Friday, March 20, 2009

AIG but at least not about bonuses

I'm thinking back to the long ago days when AIG was an AAA rated corporation. I just thought of a new financial situtation which was almost identical to the situation at the time except that AIG would not have been rated AAA.

The situtation at the time includes a special purpose entity (SPE) issues a debt instrument. A bank buys the debt instrument and insures with a CDS from AIG.

An almost identical setup, except for the ratings, would be if AIG bought the debt instrument from the SPE and issued a bond with the same face value and the SPE issued a CDS on the AIG bond. Finally AIG would issue a super special CDS on AIG which is senior to all debt (legally impossible I think) and the SPE buys this special AIG issued AIG CDS. To the client who buys the AIG bond and the CDS the flow is the same. The client is paid in full unless both AIG and the SPE go bankrupt. The client will have to pay more for the AIG bond and less for the CDS but it should be same cash flow same total price.

To AIG the risk is the same. They just pass on the interest from the SPE instrument so long as the SPE pays and take a hit if the SPE goes bankrupt. The SPE has the same flow. If counterparty risk weren't priced in CDSs the flows would be identical.

However, AIG would have a rather different balance sheet. This way everything is really almost the same, but AIG would have an additional $ 3 Trillion in debt. This would give AIG a debt equity ratio which would make an AAA rating impossible (or AA or well I don't know but they would have appeared to be super leveraged as indeed they were).

Here I think the only difference is that on balance sheets CDSs written are recorded at market value not at notional value. Thus CDSs written on $ 3 trillion of debt instruments didn't look huge on the balance sheet.

I think my current effort is a slight improvement over my past efforts to describe an example which shows why current accounting practices and ratings agencies approach to balance sheets don't work together.

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