Wednesday, March 11, 2009

Insurance (4) - Banks and Risk

The banks and other financial institutions that bought CDOs also misunderstood the nature of risk. They assumed that insurance against default had eliminated the risk, so they purchased these financial instruments as if they were risk free. The reality was that they had swapped one form of risk for another. The risk of many homeowners defaulting had been replaced with the risk of a large monoline insurance company failing and defaulting on its obligation.

The risk of AIG defaulting could not be estimated on the basis of previous history, because this type of history does not repeat frequently enough. The default risk for AIG was probably very, very small, but the impact would be absolutely huge. The banks and institutions who trusted in AIG did not take this risk into account. Once the risk of mortgage default became widespread, the risk of AIG defaulting changed quite dramatically, but by then it was too late for anyone make change to mitigate the risk.

The government has now come to the rescue of AIG, but that does not eliminate the risk. The risk has just been transferred to all the taxpayers of the United States. This is not pooling of the risk, but pooling of the costs of default.

Note: the AIG bailout money flowed on to the banks with debt and securities insured by AIG. According to the Wall Street Journal, these include Goldman Sachs ($6 billion), Deutsche Bank ($6 billion), Merrill Lynch, Société Générale, Calyon, Barclays, Rabobank, Danske, HSBC, Royal Bank of Scotland, Banco Santander, Morgan Stanley, Wachovia, Bank of America, and Lloyds Banking Group.

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