Pretrade and risk-based clearing: A case study of American International Group’s super senior CDS portfolio 2005-2008

Abstract

Purpose

Risk-based clearing has been proposed by Rausser et al. (2010) for over-the-counter (OTC) derivatives. This paper aims to illustrate the application of risk-based margins to a case study of the mortgage-backed securities derivative portfolio of the American International Group (AIG) during the period 2005-2008. There exists sufficient publicly available information to examine AIG’s derivative portfolio and how that portfolio would depend on conjectural changes in margin requirements imposed on its OTC derivative positions. Generally, such data on OTC derivative portfolio positions are unavailable in the public domain, and thus, the AIG data provide a unique opportunity for an objective evaluation.

Design/methodology/approach

This paper uses modern financial methodology to evaluate risk-based margining and collateralization for the major OTC derivative portfolio of the AIG.

Findings

This analysis reveals that a risk-based margin procedure would have led to earlier margin calls of greater magnitude initially than the collateral calls actually faced by AIG Financial Products (AIGFP). The total margin ultimately required by the risk-based procedure, however, is similar in magnitude to the collateral calls faced by AIGFP by August 2008. It is likely that a risk-based clearing procedure applied to AIG’s OTC contracts would have led to the AIG undertaking significant hedging and liquidation of their OTC positions well before the losses built up to the point they had, perhaps avoiding the federal government’s orchestrated restructuring that occurred in September 2008.

Originality/value

There has been no published risk-based evaluations of a major OTC portfolio of derivatives for any company, let alone the AIG.

Citation

Balson, W.E. and Rausser, G. (2016), "Pretrade and risk-based clearing: A case study of American International Group’s super senior CDS portfolio 2005-2008", Journal of Financial Economic Policy, Vol. 8 No. 2, pp. 228-247. https://doi.org/10.1108/JFEP-10-2015-0059