Creditflux Newsletter

Michael Lewis’s thoroughly researched article in Vanity Fair reminds us how neatly AIG fits into a historical pattern. Call it the Penn Square paradigm, if you like. This is the phenomenon where the leading proponent of a new way of extending credit collapses in disgrace. Sometimes there are misdeeds involved. But the fundamental error is always the very human failure to spot a credit bubble for what it is.

There are plenty of examples. Penn Square Bank, for example, pioneered the syndicated loan market in the late 1970s. It was the first bank to start making loans with the sole aim of distributing them rather than keeping them until maturity. Its business model was a runaway success; so much so that Penn Square ran away with itself, expanding until its balance sheet consisted of little but these loan participations. They totalled $2.1 billion when Penn Square collapsed in 1982 having lost track of its positions.

More famously, there is the example of Drexel Burnham Lambert, which collapsed in 1990 (with a little help from Rudy Giuliani) after single-handedly developing the high-yield bond market.

Dig further and it becomes clear that these stories are repeated regularly throughout financial history. For example, cast your mind back to the 14th century when the neat financial innovation of its day was the bill of exchange. This was an early example of regulatory (or perhaps that should that be religious) arbitrage. Like the modern sukuk of Islamic finance, the bill of exchange was a credit instrument designed to look like something more pious in an era when Christianity took a dim view of usuary.

The development of the bill of exchange was followed by a credit boom. The chief beneficiary was a single borrower: Edward III, king of England. But when he defaulted, the Florentine banks – and especially that of the Medici family – that had lent to him using bills of exchange, collapsed.

Then there was the development of the zero coupon perpetual government bond – or paper money as it is more commonly known. The first experiment in government debt issuance in a standardised form ended in the collapse of France’s Mississippi Company, which had evolved into a pyramid scheme, in 1721.

The innovation that AIG took to new levels was not credit derivatives, though it used them. It was not real estate lending, though it ended up doing a lot of that, too. Its business model – like that of the monolines but bigger – was to take low risk credit in unfunded form and make it profitable through massive leverage.

That is currently the most discredited business model imaginable. But here is the surprising thing. In all those historical examples, the innovation destroyed its pioneer, but the product itself lived on. In fact, in each case it grew hugely bigger within a relatively short space of time.

That leads us to the unexpected conclusion that selling unfunded credit protection may make a come-back. It may be through an insurance company, through a credit derivative product company or through some other type of company. And it will almost certainly be with ratings, or some other external stamp of counterparty approval to demonstrate that protection buyers are getting a meaningful hedge.

Of course, we should be wary of taking history as a reliable guide – look at the trouble that caused investors buying residential mortgage risk. But we can’t think of a major development in the history of the credit market that has been discredited and then disappeared. If anyone can, we would like to know.