The Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets

18

Mitigating Risk in OTC Markets

18.1 TOO BIG AND TOO INTERCONNECTED TO FAIL

In an odd way, the bankruptcy of Lehman Brothers Holdings was a last hurrah for market liberalism. The refusal of the US authorities to bail-out the stricken investment bank reflected a belief that the market could cope with the consequences of its collapse. Financial markets had, so it was argued, six months since the rescue of Bear Stearns to prepare for the failure and orderly wind down of a similarly large institution.

Within 24 hours the idea that more large interconnected financial institutions could be allowed to fail was dead. On 16 September 2008, the US government was forced to provide American International Group (AIG) with a US$85 billion loan in exchange for a 79.9% share in AIG to stave off the bankruptcy of the US insurance group. Its bail-out ultimately cost the taxpayer US$180 billion.

While Lehman Brothers was heading for collapse, the giant US insurer was haemorrhaging capital. Its problems came to light in February when AIG's auditors found a ‘material weakness’ in its internal controls over the valuation of a ‘super senior’ credit default swap portfolio built up by its subsidiary, AIG Financial Products.

By the time Wall Street's finest were converging on the New York Fed building for the fruitless attempts to save Lehman Brothers during the 13–14 September weekend, it was public knowledge that AIG had racked up losses of US$18.5 billion in the previous three quarters. Its shares ...