AIG, credit-default swaps: the leakage is already here

September 16, 2008

Most attention, at least in the mainstream media, is directed at the potential ‘leakage’ of the crisis from financial markets to other parts of the economy. The most likely avenue for such leakage according to the media is through AIG. A potential demise of AIG, a major player in the re-insurance field, would send a shock to insurance market and would affect dramatically the premiums that business pay, even if they were insured through insurers other than AIG. This assumption is correct, but what seems to be neglected is that default risk is already commoditized and there exists a very active market for default derivatives (credit-default swaps, or CDS): contracts that give their owners a protection against the default of a specific entity. Hence, the prices of such contracts can indicate whether and to what extent the crisis has leaked to the economy at large. It has to be noted that there exists no central market for default swaps, as it is an area of unregulated OTC trading. Still, there are enough market makers in CDS to provide a picture. For example:

Credit-default swaps on Morgan Stanley soared 194 basis points to 458 and Goldman Sachs jumped 122 basis points to 321, according to CMA Datavision prices. Sellers demanded 50 percentage points upfront and 5 percentage points a year to protect the bonds of Washington Mutual Inc. from default on concern that the biggest U.S. savings and loan won’t survive the credit crisis, CMA data show. That compares with an upfront cost of 40 percentage points on Sept. 12 and means it would cost $5 million initially and $500,000 a year to protect $10 million in bonds for five years.

Note: it is true that AIG is a major seller in this market too, and if it goes under it will put the market into an imbalance. Yet, I would dare to say that here AIG is more a symptom than the main cause, as it seems that the problem is not specific to certain companies and that lack of confidence is translated very efficiently to illiquidity.

2 Responses to “AIG, credit-default swaps: the leakage is already here”

  1. danielbeunza Says:

    I do not disagree with the post, but I guess I don’t see the implications. As you say, and unlike an investment bank, AIG is always on the same side on these securities (selling insurance) and is the largest provider. Removing AIG from the picture would have meant a major blow. OK, so I agree so far.

    Now, I am not sure I understand the distinction between symptom and cause, and I fail to see the implications from the distinction. Do you mean that a bailout is unnecessary? Or do you mean that AIG is fundamentally healthy and that for that reason it deserves a bailout?

  2. yuvalmillo Says:

    I’m not taking a position regarding the bailout. I referring to a different matter: has the crisis already leaked to the real economy? Some say that if AIG goes under then the crisis would leak to the rest of the economy through increasing premiums. I try to show that the crisis has already leaked, as the prices in the credit-default swaps indicate.

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