EXCERPT: 'Hot, Flat, and Crowded,' by Thomas L. Friedman

Gretchen Morgenson and Don Van Natta Jr. described AIG's misadventures into risky global finance in The New York Times (May 31, 2009): "After the 2000 legislation was passed, derivatives trading exploded, helping the biggest traders earn immense profits. The market now represents transactions with a face value of $600 trillion, up from $88 trillion a decade ago. JPMorgan, the largest dealer of over-the-counter derivatives, earned $5 billion trading them in 2008, according to Reuters, making them one of its most profitable businesses. Among the companies that expanded rapidly was A.I.G. Straying from its main business of providing property and life insurance, A.I.G. wrote a type of contract known as credit-default swaps that protected holders of mortgage securities against defaults. When millions of subprime borrowers stopped paying their mortgages, A.I.G. had to provide cash collateral that it did not have to clients that had bought its insurance."

AIG completely underpriced, and in some ways hid, the risks it was taking. AIG owned a savings and loan operation, so its banking business was regulated at the federal level. It also sold insurance, so its insurance business was regulated by insurance commissioners in every state. But its derivatives business was run out of a hedge fund it created in its London office—AIG Financial Products, or AIGFP, which was part of the vast forest of unregulated hedge funds and private equity groups that had grown up in the last two decades and today accounts for about 50 percent of global credit, dwarfing the traditional banking sector. No one global institution regulates this sector. Even though AIGFP accounted for only 1 percent of the insurance behemoth's total revenues, the risks it took on literally brought the house down when they went bad. And because this universe is very nontransparent and unregulated, few people inside AIG or outside were aware of how big the dice it had rolled were. "Before the crisis," noted Morgenson and Van Natta, "few market participants knew the size of A.I.G.'s exposure. Some derivatives transactions occur on exchanges, where the value and nature of the contracts are disclosed, but many do not. Credit-default swaps trade privately. This kept risk in these trades under wraps, leaving regulators unaware of how dangerously stretched and poorly managed the market was."

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