Why Hedge AAA?

This is a good article on naked capitalism  by Thomas Adams, at Paykin Krieg and Adams, LLP, and a former managing director at Ambac and FGIC.

“The argument that the CDO market blew up because it was so complex and speculative is fundamentally flawed. Believe it or not, the bonds that caused the damage to AIG, the bond insurers, and banks were not highly speculative, high risk bonds. They were AAA securities and were supposed to be virtually free of credit risk. In many cases, they were “super senior” bonds – meaning they had another layer of protection above the AAA level to make them even safer than regular AAA bonds. In return for this high level of safety and large levels of protection, the investors or insurers received a very low AAA level yield. In addition, because the bonds were heavily protected, AAA rated and presumably safe, the investors and insurers did not (and were not required to) allocate very much capital to them. The bonds were not considered risky, so there was little need to reserve capital against them. In contrast, the investors and insurers held much more capital against the BBB bonds in their portfolio. This was fundamental to their business model.”

Another snippet:

“Investments in AAA bonds are supposed the opposite of this type of high yield investment. It makes absolutely no sense that a AAA investor should need the same high tech models to make his investments or that if he fails to properly use his models he will be completely blown up and his investment will be worthless.

This “highly sophisticated investor” argument has been used by Goldman, other banks and a remarkably high number of journalists (in my opinion just repeating the crap they have been fed by their sources) as a way of getting the banks off the hook. But it is a fundamentally flawed argument. The CDO bonds that AIG insured were rated AAA. If you have to be a rocket scientist to understand the investment and if anything short of perfect analysis of the bonds means you will be blown up – then by definition the bonds are not AAA.

AAA = easy and low yield. BBB = complex, high yield. This is a pretty simple and bright light distinction. And yet it has been blurred and ignored throughout the discussion of this asset, as recently as two days ago by Goldman.”

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