Daniel Amerman analyzes the the bonus structure that drove bad risk assessment at AIG.

Analysts are in competition with each other to come up with rosier and rosier scenarios, because their bonuses, which they get to take upfront, depend on it. Bad enough, he says, when the underlying securities are mortgage-related. But terminally dangerous when they are corporate derivatives:

“With corporations you need to assess complex financial structures. You need to look at the industry as a whole, assess the relative competitive standing of the company, look at foreign competition, examine comparative growth rates, subjectively evaluate management capabilities, and dive into the footnotes for clues as to pension and health-care exposure, as well as including a wide array of other risks and factors. All of which require using assumptions. Now, as we saw earlier in this article, assumptions are where the money is made when it comes to derivative securities. When we compare the corporate credit derivatives market to the subprime mortgage derivatives market — there is far more room to make money through making aggressive assumptions with corporate derivatives.”

Comment: 

The two major assumptions that analysts at AIG made (because the incentive system encouraged them to) was that there was no danger of a recession and no danger of systemic risk.

Both, as it happened, were disastrously wrong…