The Devil in the (Derivative) Details: AIG, Fortis

We wrote a couple of days ago that one of the reasons for rescuing AIG was that its failure would have had a devastating impact on EU banks. The insurer had entered into credit default swaps that enabled European banks to evade minimum capital requirements. Thus, an AIG failure would have put a considerable number of banks below required levels, creating another round of panic and in an extreme case, possibly leading to more failures.

Reader John helpfully provided us with the level of the Euro banks’ reliance on AIG, at least as of the end of 2007, per AIG’s annual report:

… Approximately $379 billion (consisting of the corporate loans and prime residential mortgages) of the $527 billion in notional exposure of AIGFP’s super senior credit default swap portfolio as of December 31, 2007 represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation. …

It isn’t clear whether this translates euro for euro into reduced capital requirements (the amount of capital required under Basel II is dependent on credit rating), but $379 billion is a very big number.

Another reader pointed to this section of a on the Fortis recapitalization:

Within the CDO origination portfolio, the high grade assets are anticipated to be written down to 25% and the mezzanine and warehouse positions to 10%. On average 78% of the total CDO origination portfolio is written down.

As he noted:

I did not keep track of where other banks stand on that front, but this looks pretty bold. So I expect Fortis’ auditors to start arguing for similar cuts in their other clients’ CDO portfolios, with the dire consequences that we know in terms of solvency ratio / capital needs / share price… at least for those banks who are not “en cour” with the Treasury Secretary.

CDOs are sufficiently heterogenous that maybe, maybe, some firms still holding large CDO positions may be able to argue for better treatment. But the flip side is that the few trades that have taken place appear to be at pretty distressed prices, and the residential and commercial real estate markets continue to go south, and LBO loan prices (LBO loans were sometimes included in CDOs) are falling, so auditors have every reason to insist on lower valuations if bank have failed to implement them.

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  1. Matt Dubuque

    Matt Dubuque

    Acknowledging the heterogeneity of these instruments, my best judgement is that within six weeks, marking these CDOS at 78 cents on the dollar will prove to have been a material (though possibly not substantial) overvaluation.

    Matt Dubuque

  2. Anonymous

    Not clear if this means CDO portfolio is written down to 22% (100-78) or if 78% of the CDO portfolio is written down. I would guess the former.

  3. ruetheday

    I’m not real familiar with the Basel II details, but it seems to me that buying a bunch of risky assets and then getting CDS insurance on them to meet risk weighted capital requirements exposes a serious flaw in the regulatory regime – it allows you to trade direct credit risk for counterparty risk.

  4. Anonymous

    I suspect the CDS buying was at least partially defensive. On the face of it Basel II is designed to allow dodgy banks to choose their own capital and for the regulators to say “nothing to do with me, guv” when it all blows up. The most judgemental of the three Basell II calculation strategies basically says “rate the risk however you want but document the assumptions”.

    HOWEVER, there’s a requirement that this recalculation (for Foundation and Advanced approaches) can’t be less than a capital floor of 95%, 90% and 80% of the prior year for 2007, 2008 and 2009 respectively (according to FSA website).

    I read that to mean BASEL II can’t be used to slash minimum capital in a hurry, and thus the CDS buying was to avoid allocating MORE capital rather than pro-actively hold LESS.


  5. m

    I read “written down to 25%” to mean written down to 25 cents on the dollar.

    So on average all CDO’s are written down to 22 cents on the dollar, i.e. they lose 78% of their book value.

  6. Namazu

    I don’t see how anyone can argue with ‘mark to 22’ on definitional grounds at least. Le compte est bon!

  7. rmlnyc8

    That is precisely the problem. CDOs, like all securitizations, should contain homogeneous assets.

  8. eh

    …for the purpose of providing them with regulatory capital relief rather than risk mitigation.

    What is the reason for such arrangements other than to boost profits in a very, very risky way? And then these banks have the nerve to ask for, and in some cases to more or less expect, government/taxpayer help. I wonder how many members of Congress — who are about to vote/cave on the bailout — are even remotely aware of issues like this? Versus just responding to market blackmail — it’s either a bailout or a depression — and the whining of Paulson, Bernanke, et al.

  9. wintermute

    I recall reading that Goldman Sachs was lumbered with a $65bn LBO portfolio. Wonder how that will do on rollover dates next year…

  10. Elimo

    Basle II banking book credit risk might not allow the kind of ‘AIG’ wrap on super senior tranches but the trading book market risk internal model approach allows such offsets. No wonder BIS has proposed a sizable increase in trading book market risk internal model charge – to include a very big piece called ‘incremental risk’ as proposed on 22 Jul.

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