• (p25) - a. Credit Default Swaps
  • AIG's downfall stemmed in large part from its CDS on multi- sector CDOs, which exposed the firm to the vaporization of value in the subprime mortgage market.\25\
    • While many counterparties purchased these contracts to hedge or minimize credit risk, AIG essentially took the other side, a one-way, long-term bet on the U.S. mortgage market.\26\
    • This bet was premised on the presumed security of the `AAA'-plus ratings on the underlying CDOs, aided by the subordination structures built into the underlying collateral pools, as well as AIG's once stellar `AAA' credit rating. AIG relied on these factors to serve as a bulwark against market volatility that would undermine the value of the reference securities, and necessitate mark-to-market valuation losses and the posting of collateral to AIG's trading partners.
    • AIGFP's model for CDOs was insufficiently robust to anticipate the impact of the significant declines in value associated with the market meltdown.
    • This basic failure of comprehensive modeling and prudent risk/reward analysis on what was a relatively small slice of AIGFP's business ultimately brought down the entire firm and imperiled the U.S. financial system.
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      \25\ See Annex III for an explanation of AIG's CDS business and the CDS market more generally.
      \26\ This was in contrast to other market participants, particularly dealers, which sought to balance the risk in their portfolios by accumulating both long and short positions to better net risk positions.

2010 0610 - COP June Oversight Report - The AIG Rescue, Its Impact on Markets, and the Government’s Exit Strategy - 337p