2013-10: Pretrade and Risk-based Clearing: A Case Study of American International Group’s Super Senior CDS Portfolio 2005- 2008


Risk-based clearing has been proposed by Rausser, Balson, and Stevens [2010] for over-the-counter (OTC) derivatives. The Board of Governors of the Federal Reserve Board in FRB [2011] recognize that clearing requires collateral or margin to be posted in order to assure a high likelihood of protection for the clearinghouse from default of its covered contracts. Readily implemented and well understood methodologies are available for setting margin levels at both the contract and portfolio level.

The bespoke nature of many OTC contracts is sometimes offered as an objection to the application of real-time risk-based clearing. Yet, risk-based margin computations can be implemented to operate in a pretrade real-time transaction environment for OTC contracts. Moreover, for margin purposes, margin computations are straightforward to apply for even highly complex bespoke products such as mortgage-back securities (MBS). Therefore, we wish to illustrate the application of risk-based margins to a case study of the MBS derivative portfolio of American International Group (AIG) during the period 2005-2008. It was during this period that AIG Financial Products (AIGFP) executed over $2 trillion in notional OTC contracts and was subsequently restructured. Due to the ensuing Congressional investigation, there exists sufficient publically available information to examine AIGFP’s derivative portfolio and how that portfolio would depend on conjectural changes in margin requirements imposed on its OTC derivatives positions. Due to the rarity of detailed OTC derivatives position disclosures becoming publically available and published; there are few published risk analyses of derivative portfolios. The paper is divided into the following sections. We will first provide an overview of the pertinent aspects of risk-based clearing. We will also briefly describe the specific financial contracts that were the proximate source of AIGFP’s financial losses. We will then compute conjectural margins for risk-based clearing using a risk-based methodology and compare that margin to the actual margin calls imposed on AIGFP.

Our 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 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 AIG undertaking significant hedging and liquidation of their OTC positions well before the losses built up to the point they had, perhaps avoiding the restructuring that occurred in September 2008.

William Balson
Gordon Rausser
Publication date: 
November 18, 2013
Publication type: 
2013 Working Papers