What AIG really did, and why folks should be even angrier...

The irritating bonus kerfluffle aside, the real crime that AIG committed was way more widespread and far more damaging to the global financial system: the creation of a massive and mindless concentration of risk. Here's Gillian Tett in today's FT: Tett: (emphases mine)

After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.
But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else.
Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.

Far from promoting “dispersion” or “diversification”, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.
AIG, for its part, blames this outcome on an unforeseen outburst of “systemic risk” (or, as its website says: “It is the quintessential ‘knee bone is connected to the thigh bone . . . ’ where every element that once appeared independent is connected with every other element.”)

The real problem, though, is that AIG – like other institutions – has been extraordinarily complacent about trying to analyse correlations of risk. Before the summer of 2007, almost no one inside AIG worried about the fact that subprime mortgage contracts all tended to look very similar.
Nor did they notice that these subprime loans were being bundled into similar types of collateralised debt obligation structures, with similar trigger points – and then insured by AIG with similar deals.

Anyone want to place any bets as to what other risks - beside bank risks - have been concentrated at AIG? I, for one, wonder about massive 'shadow' banks - hedge funds, private equity firms, even perhaps some SWFs. It was interesting to note Sunday night that none of these entities were listed as secondary beneficiaries of AIG bailout money...


Another shoe to drop?