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AIG played a central role in the financial crisis by issuing swaps to investors in CDO tranches, promising to reimburse them for any losses on the tranches in exchange for a stream of premium-like payments. AIG was rated AAA in 2006. This credit default swap protection made the CDOs much more attractive to potential investors because they appeared to be virtually risk free, but it created huge exposures for the credit default swap issuers if significant losses did occur. Once investors lost faith in the quality of the protection offered by the CDS the demand for the risky tranches of CDOs fell off. This depressed the price of the underlying mortgage collateral. As the price of subprime mortgage collateral dropped the capital positions of financial institutions that were holding tranches of CDOs fell.

True or false and why?

 

Basic Finance, Finance

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