the root cause of the failure of AIG FP is that they were off by an order of magnitude as to what the risk was they were betting against
"The Seed Of Ruin Is Planted
- That year, JP Morgan approached AIG, proposing that, for a fee, AIG insure JP Morgan's complex corporate debt, in case of default. According to computer models devised by Gary Gorton, a Yale Business Professor and consultant to the unit, there was a 99.85 percent chance that AIGFP would never have to pay out on these deals. Essentially, this would happen only if the economy went into a full-blown depression, in which case, the AIGers believed, the counter-parties would be wiped out, and therefore would hardly be in a position to demand payment anyway. With the backing of Cassano, then the COO, Savage greenlighted the deals. Credit default swaps were born."
From TPM's brief history of AIG(FP)
really, their estimate was mean time between failure was 666.67 years, approximately
[that is assuming credit time scales of 1 yr - if it was multi-year it is just absurd, if it was 3-6 month terms then the odds are more sensible, but make a nonsense of the counter-parties being wiped out - hey would you estimate the rate of corporate bond delinquency being every 2000 years, as in the case of 3yr bonds...? - now if they had estimated 98.5% odds, then they'd have at least been playing in the right ballpark, but then they might have felt obliged to set aside loss reserves instead of paying out bonuses...]
the great depression started 80 years ago, the 19th century had several major economic downturns, the 18th and 17th centuries each had major crashes
666 years takes us back to the Black Death!
I'd be kind and say the AIG whiz kids thought that was the magnitude event that'd trigger their defaults, were it not for the Great Plague that came in between sometime in there.
just Bayesian estimators would tell you they're off by at least a factor of 2, and realistically they were off by a factor of roughly 10
the JPM folks got a deal though, eh
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