Over-dependence on derivatives hit AIG (With ‘Inside the financial tsunami’)October 3rd, 2008 - 5:35 pm ICT by IANS
New Delhi, Oct 3 (IANS) The US financial tsunami has washed out giant investment banks of the US and has led to many commercial banks being bought over or nationalised. But what hit the world’s largest reinsurance company, the American Insurance Group (AIG)?In the US, every fourth house, every sixth vehicle and every seventh aircraft is insured by AIG. Even then, it got into deep trouble and had to be bailed out with an $85 billion injection by the US government a few weeks ago.
The problems of AIG can be understood only with reference to the other global reinsurance giant General-Re, which was acquired by legendary investor Warren Buffet’s Berkshire Hathaway in 1998.
As early as March 2003, Buffet had warned of an investment time-bomb that was waiting to go off.
In his famous and plain-spoken “annual letter to shareholders”, Buffet had said the rapidly-growing trade in derivatives poses a “mega-catastrophic risk” for the economy and most shares are still “too expensive”.
Derivatives are financial instruments that allow investors to speculate on the future price of commodities or shares - without buying the underlying investment.
These instruments generate reported earnings that are often wildly overstated and based on estimates, the inaccuracy of which may not be exposed for many years.
Derivatives like futures, options and swaps were developed to allow investors hedge their risks in financial markets - in effect, to buy insurance against market movements - but they quickly became a means of investment in their own right.
The derivatives market exploded during the last decade, with investment banks selling billions of dollars worth of these investments to clients as a way to off-load or manage market risk.
But Buffet argued that such highly complex financial instruments were time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.
Some derivatives contracts, Buffet said, appear to have been devised by “madmen”.
He warned that derivatives could push companies onto a “spiral that can lead to a corporate meltdown”, like the demise of the notorious US hedge fund Long-Term Capital Management in 1998.
Derivatives also posed a dangerous incentive for false accounting, Buffet said.
The profits and losses from derivatives deals are booked straight away, even though no actual money changes hand. In many cases, the real costs hit companies only many years later.
For these reasons, Buffet told shareholders in 2003 that his investment group Berkshire Hathaway would pull out of the market and would close down the derivatives trading subsidiary that it bought as part of General-Re.
In his letter, Buffet compared the derivatives business to “hell… easy to enter and almost impossible to exit” and predicted that it will take years to unwind the complex deals struck by its subsidiary General Re Securities.
AIG, however, continued to deal in derivatives in the hope of creating a more diversified revenue base and now the time bomb has gone off while Buffet’s Berkshire Hathaway continues to give shareholders healthy returns.
Also, unlike Buffet’s insurance operations, AIG failed to charge enough premium for the risks it assumed. It diluted insurance standards in its urgency to grab market share and get more premium income.
A skewed risk-return spectrum and too many complex derivatives deals finally caught up with AIG and almost sent it under.
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Tags: american insurance group, berkshire hathaway, catastrophic risk, derivatives market, futures options, global reinsurance, letter to shareholders, reinsurance company, time bombs, weapons of mass destruction