IF YOU'VE HIDDEN THE RISK FROM EVEN THE GUY IN CHARGE ARE YOU STILL A CRIMINAL ENTERPRISE?:

The Man Who Crashed the World: Almost a year after A.I.G.’s collapse, despite a tidal wave of outrage, there still has been no clear explanation of what toppled the insurance giant. The author decides to ask the people involved—the silent, shell-shocked traders of the A.I.G. Financial Products unit—and finds that the story may have a villain, whose reign of terror over 400 employees brought the company, the U.S. economy, and the global financial system to their knees. (Michael Lewis, August 2009, Vanity Fair)

Here is an amazing fact: nearly a year after perhaps the most sensational corporate collapse in the history of finance, a collapse that, without the intervention of the government, would have led to the bankruptcy of every major American financial institution, plus a lot of foreign ones, too, A.I.G.’s losses and the trades that led to them still haven’t been properly explained. How did they happen? Unlike, say, Bernie Madoff’s pyramid scheme, they don’t seem to have been raw theft. They may have been an outrageous departure from financial norms, but, if so, why hasn’t anyone in the place been charged with a crime? How did an insurance company become so entangled in the sophisticated end of Wall Street and wind up the fool at the poker table? How could the U.S. government simply hand over $54 billion in taxpayer dollars to Goldman Sachs and Merrill Lynch and all the rest to make good on the subprime insurance A.I.G. F.P. had sold to them—especially after Goldman Sachs was coming out and saying that it had hedged itself by betting against A.I.G.? Since I had him on the phone I asked Jake DeSantis for what Congressman Grayson had asked Edward Liddy: names. He obligingly introduced me to his colleagues in London and Connecticut, and they walked me through what had happened—all of them speaking to someone from the outside for the first time. All, for obvious reasons, were terrified of seeing their names in print, and asked not to be mentioned by name. That was fine by me, as their names are not what’s interesting. What’s interesting is their point of view on the event closest to the center of the financial crisis. For while they disagreed on this and that, they all were fairly certain that if it hadn’t been for A.I.G. F.P. the subprime-mortgage machine might never have been built, and the financial crisis might never have happened.
The Soul of a New Machine

A.I.G. F.P. was created back in 1987 by refugees from Drexel Burnham, led by a trader named Howard Sosin, who claimed to have a better model to trade and value interest-rate swaps. Nineteen-eighties financial innovation had all sorts of consequences, but one of them was a boom in the number of deals between big financial firms that required them to take each other’s credit risks. Interest-rate swaps—in which a party swaps a stream of income from a floating rate of interest for one from a fixed rate of interest—was one such innovation.

Once upon a time Chrysler issued a bond through Morgan Stanley, and the only people who wound up with credit risk were the investors who had bought the Chrysler bond. Now Chrysler might sell its bonds and simultaneously enter into a 10-year interest-rate-swap transaction with Morgan Stanley—and just like that Chrysler and Morgan Stanley were exposed to each other. If Chrysler went bankrupt, its bondholders obviously lost; depending on the nature of the swap and the movement of interest rates, Morgan Stanley might lose, too. If Morgan Stanley went bust, Chrysler along with anyone else who had done interest-rate swaps with Morgan Stanley stood to suffer. Financial risk had been created, out of thin air, and it begged to be either honestly accounted for or disguised.

Enter Sosin, with his supposedly new and improved interest-rate-swap model (even though Drexel Burnham was not at the time a market leader in interest-rate swaps).

There was a natural role for a blue-chip corporation with the highest credit rating to stand in the middle of swaps and long-term options and the other risk-spawning innovations. The traits required of this corporation were that it not be a bank—and thus subject to bank regulation and the need to reserve capital against the risky assets—and that it be willing and able to bury exotic risks on its balance sheet. There was no real reason that company had to be A.I.G.; it could have been any AAA-rated entity with a huge balance sheet. Berkshire Hathaway, for instance, or General Electric. A.I.G. just got there first.

In a financial system that was rapidly generating complicated risks, A.I.G. F.P. became a huge swallower of those risks. In the early days it must have seemed as if it was being paid to insure against events extremely unlikely to occur—how likely was it that all sorts of companies and banks all over the globe would go bust at the same time? Its success bred imitators: Zurich Re F.P., Swiss Re F.P., Credit Suisse F.P., Gen Re F.P. All of these places were central to what happened in the last two decades; without them the new risks being created would have had no place to hide, but would have remained in full view of bank regulators. All of these places have been washed away by the general nausea now felt in the presence of complicated financial risks, but there was a moment when their existence seemed cartographically necessary to the financial world. And A.I.G. F.P. was the model for them all.

The division’s first 15 years were consistently, amazingly profitable—there wasn’t the first hint that it might be running risks that would cause it to lose money, much less cripple its giant parent. Its traders were able to claim that they were “hedged,” and even if the term was misleading, they never sold exactly the same thing as the thing they had bought—there was always some slight difference. The risks it ran were probably trivial in relation to its capital, because the risks that the financial system wanted to lay off on it were, in fact, not terribly risky. One indication of this is that, even in the middle of the calamity, the 95 percent of A.I.G. F.P. that had nothing to do with subprime-mortgage bonds continued to generate profits. By 2001, A.I.G. F.P. could be counted on to generate $300 million a year, or 15 percent of A.I.G.’s profits.

Meanwhile, the people who worked at A.I.G. F.P. got rich. Exactly how rich is hard to say, but there are plenty of hints. One is that a company lawyer—a mere lawyer!—took home a $25 million bonus at the end of one year. Another is that in 2005, when Howard Sosin and his wife divorced, she received more than $40 million of an estate valued at $168 million—and Sosin had left A.I.G. in 1993, receiving $182 million from the company! He had been replaced that year as C.E.O. by a gentler soul named Tom Savage, who had allowed Hank Greenberg to take some of the sugar out of F.P., but even then the small band of traders had, arguably, a sweeter deal than any money managers in the world. The typical hedge fund kept 20 percent of profits; the traders at A.I.G. F.P. kept 30 to 35 percent. The typical hedge fund or private-equity fund has to schlep around and raise money all the time, and post collateral with big Wall Street firms for all the trades they do. The traders at A.I.G. F.P. had essentially unlimited capital on tap from the parent company, along with the AAA rating, rent-free. For the people who worked there, A.I.G. F.P. was a financial miracle. They were required to leave 50 percent of their bonuses in the company, but they were happy to do so; many of them, viewing it as the best way to grow their own savings, invested far more than the minimum back in the company. When it collapsed, the employees lost more than $500 million of their own money.

How and why their miracle became a catastrophe, A.I.G. F.P.’s traders say, is a complicated story, but it begins simply: with a change in the way decisions were made, brought about by a change in its leadership. At the end of 2001 its second C.E.O., Tom Savage, retired, and his former deputy, Joe Cassano, was elevated. Savage is a trained mathematician who understood the models used by A.I.G. traders to price the risk they were running—and thus ensure that they were fairly paid for it. He enjoyed debates about both the models and the merits of A.I.G. F.P.’s various trades. Cassano knew a lot less math and had much less interest in debate.

Mr. Lewis rather easily identifies the answer he claims we don't have: derivatives were used to disguise risk downwards.

Posted by Orrin Judd at July 6, 2009 5:24 PM