The Wall Street Journal “Behind AIG's Fall, Risk Models Failed to Pass Real-World Test” reports that American International Group’s (AIG) modeling for credit default swaps (CDS) did not consider the impact of increasing collateral requirements. Modeling for defaults was not enough when counterparty perceived risks in AIG’s ability to pay claims increased. Perceived risks included the falling value of the insured assets and ratings agencies downgrades. Sometimes no amount of increased capital is enough to control perceived risks, so collateral calls cannot be mitigated. It is the collateral calls that drove AIG’s failure, not actual payouts.

Perceptions are also what drove the big three bank failures: National City (NCC), Wachovia (WB) and Washington Mutual (WM). All three had a large share of troubled mortgages, but it was not until depositor confidence was lost that the FDIC took action. WaMu was the first to see substantial withdraws, abetted by the constant press reports and customer baiting. CNBC had reporters outside WaMu branches asking customers if they felt safe. It was a great story until JP Morgan wrote down WaMu’s mortgages substantially, and then the press assumed Wachovia’s mortgages were worth no more than JP Morgan’s assessment of WaMu. That led the press to start baiting Wachovia’s failure and a run on Wachovia’s deposits started. National City lost deposits after Wachovia, and was denied access to the TARP.

Both collateral calls and deposit runs are the same issue of confidence. Via AIG, the government has experienced that there is no end to capital required to rebuild confidence. According to Treasury Secretary Paulson, no amount of capital could have satisfied the Fannie Mae (FNM) and Freddie Mac (FRE) debt buyers. They are still not satisfied with the government quasi guarantee. The FDIC has taken the stance that once confidence is lost, a bank cannot be saved. Solvency and capital ratios begin to lose relevance. That’s why banks with lower capital ratios than National City are still surviving independently.

The monoline (ABK and MBI) and life (MET and HIG) insurers are having their own issues with guaranteed income products. Once the underlying assets of these products lost value, they had to allocate capital to back them. This, among other reasons, caused the ratings agencies to pay close attention. Time will tell if customers start losing confidence in the insurers.

All financial institutions live or die based on confidence. This is why the draconian punishment AIG received from the Federal Reserve will make its emergence from government control far more difficult, or as former CEO Hank Greenberg said impossible. The government needed only to instill confidence in AIG’s counterparties to achieve success. So far this has not happened.

Disclosures: Author is long ABK, AIG, and MBI.