AIG: The CDS Market Bailout

I would never presume to understand what Hank Paulson is thinking. But here's one idea of why he bailed out AIG but not Lehman: the asymmetry in their respective CDS positions.

Back in the blissful days of April 2007, I wasn't very worried about the systemic risk such instruments posed:

The derivatives market can't crash, in the way that the stock market or bond market can. It's a zero-sum game where for every loser there's a winner. Theoretically, the net amount of wealth tied up in derivatives is zero, which means that no wealth can be destroyed by a market event...
The great thing about derivatives is that short of a major investment bank failing, there's very little systemic risk involved with them.

Ahem. My bad: clearly I massively underestimated the chances of a major investment bank failing. But my mistake was actually bigger than that, because there was a much greater risk than an investment bank failing, which was the failure of AIG.

Investment banks, after all, are microcosms of the derivatives market as a whole: their positions generally net out to something very close to zero. If Lehman failed, went the theory, the rest of the market could just net out Lehman's positions and carry on trading.

AIG, by contrast, had a massively asymmetrical position in CDSs. It wrote vast amounts of credit protection, but bought very little. So if AIG were to fail, many people who thought they were sitting on massive mark-to-market profits on their CDS positions would wake up one morning to find them worthless. If they started marking those swaps to zero, the failures could easily start cascading.

And so the government bailed out AIG. The insurer will now be able to pay out in full on all the protection that it wrote.

But doesn't that mean that the rest of the CDS market -- everybody but AIG -- is, in aggregate, sitting on a tidy profit on their CDS positions?

It's hard to see an accurate picture of what's going on right now, given the noise associated with the short-selling plan and the bailout plan and the inevitable repercussions of Lehman's failure. But when the dust settles, it might just be the case that the CDS market turns out not to be as destabilizing as people currently fear, thanks largely to the AIG bailout.

Instead, if this financial crisis does continue to get worse rather than better, I suspect it will be due to old-fashioned bank insolvencies rather than blowups in newfangled derivatives.

Which, I'll admit, is hardly reassuring.