Are the AIG revelations about its counterparty risk the beginning of the end for the financial crisis or the end of the beginning.

An article in the Financial Times by Gillian Tet makes some interesting points. Speaking to the recently divulged list of counterparties which received payments from AIG she says:

After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.

But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else.

Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.

Far from promoting “dispersion” or “diversification”, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.

AIG, for its part, blames this outcome on an unforeseen outburst of “systemic risk” (or, as its website says: “It is the quintessential ‘knee bone is connected to the thigh bone . . . ’ where every element that once appeared independent is connected with every other element.”)

Tett seems to believe that the banks were dumping their risk with AIG while not realizing that everyone else was also doing the same thing. That seems to be a stretch given the cozy world of banking and the constant movement of employees among the major players. It’s rather more plausible that the industry was able to churn out the risk in such incredible volumes precisely because it knew that AIG would be waiting to take it off of their hands.

Ms. Tett then goes on to argue that no one inside AIG realized that they were insuring the same thing over and over again.

The real problem, though, is that AIG – like other institutions – has been extraordinarily complacent about trying to analyse correlations of risk. Before the summer of 2007, almost no one inside AIG worried about the fact that subprime mortgage contracts all tended to look very similar.

Nor did they notice that these subprime loans were being bundled into similar types of collateralised debt obligation structures, with similar trigger points – and then insured by AIG with similar deals.

After all, when the credit markets were benign, such similarities barely appeared to matter: AIG just collected the fees. But what has become clear in the past 18 months is that those endemic similarities created the propensity for a deadly “tipping point” to occur: once one contract turned sour, numerous other deals turned sour, too. Hence those eye-poppingly large losses.

Once again, she suggests that the responsibility for figuring out that this was a disaster in the making was something AIG should have discerned. In fact, it is something that all of the players should have deciphered. She devotes some time to the notion that AIG did not understand correlation well enough. That it was a failure of quantitative analysis to point out the problem. I would suggest that the naked eye could have well discerned the problem with no assistance from mathematical formulas.

But reverting to my prior point, I think the attempt to lay all the blame at the feet of AIG is misdirected. Those laying off the risk had a responsibility to determine the capacity of the insurer to perform. At some point it would have been manifestly clear that the ability of AIG to perform had been exceeded. 

Ms. Tett winds up her article with a useful thought.

And therein lies an important moral. Notwithstanding the disaster at AIG, the basic idea of using derivatives contracts to share risk is not stupid; on the contrary, risk dispersion remains a sensible idea, if used in a prudent, modest manner.

But diversification can only occur if potential correlations are monitored – and that oversight can only take place if the business of risk transfer is made as visible as possible. That means that regulators and investors should demand dramatically more disclosure about credit derivatives deals and about their counterparties, too. The type of transparency seen at AIG this week, in other words, is not just badly overdue; it now needs to be replicated on a much bigger scale. 

Good words to remember as we move towards some new regulatory scheme. But there is something about this that keeps gnawing at me.

With the AIG counterparty disclosures we have seen what many have speculated and written on for the past few months. Specifically, the interconnectedness of the entire system and, therefore its fatal weakness. The system is so concentrated among so few players so dependent upon none failing that risk appears to never have been truly dispersed. All live or die based on the fate of the others.

But have we really gotten to the crux of the problem with AIG? Is it the center of the universe or have we just begun to lift the skirt. We are beginning to get a sense of the relationships among AIG and the rest of the financial system but is there another time bomb waiting in some other sort of multilateral relationship among the players. In effect is there another concentration of risk out there on this order of magnitude.

It would seem that we have dallied long enough in exposing the whole scheme to the light of day. It’s past time to devote some fairly significant resources to defining the extent of this whole system.