It is July of 2007 and Alan Frost, executive vice president for AIG Financial Products (AIGFP) has just received a heads up on a margin call from Goldman Sachs. The next day the company served AIGFP with an invoice for collateral worth $1.8 billion on $20 billion notional value of credit default swaps (CDS) related to the housing market. As the market fell, homeowners defaulted, making the value of the securities underlying the CDS plummet. AIGFP had up until this point thought that the prospect of every having to pay up on the CDS was virtually non-existent. Students will have to decide if the company underestimated the risk.
From Free Lunch to Black Hole: Credit Default Swaps at AIG
by: Stefan Nagel
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After reading and discussing the material, students should:
- Explain how pooling and tranching allow for the creation of tranches of relatively safe securities from a pool of risky securities.
- Recognize that tranches of securitization deals can be viewed as portfolios of options on the assets in the underlying asset pool.
- Use insights from option valuation to evaluate the riskiness of super-senior tranches in multi-layered securitization deals and the correlation of default losses on the underlying assets in the pool.
- Assess the effects that a nationwide housing price decline and loan defaults have on the value of the super-senior tranches.