AIG and default correlation mis-estimation

Felix Salmon has a nice piece on AIG FP's strategy and why it went so badly wrong.

When AIG wrote protection on CDOs and the like, it got insurance premiums in return, and considered those premiums to essentially be free money, since (according to AIG's own models, and those of the ratings agencies) the chances of those CDOs defaulting were essentially zero.

...AIG's biggest mistake was in failing to realize that this business couldn't scale in the way that most insurance does scale. Most insurance does scale: if you insure a house against fire, for instance, it's easy to lose much more money than was paid in insurance premiums. But if you insure houses across the country against fire, you'd need a nationwide conflagration in order to lose lots of money.

... The reason AIG's models said the CDOs couldn't suffer any losses was that house prices don't fall in all areas of the country simultaneously. Since AIG was only insuring the last-loss CDO tranches, investors with lower-rated tranches took the risk that prices in Florida, or Arizona, or California might fall. AIG would only lose money if prices fell in all those states at once -- which is, of course, exactly what happened.

In other words, AIG's models assumed default correlation would be low, and that there was a good measure of diversification benefit between the different CDOs it had written protection on. In reality once house prices turned down there was very little diversification, default correlations leaped up, and the mark to market on many of AIG's contracts turned against them, necessitating the collateral postings that brought the insurer into the welcoming arms of the FED.