AIG Crisis and a Risk Assessment Model - Case Study Example

AIG either misled its investors or was really in the dark about the potential risk when in during a meeting last December, it assured the investors that this model gave AIG "a very high level of comfort." The problem with the model was that while it took historical data into account to assess the potential of default, it would not consider the risk of future collateral calls or write-downs, which has destroyed AIG. The firm also suffered because it had not protected itself through hedging which resulted in exposure to very large collateral calls.

AIG has already paid around $8 billion to $9 billion to Goldman Sachs Group in collateral because it was one of the trading partners. Such payments will continue even after the bailout. Gorton had always been passionate about mathematics and joined AIG in 1990. He was paid $250 per hour or around $200,000 a year for his model. He would collect data to assess and forecast losses of various assets including home loans and corporate bonds. AIG came to depend on his models excessively. Since Mr. Gorton never considered write-downs or collateral payments to partners, his plan was faulty.

He was only focusing on covering actual default. The swap business started in 1998 and AIG was soon the largest seller of credit-default-swap protection.Debt securities became more complicated over time and so did swaps. Around 2004, AIG began selling swaps to ensure collateralized-debt obligations, or CDOs, that were backed by securities such as mortgage bonds. Merrill Lynch was a major client. By 2005, AIG started worrying about loose standards in the subprime-mortgage market. But by the time it stopped selling credit protection on multisector CDOs, its exposure to multisector CDOs had ballooned to $80 billion.

By mid-2007, concerns started mounting at AIG about credit-default swaps and the real blow came when Goldman demanded $1.5 billion in collateral saying that assets backing its securities were losing value. The deal was settled when AIG agreed to pay $450 million to Goldman.Things kept worsening and by July 31, 2008, AIG had handed over $16.5 billion in collateral on its swaps. By the following month, the loss was estimated at $8.5 billion. When trading partners began demanding additional collateral in September and August, AIG was in serious trouble.

And that same month, its collapse became public. The government rescue plan stepped in but failed to stop the demands for collateral payments and by Oct. 8 it had risen to $123 billion.One morning last week, MR. Gorton explained to his students at Yale University why the model had collapsed and said that it was a problem in just one sector and didn't necessarily put the integrity of the entire model in question.