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AIG's Risk Models Missed Major Risks

Getty ImagesIt seems just about every week we hear about more money the government is funneling to insurance giant AIG. Today’s Wall Street Journal helps explains how such a massive company ended up becoming a pauper (subscription only).

It turns out, the fancy pants computer models on which AIG depended to gauge risk didn’t actually account for, well, the major risks.

As we have noted, AIG was brought down by its huge trades in credit-default swaps, which are essentially insurance on investments. Companies would buy swaps from AIG – paying AIG a regular fee – and in turn AIG would promise to pay up if the underlying investment went belly up.

It was a massive business for AIG. As of last year, it had a portfolio of swaps worth about $500 billion.

AIG used complex computer models to calculate the risk that investments would default and thus AIG would have to cover the losses. Except as the Journal details, the models skipped over other major of types of risk:    

The buyers of the swaps -- AIG's "counterparties" or trading partners on the deals -- typically have the right to demand collateral from AIG if the securities being insured by the swaps decline in value, or if AIG's own corporate-debt rating is cut. In addition, AIG is obliged to account for the contracts on its own books based on their market values. If those values fall, AIG has to take write-downs.

The problem for AIG is that it didn't apply effective models for valuing the swaps and for collateral risk until the second half of 2007, long after the swaps were sold, AIG documents and investor presentations indicate.

The calls for collateral, which AIG’s models ignored, have been at the center of AIG’s cash crunch.

As the subprime market was continuing to go downhill last year, AIG’s clients began worrying AIG wouldn’t have the cash on hand to pay them if more investments went bad. So they began demanding more collateral from AIG. Then, the Journal reports, in December of last year, AIG’s outside auditor warned of "material weakness" in the company’s positions and risk assessments.

Days after that warning, AIG’s then-CEO, Martin Sullivan, gave a presentation to investors telling them the company’s risk models were "very reliable."

According to the Journal, the FBI is now investigating "whether AIG executives misled investors at that meeting."

Another item on the investigation list, says the Journal, is the question of whether AIG also "misled its outside auditor."

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