The markets are inundated with zombie myths. No matter how many times you stab them through the heart, you just can't kill them.
 
What's taking down these grand financial icons such as Lehman and A.I.G.? It couldn't possibly be that the companies themselves made stupid and shortsighted decisions. So it must be a conspiracy of the short-sellers. It must be some wrong-headed accounting rules and bad regulation.
 
In the wake of the demise of A.I.G., we are hearing them again. If only the insurer didn't have to mark its positions to market, this foolishness would have been avoided and we'd all be celebrating how wonderful the economy is. The S.E.C. has rushed to put up restrictions against short-selling again.
 
And in the Wall Street Journal today, Zachary Karabell writes that the "root cause" of the current meltdown is "bad regulation." His evidence? That A.I.G. had to mark its positions to the market even though it issued a statement saying that the market was getting it wrong.
 
It issued a statement! Well then! Case closed.
 
Not so fast. It seems we must review the case of A.I.G. What exactly went wrong at the insurance behemoth?
 
For several years, A.I.G. dove headfirst into an insurance-like product called credit default swaps. It wrote hundreds of billions worth of protection mostly on the top slice of mortgage-backed structured financial products. Short-sellers and accounting rules didn't cause A.I.G. to enter the C.D.S. protection business.
 
Supposedly A.I.G. had an expertise in insurance, being the largest of its kind in the world. Insurance is hard to price correctly. When the hurricane hits, were you getting enough money from homeowners all those years? It's a difficult question. But when it was initially writing all that C.D.S. protection, A.I.G. thought it wasn't possible to take a penny of losses because its contracts were backstopping such highly rated, highly protected slices, according to an ex-A.I.G. Financial Products employee I spoke with this week. (That makes perfect sense since this was the same mistake made by the bond insurers M.B.I.A. and Ambac.)
 
Each time the company wrote one of those contracts, a grain of sand should have dropped to the bottom of the hourglass until an A.I.G. risk-management official said: "Enough. You can't write anymore." But that didn't happen. Short-sellers and accounting rules didn't make the company put little-to-no capital against these positions.
 
Back when A.I.G. started writing these contracts, the credit-ratings agencies rated the insurer Triple A. Accounting rules didn't prevent the ratings agencies from re-assessing the rating before the crisis. And while it may be hard to believe, short-sellers did not stick their voodoo dolls with their "Maintain the Triple A Rating Until It's Too Late" pins.
 
A.I.G.'s counterparties didn't require that the insurance company put up any collateral—called initial margin— because its rating was so high. This wasn't an accounting rule. This was a general agreement among the players in the C.D.S. market.
 

Then the underlying mortgage-holders started to default, leading to the value of the super-senior tranches to decline and the spreads on the C.D.S. to widen. Counterparties wanted some collateral to reflect the changes in the market. The credit-ratings agencies downgraded A.I.G., leading to even more demands for collateral.
 
Does anyone seriously think that the counterparties said to A.I.G., "Hey man, we don't want you to put up any cash. We know it's stupid, but our hands are tied by those damn accounting rules!" Hardly. They wanted their cash now. If these positions were marked-to-model rather than marked-to-market, does anyone think that the counterparties wouldn't have written any collateral triggers into the contracts?
 
And here let's pause to dispense with a ridiculous assertion from Karabell, which makes one seriously question the credibility of his argument that the market is somehow overreacting ridiculously. He writes in his WSJ op-ed today that the value of the mortgages only has dropped about 10 percent or 20 percent, so how could the value of the securities been wiped out? "There's something wrong with that picture: Down 20 percent doesn't equal down 100 percent," he says.
 
But of course it can. That's what "leverage" means. When you have a C.D.O. made up of mezzanine tranches of subprime M.B.S., down 20 percent in the underlying can mean exactly that.
 
Now for the sake of argument, let's say that the market overreacted horribly. Let's contemplate that short-sellers were too convincing. They caused needless panic, helping drive the spreads on the C.D.S. protection way too wide, in turn driving the value of A.I.G. equity down to absurdly low levels. This was causing paper losses, but there were also real credit rating agency downgrades. But it wasn't anything substantive—a mere liquidity crisis at the insurer.
 
If that were so, why didn't the insurer find buyers? Why didn't the private-equity firms swoop in? They did examine A.I.G.'s books this past weekend. What they found was that the amount that A.I.G. needed was undeterminable. It was an unfathomable black hole. At first it seemed like the company would only need $20 billion. Then on the weekend, the number doubled to $40 billion. Then on Sunday, the Asian markets opened and suddenly the firm needed $60 billion, according to the WSJ. Was $60 billion the right number? Who knows?
 
The private-equity firms weren't basing their estimates off of silly securities regulations or dumb accounting rules. They were trying to estimate the value of the company. They were allowed to use whatever valuation technique they liked. And they couldn't come up with anything because they couldn't determine the value of the underlying assets.
 
A.I.G. got into something it didn't understand and didn't protect itself properly. The market-based watchdog—the rating agencies—failed to assess its risk properly. In the market panic, A.I.G.'s counterparties acted rationally to demand more cash, their actions having nothing to do with accounting rules. And the buyers balked.
 
And no amount of zombie tales will bring the company back.