At long last, Michael Lewis’s article on the destruction of AIG is online. One of the most striking things about the article is that there was no secret quantitative formula at work behind AIG’s credit default swap sales. In fact, the guys running AIG don’t seem to have understood how much subprime insurance they were selling at all. And they only discovered it by accident, when it was too late.
Lewis explains how Joe Cassano the head of AIG’s Financial Products group wanted to hire a fellow named Gene Park to be the sales ambassador to Wall Street’s securitization desks. Park decided that before he took the job he’d better look into how the business was working. One of the things he discovered is that no one was watching the shop.
He suspected Joe Cassano didn’t understand what he had done, but even so Park was shocked by the magnitude of the misunderstanding: these piles of consumer loans were now 95 per cent U.S. subprime mortgages. Park then conducted a little survey, asking the people around A.I.G. F.P. most directly involved in insuring them how much subprime was in them. He asked Gary Gorton, a Yale professor who had helped build the model Cassano used to price the credit-default swaps. Gorton guessed that the piles were no more than 10 per cent subprime. He asked a risk analyst in London, who guessed 20 per cent. He asked Al Frost, who had no clue, but then, his job was to sell, not to trade. “None of them knew,” says one trader. Which sounds, in retrospect, incredible. But an entire financial system was premised on their not knowing—and paying them for their talent!
Park winds up turning down the job and convincing Cassano to meet with the big Wall Street firms to discuss the logic of the deals AIG was insuring. What they discovered was that all of the CDOs were based on the premise that there wouldn’t be a national decline in house prices.
“They all said the same thing,” one of the traders present at the meeting told Lewis. “They’d go back to historical real-estate prices over 60 years and say they had never fallen all at once.”
Lewis notes that the only exception was to this view was Goldman Sachs. “Two months after their meeting with the investment bank, one of the A.I.G. F.P. traders bumped into the Goldman guy who had defended the bonds, who said, Between you and me, you’re right. These things are going to blow up,” Lewis writes. (Attention Matt Taibbi: your next column is already writing itself.)
The AIG FP executives had apparently blindly trusted that the smart guys on Wall Street had some sophisticated theories underpinning their CDO machinery. On the one hand, you can see how a bunch of guys in the branch office of an insurance company could assume that the guys in fancy shoes from fancy schools at Wall Street banks would have worked out everything in endless spreadsheets.
On the other, it is shockingly naïve. After all, these guys who were telling the AIG FP guys that the deals were good were asking AIG to insure their risk. AIG seems to have assumed they were doing this purely for regulatory compliance reasons—banks could increase the capital they could deploy in the markets by having AIG insure assets. But it’s hard to escape the sense that the rest of Wall Street just regard AIG FP as an extraordinarily wealthy mark to be taken for everything it had.
After these meetings, AIG FP actually got out of the business of selling credit default swaps on subprime mortgages. But it was too late. AIG had spent 2004 and 2005 taking on a huge amount of the risk from subprime mortgage bonds—Lewis says they took most of it, in fact. And by that point it was all over.
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