So Much for Computer Models

The experts and their computer models indicated it was practically impossible. Yet, the supposedly remote possibility that credit default swaps (CDS) would wreck AIG was a virtual certainty when the company's management decided to take the plunge into selling contracts on securities backed by sub-prime mortgages.

A CDS is similar to insurance in that the buyer of the contract pays a premium to the seller (AIG) in exchange for protection against the default of the security or loan. AIG entered the business on the basis of the estimate that there would be a 99.85 percent chance of never having to pay out. This estimate was based on years of data collected on the ups and downs of corporate debt. According to the model, in order for AIG to suffer a major loss on these contracts by having to cover the defaults the economy would need to go into depression. In the short run, the company made hundreds of millions of dollars from the fees it collected on the contracts.

Of course, the problem with this is that mortgage-backed securities are not corporate bonds, no matter how highly rated they are. Add to this the fact that the rating agencies were not really doing their job, and the result was predictable: AIG would eventually receive demands for huge payouts it simply could not cover. The rest is bailout history.

For an excellent discussion of the bailout and how AIG got into this mess see the Washington Post series The Crash: What Went Wrong? http://www.washingtonpost.com/wp-srv/business/risk/index.html