The bailout of AIG stands out as the largest commitment of public funds for a single private company in financial history. How did the world’s biggest insurance company become the largest corporate ward of the government, of all time?
For the curious, I recommend pages 2-4 of SIGTARP’s latest AIG report as it reports on the growth of the credit default swap business – which subsidiary AIG Financial Products (AIG FP) jumped into in a big way, and which ultimately brought down the whole company, and very nearly the global financial system with it.
For the even more curious, let me explain what I saw on Wall Street in the years before AIG blew up.
When I joined Goldman’s mortgage department in January 2002, I was paired with a senior mortgage bond salesman to help me learn the business as well as to help back up his clients while I built my own book of institutional business. My sales partner’s biggest client – by far – was AIG FP. I remember sitting down with him as he explained the trades Goldman was doing with AIG FP that had recently earned my partner the biggest “Atta-boys” from Lloyd Blankfein, then the head of the fixed income department.
Here’s my explanation of his explanation, in layman’s terms:
AIG Financial Products and Goldman jointly picked a large portfolio of companies on which Goldman wanted credit protection for a 10 year period. For an annual fee paid by GS, AIG FP guaranteed to make up the difference, financially, if a large number of these companies defaulted at the same time. The companies chosen for these portfolios were highly-rated and well known, and each individually seemed highly unlikely to default. In addition, the trades were structured so that only a highly improbable simultaneous default could put AIG FP on the hook for paying the credit insurance money to Goldman.
My first thought, and I said as much to my sales partner, was that AIG FP was selling deep-out-of-the-money “puts” to Goldman. He agreed. I had just moved internally, the month before, from the Emerging Markets desk at Goldman, where one of the well-known rules in EM was that selling deep-out-of-the-money puts always, always,ALWAYS comes back to bite you. I filed this new information away as a thing to keep in mind.
For the next few years backing up sales coverage of AIG FP, I assisted my sales partner as he executed a number of similar, gigantic trades with AIG. The trades often took weeks or months to put together – essentially an eon in the life-span of the trading floor, where a simple $ billion mortgage bond trade can be executed faster than you can read this paragraph. My partner developed a reputation as an ‘elephant hunter,’ the guy who took a long time on his derivatives trade, but when they got done, they were huge – for him, for the mortgage department, and for the whole firm itself.
In combination with a few other large, timely trades done in the mortgage department in 2007 and 2008, these elephant trades positioned Goldman to survive the Credit Crunch better than any other firm on Wall Street. Also, in combination with similar trades done with other Wall Street firms, these trades took down AIG in 2008, nearly bringing the world financial system with it.
Each time these credit default swap portfolio trades were done with AIG FP, a number of senior managers would descend on our section of the trading floor to pat my friend on the back and offer high fives.
The really interesting thing about these trades, though, and something almost too deliciously ironic for words, is that over at AIG FP in Connecticut, the exact same thing was happening with our client. Whenever he executed one of these trades, his own senior manager, including the now infamous London-based Joe Cassano, would offer huge congratulations and high fives.
As my sales partner explained, both AIG FP and Goldman thought they were taking advantage of the other side. Each one walked away from the closing table of the deal convinced that they’d gotten one over on the other side.
AIG FP, for its part, used quantitative models that showed, to their satisfaction, that the likelihood of simultaneous bond defaults by high quality companies, and therefore the probability of having to make default insurance payouts to Goldman on the portfolio, was virtually impossible. For them, the premiums Goldman paid were – at least according to their models – free money.
For the Goldman mortgage department, by contrast, the trades provided end-of-the-world insurance against the 1,000 Year Financial Flood, which the Goldman traders kind of know happens approximately once every 10 years. In more technical terms, however, the Goldman traders also incorporated into their models the fact that the real world correlation between corporate defaults actually changes the probability of credit default insurance payout, when compared to simply taking the probability of corporate bond defaults in probabilistic isolation, i.e. one at a time.
The analogy here, in property insurance terms, is the difference between assuming that damage from destructive hurricanes occurs via a randomly distributed weather pattern, without taking into account the idea, in a global warming sense, that the appearance of one devastating hurricane may indicate that more devastating hurricanes are on the way. With this difference in outlook between AIG FP and Goldman, both sides could reasonably believe they had gotten the much better end of their deals.
In retrospect, on these trades, AIG FP got one thing basically correctly, and a few things devastatingly wrong.
First, what they got right: AIG FP’s head, Joe Cassano, famously insisted on an investment analyst conference call in August 2007, in the face of the market moving against their CDS portfolio trades, that “It is hard for us, without being flippant, to even see a scenario within any kind of realm or reason that would see us losing $1 in any of these transactions.” I believe his statements to be technically correct, in the sense that the trades did not actually trigger insurance payouts.
What Cassano forgot, or willingly misled investors on that call through elision, was a combination of key investing rules:
First, markets can remain irrational longer than you can remain solvent. It wasn’t the actual losses on the portfolio, but rather the need for cash to post collateral, and then the suddenly unexpected unavailability of cash just at the wrong moment. If AIG FP needed $20 Billion to post collateral for a trade in any other environment except the Credit Crunch of 2007/2008, they could have just raised it in about a week from the bond markets. But they needed money precisely because the environment was terrible. Markets are correlated. As they always become when you’ve sold deep-out-of-the-money puts.
Second, a AAA-rated derivative structure made with investment grade corporate bonds – CDS trades AIG FP did with Goldman circa 2000 to 2004 – does not always translate positively to AAA-rated derivative structures made with nominally investment grade mortgage bonds based on sub-prime mortgages – CDS trades AIG FP did with Wall Street circa 2004 to 2006.
The third rule of investing Cassano and AIG FP forgot is that when you fry up on the griddle a combination of open-ended liabilities with heavy leverage, and then mix in complexity, you’re cooking a sh*t pancake.
So on that summary note, what else do we learn about AIG from the SIGTARP report?
The SIGTARP report on AIG points to a number of primary causes:
First, no central government regulator had ultimate responsibility for overseeing AIG’s operations, which spanned the globe and straddled the insurance and Wall Street banking worlds. The Office of Thrift Supervision (OTS), a relatively weak bank regulator, nominally had responsibility for AIG’s non-insurance financial operations, because of a small Wilmington, DE thrift that AIG owned. The OTS had about as much chance of reining in AIG FP as Boss Hogg and Roscoe P Coletrane would have of taking on the Zetas in Northern Mexico right now. OTS clearly got run over, in the years leading up to 2008.
With the benefit of hindsight we know the OTS had no way of regulating a sophisticated operation like AIG’s, and we can assume AIG benefitted in the lead-up to the Credit Crunch from a form of ‘regulatory arbitrage,’ in which the company chose which regulator to work with depending on its own advantage, rather than the public welfare.
This kind of regulatory shopping happens all the time, of course, but it’s still a failure of regulatory leadership which we need to notice. Fortunately it appears that, as a result of Dodd-Frank, AIG will be designated a Systemically Important Financial Institution (SIFI) and will be regulated by the Federal Reserve Bank in the future.
We also know from the SIGTARP report, as well as subsequent news articles, that AIG will not trigger the next financial crisis. The SIGTARP report tracks the halving of the AIG balance sheet in the last few years, through the sale and disposition of various lines of core and non-core businesses. Unlike the Too Big To Fail Banks, AIG hasactually gotten smaller and more focused, making it systemically less important, as seems appropriate, given its history.
The TBTF Banks, by contrast, actually control a larger share of assets and the US banking sector than before the Credit Crunch four years ago, entirely inappropriately, given their history.
AIG’s shrinkage, as tracked by SIGTARP, gives cause for celebration of public regulation for public good. The TBTF banks’ growth since the crisis, unfortunately, represents the opposite.
As the SIGTARP reported earlier, we will not know the cost of this failure to address the pressing TBTF issue until the next crisis hits.
In simplest terms, “credit protection” means that if a company defaults on its bond obligation and ceases to pay, the insurer offers to make up the difference to the buyer of credit protection. In the case of the AIG FP and GS trades, GS wanted to buy insurance and AIGFP offered to sell the insurance.
 A put option allows the put buyer to sell something to the seller at a price below where the market is today. In other words, the put option allows you to dump something at a set price if the price drops dramatically. When markets go bad, it’s wonderful to own puts, and it’s awful to have sold puts.
 “Deep-out-of-the-money” here means the agreed-upon put price is well below where the market is at the time of the derivative trade. Things have to get really bad for ‘deep-out-of-the-money’ puts to become relevant. Like, for example a 5 standard deviation move, also known as the proverbial “1,000 year flood” in financial markets. By the way, has anyone else noticed that 1,000 year floods in financial markets seem to happen about once every 10 years, or is that just me?
 Goldman’s so-called “Big Short” of 2007 – for which Michael Lewis’ book is named but which he barely describes -would also be on the short list for major firm-saving moves that Goldman’s mortgage department enacted. Goldman’s Big Short itself is better described in the final chapters of William Cohan’s Money and Power: How Goldman Sachs Came to Rule the World, reviewed by me here, for which Cohan got access to a few of my former mortgage bond colleagues, including Dan Sparks and Josh Birnbaum.
 I still consider it unknowable whether Goldman could have survived the weeks following Lehman’s bankruptcy without the US Treasury’s purchase of preferred shares in Too Big To Fail banks. But I would argue that Goldman was in a better position than any other bank at the time. My sales partner’s trades with AIG FP had a lot to do with that positioning.
 Now technically, the trades themselves did not incur actual credit losses for AIG. Rather, the combination of credit downgrades, mark-to-market changes, and the resultant collateral calls from counterparts such as Goldman and a few others, is actually what made AIG insolvent in a matter of weeks. But these were the trades that led to all that mess.
 I just made up that investing rule of course, but I do like the sound of it.