AIG – Was it overconfidence?

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007

AIG was  bailed out by the US Government roughly a year later.

AIG, then one of the largest insurers in the world, was expert at insuring what are known as the insurable risks – life insurance, property insurance, etc. These risks are such that history is a good indicator of what to expect since most risks do not manifest together. Not all insured would die simultaneously. History suggests that even in case of wars, natural calamities or disease outbreaks, the number of deaths are not unusually high. This turns out to be  astable business for the insurers.

During the great liquidity rush, practiced by the US Federal Reserve Bank under the chairmanship of Alan Greenspan, the financial intermediaries found a very lucrative opportunity to make money – insuring against the default risks of borrowers. Thus came the CDS or the Credit Default Swaps. These risks were very different from the insurable risks we discussed earlier. There is a higher possibility that an unusually large number of borrowers may default together, if the economic conditions change, e.g. interests rise – thus making the floating-rate home loans costlier to service or if the house prices fall – thus reducing the value of the house collateral less than the outstanding loans.

This was (probably) not understood by AIG FP or to respect their financial acumen, one may say that they preferred to ignore the risks. Was it overconfidence in their abilities?

Be careful of the overconfidence. It can lead one to make very costly mistakes.

#RidingTheRollerCoaster – 166

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