The collapse of American International Group (AIG) was largely the result of a little understood investment strategy that allowed the insurance giant to make optimistic bets on the housing market and other asset classes without having to actually buy the bonds backed by mortgages or other assets.
The details of AIG’s investment strategy have been largely obscured by the analogy with insurance. In the typical telling, AIG is depicted as insuring mortgage bonds packaged by banks. AIG often seems to be almost a passive and unsophisticated player that came in after the deal.
In reality, AIG was deeply involved in the creation of the financial products it insured, according to a person familiar with the matter.AIG was frequently involved right from the start of deals to securitize assets. It conducted its own due diligence on asset backed securities, sometimes going further than the banks that were actually buying the securities. Its financial professionals at times pitched deals AIG wanted insure to underwriters. It was an active participant in the market with a sophisticated, if risky, strategy for investing in the housing markets and infrastructure projects.
AIG As A Buyer Of Risk
AIG’s financial products division became what is known on Wall Street as a “synthetic buyer” of a variety of asset backed securities, including mortgages and infrastructure linked bonds. AIGFP would sell credit default swaps that performed for the company much like an ordinary bond would for a bond investor. As long as the insured bonds were performing, AIG would receive a regular revenue stream from the buyer that mirrored the regular payments of interest and principle that a bond holder would receive. AIG was able investing in the bonds without actually having to buy them.
AIG, in other words, was essentially performing the financial product equivalent of buying a house with out having to make a down payment.
Goldman Sachs, which has been depicted in the press as “stuffing” AIG with risk to bad mortgages, frequently found itself packaging bond deals specifically to meet the demand from AIG for mortgage exposure, sources familiar with the matter say.
For AIG, investing in the bonds synthetically by selling credit default swaps had a major advantage over buying the bonds directly. Much of AIG’s capital was tied up in regulated insurance business, which meant that despite its huge balance sheet it could only deploy investment assets in limited ways. Insuring bonds rather than buying them allowed AIG to take a position and earn profits from the mortgages without having to pay any money up front to make the investment. In fact, AIG received a fee from the buyer of the swaps. So AIG was basically getting paid to make its synthetic investments in asset backed bonds.
The Collateral Risk
Of course, this strategy of synthetically investing in bonds was far riskier than AIGFP appreciated. When the value of the bonds declined, AIG had a contractual obligation to post collateral to its counter-parties. Many of the bond insured were relatively illiquid, which meant that judgment calls were frequently involved in deciding whether or not more collateral had to be posted.
Some banks, including Merrill Lynch, that had done these synthetic deals with AIG were hesitant to demand more collateral because they had such large portfolios of mortgage backed bonds. If they insisted the bonds had declined in value, they would be forced to take write-downs on the value of similar bonds they were often still holding at face value. For much of 2007, there was something of a self-deceiving circle between AIG and many of its customers about the value of the insured assets.
Goldman Sachs took a more negative view of the market. Traders at Goldman had become nervous about the mortgage market following the release of home sales data by the National Association of Realtors in 2006.
“More than half of the country’s housing markets are experiencing a meaningful cooling, making them fragile and vulnerable to higher interest rates,” David Lereah, the chief economist of the NAR, wrote in an August 2006 newsletter article titled “Fragility in housing markets is a greater risk than inflation now.
“Think of all the variable-rate loans originated over the past two years. If the Fed continues to push interest rates up, the higher monthly mortgage payments from the repricing of variable rate mortgages could result in higher delinquency and foreclosure rates, which could aggravate already sluggish local housing markets,” Lereah wrote.
Early that year, the ABX index tracking home loans was launched, providing traders with additional indicators of mortgage risk. Goldman began marking its mortgages down and reducing its exposure to the mortgage market. Since the assets were already marked down in the mortgage books, Goldman was less hesitant than its rivals to ask for additional collateral.
A Long History With Goldman Sachs
Goldman had been dealing with AIGFP for years. In early 2003, the private operators of the two airports in Italy’s Rome issued asset backed securities that were wrapped with a guarantee from Ambac. AIG approached Goldman Sachs with a proposal to offer additional protection on the securities. Goldman was unique among Wall Street firms in that it did not like to do business with the monoline insurers because they insisted on not posting collateral. AIG was willing do post collateral, despite its triple A credit rating, which made it a perfect partner for Goldman.
By insuring the bonds, AIGFP got to share in the cash flow from the Rome airport deal without having to put any money down. Goldman got a piece of the innovative securitization while minimising its risk. The Rome airport bonds performed well, which meant that AIG did not have to post additional collateral. For Goldman, however, the deal was not as profitable as it would have been if they had foregone credit protection from AIG. The cost of protection mean the bonds had a lower yield for Goldman.
That was the first deal in which AIGFP acted as a synthetic buyer of bonds that Goldman purchased outright. It became the model for many subsequent deals, where AIG would spot a market that was not dominated by the monoline insurers and work with underwriters in structuring deals. Goldman would sometimes act as the underwriter but more often than not it was purchasing bonds so that AIG could then synthetically purchase them by insurance. Goldman made profits off of the spread between the bond yield and the cost of insurance—or the yield on the synthetic bonds.
This seems to be what Goldman means when it says that many of its deals with AIGFP were initiated by its customers. That customer was often AIGFP.
Goldman Gets Worried
As is now well-known, Goldman began demanding more capital when it concluded that the mortgage market was in trouble. In general, the additional collateral was simply cash or sometimes Treasuries that would be wired into Goldman’s account.
In effect, when AIG had to post more collateral, it was forced to make the down payment it had skipped when it first made its synthetic purchase of the bonds through the sale of the swaps. But AIG quickly discovered that it had extremely over-extended itself by making so many synthetic purchases of bonds. In total, AIG had sold protection on $527 billion of asset backed securities.
Goldman traders initially believed that AIG was a safe counter-party. It was the world’s largest insurance company, a legendary Goliath of Wall Street. AIG had stopped insuring subprime bonds in 2006, around the same time Goldman had become nervous about the housing market. This was regarded as a sign that AIG was probably in good shape.
But as conditions further deteriorated in the housing market and Wall Street firms began wracking up losses, Goldman took the extra-step of covering its counter-party exposure to AIG by buying protection on AIG from other banks. The protection was available relatively cheap, in part because few others realised that AIG was so over-extended. Goldman protected itself further by requiring collateral from the sellers of protection on AIG, just in case an AIG collapse triggered a domino effect that would knock-out other banks.
This protection on protection ate into the Goldman traders profits. Some at the firm questioned whether the trading desk was needless piling up costs and eating away at the yield it had.
When the crash came, however, these moves seemed prescient. Goldman famously found itself with $20 billion of exposure to AIG. The odds of the underlying bonds going to zero, however, were slight. Even if AIG defaulted on its swap obligations, Goldman would still own the bonds that could be sold at some price or even retained for whatever revenue they continued to spin off. What’s more, Goldman had received cash collateral for around half of that exposure.
Let’s say Goldman’s bonds were worth only 5 cents on the dollar after an AIG default. That would mean that Goldman would have a $19 billion shortfall. But with the cash collateral from AIG, only around $10 billion of that would remain. The credit protection Goldman had purchased on AIG was collateralized with even more cash. So even if the domino scenario knocked out the other CDS counter-parties, Goldman’s overall exposure would have likely have been less than $4 billion, according to a rough estimate by a person familiar with the matter.
The Irony Of Protection
Ironically, the critics of the cautious traders turned out to be right. All of this credit protection on AIG was unnecessary because the government paid AIG’s counterparties 100 cents on the dollar. Those legendary Goldman credit traders had spent years creating deals with diminished yields due to the costs of credit protection when the firm could have bet on the bailout.
Other firms seem to have made precisely this bet. Merrill Lynch did not have the same level of risk management as Goldman, according to a former Merrill employee. This meant that the deals Merrill did with AIGFP were far more profitable for the firm. When AIG was bailed out, that “reckless” strategy turned out to be the correct one for the firm.
AIGFP played a critical role in creating the demand for asset backed bonds because of its insatiable hunger for making synthetic purchases of the bonds. Ironically, it is now all but absolved for its recklessness by the many media accounts that insist banks “stuffed” AIG with exposure to bad loans. But in reality, AIG wasn’t stuffed by anyone but its own gluttonous hands.