Friday, November 14, 2008

October 8th, 2008 1437 GMT
AIG is in better health than most of us as you can see that we are not able to have a retreat that AIG were enjoying not so long ago. Something is definitely wrong with the whole reaction to the current crisis and are we seeing the forest for the tree? by elberty chanty in
compare with October 02, 2008 in Knowledge@Wharton
That was the beginning of the housing price cycle, housing prices going up. So far, so good. You keep going and say okay, now what happened and how far did it go? And we all know it went a very long time. There were a couple of things that were really important, though, that got everybody sort of out of kilter. Usually when these bubbles happen, it's almost always because of the fact that you miss the forest for the trees. And the way this cycle- People missed the forest for the trees. They relied on the rating agencies, the paper coming off was triple-A. Triple-A paper. Think about that. If you're a risk manager and you say, "This is a triple-A piece of paper." And they stress it. How bad can it be? I'm not so sure
too many would say it could go to zero. I can understand it can go down, but there are not too many people in any risk management area that's going to say it's going to go down to zero. So that was the first thing. The second thing that everybody relied on was while this securitization. And this paper was made to satisfy the fixed income demand out there, this paper was distributed wildly. The risk was distributed-- so back a year ago, in July, when all this started, people were pretty relaxed about it. They said, "You know what? This risk, I know there's risk, but it's fully distributed. Each one of us own $3.50 of this, so what's the big deal? We can take the losses, move on."
The other major surprise was that 15 to 20 large financial institutions owned basically all the risk. Now, you know. So the reason why we're here today is, in many ways, the fact that a large group of people missed the forest for the trees. It's not that they weren't managing risk correctly. They were. But how do you think about risk in a triple-A bond? It's very hard to figure out what that is. It's not that they weren't thinking, "Well, you know, I want to make sure these things are priced correctly." They were. But they assumed everything was fully distributed. You make very different assumptions if you thought 15 people owned all the risk. And the net result of all of that is that through everything that happened, the real shock to the financial system was that the banking industry, as a result, did not have enough capital to cover the losses that were coming through.
And the result of that is what you're seeing in the markets today. A lack of lending by banks. It is a mad fervor to say, if I am too overleveraged as a bank, how do I sell assets to de-lever and in that cycle, what happens is that you get to the kind of strains and stresses that occurred over the last couple of weeks, where people say, "Well, you know, if these financial institutions have taken losses and they have to de-lever, I am not so sure I want to own their stock or their bonds. I don't know what the risk profile is." And it creates a little bit of panic.
So that's what happened. Now it was important for me to share that with you. I can do this in sound bites, by the way, very well as well. But you are all students of finance and I wanted you to sort of understand, sort of piece by piece, what came together. I don't know if you're ever going to stop this "forest for trees" problem and I'm not so sure that's an objective, ever. No risk means no business. So the reality is that it's not about removing the risk of having these kind of things happen; it's about trying to find some balance and optimizing and finding a financial system architecture that can help you deal with these things so you don't get to the kind of stages we got to. One thing we all have to keep in mind is that the architecture, the regulatory architecture of the U.S. was set in the first 30 years of the last century and there were changes to it, but not enough. ... Now the principles haven't changed but the technology has changed a lot, and so a big part of what we have to do is re-do the regulatory architecture of the U.S. financial market. And when you think about that, it's going to have to be as comprehensive as it was, following the '20s of the last century and what happened in the '30s -- '33 Act, '34 Act, '35 Act and on and on and on. That's [what] we're headed towards.

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