« "Transatlantic Divergence in Tackling the Crisis" | Main | The Temptation for Protectionism: Lessons from the Great Depression »

Tuesday, March 17, 2009

“Concentrations of Risk, Plagued with Deadly Correlations”

Brad Setser says we can think of AIG as the "insurer-of-last resort to the United States’ own shadow financial system":

“Concretations of risk, plagued with deadly correlations”, by Brad Setser: [Update: Brad DeLong gives this post the descriptive title "Why We Own AIG".] The FT’s Gillian Tett makes a simple but important point: AIG’s role in the credit default swap market meant that a lot of risk that the bank regulators thought had been dispersed into many strong hands ended up in a single weak hand.

Tett:

...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. ...

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.

If the US creates a “systemic risk” regulator, it should be on the lookout for similar concentrations of risk.

One other point. The fact that several of AIG’s largest counterparties are European financial firms is by now well known. What is I think less well known is that the expansion of the dollar balance sheets of “European” financial firms — the BIS reports that the dollar-denominated balance sheets of major European financial institutions (UK, Swiss and Eurozone) increased from a little over $2 trillion in 2000 to something like $8 trillion (see the first graph in this report) — played a large role in the US credit boom.

As the BIS (Baba, McCauley and Ramaswamy) reports, many European banks were growing their dollar balance sheets so quickly that many started to rely heavily on US money market funds for financing. And if an institution is borrowing from US money market funds to buy securitized US mortgage credit, in a lot of ways it is a US bank, or at least a shadow US bank.

Consequently I think it is possible to think of AIG as the insurer-of-last resort to the United States’ own shadow financial system. That shadow financial system just operated offshore. There was a reason why investors in the UK were buying so many US asset backed securities during the peak years of the credit boom.

One of the selling points of financial innovation was that it would distribute risk widely thereby insulating the the financial sector from large shocks. Everyone would take a small loss, but no loss would be large enough to cause any real difficulties. That turned out to be a false promise in the face of a large, systemic shock. As problems began developing in these markets, it became evident that risk was far more concentrated than the promoters of new financial products had claimed.

    Posted by on Tuesday, March 17, 2009 at 10:44 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (52)

    TrackBack

    TrackBack URL for this entry:
    https://www.typepad.com/services/trackback/6a00d83451b33869e2011168fde038970c

    Listed below are links to weblogs that reference “Concentrations of Risk, Plagued with Deadly Correlations”:


    Comments

    Feed You can follow this conversation by subscribing to the comment feed for this post.