Professor of Finance at the Ross School of Business) atthe University of Michigan to be the basis for class discussion rather than to illustrate either the effective or ineffective handlingof a situation. Secondary research was performed to accurately portray information about the featured organization. Companyrepresentatives were not involved in the creation of this case.Alan Frost, executive vice president for AIG Financial Products (AIGFP), was on vacation when hereceived a disturbing email from Andrew Davilman at Goldman Sachs in the evening of July 26, 2007 (seeExhibit 1).In the years leading up to 2007, AIGFP had written $75 billon notional value of credit default swaps(CDS) tied to subprime mortgage-backed securities (MBS). Through these CDS, AIGFP provided creditinsurance to its counterparties, meaning that AIGFP would absorb losses on the MBS underlying the CDS ifhomeowners defaulted on their mortgages.1 Goldman Sachs was the counterparty for more than $20 billionnotional value of these CDS contracts.2 For several years, AIG had profited handsomely from these contractsand had judged that there was a virtually zero risk that AIG would ever have to make a payment on theseCDS. But now, as housing prices started to fall, subprime borrowers began to default in greater numbers,and market values of the subprime MBS underlying the CDS dropped substantially. In Goldman Sachs’ view,these circumstances were a clear indication that the marked-to-market value of the CDS contracts with AIGhad shifted in Goldman Sachs’ favor. Referring to the CDS contract terms, Goldman Sachs therefore askedAIG to provide collateral. On July 27, the day after Frost received the heads-up from Davilman about theforthcoming margin call, Goldman Sachs formalized its demand for collateral by sending AIGFP a collateralinvoice requesting that the company provide it with collateral worth $1.8 billion.3American International GroupIn 2007, American International Group (AIG) was one of the biggest insurance companies in the world.It operated in 130 countries and employed close to 100,000 people.AIG was founded in 1919 as an insurance agency in Shanghai. In wake of the revolution in China,the company moved to New York City in 1949. AIG went public in 1969, with Maurice R. Greenberg asCEO. Greenberg led the company through an enormous expansion until he was forced out in 2005 amidinvestigations into accounting irregularities by the New York Attorney General. Greenberg remained a largeshareholder in AIG, and contested the charges of accounting irregularities and the circumstances of hisforced departure from AIG.After Greenberg’s departure, Martin J. Sullivan, a long-time AIG employee, took over as CEO.4This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.2From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41Exhibit 1Email from Andrew Davilman to Alan FrostSource: Financial Crisis Inquiry Commission. <http://fcic.law.stanford.edu>.AIG Financial ProductsEarlier, looking for new business opportunities, AIG created its AIG Financial Products (AIGFP) subsidiaryin 1987. AIG was looking for ways to profitably exploit its AAA credit rating and its strong capital base.Its objective in starting AIGFP was to participate in the growing over-the-counter markets for financialderivatives.5It hired a group of traders from Drexel Burnham Lambert, the firm that had pioneered the junk bond marketin the U.S. The firm was in deep trouble at the time amid allegations of insider trading and investigations byRudy Giuliani, the U.S. attorney for the Southern District of New York.6 One member of this group was JosephCassano, who first served as chief financial officer of AIGFP and, from 2001, as head of AIGFP.7AIG located its AIGFP unit in London, but its business was nevertheless subject to U.S. regulation.Because AIG owned a small savings and loans institution, it was able to choose the Office of Thrift Supervision(OTS) as its federal regulator for its non-insurance businesses (which included AIGFP). OTS was therefore alsoresponsible for supervision of the AIGFP subsidiary (AIG’s U.S. insurance business was supervised by stateregulators). Since AIGFP agreed to supervision by OTS, it avoided regulation by the U.K. Financial ServicesAuthority (FSA). OTS, typically responsible for supervision of small savings and loans institutions, had littleexpertise in the type of business conducted by AIGFP.8AIGFP engaged in transactions with interest-rate swaps, derivatives on commodities, and many otherderivatives products. In the 1990s, AIGFP expanded its activities into the nascent market for credit defaultswaps (CDS). AIGFP’s earnings rose from $150 million in 1993 to $323 million in 1998 and to $758 millionin 2001.9This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.3From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41Credit Default SwapsCredit default swaps (CDS) were invented in the 1990s as an instrument for transferring credit riskbetween financial institutions. For example, a bank that made a loan to a company could use CDS to transferto another party (e.g. an insurance company) the risk that this company might default on the loan. Thebank in this example is the credit-protection buyer and the insurance company is the credit-protection seller.To compensate the insurance company for assuming the default risk of this loan, the bank makes a smallperiodic payment, as long as the company does not default on the loan. In the event of default, the insurancecompany is required to make a payment to the bank to cover the bank’s losses on the loan. The same idea wassoon applied to corporate bonds, mortgage-backed securities, and other securities, for which CDS providedcredit protection in the event that the borrower defaulted on the obligations under these securities.More precisely, a CDS pays out to the credit-protection buyer if a credit event occurs with respect to theunderlying reference entity (e.g., the company that received the loan in the above example). What exactlyconstitutes a credit event is defined in the terms of the CDS contract. A credit event can involve outrightdefault of the underlying reference entity, but it can also be an event involving some restructuring of thedebt, for example. Many CDS are conducted on the basis of terms laid out in a master agreement by theInternational Swaps and Derivatives Association (ISDA).As an example, suppose that IBM has a floating-rate bond outstanding with more than seven yearsremaining until maturity that trades at par. Suppose party A, the credit-protection buyer, enters into a CDSwith party B, the credit-protection seller, with seven years maturity. The notional value of the CDS contractis $1 million. In the CDS contract, the two counterparties agree that as long as IBM does not default onthis bond during the next seven years, A pays B an annual payment of u% (the “CDS rate,” which would bespecified as a specific number in the contract) of the notional value of $1 million. In the event that IBMdefaults, B makes a payment to A equal to the notional value of $1 million times the “loss given default”and the contract terminates. For example, if IBM defaults, and subsequent to the default event, the IBMbonds are trading at 60% of their face value, then the loss given default is 40%, and the required paymentwould be 40% times $1 million = $400,000. Thus, the credit-protection buyer would be fully insured againstthe default risk inherent in a $1 million position in these IBM bonds. Exhibit 2 illustrates these cash flowspatterns schematically for a floating-rate bond with face value F, time of default d, CDS rate u, CDS maturityT, and market value Pd of the underlying bond in the event of default.Financial institutions had a variety of motivations for entering into CDS. Part of it was to lay off creditrisk to institutions that could better diversify these risk exposures. For example, if a bank makes a largeloan to a company, this bank may have a large concentrated credit risk exposure to this single counterparty.By entering into a CDS, the bank can transfer all or part of this credit risk exposure to another financialinstitution that is in a better position to bear the risk. For many CDS transactions, the motivation, however,was driven by regulation. For example, European bank regulators calculated the amount of equity capital abank needed to hold as a buffer against possible losses based on the risk exposure of the bank’s assets. Bylaying off credit risk to an entity like AIG through a CDS transaction, the bank could reduce the amount ofcapital it was required to hold. To the extent that the payments that AIG charged for taking on the creditrisk were lower than the cost that banks perceived for putting up more equity capital against risk exposures,banks were happy to enter such trades. At the time, this credit-risk transfer was also welcome by regulators,as it transferred credit risk away from highly levered banks, which enjoyed, to some extent, implicit andexplicit government (i.e., taxpayer) support to institutions like AIG outside the regulated banking sectorthat had large amounts of equity capital and which were perceived at the time not to enjoy similar incentivedistorting government support.This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.4From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41Exhibit 2CDS Cash Flows from Perspective of Credit-Protection BuyerSource: Created by the author of the case.Until the early 2000s, AIG’s credit risk exposure through its CDS transactions was mostly to corporatecredit. However, this took a drastic turn, as financial innovation in the mortgage market involved AIG as akey player.Synthetic SecuritizationThe set of participants in the credit default swap market was relatively narrow. Most of the counterpartiesin credit default swaps were banks (including investment banks), hedge funds, and some insurance companies.In the mid-1990s, several banks were developing ideas on how to transfer credit risk from bank balancesheets to a broader investor population. In 1997, J.P. Morgan set up its groundbreaking transaction calledBISTRO (Broad Index Secured Trust Offering). In a BISTRO structure, a bank that originated a portfolio ofloans bought credit protection for this portfolio from J.P. Morgan via a CDS. J.P. Morgan in turn bought creditprotection on this portfolio of loans from a special purpose vehicle (SPV), a shell company set up by J.P.Morgan only for the purpose of this BISTRO transaction.10For example, in the first BISTRO deal in 1997, the SPV takes on the credit risk of a loan portfolio worth$9.7 billion.i In return, the SPV receives a regular payment (based on the CDS rate) from J.P. Morgan. Ifa credit event occurs on the underlying portfolio, the SPV has to make a payment that compensates J.P.Morgan for the loss in value on the loans associated with the credit event. To have assets available that canbe used for these payments in case of credit events, the SPV issues notes in capital markets. The amountraised from the issuance of these notes is invested in safe securities such as government obligations untilit is needed to make any payments on the CDS due to credit events in the underlying portfolio of loansthat the SPV insured. Thus, just like in traditional securitization, the credit risk of the underlying loans wastransferred from the originating bank to capital market investors, but in this case not by transferring theactual loans from the originating bank’s balance sheet, but instead by just transferring the credit risk ofthese loans, using CDS contracts (see Exhibit 3). This process is called synthetic securitization.11i The originatng bank would bear the frst 1.5% loss on the underlying loan portolio. The author ignores this feature in this illustratvediscussion.This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.5From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41In the first BISTRO deal, the SPV issued only $700 million worth of notes, an amount much smaller thanthe notional value of the loan portfolio ($9.7 billion) that the SPV insured. Up to losses of $700 million,any credit losses on the loan portfolio would be borne by the capital market investors that bought the notesissued by the SPV. If losses on the loan portfolio exceeded $700 million, the capital market investors wouldbe wiped out, and J.P. Morgan would bear the additional losses.The loans underlying BISTRO deals were, on average, of investment-grade quality, and hence the riskthat losses on a diversified portfolio of such loans might exceed $700 million was judged to be miniscule.This risk was seen as smaller than the risk of loss on a typical AAA credit. For this reason, this remainingcredit exposure that J.P. Morgan was exposed to was labeled to be “better than triple-A” or “super-senior.”12Exhibit 3BISTRO DealSource: Created by the author of the case.This super-senior risk was mostly correlation risk: For the losses on the loan portfolio to exceed $700million, many borrowers would have to default at the same time. Assessing the super-senior risk thereforerequired a judgment about the degree of correlation in borrowers’ defaults. Based on a long history of dataon corporate defaults, the correlation of defaults appeared sufficiently low so that super-senior lossesseemed extremely unlikely.Partly because of pressure from regulators in some jurisdictions to hold some amount of reserve capitalagainst this super-senior risk, and partly because of concerns about the potentially huge (even thoughunlikely) magnitude of the risk exposure, J.P. Morgan was looking for some counterparty to insure this supersenior risk. A suitable counterparty would have to have a strong balance sheet and a triple-A credit rating.Enter AIG.AIG’s Financial Products division was willing to insure J.P. Morgan’s super-senior risk. AIGFP would enterinto a CDS contract with J.P. Morgan to assume the super-senior risk and, in return, earn a small periodicfee. For the first deals, AIGFP was paid 0.02% of the insured amount per year. In the initial BISTRO deal,this would amount to $1.8 million per year for insuring a notional value of $9 billion of super-senior riskexposure. In subsequent deals, AIGFP managed to contract a higher rate of 0.11%.13Mortgage Securitization and Collateralized Debt ObligationsIn the early 2000s, Wall Street started applying the same credit-risk transfer technology not just tocorporate credit, but also to consumer credit such as automobile loans, student loans, credit-card debt,This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.6From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41and mortgages. These consumer loans were transferred from originating lenders to capital market investorsthrough the creation of asset-backed securities (ABS) or mortgage-backed securities (MBS).Until the early 2000s, most securitization of mortgages was carried out by government-sponsoredenterprises Fannie Mae and Freddie Mac, which took on the credit risk of the mortgages that were securitized.14In the early 2000s, however, Wall Street started to securitize mortgages that did not satisfy the eligibilitycriteria required by Fannie Mae and Freddie Mac, for example, because borrowers had low credit scores and/or lacked documentation of income, the loan-to-value ratios were high, or the size of the mortgage exceededset limits. (See Exhibit 4).Exhibit 4Role of AIG in Mortgage SecuritizationSource: Created by the author of the case.In these “private-label” mortgage securitizations, MBS are issued by an SPV, and the SPV uses theproceeds from MBS issuance to purchase mortgages from an originating bank (or from an intermediary thatwas “warehousing” the loans for a brief period). The MBS are often issued as tranches that differ in creditquality. If credit losses occur on the underlying portfolio of mortgages, the (unrated) equity (or “first-loss”)tranche bears the first losses. In the example shown in Exhibit 4, the BBB-tranche starts to suffer any lossesonly if the equity tranche is completely wiped out. The AAA-tranche is the last one to suffer losses, whichoccurs only if all the other lower-rated tranches have been wiped out. The AAA-tranche would typicallyaccount for the bulk of the notional value of the MBS, often around 80%. Thus, roughly speaking, investorsin the AAA-tranche suffer losses only if the losses on the underlying portfolio of mortgages exceed 20% ofthe combined face value of the underlying loans.15This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.7From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41While there was plenty of demand for higher-rated tranches, BBB-rated tranches were difficult to sell.As a consequence, it became common in the 2000s that the BBB-tranches were used as raw material for asecond layer of securitization, with the goal of “manufacturing” more highly rated paper. In this secondlayer, an SPV issues so-called collateralized debt obligations (CDOs), which are also issued in tranches, andthe proceeds from the issuance of these debt obligations are used to purchase the BBB-tranches of the MBSfrom the first layer of securitization (CDO of asset-backed securities (ABS)).16CDOs backed by a pool of BBB-tranches are “mezzanine CDOs” (this is the case shown in Exhibit 4).In some cases, CDOs were backed by a pool of higher-rated tranches and called “high-grade CDOs.” Often,CDOs would be set up with a mixed pool of underlying assets, partly consisting of tranches from mortgagesecuritization and partly with tranches from securitization of other consumer credit or corporate loans (a“multi-sector CDO”).17The CDO tranches were typically structured to include a super-senior tranche. For example, the supersenior tranche might account for 70% of the combined face value of all tranches and the AAA-tranche mightaccount for 10%. Roughly speaking, the AAA-tranche bears losses if the credit losses on the underlyingassets (BBB-tranches from the first layer of securitization) exceed 100% – 80% = 20%. But due to thepresence of the super-senior tranche, the AAA-tranche is wiped out if the losses exceed 100% – 70% = 30%,the so-called “attachment point.” Thus, the AAA-tranche is a lot riskier than it would be in the absence ofthe super-senior tranche. Nevertheless, ratings agencies were willing to rate it AAA.18In this example, the super-senior tranche would experience losses only if the credit losses on theunderlying assets exceeded the attachment point of 30%. For a proper risk assessment, though, it is alsoimportant to consider that the assets underlying the CDO are themselves from a tranched structure. In a CDOon BBB-rated MBS, losses of 3-4% on the loans underlying the MBS can be enough to wipe out the entireBBB-tranche. In this case, all tranches of the CDO, including the super-senior, would become worthless.The super-senior tranche was typically retained by the financial institution that sponsored the creationof the CDO. According to one estimate, banks held around $216 billion worth of super-senior tranches in2007.19 While some financial institutions decided to bear the super-senior risk, others were looking for waysto insure at least part or all of it and they approached AIGFP. As in the original BISTRO deals describedabove, AIGFP was willing to enter into CDS contracts to sell super-senior credit protection.20As subprime lending and the volume of private-label MBS expanded enormously in 2004 and 2005(see Exhibit 5), the notional volume of super-senior risk that AIG insured quickly grew to $79 billion (seeAppendix A). The asset composition of the multi-sector CDOs also changed substantially during these years.While the share of subprime MBS was very small initially, by 2006 a large part contained subprime MBS.About a third of AIG’s super-senior exposure from multi-sector CDOs was from mezzanine CDOs, i.e., wherethe MBS and ABS assets backing the CDO were rated BBB, and two thirds of the “high-grade” variety wherethe assets underlying the CDO were rated A or AA.21 (See Exhibit 5.)This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.8From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41Exhibit 5Global CDO Issuance and U.S. Private-Label Residential MBS Issuance ($bn)0.0100.0200.0300.0400.0500.0600.0700.0800.02000 2001 2002 2003 2004 2005 2006 2007CDO (Global) Private-label RMBS (US)Source: Securities Industry and Financial Market Association (SIFMA). <http://www.sifma.org/research/statistics.aspx>.Goldman Sachs was AIG’s largest counterparty for multi-sector CDO super-senior CDS, with a totalnotional amount of $23 billion of credit-protection written by AIG. The second largest counterparty wasSociété Générale, followed by Merrill Lynch (see Exhibit 6).Exhibit 6AIG’s Main CDS Counterparties for Multi-Sector CDO Super-Senior TransactionsCounterparty Notional Amount ($bn)Goldman Sachs 23.0Société Générale 18.6Merrill Lynch 9.9UBS 6.3Calyon 4.5Bank of Montreal 1.6Royal Bank of Scotland 1.4Wachovia 0.8Deutsche Bank 0.6Source: Created by the author based on data gathered from: Financial Crisis Inquiry Commission, 2007-12-31_AIG_Status_of_Collateral_Call_Postings. 31 Dec. 2007. <http://fcic.law.stanford.edu>.End of the House Price BoomIn the months leading up to June 2005, as CEO Greenberg was forced out during investigations, the majorratings agencies downgraded AIG from its prized triple-A rating. Until the downgrade, AIGFP’s counterpartieshad been willing to enter into CDS contracts without requiring AIGFP to put up any collateral. AIGFP’spromise to make payments on the CDS contracts in case of a credit event was sufficient until that point.But after the loss of the triple-A rating, counterparties asked for collateral. In 2005, the required collateralThis document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.9From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41amounts were small, though, as the risk of a credit event on the super-senior risk seemed remote and thesuper-senior tranches were valued at par.22In December 2005, AIGFP stopped writing credit-protection on super-senior tranches of multi-sectorCDOs. Thus, no new super-senior risk exposures would be added to the existing ones in AIGFP’s portfolio ofCDS. However, AIG did not undertake any steps to hedge the existing super-senior risk exposures. In AIG’sview, the risk that it would ever have to make a payment on the super-senior CDS was still negligible.23In early 2006, house prices took a drastic turn, as illustrated in Exhibit 7 with the S&P/Case-Shiller U.S.National House Price Index.Exhibit 7S&P/Case-Shiller U.S. National House Price IndexSource: S&P/Case-Shiller. <http://us.spindices.com/index-family/real-estate/sp-case-shiller>.During the years leading up to 2006, housing prices in the U.S. had doubled within less than a decade.During those years of rising house prices, defaults on subprime mortgages had been minimal. These lowdefault rates were due to the particular design of subprime mortgages. A typical subprime mortgage featureslow monthly payments (based on a low “teaser” rate) for an initial period of two to three years. Then thepayments reset to a much higher rate. For many subprime borrowers, paying the higher rates after the resetdate would have been impossible, given their typically precarious financial situation. However, as long ashouse prices were rising, subprime borrowers could simply re-finance before the reset and take out a newmortgage, now based on the appreciated home value, again with an initial low “teaser” rate. But as houseprices began to decline, this refinancing option disappeared. Defaults on subprime mortgages acceleratedquickly.The rise in the frequency of subprime mortgage defaults severely impacted the value of mortgagebacked securities that contained subprime material, particularly the lower-rated tranches. However, it wasgenerally rather difficult to obtain reliable market prices for MBS tranches, as there was little trading inthese securities, and the market was over-the-counter with little price transparency for parties other thanthe dealers in this market. In January 2006, this changed with the introduction of the ABX.HE indices byMarkit Group, Ltd.24This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.10From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41The ABX.HE indices track the prices of CDS contracts written on baskets of subprime residential MBS.Specifically, each ABX.HE index tracks CDS contracts written on baskets of tranches with a specified rating(the rating at the time the MBS were issued), and of a specified vintage. For example, the ABX.HE BBB-06-01index tracks a basket of CDS contracts on BBB-tranches of subprime MBS issued in the second half of 2005.Every six months, a new vintage of the index is created. For example, the ABX.HE BBB-06-02 index started inJuly 2006, and it references BBB-tranches of subprime MBS issued in the first half of 2006. For the first time,the publication of the ABX.HE indices allowed a wide range of market participants to observe information onthe pricing of credit risk in subprime MBS tranches. Exhibit 8 plots four vintages of the ABX.HE BBB indices.Exhibit 8ABX.HE index for BBB-tranches of subprime MBSSource: Stanton, R., and N. Wallace. “ABX.HE Indexed Credit Default Swaps and the Valuation of Subprime MBS.” UC Berkeley Working Paper. 2009. <https://escholarship.org/uc/item/5s75x0ns>.While “single-name” CDS contracts on corporate debt were typically quoted in terms of a CDS ratethat represents the periodic payment that the credit-protection buyer has to make, the ABX.HE index wastypically quoted in terms of a price that approximately resembles the implied price at which the underlyingMBS would be expected to trade relative to their par value, given the pricing of the CDS contracts that enterinto the calculation of the ABX. For example, an ABX index value of 80 would imply, approximately, that theunderlying MBS (assuming they were issued at par) should trade at “80 cents on the dollar,” or 80% of theirpar value.As Exhibit 8 shows, the four vintages of the ABX.HE-BBB index showed little price movement during2006, but they began to decline in 2007. By mid-2007, they had fallen to levels between 40 and 60 centson the dollar. At the same time, ratings agencies downgraded hundreds of subprime MBS.25The ABX index provided for the first time a relatively transparent view on prices at which marketparticipants were willing to conduct trades of CDS on subprime MBS with various ratings. However, it wasstill difficult to extract information from the ABX indices about the valuation of CDO tranches, because theThis document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.11From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41CDOs were built from pools of subprime MBS with particular ratings (often BBB). Thus, the ABX indices shedlight on the valuation of MBS that entered into the MBS pool underlying CDOs, but did not allow someoneto directly infer the valuation of tranched exposures to this pool.In February 2007, Markit Group introduced a new index, called TABX.HE, which addressed this issue. TheTABX.HE BBB referenced 40 CDS on subprime MBS with initial BBB ratings in two consecutive vintages of theABX.26 While the ABX represents CDS written directly on these subprime MBS individually, the TABX representsCDS on tranched exposure to a pool of these MBS. Just like in a typical CDO, one of the tranches is a supersenior tranche, labeled the 35-100 tranche, which is the most senior tranche and accounts for 65% of thecombined face value of all tranches. Effectively, the CDS underlying the TABX.HE index represent a syntheticCDO, and the index values of this newly constructed TABX.HE index provided, for the first time, a relativelytransparent perspective on the valuation of super-senior CDO tranches.Exhibit 9 presents end-of-month values of the super-senior tranche of the TABX.HE constructed fromCDS on the subprime MBS pools underlying the 06-02 and 07-01 vintages of the ABX. By the end of July2007, the index level had fallen to around 55 cents on the dollar.Exhibit 9TABX.HE Super-Senior Tranche (35-100) (Vintage ABX 06-2 and 07-1)Source: Bloomberg.Collateral CallsWhile AIGFP executives were on vacation in the summer of 2007, they received disturbing news. On July27, 2007, Goldman Sachs asked AIGFP to send $1.8 billion of collateral (see Exhibit 10). Goldman Sachs hada total notional amount of $23 billion of super-senior CDS outstanding with AIG, and it requested collateralfor $12 billion of those. These included CDS written on super-senior tranches of CDOs with subprime MBS forwhich the CDS contract allowed Goldman Sachs to request collateral.ii On August 2, 2007, after some furtherii For example, Goldman Sachs did not yet request any collateral for the $5.2 billion notional super-senior CDS on Abacus CDOs,because the credit support annex of these CDS specified that Goldman Sachs could request collateral only if the junior tranches ofthese CDOs were downgraded, which had not happened yet by August 2007 (see Financial Crisis Inquiry Commission, 2007_07_27Collateral Call, July 27, 2007).This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.12From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41analysis, Goldman Sachs revised its collateral call down to $1.2 billion. Goldman Sachs valued the $12 billionnotional value of super-senior CDO tranches underlying the CDS at 80 to 97 cents on the dollar.27AIGFP sent $450 million to Goldman Sachs on August 10, 2007, substantially less than the amountrequested. Negotiations between the two counterparties kept going on. AIGFP still maintained that there wasessentially zero risk that it could ever lose money on the CDS if it held them to maturity. In AIG’s earningsconference call on August 9, 2007, Joe Cassano said “…it is hard for us, without being flippant, to even seea scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.”28Exhibit 10Goldman Sachs Collateral Invoice from July 27, 2007Source: Financial Crisis Inquiry Commission, 2007_07_27 Collateral Call, July 27, 2007. <http://fcic.law.stanford.edu>.Goldman Sachs argued that market values of the underlying super-senior tranches had fallen. Thesource of the disagreement with AIGFP was that no actual trading was taking place in these super-seniorThis document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.13From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41tranches.29 Hence, “true” prices of actual transactions were not available. Goldman Sachs used prices of theTABX (trading was still taking place in the CDS that the TABX was constructed from), and bid/ask quotesfor super-senior tranches it obtained from other dealers and from its own trading desks, to estimate themark-to-market value of AIGFP’s super-senior CDS. While some dealers had revised down their quotes, somedealers still maintained, according to Goldman Sachs, that “… super-senior CDOs should be worth about par(i.e., one hundred cents on the dollar). However, when we asked if they would take on additional risk bytrading at those levels, they refused. We believed that these underwriters had large amounts of super-seniorCDOs in their own inventories and thus had incentives to maintain higher prices than the market genuinelyreflected.”30AIGFP continued to dispute Goldman Sachs’ valuations. But AIGFP’s efforts were hampered by the factthat it did not have its own internal pricing model to value the super-senior tranches on which it had soldcredit protection. AIGFP had to rely on price quotes from third-party dealers. These dealers provided quotesthat were often higher than Goldman Sachs’ quotes, but they were reluctant to provide firm quotes at whichthey would actually stand ready to buy a significant amount.ConclusionUntil this point, AIGFP never had to make any cash payouts on super-senior CDS. Did the price declinesin the subprime mortgage MBS market, and the margin calls that resulted from this decline, represent just atemporary liquidity problem that would go away if markets went back to a normal mode of operation soon?Or could the situation deteriorate further, with margin calls escalating far beyond the amounts that AIGFPrequested to post at this point in August 2007?AIGFP’s models suggested that the chance of a loss on the super-senior CDS was virtually nil. After all,AIGFP’S CDS provided credit insurance for the safest tranches of CDOs. How could these super-senior tranchespossibly suffer any default losses? Or did AIGFP’s models underestimate the risk of super-senior defaultlosses? (For additional insight see Appendices B and C).This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.14From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41AppendicesAppendix AConsolidated Balance Sheet of AIG, December 2006This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.15From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41Appendix A (continued)Source: AIG Form 10-K 4th quarter of 2006. Securities and Exchange Commission. <http://www.aig.com/Chartis/internet/US/en/2006-10k_tcm3171-440889.pdf>.This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.16From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41Appendix BConsolidated Income Statement of AIG, December 2006Source: AIG Form 10-K 4th quarter of 2006. Securities and Exchange Commission. <http://www.aig.com/Chartis/internet/US/en/2006-10k_tcm3171-440889.pdf>.This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.17From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41Appendix CAIG’s Perspective on Its Super-Senior Exposure in August 2007This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.18From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41Appendix C (continued)Source: AIG Residential Mortgage Presentation. 9 Aug. 2007 (financial figures are as of June 30, 2007). <http://www.aig.com/Chartis/internet/US/en/REVISED_AIG_and_the_Residential_Mortgage_Market_FINAL_08-09-07_tcm3171-443320.pdf>.This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.19From Free Lunch to Black Hole: Credit Default Swaps at AIG W04C41Endnotes1 Financial Crisis Inquiry Commission. The Financial Crisis Inquiry Report. Jan. 2011. p. 268. Accessed 19 June 2015. <http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf>.2 Financial Crisis Inquiry Commission.3 Financial Crisis Inquiry Commission.4 Boyd, Roderick. Fatal Risk: A Cautionary Tale of AIG’s Corporate Suicide. John Wiley & Sons, Hoboken, NJ, 2011. Ch. 6-7.5 Boyd.6 Paltrow, Scot J. “The Drexel Agreement to Settle: The Prosecutor Giuliani Has Fans, Foes in War on White-Collar Crime.” LosAngeles Times. 22 Dec. 1988. Accessed 19 June 2015.7 Lewis, Michael. “The Man Who Crashed the World.” Vanity Fair. August 2009. Accessed 19 June 2015. <http://www.vanityfair.com/news/2009/08/aig200908>.8 Lewis.9 Teitelbaum, Richard, and Hugh Son. “Unwinding at AIG Prompts Pasciucco to Ponder Systemic Failure.” Bloomberg. 1 July 2009.Accessed 17 June 2015. <http://www.bloomberg.com/apps/news?pid=newsarchive&sid=afDX3.N1Kdgw>.10 Lanchester, John. “Outsmarted: High Finance vs. Human Nature.” The New Yorker. 1 June 2009. Accessed 19 June 2015. <http://www.newyorker.com/magazine/2009/06/01/outsmarted>.11 Lanchester.12 Lanchester.13 Tett, Gillian. Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe. Simon& Schuster. New York. 2009. pp. 51-56.14 Green, Richard K. and Susan M. Wachter. “The American Mortgage in Historical and International Context.” Journal of EconomicPerspectives. 2005. Vol. 19, no. 4, pp. 93-114.15 Tett.16 Tett.17 Tett.18 Tett.19 “Put Out.” The Economist. 6 Dec. 2007. Accessed 17 June 2015. <http://www.economist.com/node/10259167>.20 Tett.21 AIG Form 10-Q 3rd Quarter 2008. Securities and Exchange Commission. p. 116. Accessed 19 June 2015. <http://www.aig.com/Chartis/internet/US/en/Q308_10Q_tcm3171-443302.pdf>.22 Lewis.23 Lewis.24 Tett.25 CNBC.com. “Moody’s Downgrades Residential Mortgage-Backed Securities.” 10 July 2007. Accessed 17 June 2015. <http://www.cnbc.com/id/19698687>.26 Markit Financial Information Services. “Current Prices.” Accessed 17 June 2015. <https://www.markit.com/Documentation/Product/TABX>.27 Financial Crisis Inquiry Commission. p. 267.28 Financial Crisis Inquiry Commission. p. 268.29 Financial Crisis Inquiry Commission, Ch. 14.30 Financial Crisis Inquiry Commission, 2010-08-31 Goldman Sachs – Valuation and Pricing Related to Initial Collateral Calls onTransactions with AIG, August 31, 2010. <http://fcic.law.stanford.edu>.This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.Established at the University of Michigan in 1992, the William Davidson Institute(WDI) is an independent, non-profit research and educational organization focused onproviding private-sector solutions in emerging markets. Through a unique structurethat integrates research, field-based collaborations, education/training, publishing,and University of Michigan student opportunities, WDI creates long-term value foracademic institutions, partner organizations, and donor agencies active in emergingmarkets. WDI also provides a forum for academics, policy makers, business leaders, anddevelopment experts to enhance their understanding of these economies. WDI is oneof the few institutions of higher learning in the United States that is fully dedicated tounderstanding, testing, and implementing actionable, private-sector business modelsaddressing the challenges and opportunities in emerging markets.This document is authorized for use only by Bowei Zhen (1264531423@qq.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or800-988-0886 for additional copies.
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