AIG World of $1.6 Trillion Derivatives Trouble
By - March 20, 2009

The investors that own many of the derivative securities at the center of American International Group's collapse are among the world's and this country's biggest investors, sources told The Post. People familiar with the matter said buyers of AIG Financial Products' derivatives, which consist mostly of collateralized debt obligations tied to mortgages, include Middle Eastern sovereign-wealth funds and the Chinese and Indian governments, which are also among the biggest holders of US Treasury securities. Exactly how much AIG has in derivative exposure is subject to debate. While AIG's beleaguered CEO Ed Liddy (pictured above) told a House subcommittee yesterday that the insurer's exposure is around $1.6 trillion, others have dismissed that figure as not reflecting actual losses. – NY Post

Dominant Social Theme: AIG – a pretty big mess!

Free-Market Analysis: Here's our question. If AIG has a potential US$1.6 trillion exposure, and it is JUST ONE COMPANY, how much more exposure is out there of this nature? Journos in business pubs throw around the figure US$400 trillion and it seems perfectly likely if, indeed, AIG's exposure is one and a half trillion. What is even more interesting is that according to the article excerpted above, no one seems to know, even now, how much of this exposure has made a loss.

"[If] somebody's got $1.6 trillion in notional exposure, they could potentially be at great risk, but we just don't know," Campbell Harvey, finance professor at Duke University said. "It's really hard to tell, and it's very frustrating. We own this firm but we're not privy to the information." But others who know AIG's derivatives business model said the $1.6 trillion figure represents the total that AIG could be on the hook for if things go awry. "If everything they wrote 'protection' on goes to zero, it would equal that [$1.6 trillion]," said one derivatives trader. "Generally they're not hedged."

In the case of AIG then, everything we were led to believe about derivatives exposure seems at least partially true. For the financial world, certain large firms like AIG have tremendous exposure and little in the way of hedging. If the bets all go against AIG, the current bailout of AIG would have to be upped at least tenfold into the trillions. And, again, AIG is just one company.

What are the chances that things continue to go awry for AIG? In fact, there are further complications. These have to do with fairly extensive bets in the commercial real estate market that AIG execs apparently fear is going south. Will it turn as sour as the home-mortgage market? In the current environment who would bet on the proverbial V shaped recovery? The chances seem far greater that the economy will continue to unwind in the United States and Europe until a point of maximum inflection is reached. And that could be many billions or trillions and several years away. In Japan, the unwinding, cushioned by government reluctance to let nature take its course, lasted at least a full decade. And actually Japan is back in the soup once more. Bailouts soften the descent perhaps, but they also prolong it.

The company is also worried about the commercial real-estate market, which has yet to record the same kinds of losses, but is very much a ticking time bomb. According to internal documents assessing AIG's systemic risk, "AIG's original problem, an overreliance on US residential mortgage-backed securities in its investment portfolios, has now been deepened by weakness in the commercial mortgage-backed securities market."

Again, keep in mind that AIG is just one company among many. Almost every very large financial firm, and many banks, must have a backlog of fairly large derivatives plays. It is this, we have supposed that is weighing on the market, and until these bets are better known, and even unwound, it is difficult to see how the financial crisis will end. What good does it do to print money, or even give people make-work jobs when the financial system itself remains in such apparent jeopardy.

After Thoughts

It is not odd but fairly disheartening that with the exception of scattered articles the mainstream press has not exactly pressed the derivatives story. It is a BIG story but the screaming headlines on the front covers of Business Week, Forbes, Fortune and European mags as well seem to be lacking. Is the idea that if the financial community ignores the derivatives exposure of the world's major financial entities that it might somehow go away? Perhaps the derivatives time bomb is not so dangerous after all and will work itself out. But there are several other possibilities. It might just shatter what remains of the world's modern financial system. In doing so, it may usher in a new kind of currency, or failing a consensus on what to do next, the world might just lapse back into a private silver-and-gold market standard. We would bet, not happily, that there is still plenty of pain to come.

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