“...the small group of men and women that sold these products allowed counter parties on all derivatives to demand cash collateral in the event of a downgrade or movement in the asset tied to the derivative.”
Why?
The honest answer? They’re educated fools (they test great but have zero common sense). It’s not very polite to say, but most of them believe that everything in life fits in nice, academic models of how humans behave. Yet, if they had bothered to look back to past panics (especially 1907), they would have understood that when crisis enters the system, asset prices don’t reflect reality because you can’t find a willing buyer in that short of a time period and those that do want to buy can’t find a willing financier to lend them the capital.
This is a real problem in economics. The academic literature teaches graduates that everyone behaves rationally. Yet, people are integrated “wholes”. Sam Walton went back, bought a bank that denied him a loan in Arkansas, and fired most of the staff. Was that rational? No. It was based on a psychological need he had. When markets fall apart, these models don’t factor basic, human emotion into their forecast so they consider the possibility that AIG would ever be downgraded simultaneously with a huge drop in the value of AAA rated third party bonds to be a near impossible statistical event.
Buffett, on the other hand, has said that when he wrote the contracts, he figured the last thing he’d want to do was come up with cash at a time when everything was falling apart. Even though that probably would never happen, he made sure the contracts reflected that provision because he thought it was a real risk, no matter how remote. That’s how people should run their businesses but they’re lured into a false sense of confidence. It helps that Buffett is nearly 80 and so has lived through several crashes, whereas the average 40 year old has not because we’ve lived through the greatest economic expansion in world history over the past few decades. The younger managers now running most firms had never experienced a real contraction.
A lot of this comes from high schools not teaching probability theory, which is far more important to the average citizen than geometry or trigonometry. Most people don’t realize that the odds of you hitting the jackpot when you sit down to a slot machine are *exactly identical* the moment after the jackpot has been hit as it was before. You have the same statistical probability of winning the lottery this week with the same numbers that were drawn last week. Unless someone has been trained to rationally address these counter-intuitive realities, they make mistakes.