There have been many stories about the collapse of AIG. There have also been many stories about the internal flaws at AIG. The pitchforks were out when bonuses were announced in March. One of those executives was Jake DeSantis who wrote a New York Times OP-ED about his bonus. (AIG Bonus – My Thoughts) It turns out that Mr. DeSantis also contacted Michael Lewis.
The end result is a story in the August issue of Vanity Fair: The Man Who Crashed the World. As you can guess from the title, Lewis pins much of the blame on one man: Joe Cassano, the former president of AIG Financial Products.
After reading the article, I am not sure it’s fair to pin so much blame on Mr. Cassona. The article does provide a great deal of insight and clarity into the interconnections between AIG, sub-prime lending, credit default swaps, and the collapse of US house prices.
“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.”
At first, credit default swaps were mostly for commercial credit risk. Then, they started to expanding to consumer credit risk. The thought inside AIG Financial Products was that it was sufficiently diverse that it was unlikely to all bad at once. At first, the consumer products did not include sub-prime loans. Then, in 2004, the less credit-worthy sub-prime loans started becoming part of the credit pools. They eventually pulled the plug, feeling confident that their 2005 risks would not suffer any credit losses. (They were wrong.)
The bigger problem came when AIG lost its AAA rating, the day after Hank Greenberg was forced to resign. With its AAA rating, AIG has resisted being required to post collateral to back up its outstanding obligations under the derivative products it was selling. With a downgrade in its credit rating, it had agreed to post collateral. When the debt AIG insured started going bad, AIG had to put up cash collateral to back up its obligations. There was the equivalent of a run on a bank.
Lewis alludes to AIG’s risk-taking for residential loans may have been one of the factors that contributed to the dramatic run up in house prices, that eventually lead to more sub-prime borrowing, to a further increase in home prices and to more bad debt. That liquidity and poor underwriting lead to loans being made that, in retrospect, should not have been made.
Lastly, since AIG turned off its supply of risk-taking for residential mortgage loans, banks kept more of that risk on their books. That may have lead to the collapse of Bear Stearns, Merrill Lynch, and Lehman Brothers.
Lewis pins the blame on Cassano for not realizing that AIG was increasing taking on more sub-prime risk than they realized. At one point, when pools were up to 95% sub-prime, many internal risk analysts guessed that there was no more than 20%. Even when confronted with this Cassano dismissed the problem, conluding that house prices could never fall everywhere in the United States at once. (He was wrong.)
You can read the article and determine for yourself if Cassano should really be the fall guy.
In the end, the lesson to be learned for compliance and risk professionals is the importance of listening to your front line employees. They see many problems coming long before you do.
If you like that article, Michael Lewis also did a great story in the April issue of Vanity Fair on the financial collapse in Iceland: Iceland’s Meltdown.
UPDATE: The Wall Street Journal published an article indicating that Mr. Cassano is the subject of a grand jury inquiry. Prosecutors Are Poised to Impanel AIG Grand Jury. The possible case against Mr. Cassano (and others) could rely partly on tape recordings of 2007 phone calls involving AIG Financial Products employees who discussed the value of their derivatives trades.