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August 6, 2010 | www.thenation.com
The government’s $182 billion bailout of insurance giant AIG should be seen as the Rosetta Stone for understanding the financial crisis and its costly aftermath. The story of American International Group explains the larger catastrophe not because this was the biggest corporate bailout in history but because AIG’s collapse and subsequent rescue involved nearly all the critical elements, including delusion and deception. These financial dealings are monstrously complicated, but this account focuses on something mere mortals can understand—moral confusion in high places, and the failure of governing institutions to fulfill their obligations to the public.
Three governmental investigative bodies have now pored through the AIG wreckage and turned up disturbing facts—the House Committee on Oversight and Reform; the Financial Crisis Inquiry Commission, which will make its report at year’s end; and the Congressional Oversight Panel (COP), which issued its report on AIG in June.
The five-member COP, chaired by Harvard professor Elizabeth Warren, has produced the most devastating and comprehensive account so far. Unanimously adopted by its bipartisan members, it provides alarming insights that should be fodder for the larger debate many citizens long to hear—why Washington rushed to forgive the very interests that produced this mess, while innocent others were made to suffer the consequences. The Congressional panel’s critique helps explain why bankers and their Washington allies do not want Elizabeth Warren to chair the new Consumer Financial Protection Bureau.
The report concludes that the Federal Reserve Board’s intimate relations with the leading powers of Wall Street—the same banks that benefited most from the government’s massive bailout—influenced its strategic decisions on AIG. The panel accuses the Fed and the Treasury Department of brushing aside alternative approaches that would have saved tens of billions in public funds by making these same banks “share the pain.”
Bailing out AIG effectively meant rescuing Goldman Sachs, Morgan Stanley, Bank of America and Merrill Lynch (as well as a dozens of European banks) from huge losses. Those financial institutions played the derivatives game with AIG, the esoteric practice of placing financial bets on future events. AIG lost its bets, which led to its collapse. But other gamblers—the counterparties in AIG’s derivative deals—were made whole on their bets, paid off 100 cents on the dollar. Taxpayers got stuck with the bill.
“The AIG rescue demonstrated that Treasury and the Federal Reserve would commit taxpayers to pay any price and bear any burden to prevent the collapse of America’s largest financial institutions,” the COP report said. This could have been avoided, the report argues, if the Fed had listened to disinterested advisers with a less parochial understanding of the public interest.
Fed and Treasury officials dismiss this critique as second-guessing of tough decisions they had to make in the fall of 2008, amid the fast-moving global crisis. Yet two years later, those controversial decisions remain highly relevant. Public anger has not abated. It fuels the election turmoil that this year threatens to bring down incumbents in both parties who voted for bank bailouts.
... ... ...
Savvy bankers understand what Fed officials understand—the central bankers are trapped in a game of chicken with important banks that can call their bluff. If the Fed acts in a prompt fashion to curb or punish reckless behavior before it get dangerous, the bankers will accuse it of stifling profit and progress. Bank examiners are chastened, told to back off.
If the Fed waits too long to intervene, as it regularly did during the past twenty-five years, then it may be faced with a far more dangerous situation: given the globalization of financial markets, the system now operates with a hair-trigger response to threatening rumors or disclosures. We saw it happen in the fall of 2008. A broad panic raced around the world, freezing credit markets, collapsing financial assets and bringing down major institutions.
This discreet power struggle is never candidly acknowledged by the governing institutions (who fear it would weaken them further), but it has fed the growing instability for several decades. Fed regulators have lacked the nerve (or the hard evidence) to stop dangerous practices by banks before they reach the crisis stage. Yet once calamity appears imminent, it’s feared that taking action might provoke a wider disaster—a global “run” by investors—since other banks are engaged in similar behavior.
We might feel more sympathy for the Federal Reserve, except its leaders have actively contributed to their predicament. Paul Volcker, Fed chairman in the Carter and Reagan era, privately grumbled that removing ceilings on interest rates would weaken the central bank’s hand, but he reluctantly supported it. His successor, Alan Greenspan, led cheers for liberating the banks from government regulation. The consequences are now fully visible.
Goldman Sachs executives first threatened to stop making exotic trades with the American International Group in July 2007 unless the insurance giant posted $1.8 billion in cash collateral to compensate for a slide in the mortgage securities market, internal AIG e-mails show.When AIG refused to meet its demands, Goldman began betting hundreds of millions of dollars on the insurer's collapse, ramping up those wagers to $3.2 billion over the next 10 months in a strategy that put AIG under huge financial pressure, a congressional commission found.
While Goldman executives defended those tactics in testimony to the Financial Crisis Inquiry Commission Thursday, panel members took turns publicly pushing the embattled investment bank to fully disclose dealings that brought it hefty profits and might have helped force a $162 billion taxpayer bailout of AIG.
A central issue surrounding Goldman, panel Chairman Phil Angelides said, was whether the Wall Street titan turned the screws so tightly on AIG that it created a "self-fulfilling prophecy," forcing the insurer into a massive cash squeeze.
The commission, appointed by Congress to ferret out the root causes of the worst financial crisis since the Great Depression, was mostly docile in January in taking sworn testimony from Goldman chief executive Lloyd Blankfein.
However, with four Goldman executives and six present and former AIG officials under oath over two days this week, several panel members turned skeptical and confrontational in asking about AIG's management failures and Goldman's wagers against the housing market that drained the world's largest insurer of more than $15 billion.
The panel also heard from present and former state and federal officials also described gaping regulatory holes that allowed a London-based unit of AIG to build a $2.7 trillion book of exotic trades with little reserve capital, all but forcing the taxpayer bailout of the insurer to avoid systemic chaos.
David Viniar, Goldman's chief financial officer, told the panel that Goldman behaved toward AIG as it always does with insurance-like contracts known as credit-default swaps. When the housing market began to sour in the summer of 2007, he said, Goldman "tightly managed" contract provisions requiring AIG to post collateral to compensate for drops in the securities' value.
"We're pretty passionate about fair value accounting," Viniar said. " . . . We have 1,000 people in our controller's department. Probably half of them spend their time trying to verify marks," or securities' valuations.
In a lesson in how steel-knuckled Wall Street executives duke it out in high-stakes deals, commission investigators pieced together a chronology of Goldman's negotiations with AIG. Even in July 2007, the market for mortgage securities had begun to freeze, leaving few trades on which to gauge the market value of securities in the AIG deals.
Nonetheless, on July 27, Goldman jolted AIG with a demand for $1.8 billion in collateral, simultaneously making its first purchase of swaps that would pay $100 million if AIG went bankrupt.
The moves led to a series of tense exchanges over the ensuing days. After a conference call on Aug. 1, Tom Athan of AIG's Financial Products unit e-mailed Andrew Forster, a former AIG senior vice president for financial services, that Goldman had warned that AIG must honor the contract or it wouldn't do similar deals in the future.
Goldman executives promised to set a mid-market valuation of the securities to determine collateral requirements, AIG executives wrote, but that Goldman posed "a very credible threat" because it could influence market valuations.
For example, Athan wrote on Aug. 8, 2007, if Goldman asked rival Merrill Lynch to submit bids on 100 mortgage-backed bonds similar to those that AIG was insuring and prices them at 80 cents of face value, dealers could use the bid to set market prices.
By Aug. 10, investigators wrote, Goldman had bought $575 million in swaps that would pay off if AIG defaulted. AIG ultimately posted $450 million in response to Goldman's demands, but that was just round one.
On Aug. 16, Forster wrote that he'd heard rumors that Goldman was "marking down asset types that they don't own so as to cause maximum pain to their competitors."
The two companies haggled over the next year, as Goldman's collateral demands mounted and its swap "protection" reached $3.2 billion.
Viniar told the commission that Goldman was primarily an "intermediary" buying swaps with AIG after selling similar credit insurance to investors. When AIG posted collateral, he said, Goldman posted the same amounts in cash with investors.
However, Commissioner Byron Georgiou pressed Goldman executives about a McClatchy story published Tuesday describing Goldman making proprietary trades — wagers with its own money — on so-called bets with AIG in which neither party actually bought any mortgage securities.
When Viniar said he knew nothing about it, Angelides and Vice Chairman Bill Thomas told Viniar that the commission wants records of all such trades.
The commission, which recently subpoenaed documents from Goldman, wasn't through with its demands for information.
Georgiou asked Viniar to identify the companies that sold Goldman coverage on an AIG collapse, saying he was "incredulous" that other financial institutions could cover such huge bets if AIG couldn't during the meltdown of 2008.
"I do not know the specific names of the parties," Viniar said, but added that the bets "were predominantly with other major financial institutions."
In addition, Georgiou noted that Goldman likely sold swaps for higher fees than the typically modest amounts it paid to AIG, saying that Goldman's $2.1 million in fees for $1.76 billion in coverage in a 2004 deal amounted to 0.12 percent. He asked Goldman to provide details of all fees it charged clients for whom it was an intermediary with AIG.
Commissioner Brooksley Born, a former chairwoman of the Commodities Futures Trading Commission, said she found it odd that Goldman couldn't say how much profit it made on swaps and other exotic bets known as derivatives.
"Your risk officer said the other day you can't manage something that you can't measure," she said. "I am very skeptical that you can't measure these profits."
Born also demanded to know how Goldman and other swap partners of AIG wound up with releases of legal liability, meaning taxpayers would have a difficult time suing them for fraud, as part of settlements awarding them the full $62 billion face value of those contracts in late 2008.
Viniar said that Goldman would cooperate with the panel's requests.
July 2, 2010 | The Independent
Goldman Sachs denied responsibility for the collapse of insurance giant AIG in 2008, saying its demands for billions of dollars in collateral from the company were a prudent response to deteriorating financial conditions. Executives at the two companies traded accusations in front of the Financial Crisis Inquiry Commission yesterday, on the second day of a hearing into the role of derivatives in the credit crunch.
Goldman had earlier been accused by the FCIC chairman, Phil Angelides, of behaving like "a cheetah chasing down a weak member of the herd" as it demanded more and more money to protect itself from losses on AIG's mortgage trading with the bank.
Demands for collateral were generated mathematically, based on calculations about the market value of AIG's mortgage positions, Goldman's chief financial officer, David Viniar, said. AIG had insured trading partners such as Goldman against losses on hundreds of billions of dollars of mortgage derivatives. The insurer believed the eventual losses would be so small that it could make easy money from the premiums, but it did not count on clauses in the contracts that allowed trading partners to demand collateral.It was those demands that crippled the company and forced it into a $180bn (£120bn) bailout by the US government. An AIG official, Elias Habayeb, told the panel that AIG tried to negotiate with Goldman and other counterparties to lower their demands, but with little success. "Unfortunately, AIG had little negotiating leverage," he said.
Even if AIG went bankrupt, the counterparties would get special protection under bankruptcy law. By March 2009, Goldman had received $12.9bn of the $93bn in money paid to AIG counterparties, the most of any bank. Mr Angelides again yesterday wondered if Goldman was deliberately driving prices down on the debt securities linked to the credit insurance sold by AIG. Mr Viniar and other Goldman officials insisted they based their collateral demands on the price of actual trades – trades the panel has asked for further details on.
The Financial Crisis Inquiry Commission grilled Goldman chief operating officer Jonathan Cohn and CFO David Viniar this week, with today’s session focusing on AIG, and in particular, whether Goldman’s collateral calls were abusive and damaged the insurer.
Readers know that I have perilous little sympathy for Goldman. However, it is important that investigations focus on matters likely to hit pay dirt. And despite the sabre rattling at the New York Times and various websites on the matter of Goldman’s collateral marks, we think the ire is misguided, and this is one of the few cases where Goldman’s defense is sound. By contrast, the Commission missed other smoking guns.
To recap: Goldman, like other major dealers, had bought credit default swaps from AIG to hedge against some CDO exposures. The case against Goldman, in simple terms, is:
1. Goldman was overly aggressive in marking down the CDOs it had insured with AIG. Remember, the bigger the losses reported on the CDOs, the more cash AIG would have to pony up to Goldman
2. Goldman’s actions contributed to AIG’s demise.
Tom Adams, a former monoline executive, and I have performed considerable, in-depth examination of the AIG CDS on CDOs that were bought out by the Fed at par (the CDOs wound up in a vehicle called Maiden Lane III). We debunked this thesis, presented in a New York Times article, in February:
There is a wee problem with this account. Goldman’s marks were proven correct. With the benefit of hindsight, most players, particularly AIG, were in denial….
In late 2007 and early 2008, the monolines were facing similar issues to AIG….The rating agencies not long afterwards started downgrading AAA asset backed securities CDOs, verifying the “aggressive” position [monoline short Bill] Ackman and Goldman were taking.
The story also repeats the AIG/Fed flattering claim that these CDOs have “rebounded.” We’ve discussed long form in other posts that given the continued, serious deterioration in the underlying mortgages, this notion is simply not credible. The decay in credit quality across the portfolio is severe, and there has been no “rebound” in prices of severely distressed CDOs….
The jig was up for AIG by January of 2008 and the debate was only one of timing, not of what the actual outcome would be. Coincidentally, Ambac, FGIC and XLCA were downgraded in January 2008 directly as a result of high expected losses in their CDO portfolios. Any case against Goldman for aggressive marks against AIG by the SEC or other parties would have take the market environment into consideration. Across the board, CDOs were causing losses and downgrades for the people who insured them. It therefore makes plenty of sense that Goldman would be requesting more collateral for their exposure with AIG.
Yves here. So why were the other AIG counterparties more generous in their marks than Goldman? They held considerable CDO inventory. If they were the packager and had marked down their AIG positions, they’d have to provide similar marks to any customer who had bought a long position in the same CDO from them. And more important, they might be required by auditors or regulators to reduce the prices of similar CDOs, which would result in losses.
While this line of inquiry looks misguided, others have been neglected. Why has no one questioned any of the banks of the absurdity of relying on guarantees from the monolines and AIG? Insurance on subprime was rife with what traders call “wrong way risk”: if you needed to collect on your insurance policy, the very events that would lead you to put in a claim would be likely to damage the guarantor. (Goldman would assert it did recognize the risk and had bought CDS on AIG, but that is similalrly absurd: as we saw, an AIG default was a probable systemic event. Those contracts suffered from wrong way risk too). Put more bluntly, the idea that you could hedge subprime risk, particularly on the scale Goldman could likely have inferred was taking place, was almost certain to result in non-performance on the insurance. Did this occur to Goldman’s vaunted risk management operation? It might be revealing to follow that thread.
The Independent highlighted another missed opportunity:
As well as diffusing the spat with the FCIC, Mr Cohn provided new numbers that he said proved the bank did not “bet against its clients” in the market for mortgage derivatives as the credit crisis unfolded, as has been alleged…..
He said Goldman had reviewed all the mortgage securities and derivatives it had created since December 2006, following fraud charges levelled by US regulators earlier this year. It underwrote $47bn (£31bn) of residential mortgage-backed securities and $14.5bn of collateralised debt obligations, and took short positions on the products – which would rise in value if the products fell – of less than 1 per cent of their value.
“During the two years of the financial crisis. Goldman Sachs lost $1.2bn in its residential mortgage-related business,” Mr Cohn told the panel. “We did not ‘bet against our clients’, and the numbers underscore this fact.”
Yves here. This smacks of being the sort of artwork that is technically accurate in its detail, but misleading in the picture it presents.
The role of a financial firm is to facilitate commerce, by helping companies raise money, by allowing investors and savers to deploy funds. But they have lost sight of their role, and many of their activites at best have no social utility and at worst are extractive and destructive. For instance, short sellers have a useful role to correct the pricing of instruments that were created for legitimate uses. But no one until recently would have considered creating positions anew to serve the interests of short sellers was a good idea. It is pouring talent and capital into purely speculative activities. Bear Stearns, far from a vestal virgin, refused to work with subprime short John Paulson to create synthetic CDOs designed to suit his interests.
Now let’s look at Cohn’s remarks. They aren’t just a little misleading, they are a lot misleading.
1. Cohn isolates Goldman’s shorting in 2007 and 2008. But Goldman’s Abacus program, which was designed for the firm to establish short positions, started in 2004. Goldman had insured 5 2004 and 2005 Abacus trades with AIG, along with 22 2004 and 2005 CDOs structured by Merrill, 9 2004 and 2005 CDOs structured by other banks, and 2 of its own 2005 cash CDOs. So the roughly $15 billion that Goldman made from AIG is expressly excluded from Cohn’s presentation.
2. The comparison is further misleading by comparing its activity over a period of time (underwriting over a two year period) versus its short position that was presumably measured at a single point in time
3. What does “short positions on the products” mean, exactly? Technically, if you take down the short sided of a synthetic CDO, you have short positions in tranches of subprime bonds and other assets. If you only kept the short side on particular RMBS in that CDO, not all, you are arguably not short the CDO, but short some bonds. Similarly, Goldman may also have used the ABX or the TABX indices to establish short positions, so it could be taking a view against the market without being short the specific transactions it was pedalling.
4. Pray tell, how was this “less than 1%” arrived at? The dollar amount of the short position was CERTAIN to be small because Goldman used credit default swaps. The cost of establishing a short position was only 100-140 basis points until spreads started blowing out at the end of 2006 (and they tightened again in March 2007). The proper comparison would be the notional amount insured versus the cash position.
The FCIC also bears other signs of being badly unprepared, witness this exchange reported in the Huffington Post (hat tip reader Francois T):
The panel created to investigate the roots of the financial crisis escalated the government’s assault on Goldman Sachs on Thursday, criticizing the Wall Street firm for failing to turn over basic documents and accusing it nearly lying under oath.
For a second consecutive day, the bipartisan Financial Crisis Inquiry Commission reiterated its request for additional data from Goldman, namely figures regarding the firm’s derivatives activities. And for a second consecutive day, Goldman’s top executives demurred.
“We generally do not have a derivatives business,” David Viniar, Goldman’s chief financial officer, told the panel Thursday under oath.
Goldman Sachs holds more than $49 trillion in notional derivatives contracts, making it the third-largest derivatives dealer among U.S. banks, according to first quarter figures from national bank regulator the Office of the Comptroller of the Currency. The commission has found that Goldman is a party to more than 1 million different derivatives contracts, Commissioner Brooksley Born disclosed Thursday.
“We don’t separate out derivatives and cash businesses,” Viniar clarified under questioning. The derivatives units are “integrated” into the firm’s cash businesses, making it difficult for the firm to isolate its derivatives data, he said.
In January, the panel asked Goldman chairman and chief executive Lloyd C. Blankfein for a breakdown of the firm’s revenues and profits from its derivatives activities. He said the firm would comply. The commission reiterated that request Wednesday and Thursday.
Viniar said the firm doesn’t “keep” records outlining its revenues from its derivatives dealing.
“I am very skeptical that you can’t measure these revenues and profits,” Born told Viniar. “I urge you to provide us with this information. It’s been about six months we’ve been asking for it… and it makes one wonder also why Goldman has the incentive or impetus not to reveal this information.
“You’re suggesting you don’t give it to your regulators. You don’t put it in your financial reports… so you don’t give it to the market… [or to your counterparties],” Born continued. “And you’re refusing to give it to us. I hope very much that we will see this very shortly.”
Viniar took exception to that last comment.
“Commissioner, again, we’re not refusing anything,” Goldman’s chief financial officer said. “We don’t have a separate derivatives business.”
Viniar then said that Goldman isn’t alone in not breaking out its derivatives-specific revenues and profits.
Born quickly shot back.
“They don’t,” Born, the nation’s former top derivatives regulator, conceded. “But some other firms have provided us with that data when we’ve asked for it, and Goldman Sachs hasn’t.”
Phil Angelides, the panel’s chairman, could barely contain his incredulousness.
“Are you telling me you have no system at your company that tracks revenues or assets of contracts, and liabilities and payments under contracts?” Angelides asked. “You have no management reports, no financial reports that track these contracts?”
“I’ve never seen one,” Viniar responded. Pressed further, Viniar added that the firm doesn’t track these things because it’s “not meaningful.”
Viniar again was asked to provide the data.
Yves here. I have to tell you, this is a ridiculous line of questioning. What the hell is the FCIC trying to get at? There is NO SUCH THING as a “derivatives business”. This in fact illustrates how industry lobbyists have managed to muddy policy debates, to the advantage of the industry, by lumping a lot of disparate activities under the derivatives banner.
Goldman no doubt has commodities futures businesses, FX and currency swaps, and corporate and asset backed credit default swaps activities. I’m sure it also engages in stock and bond index and futures trading in a number of markets. I’m a big believer in knowing what questions you are trying to answer when drilling into data, and I see no utility in having an aggregate figure across these activiites.
And some firms do manage the cash and derivatives businesses of related businesses on an integrated basis. In particular, it appears from the voluminous Goldman documents released by the Senate that Goldman ran its cash and synthetic CDO packaging business from the same business unit. This would not be unusual.
Now the flip side is Goldman clearly does have transaction level information and could no doubt provide analyses to address specific FCIC questions . But it isn’t clear at all what the FCIC wants. This reminds me of the sort of exercise I’d fight tooth and nail as an associate at McKinsey, because it was a complete waste of client time and money, that of simply taking whatever data the client had and cutting it various ways to see if anything emerged. It would provide a lot of charts for a progress review, and if it produced any insight, it was completely random and could have been arrived at much more cheaply with a more deliberate approach.
So as much as Goldman is a deserving target, the FCIC appears to be quite overmastered by them, in part due to insufficient preparation (a function of insufficient budget, staffing, and unrealistic deadlines) and lack of well honed interviewing skills on behalf of its commissioners.
charles:
‘We were gratified to hear that Brooksley Born left Viniar with the obligation to provide a P&L split. The second this document is public we will assist the FCIC in decoding it: we are certain that for Goldman, which derives the bulk of its profits by being the monopolist in wide bid/ask-spread OTC products, most notably CDS, about 80% of trading revenue will come precisely from unregulated derivatives trading.’
Francine McKenna:
We’re getting closer to the question and maybe the answer of why AIG held onto high marks when others were writing things down. Davidowitz said it yesterday to Aaron Task on Yahoo’s Techticker and I have been saying it on my site for years: The auditors allowed it so the executives could further an illusion for their own interests. Fraud occurred. The case of AIG/GS is particularly interesting because it is the same firm, PwC, on both sides. I’ve written about it extensively and you have linked to these stories. The crime of the century is that PwC is still AIG’s auditor, earning 205 million from the engagement last year.
Independent Accountant:
Francine:
Agree! That’s why I oppose the PCAOB’s existence. Would PWC have had the nerve to do what it did without the SEC, Treasury and NY Fed running interference for it?
IA
by Tyler Durden on 07/01/2010 23:47 -0500Today, during the FCIC's second day of hearings, Goldman CFO David Viniar was forced to provide additional data about the firm's AIG CDS trades. Luckily the firm kept a record of all entry and exit points, and thus will be able to confirm just what the P&L of the associated trades is (and if not, we are happy to teach Goldman's risk department how to use the Bloomberg CDSD function in conjunction with RMGR run scraping to build a real time CDS portfolio tracker)... Which is ironic, because when asked by Brooksley Born why the firm has not yet provided a break down of its derivative revenue Mr. Viniar by all accounts perjured himself. As Bloomberg reported: “We don’t have a separate derivatives business,” Viniar told the panel. “It’s integrated into the rest of our business.”
Uh... what?
Every evening, a firm's back office (and that most certainly includes Goldman) takes the EOD CDS and cash marks from every single prop trader, be they equity, fixed income, mortgage, FX, etc. and using its own integrated pricing system or an outsourced one, compiles a daily P&L which is immediately sent to the head of the risk division, the head of trading, and other various listserv participants. And most certainly the traders, who have every interest of knowing just how they did in any given day as they prepare their bonus speech at the end of the fiscal year. Traders, who combine cash and CDS trading simply look at a consolidated P&L on the basis of DV01 exposure, which makes the form of product used completely irrelevant, and is a process whereby every change in 1 basis point in interest rates is equivalent to a profit or loss. Every single derivative is presented in Goldman's daily risk summary on a DV01 basis to show not only maximum possible loss, but what the daily profit or loss may have been. This makes the tracing of both revenue from derivatives and cash products seamless.
Obviously even the FCIC panel was fully aware of this:
“When you tell us that you don’t know how much you make in your derivatives business, nobody here really believes it,” [Commissioner Byron] Georgiou told Viniar. “Nobody here believes that you don’t know how much money you’re making on the various aspects of your business, it doesn’t make any sense.”
And Goldman's very own documents confirm that the firm, as part of its daily P&L summary, tracks the revenue by every product line, most certainly including derivatives, as can be seen from the email by Ki-Jun Bin from July 20, 2007, obtained as part of the Abacus discovery process:
As for Goldman's claim that due to possible commingling of strategies between cash and synthetic legs, any P&L report will be distorted, you will pardon our French, but this is a pile of crap. Every time a trade ticket is punched, it is the responsibility of the trader and/or their supervisor to allocate a trade to a given strategy. In other words, in the P&L of a given group, the 20MM notional of XYZ CDS would be paired with the 5MM in cash bonds of the firm whose CDS are being referenced, and then the combined EOD P&L would be derived based on the change in DV01. But leave it to Moody's to not be aware of this most fundamental principle of how banks organize their risk by various strategies:
“Reporting a revenue number, just the profit on derivatives without looking at cash positions associated with hedging those, is going to be a highly imprecise exercise,” Yavorsky said in an interview today.
Fine, so look at the cash positions which can all be reconciled. As for commingled legs, it is again the trader's responsibility to allocate portions of any given trade to various strategies on a pro rata basis. At the end of the day, it is the "view by strat" of any portfolio, and every single back office can do this, that provides precisely this data. And out of this view, the cash legs, if any even exist, can immediately be removed. Of course, Goldman knows this all too well.
Yet all of this is very much irrelevant. As the Abacus discovery taught us, Goldman rarely if ever actually hedges: recall that the firm's Mortgage group was almost exclusively short in trading daily derivatives (look at the P&L above and note how many various portiona have the same sign) in order to hedge existing legacy cash product balance sheet exposure. In other words a forensic analysis of all Goldman positions in a given period will indicate that the prop trades were mostly unidirectional and unhedged, making all of Viniar's and Moody's concerns moot. Typically traders put on one position via either cash or CDS, and on 10%, a combination of both, and wait for it to hit stops on either side. In other words, 90% of trades will be completely unhedged, with not confusion about what is attributable to derivatives and what to cash.
We were gratified to hear that Brooksley Born left Viniar with the obligation to provide a P&L split. The second this document is public we will assist the FCIC in decoding it: we are certain that for Goldman, which derives the bulk of its profits by being the monopolist in wide bid/ask-spread OTC products, most notably CDS, about 80% of trading revenue will come precisely from unregulated derivatives trading. Which, of course, is the real reason why David Viniar is stalling so hard and doing everything in his power to avoid disclosing that not only would derivative regulation massively impair the firm's profitability, but that the ongoing lie about Goldman generating just 10% from prop trading is blatantly false, and in reality the real number is the inverse. Which also explains why by the time the Fin Reg bill finally passes, the Volcker Plan will be gutted beyond all comprehension and Wall Street will be back to doing everything it used to do before, but this time with the Frank-Dodd stamp of approval.Until the next inevitable crash.
Michael Lewis has a generally very good piece in Vanity Fair on the AIG Financial Products mess, filing in some bits that were missing from the equation. He does go a bit overboard in saying nice things about Jake DeSantis, the man who wrote the New York Times "Dear AIG: I Quit!" op ed. To me, it was another case of Wall Street, and its co-conspirators not getting it. Anyone in a normal business knows if the company has massive losses or is bankrupt, you probably don't have a job any more and whatever bonus you thought you might get just went poof. He got a very juicy retention bonus, over $700,000 after taxes. My dim recollection is that the partners at LTCM were paid $250,000 a year before taxes to clean up their mess, even adjusted for inflation, much less than what DeSantis was paid. As much as I take the LTCM "talent" story with a handful of salt, DeSantis is no Myron Scholes or Lawrence Hilibrand.
The story recounts how an AIG FP employee, Gene Park, was promoted at the end of 2005 to be the unit's liaison with Wall Street subrprime desks. Park takes one look at the exposures and freaks out. The big boss, Joseph Cassano. tries to browbeat him into compliance but comes around to his point of view and stops writing guarantees on subprime.
Here's the bit that caught my eye.Every firm on Wall Street was making fantastic sums of money from this machine, but for the machine to keep running the Wall Street firms needed someone to take the risk...OK, I need reader help here. Let's unpack this.
The Wall Street firms solved the problem by taking the risk themselves. The hundreds of billions of dollars in subprime losses suffered by Merrill Lynch, Morgan Stanley, Lehman Brothers, and the others were hundreds of billions of losses that might otherwise have been suffered by AIG. Unwilling to take the risk of subprime mortgage bonds in 2004 and 2005, Wall Street firms swallowed the risk in 2006 and 2007,
First, things went crazy in subprime in late 2005 and 2006. Those 5-6 quarters were when the most damage was done, the dreckiest paper in big volumes. Lew Ranieri said the paper got worse around then (not that it was great before, mind you). Even thought the paper was even more toxic in 2007, the volume fell off as subprime woes were coming into sharp focus. So understanding what happened in 2006 is important.What does Lewis mean, exactly, by "take the risk?" AIG had written CDS against the bonds, or at least that's what the piece implies, as opposed, say, to CDOs that contained subprime mezz paper. Did the investment banks start writing CDS against subprime bonds? Their credit ratings weren't so high that that action would have accomplished much in the way of credit enhancement (or was everyone so punch drunk that any name would do?). Did they rely on overcollateralization and keep the equity layer? I haven't seen anything that would suggest that the big brokerage firms stepped up and did credit enhancement of subprimes, but it isn't impossible.
The reason I am a bit confused here is that the accounts of subprime writedowns at the big broker dealers (plus Citi, which apparently was happy to do deals without AIG guarantees, thank you very much) was that they took losses on subprime paper (I had presumed mortgages they held as trading inventory, plus perhaps also warehoused mortgages) and CDO paper. Merrill and Citi both had large exposures to the super senior layer. That ins't consistent with the story that they took the risk to get the deals done. For Merrill, it seemed as if the firm kept blindly originating deals even though the stuff was getting harder to place (the various AAA layers were 70-80% of the value of the whole CDO) and believed in the stuff enough to carry it. Really bad underwriting practice, in other words, Not as clear why Citi wound up with so much paper, but they had been putting some (a lot?) in SIVs, so as those got unwound, Citi may have taken them on balance sheet.
It is also useful to understand where the credit enhancement was occurring pre and post AIG. CDO volumes were exploding. The party that takes the risk of an equity layer in a CDO winds up eating a lot of the risk of the subprime paper that went into the CDO. Not sure how far that would have gone in supplanting AIG, but it could conceivably have gone a fair way.But I was also under the impression that hedge funds pursuing credit oriented strategies were important buyers of the equity layer in CDOs. Did they come to play a bigger role in this period?
Any answers to these questions very much appreciated. Please feel free to ping me at [email protected], but leave a comment if you are set up to do so. Thanks!
- Bob Goodwin said...
- I slurp up every bit of M Lewis that I can. He writes fabulous narative. But understand that his stories are first and foremost about villians and the rest of us. If you read his story closely, he admits that he is writing the story from the perspective of the insiders of AIG. I thank him for that, but never lost the point. Perspective is everything.
When you pick apart the point of whether the banks actually took the risks that AIG previously had taken in 2006, I did not perceive that as a statement of fact, rather the perspecitive of the AIG traders.In reality, we know that a lot of paper was sold far and wide, to chumps who wanted to buy high yielding bonds. But the banks had a pipeline, and obviously got caught with a large bag of dreck too.
I thought the piece brought a lot of new perspective to the conversation, namely that Goldman made AIG post collateral on a downgrade. I also get the sense that far from dancing until the music stopped, players wanted to stop but were unable.
May 17, 2009 | The Sunday Times
This is Joseph Cassano. He is the multimillionaire trader accused of bringing down the insurance giant AIG — and with it the world’s economy. So is he a criminal, an incompetent or a scapegoat?
(PAUL VICENTE/SUNDAY TIMES)
They were frightened for a long time, then suddenly they were angry. For millions of Americans, anxiety about a jobless, debt-laden future turned to disbelief when it emerged that AIG, the company at the centre of the world’s financial crisis, was handing out £300m in bonuses. It was the superpower’s Sir Fred moment. Just as Britain reacted with fury to the disclosure that Sir Fred Goodwin’s pension pot had been doubled as his bank neared collapse, so the US was shocked. The death threats came soon after. “I want them dead!” said one of a stream of messages that caused AIG staff to travel in pairs, park in well-lit areas, and dial 911 if followed. “I want their spouses dead! I want their children dead! I want their children’s children dead! I want the earth upon which they have walked salted so nothing will ever grow again!”
This was one of the greatest bailouts in history, after the biggest corporate loss in history, during the most serious challenge to world stability since the 1962 Cuban missile crisis. And here was AIG, the recipient of so much taxpayers’ money that the cheques exceed the value of the gold reserves in Fort Knox, paying bonuses to the very people who engineered the catastrophe.
Protesters toured the posh houses on Long Island Sound, an estuary northeast of New York City, with letters for AIG executives describing the plight of homeowners. But they were in the wrong place. Because the man who knows most about AIG’s troubles lives in a stucco-fronted house 3,000 miles away. Some call him Patient Zero: the virus that infected the world financial system was transmitted from a genteel square near Harrods. If you wait patiently in Knights-bridge you will see him, and he appears not to be a risk-taking type. He puts on his red crash helmet and cycles greenly off across the city, politely declining to comment on global calamities. This does not look like a person waiting at the curtains for the arrival of the FBI.
Can one man in London really be to blame for the collapse of capitalism?
Until now, the economic crisis has been seen as a giant intellectual error, and AIG’s multimillionaire employees in England were simply the people who made the biggest mistakes. The first to own up to misjudgment was Gordon Brown’s friend Alan Greenspan — once so revered in his role as America’s central banker that to be photographed with him was as flattering as being seen now with President Obama. “I have found a flaw,” said Greenspan, referring to his free-market philosophy, after the banks started falling over. “I don’t know how significant or permanent it is. But I have been very distressed by that fact.”
Others have repeated this innocent-sounding explanation for the wrecking of so many lives. “There is no fail-safe way to offset this human tendency to collective error,” says Lord Turner, chairman of the Financial Services Authority (FSA). And it is true, of course. Now and again, historical forces come together in a way that is mutually reinforcing, and individual changes that are powerful in themselves become so strong that their effects are wrongly seen as permanent. If 150m people — 2Å times the British population — stop tilling the land and start making things, as happened in China between 1999 and 2005; if the Chinese recycle their export earnings into cheap credit; if interest rates stay low for reasons that seem important at the time (the millennium bug, the tech-stocks crash, 9/11); if new ideas allow you to spread financial risk? well, by now you know the explanations. It became easy to imagine that the world was growing rich because we understood the universe better than our ancestors, until we didn’t.
There is, however, an alternative reading. This says that the furore over bonuses is a convenient distraction from the real causes of the crisis, which go to the heart of how the world is run. There is dishonesty in this collapse, on a scale that is almost too vast to comprehend. There are conflicts of interest in American finance and politics that make our own, dear House of Lords look like beginners. There are frauds so large, and so long-standing, that it can be hard to see them for what they are. And all these things were allowed to thrive in an intellectual atmosphere that tolerated no dissent. This reading is optimistic for those who believe in free markets, even if it is pessimistic for the US. “Capitalism has not failed,” says Bernard-Henri Lévy, the French philosopher. “We have failed capitalism.” The thesis can be tested through Patient Zero.
The official version is that Joseph Cassano, who occupies the stucco-fronted house near Harrods, brought down a safe and stable company — and by extension, the world — with incompetent gambles. “You’ve got a company, AIG, which used to be just a regular old insurance company,” Obama explained during a recent TV appearance. “Then they decided — some smart person decided — let’s put a hedge fund on top of the insurance comp-any, and let’s sell these derivative products to banks all around the world.” Ben Bernanke, the chairman of the Federal Reserve, adds: “This was a hedge fund, basically, that was attached to a large and stable insurance company.”
Cassano, who ran AIG’s financial-products division in London, “almost single-handedly is responsible for bringing AIG down and by reference the economy of this country”, says Jackie Speier, a US representative. “They basically took people’s hard-earned money, gambled it and lost everything. And he must be held accountable for the dereliction of his duty, and for the havoc he’s wrought on America. I don’t think the American people will be content, nor will I, until we hear the click of the handcuffs on his wrists.”
This account is as satisfying as it is easy to understand. It treats the blowing up of the world financial system like a global version of Barings, the bank that collapsed in 1995, with Cassano in the role of Nick Leeson. Operating from the fifth floor of a polished white stone building in Mayfair, Cassano’s unit sold billions of pounds of derivatives called credit-default swaps (CDS), allowing banks to buy risky debt without attracting the attention of regulators. AIG took the fees, but did not have the money to pay up if the loans went bad. By the time the music stopped, European banks had protected more than $300 billion of debt with this bogus “insurance”. And that is just one corner of a web of risk extending to over 1,500 big corporations, banks and hedge funds. In a 21-page paper known as the Mutually Assured Destruction memo, AIG claims that if the bailouts stop and the company is allowed to go bust, it will take the world with it. Cassano must have played with handcuffs as a child: he is the son of a Brooklyn cop. Now he waits for the fallout.
But the official version overlooks many things, including episodes of fraud at AIG that go back at least 15 years. It fails to explain why Public Enemy No 1 was allowed to leave the company on generous terms, with a retainer of $1m a month and up to $34m (£23m) in bonuses. And it does nothing to tell us why other big companies, whose profits looked as smooth and certain as AIG’s in the good times, are also fighting for survival.
When Forbes published its first list of the world’s biggest companies in 2004, AIG ranked third, after Citigroup, the dying bank, and General Electric, the industrial giant now drowning in its own debt. If you can think of a risk to insure, AIG was there: the company even made plans to survive a nuclear holocaust. It was built into a behemoth by one of the 20th century’s corporate titans, Hank Greenberg. Less famous than the other insurance legend, Warren Buffett, Greenberg gave shareholders a return of 14% a year, and was equally loved. “I just think you are the most stupendous, unbelievable person in the entire industry, the entire world,” one investor told an annual meeting, without irony.
But Greenberg faced a problem. Insurance is not like iPods, where if you invent the market, growth comes fast. Over time, it performs in line with the economy. In 1987 he found an answer: AIG would enter a joint venture with Howard Sosin, a pioneer in the new “Frankenfinance” of derivatives trading. You can thank Sir Isaac Newton for Frankenfinance. By showing in the 17th century that the universe conforms to natural laws, he encouraged our age to see money as a branch of physics. Starting in 1952, two generations of economists worked to show that people are like molecules, whose behaviour can be predicted in ways that are stable over time. Science then infected everything, from how much capital banks need to protect themselves against insolvency, to the risk in credit-default swaps. But there was a flaw: the City’s faux physicists never go back far enough in their analysis, because the data on the Bloomberg terminal cover a tiny period of history. “Real scientists tend to be much more sceptical about their data and their models,” says William Janeway, an MD of the private-equity firm Warburg Pincus and a Cambridge University lecturer. “They had all of the maths, but none of the instincts of good scientists.” There is also the 4x4 effect: if you give people a safer car (read, a safer world through financial innovation), they tend to drive faster. But we are getting ahead of ourselves.
To start with, AIG trod carefully in the new, scientific universe. Sosin’s idea was to buy financial risk from people who did not want it, then sell the risk to others in a series of “hedges” so that AIG kept the fees but not the risk. If a big organisation wanted to lock in an interest rate, for example, AIG would promise to pay the difference in costs if rates rose, then pass the risk to other parties in separate contracts. Sosin supplied the nerds and the models, AIG supplied the reassurance of its AAA rating, and for a long time the alchemy worked. AIG Financial Products (AIGFP), a unit with 0.3% of AIG’s 116,000 employees, made over $1 billion in profits between 1987 and 1992, a vast sum at the time. But Sosin left. And so did his successor, a mathematician named Tom Savage. When Savage departed in 2001, Greenberg put in charge a man he saw as “smart, tough and aggressive”: the unit’s chief operating officer, Joseph Cassano. The new leader had no background in Frankenfinance; his degree, from Brooklyn College, was in political science. The cop’s kid had ascended through what is called the “back office”: his expertise was in supervising the contracts and running the lawyers and accountants. This did not matter, Greenberg thought. Underlings had the right maths, and besides, Greenberg’s AIG held everyone, Cassano included, to account. The London team would be scrutinised. Which was just as well, as the huge intellectual error meant nobody else was in charge. “Why did no-one see it coming?” asked the Queen last November, on a visit to the London School of Economics. Well, they did, ma’am. Charles Bowsher, head of the US government’s General Accounting Office, testified as long ago as 1994 that “the sudden failure or abrupt withdrawal from trading” of large dealers in derivatives “could cause liquidity problems in the markets and could also pose risks to others, including? the financial system as a whole”. It took another 13 years, but that is exactly what happened.
One regulator tried to act on Bowsher’s warning, but she was silenced. Brooksley Born, who monitored the futures markets, tried to extend her remit to unregulated derivatives. Alan Greenspan and Robert Rubin, the then Treasury secretary, persuaded Congress to freeze her already limited power, forcing her departure. Rubin had come into government from Goldman Sachs; when he left he went back to banking, and pushed for Citigroup to step up its trading of risky, mortgage-related investments. For his advice, he earned over $126m (£84m) and then, as Citigroup collapsed, became an adviser to Barack Obama. After Greenspan stepped down from the US central bank in 2006, he became a consultant to Pimco, the world’s biggest bond fund, where his insights have been praised by his boss. “He’s made and saved billions of dollars for Pimco already,” said Bill Gross last year. Greenspan is also an adviser to Paulson & Co, a hedge-fund group that has made billions from the collapse in American housing.
The lightness of touch reached a level that defies belief. America has an Office of Risk Assessment, set up in 2004 to co-ordinate risk management for the main regulator, the Securities and Exchange Commission (SEC). Jonathan Sokobin, its director, says it is charged with “understanding how financial markets are changing, to identify potential and existing risks at regulated and unregulated entities”. According to its website, it also helps to “anticipate, identify and manage risks, focusing on early identification of new or resurgent forms of fraud and illegal or questionable activities? across the corporate and financial sector”. By early 2008, this office was reduced to a staff of one. “When that gentleman would go home at night,” says Lynn Turner, the SEC’s former chief accountant, “he could turn the lights out. We had gotten down to just one person at the SEC responsible for identifying the risk at all the institutions.” The $596-trillion market in unregulated derivatives, including $58 trillion in credit-default swaps, was being watched by one person. That’s when he wasn’t looking at the rest of the corporate world, of course.
We are in a hotel in London, sitting on cracked red leather sofas. The interview is with one of the finest analysts of financial statements on the planet. Where you or I see pages of numbers, he sees a narrative. Sometimes the theme is a company’s potential for growth. Sometimes it is the prospect of self-destruction. And at times the story does not make sense, because the figures are hiding a fraud. Charles Ortel, managing director of Newport Value Partners — a firm that provides research to professional investors — is explaining the potential for fraud in insurance. Insurers share their big risks with others. Imagine it is September 12, 2001, and you get a report on the previous day’s terrorist attacks. You don’t know your loss, because it takes time for victims to come forward and costs to be calculated. You decide it’s $12 billion and do a deal with another insurer: I will write you a cheque now for $9 billion, and we agree my liability is capped at $12 billion. If the eventual losses are higher, the second insurer will pay. In the meantime, it is free to invest the $9 billion. Insurers make much of their money from investing premiums while they wait for a claim.
The second insurer can book some of the $9 billion as income. It shouldn’t, because it is exposed to risk. But there’s flexibility in how the numbers can be treated. If the second insurer is not having a good year, the flexibility creates the temptation to book phantom earnings, illegally supporting the share price. In the past, AIG has admitted episodes of improper accounting.
One question has not been answered. Was Cassano’s team simply the dumbest in the room, betting on an ever-rising housing market against the likes of Goldman Sachs? Or was the world financial system brought down by fraud — a fraud made possible by the gradual but relentless takeover of public life by the insiders’ club of finance?
In 2001, with AIG trading at $85 on the New York Stock Exchange, The Economist decided to commission some research on the company’s true value, and chose the little-known firm Seabury Analytic to do it. This was deliberate. The magazine’s New York bureau chief, Tom Easton, had been around long enough to know that nobody on Wall Street ever says “sell”, except perhaps when a market is about to go up, and that the big security firms could not be trusted to give a candid view of AIG.
The research, which took five months, was the work of a team led by Tim Freestone, who is speaking here for the first time. Most analysts are upbeat: their colleagues’ bonuses depend on fees from the company under scrutiny. But Freestone’s firm (now called Crisis Economics) is independent. He judged that AIG was highly overvalued, and he would later realise that its shares were supported by an ability to stifle criticism. In his report for The Economist, however, he was tactful. To justify the share price, he said, “it would have to grow about 63% faster than [its] peers for the next 25 years. If investors believe that AIG can sustain this type of performance for that period of time, then AIG is properly valued”. Any investor who believed that would need to be certified.
After the article came out, researchers from the big banks contacted him, incredulous that he had dug deeper than the industry norm and dared to release the findings. They seemed to be in awe, and at the same time jealous; nobody breaks the rules like this — not without paying a price. A delegation from AIG arrived at his office and presented him with a letter that seemed to renounce the story and to condemn its distortion of his research. He was intrigued to see the author’s name at the end of the letter — why, it was his name, and the AIG contingent was awaiting his signature. The company also sent its executives on a private plane to The Economist headquarters in London to demand a retraction. Legal threats followed.
“I assumed AIG was attempting to railroad us out of business,” says Freestone, who did not sign.
Greenberg was forceful when it came to his share price. He was often on the phone to Richard Grasso, the head of the New York Stock Exchange, with expletive-laden threats to move AIG to the Nasdaq unless the exchange did a better job. Grasso would then be seen on the floor of the exchange, talking to the market-maker for the stock. Grasso says he never asked the market-maker to bid the shares higher, which is just as well: both men could have gone to jail.
What does all this have to do with Joseph Cassano? Seabury Analytic’s research suggests that when Cassano took over the Frankenfinance unit, the parent company was in trouble. “Its ‘distance to default’ was much closer than anyone realised,” says Freestone, whose models would later identify AIG and three peers — Lehman Brothers, Merrill Lynch and Bear Stearns — as insolvent when the markets saw everything as fine. He is not alone in his view. Another authority believes that as the man in Mayfair wrote his credit-default swaps, AIG was already doomed. “AIG’s foray into CDS was really the grand finale,” says Christopher Whalen, managing director of Institutional Risk Analytics, an expert on banking who has testified before Congress. Towards the end, it looked much like a Ponzi scheme, “yet the Obama administration still thinks of AIG as a real company that simply took excessive risks”. In other words, there was never a chance AIG would honour its contracts: its income was nowhere near enough to cover the payouts.
Whalen has a reputation to protect: he is global risk editor of The International Economy magazine, co-founder of the Herbert Gold Society, a group of current and former employees of the US Treasury and the Federal Reserve, and regional director of the Professional Risk Managers’ International Association. His assertion is not an impulse. It comes from months of talking to forensic specialists such as Freestone, insurance regulators “and members of the law-enforcement community focused on financial fraud”. As
evidence of dishonesty, Whalen points to AIG’s occasional habit of using secret agreements to falsify financial statements — either its own or those of other companies. In 2005, a former senior executive at the insurer General Re pleaded guilty to a conspiracy to misstate AIG’s finances, after General Re paid $500m in premiums for AIG to reinsure a nonexistent $500m risk. The transaction was a sham; the only economic benefit to either party was the $5.2m fee paid by AIG for Gen Re’s help.
When the $500m in loss reserves were added to AIG’s balance sheet in 2000 and 2001, Greenberg was able to claim an increase in reserves, when in fact they had declined. “They’ll find ways to cook the books, won’t they?” John Houldsworth, the former executive, said in a recorded phone conversation with Elizabeth Monrad, his chief financial officer. She observed that “these deals are a little bit like morphine; it’s very hard to come off of them”.
Similarly, in 2003 AIG was fined $10m for helping a telecoms company, Brightpoint, hide $11.9m in losses with a “non-traditional” insurance product that AIG offered for “income statement smoothing”. Brightpoint paid $15m in premiums, and AIG refunded $11.9m in fake insurance claims. The ruse allowed Brightpoint to spread its loss over three years, overstating its 1998 net income by 61%. And in 2005, AIG restated five years of financial statements, admitting that they had exaggerated its income by $3.9 billion.
Whalen believes that at some point between 2002 and 2004, AIG concluded that the game was up for secret agreements, and that other methods of enhancing revenue were needed. “The thing I haven’t satisfactorily answered,” Whalen adds, “is whether AIG was so unstable coming out of 2000, 2001, that Cassano was trying to cover up a wounded, dying beast. Was he doubling up, to try and hit a home run and save the house? It looks like it, because otherwise it was just greed on his part, and he was writing as much of this crap as he could to inflate his bonus.” If he is right, the implications are profound. Any bank that thought it was protected by credit-default swaps with AIG would have been exposed from the start, putting taxpayers at risk. The banks’ credit traders would — or should — have realised that AIG was never likely to pay out. “The key point that neither the public, the Fed nor the Treasury seems to understand,” says Whalen, “is that the CDS contracts written by AIG were shams, with no correlation between fees paid and the risk assumed. These were not valid contracts but acts to manipulate the capital positions and earnings of financial companies around the world.”
The investigation into the General Re affair prompted AIG to oust Greenberg in 2005. He has always denied wrongdoing. In fact, he is suing AIG, claiming his successors abandoned risk controls and destroyed the firm. The old man’s departure meant the brakes were off for Cassano; the new CEO, Martin Sullivan, had risen through the “property and casualty” side of the business. As he is fond of pointing out, he is not an accountant. Who would scrutinise the financial-products team now? The pace of CDS deals suddenly accelerated, until Cassano halted them for ever, all in the space of a few months. He had realised that sub-prime mortgages accounted for an increasing proportion of his trades, and that the underwriting standards were shocking. No model, however carefully constructed, can protect you from that. It was too late: the bomb on AIG’s books was ticking.
For the world to go truly insane, leading to what the Bank of England has called “possibly the largest crisis of its kind in human history”, two things are needed. The first is the intellectual capture of the Establishment, so that everyone — politicians such as Gordon Brown, regulators such as the SEC and the FSA, and academic and media commentators — is persuaded that a new way of thinking is in the public interest. The second step is when vested interests exploit the intellectual capture and take it to extremes.
Alpha males such as Cassano push at boundaries. You could say it is their evolutionary purpose. That is one reason we need governments, to protect us when male ambition reaches too far. But our governments were mesmerised by our bankers. “From 1973 to 1985,” says Simon Johnson, a former chief economist at the IMF, “the financial sector never earned more than 16% of [US] corporate profits. In the 1990s, it oscillated between 21% and 30%, higher than it had ever been in the post-war period. This decade, it reached 41%.” The whole point of financial companies is to allocate your savings to those who can use the money best. If they are taking 41% of the profit in an economy, something is out of balance. These figures reveal an enormous transfer of wealth.
Which brings us back to bonuses. In August 2007, as the financial crisis broke, Cassano claimed everything was fine. “It is hard for us, and without being flippant, to even see a scenario, within any kind of realm or reason, that would see us losing $1 in any of those transactions,” he told investors, as his CEO listened in on the call. But it seemed to be a different story inside AIG. The company had hired Joseph St Denis, a former SEC official, as part of an effort to improve its internal controls. Cassano shut him out. “I have deliberately excluded you from the valuation of the super seniors [a type of debt] because I was concerned that you would pollute the process,” St Denis recalls Cassano saying. The auditor resigned in protest, yet the minutes of AIG’s audit committee show no sign of concern.
In the final three months of 2007, AIG lost over $5 billion. Under the terms of the bonus scheme, top executives should have had their pay cut for poor performance. When the compensation committee met in March 2008 to award bonuses, however, the Essex-born CEO urged it to ignore the losses. The board approved the change, even though losses were growing by the month, and Sullivan pocketed $5.4m. He was also awarded a golden parachute worth $15m. He was out of the company three months later, with a severance package worth $47m (£31m). That is $39,500 (£26,000) for every day he was in charge. Pension funds and other savers holding AIG shares lost $58.4m (£39m) a day during his tenure.
In seven years, the 400 employees in Cassano’s division were paid $3.5 billion. Cassano received $280m. When the losses became public, AIG parted company with him immediately. But he wasn’t fired: he “retired”, with a contract paying him $1m a month for nine months, and protecting his right to further bonus payments. “Joe has been a very valuable member of the AIGFP senior management team for over 20 years,” said Sullivan, who was soon to leave the scene himself. “He has had a great career with us, and we wish him the very best in the future.”
Cassano’s division then imploded. As house prices fell, credit ratings were cut and bankers began to panic, AIG posted the biggest quarterly loss in corporate history: $61.7 billion. This is equivalent to losing $28m (£19m) an hour, every hour, for the final three months of 2008. But by now, the company’s problems were the property of the American taxpayer, creating extraordinary new conflicts of interest. Hank Paulson, the Treasury secretary in the outgoing Bush administration, was an ex-CEO of Goldman Sachs. He received tax benefits of about $200m (£133m) for taking on a government role. When the US decided to bail out AIG, the chief beneficiary of the rescue was? Goldman Sachs, which received $12.9 billion of public funds via the insurer. The new CEO, Edward Liddy, whose task is to wind down the company and to close $1.6 trillion in trades that are still outstanding from the Cassano era, is ex-Goldman Sachs. He even has $3.2m in the bank’s shares.
AIG tried to keep secret its payments to Goldman Sachs and others, somehow imagining you could have $182.5 billion of taxpayers’ money and not say how you were using it. And so the task facing Obama is even greater than we imagine. Intellectually, the president might see what is required, but execution still depends on the very club that helped bring about the collapse in the first place. “It is not outright fraud that has caused the most damage to the market,” says Tim Freestone, the analyst first to see AIG’s troubles. “It is the suppression of information, wittingly or unwittingly, by most of the market’s players.” A rush to regulation is not the answer, he adds: each new rule creates a minimum target for compliance, with unintended results. The challenge is to confront the keiretsu, the interlocking relationships that give insiders such an advantage.
Bankers and politicians like to blame the catastrophe on this or that cause, which swelled into a tsunami nobody could have foreseen. But as Simon Johnson points out, each reason — light regulation, cheap money, the promotion of homeownership — has something in common. “Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector.”
AIG’s early trades showed genuine brilliance; their later CDS deals, many of which were not even “hedged”, were as foolish as can be. Was it fraud? Yes, in the widest sense — but it was fraud as wilful ignorance, in which a whole industry is based on false assumptions, and each participant has little reason to question the system as long as it continues to make him rich. “There is no need to have an overt conspiracy, or to be incompetent,” says a thoughtful internet poster called Anonymous Jones. “Unfortunately, those ultimately bearing the risk — savers, taxpayers — did not have as strong a personal incentive to keep watch over the system, and those in charge of the financial sector ran roughshod over the entire enterprise, extracting profits far in excess of any value generated by their actions. When there are enormous incentives for each participant to cheat, the efficiency of any market breaks down.”
In recent weeks, Cassano has grown a beard and changed his crash helmet, which is no longer red but silver. The disguise might not be enough; prosecutors are said to be close to criminal charges. They think he misled investors, an easier case to make than that of knowingly risking the financial system. “To date, neither AIG nor AIGFP is aware of any fraud or malfeasance in connection with the underwriting and creation of the multi-sector CDS portfolio,” says AIG, referring to the trades under scrutiny, “as opposed to what, with hindsight, turned out to be bad business decisions.”
If they were bad decisions, they had a context. “Once people who push boundaries understand that the police don’t want to issue tickets,” says Charles Ortel, “they start pushing. ‘If you’re not going to arrest me for going 10 miles over the speed limit, well, I’ll try 20. If I can do 20, I’ll try 30. And then I’ll try flying a plane on a road.’”
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Hhhm, are investigations disappearing into the night just like FDIC resolutions, Friday night massacres so as not to upset the great unwashed public?
Joe Cassano, head of AIG’s Financial Products Group and individual most responsible for the insurer’s collapse, will not be prosecuted. Per the Wall Street Journal:
Federal prosecutors will not bring criminal charges against current and former American International Group Inc. executives for their role surrounding financial contracts that nearly brought down the insurer about two years ago
Yves here. Now how could this possibly have come to pass? Wellie, if you rope your advisors like your accounting firm into signing off on your stupid or possibly even criminal behavior, then you get off scot free:
But after a series of meetings with the targets of their probe, prosecutors obtained information about Mr. Cassano’s disclosures to AIG senior executives and AIG’s outside auditor, PricewaterhouseCoopers LLP. That changed the course of the investigation, these people said.
Yves here. Now why hasn’t the bright spotlight been turned on PwC? They are too big too fail. Now that there are only four accounting firms deemed capable of auditing Fortune 500 companies, no one in the officialdom is about to launch an action against them that might lead to their demise, no matter how well deserved it might be. Francine McKenna has written at considerable length about the fact that PwC was auditor to both Goldman and AIG, and was clearly signing off on valuations of the SAME instruments at DIFFERENT prices at each firm:
Why didn’t PwC speak up, act more strongly to match mismatched valuations between entities like AIG and Goldman Sachs, raise their hand and shout fire, or at least warn of suffocating black smoke obscuring woefully inadequate risk management and of pricing “models” strung together like so many holiday lights electrical cords, faulty wiring and all, ready to blow the circuits?
Was it the fees?
Well, there’s certainly $230 million plus reasons in 2008 to play nicey-nice between the two clients. But that explanation would be too simple.
Another little problem which has been completely missed in our rush to get Potemkin financial reforms in place is that prosecutors often cannot pursue lawyers and accountants even when they play a key role in perpetrating dubious or even criminal conduct. As we wrote in ECONNED:
Legislators also need to restore secondary liability. Attentive readers may recall that a Supreme Court decision in 1994 disallowed suits against advisors like accountants and lawyers for aiding and abetting frauds. In other words, a plaintiff could only file a claim against the party that had fleeced him; he could not seek recourse against those who had made the fraud possible, say, accounting firms that prepared misleading financial statements. That 1994 decision flew in the face of sixty years of court decisions, practices in criminal law (the guy who drives the car for a bank robber is an accessory), and common sense. Reinstituting secondary liability would make it more difficult to engage in shoddy practices.
Another perverse aspect is that the fact that AIG as a company, as opposed to individuals, may have engaged in criminal conduct is deemed to be moot. The attitude seems to be, “AIG is a ward of the state, why bother?” But that misses the point. UBS, which was rescued by the Swiss government, had to have outside investigators prepare a report of what went wrong. Why hasn’t every other bailed-out entity been required to make similar reports? The public, and more important, regulators and legislators would have a much better understanding of why the financial system went off the rails. And in the case of AIG in particular, there is ample evidence the company at a minimum had poor accounting and controls (recall the scenes in Andrew Ross Sorkin’s Too Big to Fail, where the AIG top brass has only a dim idea of how bad its cash shortfall is, and at a very advanced stage, discovers a $20 billion leak in its securities lending operation).
Given that AIG had a dubious and contested relationship with a sister firm, C.V. Starr (controlled by Hank Greenberg), which appears to have served as an executive enrichment vehicle, the sloppy accounting may have served as a cover for other types of executive-wallet-flattering activities. But the decision has clearly been made to pull a veil over AIG, to the detriment of the interest of taxpayers who are paying for its lapses.
attempter says: This reads like a mini-clinic in the abdication of “the law”.
Now how could this possibly have come to pass? Wellie, if you rope your advisors like your accounting firm into signing off on your stupid or possibly even criminal behavior……
Now why hasn’t the bright spotlight been turned on PwC? They are too big too fail…..Another little problem which has been completely missed in our rush to get Potemkin financial reforms in place is that prosecutors often cannot pursue lawyers and accountants even when they play a key role in perpetrating dubious or even criminal conduct….
Another perverse aspect is that the fact that AIG as a company, as opposed to individuals, may have engaged in criminal conduct is deemed to be moot.
These are the fruits of the systematic top-down rigging, subversion, and hijacking of the law. There is no longer any rule of law.
But of course the system hacks and their enablers among the non-rich continue to claim that the people should respect “law” and “contracts” in their dealings with gangsters.
MF says:
Stupidity and greed have never been criminal offenses. I agree with you that maybe they should be.
It is pretty obvious that AIGFP was a choking point of naked CDS they were the ones ultimately insuring and effectively created the conduit to the public purse for the gangsters.
I think very little of this type of corporate america anyway. Pastry white faces, incompetent, vague smell of sickness about them. Just talk about their acts, expose them for the frauds that they are.
Since regulation didn’t require proper collateral posting for CDS in general then these little piggies counted all the premium as income. There was no “setting aside”. This regulation is about to change and thank god for that.
AIGFP is just despicable, a prime example of 21st century financier behavior.
Bah!
Independent Accountant says: YS:
No surprise here. I bet Cassano knows where all the bodies are buried and told the SDNY US Attorney’s office, if he went down: Vampire Squid, some of its executives, Timmy Boy, Zimbabwe Ben and Henry Paulson were coming too.The case against Cassano reminds me of 1994’s Joseph Jett (JJ) case. No criminal case could have been made against JJ without taking down many Kidder Peabody officers and GE’s CPA firm, KPMG. By the way, I think JJ was not a criminal, just a trader who was fooled by Kidder’s accounting system which predated his joining Kidder. Consder, did KPMG ever tell GE Kidder’s income recognition policies were wrong?
Go Cassano.
I’ve commented on PWC’s improprieties at AIG many times. Where has the PCAOB been on this? Hiding under the Treasury Department’s blanket.
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Last modified: March 12, 2019
Haven't had time to read Michael Lewis's article, but the logic outlined in your post seems quite rational. From my understanding, AIG and the monolines were writing guarantees on the AAA tranches of the subprime securitisations. The mezz tranches were largely stuffed into CDOs for resecuritisation. Because the AAA tranches had credit enhancement in the forms of both subordination of lower-rated tranches and credit guarantees from AIG, they were easier to sell to investors. When AIG stopped providing the guarantees, the AAA tranches could only rely on subordination, and from all accounts, became harder to sell, so the banks retained the AAA tranches from 2006 onward. So, the banks took the risks because they held on to the AAA tranches without CDSs from the insurers. By saying "getting the deal done", it just means that they structured the deal, but they maintained large exposures.
AAA tranche investors are most concerened with correlation risk, where a large number of underlying assets default at the same time. This is what happened to subprime, where geographical diversification did not lower correlation. In any event, I believe all of AIG's subprime exposure was all to the AAA tranches.