“All I can say is beware of geeks bearing formulas,” Warren Buffett once said. AIG didn’t heed his advice. The huge insurer bet tens of billions on credit-default swaps, guided by imperfect risk-assessment models created by a moonlighting finance professor, the Wall Street Journal reports. AIG knew Gary Gorton’s models left out many market forces, but followed them anyway.
In December, AIG’s CEO told investors he had “a very high level of comfort” with his risk, and that all transactions went through the models’ calculations. But they measured only past defaults, not current conditions. “The models are all extremely simple,” Gorton told investors. Too simple, it turned out, to account for the rising collateral calls that eventually forced AIG to take federal handouts.