All the Devils Are Here

by Bethany McLean; Joe Nocera

  “On what?” asked Frost.

  “20bb of super-senior,” replied the official.

  The next day the demand for cash officially arrived. It sought $1.8 billion, meaning that the counterparty was claiming that $20 billion in super-seniors that AIG had wrapped had declined by that amount, and FP had a contractual obligation to make up the difference. FP executives were stunned at the size of the demand. It “hit out of the blue, and a fucking number that’s well bigger than we ever planned for,” Forster complained in another phone call a few days later. Nor was this your run-of-the-mill counterparty that was making this demand. It was Goldman Sachs.

  Faced with its first collateral call, AIG-FP pushed back hard. For the next few days FP and Goldman Sachs argued ferociously about how much collateral AIG needed to put up. FP insisted that because the actual underlying collateral remained sound, it was not required to mark the securities to market and could keep it at par. Which meant it didn’t have to put up any cash. It also argued that Goldman was unfairly lowballing the marks to squeeze more cash out of AIG than was justified.

  For its part, Goldman argued that under the terms of the contract, it didn’t matter how sound the underlying collateral was. All that mattered was how the market was valuing it at any given moment. At this given moment, the market was saying that the value of the super-seniors had declined. Therefore FP’s marks had to be lowered—and it had to put up cash. Those were the rules of the game.

  On August 1, FP executive Tom Athan e-mailed Forster; he had just gotten off what he described as a “tough conf call with Goldman.” The firm, he said, was “not budging and acting irrationally.” “I played almost every card I had,” he wrote. “Legal wording, market practice, intent of the language … and also stressed the potential damage to the relationship… .” Goldman was unmoved. Meanwhile, Goldman Sachs executives viewed AIG as the irrational party. Goldman was making similar demands to counterparties all over town. Nobody was happy about it, but nobody was fighting it like AIG. “These were head-butting conversations,” says a former Goldman employee.

  On August 2, Cassano got involved. Taking another look at its marks, Goldman lowered its collateral demand to $1.2 billion and sent a new spreadsheet with its marks for the disputed securities. An AIG accountant then put together a spreadsheet for Cassano showing how Merrill Lynch was valuing the same securities. Goldman had one CDO valued at 85 cents on the dollar; Merrill had it at 98 cents. Goldman had another CDO at 85 cents that Merrill valued at 99 cents. AIG-FP had them both valued at par.

  Finally, on August 10, after another week of wrangling, Cassano and the Goldman trader he was negotiating with agreed that FP would post $450 million in collateral. Why that amount? Not because the two sides had come to an agreement. (In fact, they signed a separate side letter acknowledging that the $450 million did not satisfy the collateral agreement.) The real reason, recalls a former AIG executive, was that “they were both going on vacation and didn’t want it lingering.” For Goldman, the fact that it had gotten money out of AIG was viewed as a victory. For the FP executives, the fact that the amount was less than half of what Goldman had demanded caused them to mistake Goldman’s seriousness of purpose in getting the collateral it felt it was owed. “We thought, ‘This can’t be real,’” recalls a former AIG executive. “If they had been serious about the $1.2 billion, they would have been in here with an ax.”

  A few days later Frost e-mailed Forster again. The posting of $450 million, he wrote, was an effort “to get everyone to chill out.” But, he added, “this is not the last margin call we are going to debate.” Forster agreed. “I have heard several rumors now that gs is aggressively marking down asset types that they don’t own so as to cause maximum pain to their competitors,” he e-mailed back. “It may be rubbish, but it’s the sort of thing gs would do.”20

  Unbeknownst to AIG, Goldman Sachs did something else to protect itself. Concluding that it could no longer trust AIG to pay off its swap contracts in full if the triple-A tranches started to default, Goldman began buying protection on AIG itself. Goldman would later claim that this was standard practice: it always bought protection on a counterparty if that counterparty was fighting margin calls. But it’s also true that Goldman, having done so many deals with AIG over the years and having served as AIG’s longtime investment banker, had a deeper understanding of AIG and all its foibles than anybody else. If anyone knew in advance that AIG was headed for trouble, it was going to be Goldman. Whatever the reason, between August 1 and August 10 Goldman bought $575 million worth of credit default swaps on AIG—swaps that would pay off in the event of an AIG bankruptcy.

  From all outward appearances, AIG seemed to have done remarkably well in the two-plus years since Hank Greenberg’s departure. Having gotten through the trauma of Greenberg’s abrupt leave-taking, and then the earnings restatements, the company still wound up making enormous sums in both 2005 and 2006—more than $10 billion in 2005, followed by a record year in 2006, with profits that exceeded $14 billion and revenue that topped $113 billion. Its total assets were around $1 trillion, while its stock, which had dropped into the low fifties after Greenberg’s resignation, rose back up to the seventies. Sullivan was amply rewarded: his pay package in 2006 was $26.7 million.

  In the view of the AIG board, Sullivan had earned those millions. When Greenberg left—with all of AIG’s secrets in his head—Sullivan had been running AIG’s sprawling insurance unit and had a seat on the AIG board. Though he was often described as Greenberg’s handpicked successor, that was a wild overstatement. There was no one at AIG Greenberg viewed as a worthy successor; Sullivan was picked because the board knew him and because he headed the company’s biggest division. Greenberg, who for a brief time remained chairman of the board, signed off on Sullivan’s promotion because there was no better option. Succession planning wasn’t exactly his strong suit.

  Sullivan knew insurance as well as anyone at AIG, but despite being a director, he knew very little about the other parts of the company—which of course was the way Greenberg had always wanted things. Nor was Sullivan a natural leader. A diffident man, he had joined the company at the age of seventeen, had never gone to college, and had spent his life deferring to Hank Greenberg while he rose through the ranks. When Sullivan was preparing for the press conference that would introduce him as AIG’s new CEO, he kept referring to his predecessor as Mr. Greenberg. Someone finally asked him, “Why are you calling him Mr. Greenberg?” Replied Sullivan: “I’ve always called him Mr. Greenberg.”

  And yet for a brief, shining moment, Sullivan rose to the occasion. The combination of Greenberg’s departure, the restatements, and the various probes by the New York attorney general, the SEC, and the Justice Department were “life-threatening events for AIG,” says someone who was there. “It was like having a heart attack and a stroke at the same time.” This person adds, “Sullivan saved the company.” He had to deal with the rating agencies, the investment community, government investigators, and his fellow executives. He had to mollify the accountants from PricewaterhouseCoopers, who were crawling all over the company, and AIG’s employees, many of whom felt lost without Greenberg. “He did a great job of holding on to talent,” says this same person. He was a calming influence at a time when AIG needed exactly that.

  He also tried to bring AIG into the modern age, spending millions to upgrade the systems that Greenberg had always ignored. But in truth, these were mainly cosmetic changes. What Sullivan didn’t do—what he lacked the capacity to do—was change AIG at its core. The silos that Greenberg had erected still existed. The sharing of information, especially bad news, was almost nonexistent. Division heads told headquarters only what they wanted headquarters to hear; there were still no systematic processes that cut across all divisions, the way there are at most big companies. Division managers could reach for extra profits however they saw fit—even if it entailed taking undue risk. Because executives didn’t fear Sullivan the way they’d feared Greenberg, th
ey often took liberties they would never have taken under Greenberg. Sullivan lacked the force of personality to curb their excesses.

  Risk management, in particular, was a glaring weakness under Sullivan. Whatever Greenberg’s other shortcomings, he did have a keen sense for when to take a risk and when to pull back—and of course he had all the information he needed at his fingertips, because when Hank Greenberg demanded it, he got it. Regular meetings that Greenberg had conducted about risk were canceled by Sullivan, who bumped most risk decisions to underlings. Under Sullivan, the risk managers were almost entirely dependent on the division heads for information. They often didn’t have enough information to push back in areas where excessive risk might be building up. And they treated each division’s risks as individual issues, never looking across the entire corporation to see if there were company-wide risks that needed to be addressed.

  AIG’s securities lending program, which was run out of the investment division, was a classic example of the company’s risk management failings. That was the program in which, for a fee, AIG would lend out its securities to short sellers, who put up cash collateral. Then it would invest the proceeds in short-term securities that could be sold quickly when the short seller wanted his cash back. At the end of Greenberg’s last full year, 2004, AIG had already begun the dangerous practice of investing some of the cash in mortgage-backed securities, which generated a higher return for AIG but were hardly the kind of short-term, liquid securities that could easily be sold.

  In late 2005, the executive in charge of the securities lending program went to Bob Lewis, requesting that the company raise the limit on the securities he was allowed to purchase in the mortgage market. He also wanted to rev up the program itself, which at the end of 2004 had a balance of $53 billion. He made this request at the very same time that AIG-FP had decided to stop insuring the super-senior tranches because the subprime underwriting standards had deteriorated so badly. A well-run risk department would have immediately realized that one AIG division was asking to take more risk in the exact area where another division, far better versed in these kinds of securities, was cutting back. A good risk manager would have said no.

  But Lewis did not say no. Instead, he cut a deal. As he later testified before the Financial Crisis Inquiry Commission, he agreed to raise the limit, but insisted that the securities lending program only invest in the “highest-quality” residential mortgage-backed securities. “No CDOs,” he added. But while the securities the investment division bought weren’t CDOs, they were still securitized subprime mortgages that had the same underwriting problems that FP was worried about. By the end of 2006, the balance on the securities lending program had risen by $20 billion, to $73 billion. And by the end of 2007, it had risen to $83 billion—by which time clients were rushing to return the securities they had borrowed and get their cash back. Because the mortgage-backed securities AIG owned were impossible to sell, the securities lending program began to have cash shortfalls—$6.3 billion by the end of 2007, and a staggering $13.5 billion one quarter later. The inability to return cash to clients in the securities lending program was one of the things that would eventually bring AIG down. Not long after AIG was bailed out by the federal government, Larry Fink, who had been brought in to help the company sort through its problems, was shown the details of AIG’s securities lending program. “In all my years,” he exclaimed, “I have never seen such disregard for managing money.”

  And then there was the relationship between AIG and AIG-FP—and between Sullivan and Cassano. If other divisions told headquarters as little as they could get away with, FP told headquarters even less. Cassano used to meet with Greenberg regularly; Cassano and Sullivan rarely met. (One former FP executive says that in three years, he saw Sullivan in the Wilton, Connecticut, office only once.) As little as Sullivan knew about, say, AIG’s airline leasing business, he knew even less about its derivatives business. Cassano did little to enlighten him. For the most part, Cassano dealt with an AIG executive named Bill Dooley, who, as head of AIG’s financial services division, which included AIG-FP, was nominally Cassano’s boss. Mostly, they fought.

  On the other hand, Sullivan had so many other fish to fry that it was easy to leave Joe Cassano alone. By all the obvious measures, he seemed to be running a shop that was at the top of its game. In 2006, the division made nearly $950 million in profits, meaning it was not only helping AIG’s income statement but also minting millionaires, since the division still kept around a third of its profits as bonuses. (Cassano later acknowledged that he made around $300 million during his time at AIG-FP, although his lawyers claim that $70 million of that was deferred compensation that he lost when the AIG was bailed out by the government.)

  As for the risks it was taking, no one could really see any significant problems on the horizon. The total notional value of AIG-FP’s derivatives business was $2.66 trillion. Of that, some $527 billion was in the credit default swap book. Of that, FP insured a “mere” $60 billion in multisector CDO tranches. FP’s subprime exposure, in other words, seemed like a relatively small piece of the business, around 3 percent of its total derivatives exposure. And no one at headquarters knew about the existence of the collateral triggers—including Dooley. When the risk managers at AIG headquarters ran FP’s various derivatives business through their risk models and stress scenarios, it got a clean bill of health. After the big 2005 restatement—which included significant changes in the way FP accounted for some of its hedges—the board told Sullivan that he should take tighter control of FP. He agreed. But it never happened, in part because Cassano wouldn’t let it happen. Sullivan kept telling the board he was moving in that direction, but there were always more immediate issues that took up his attention instead. And since FP was doing so well, nobody pressed the point.

  By early 2007, the board of directors was beginning to get antsy about Sullivan’s management. It wasn’t just his unwillingness to get his arms around FP; there were lots of similar issues that the board wanted him to tackle but which he seemed to be avoiding. Sullivan was still resistant to the cultural changes that were so clearly necessary. With the 2005 crisis now well in the past, the board wanted Sullivan to begin accelerating the pace of change.

  “By the summer of 2007,” says a former AIG executive, “we were getting to the point where members of the board were saying, ‘We need to start setting some harder milestones.’”

  Which, of course, was exactly when the collateral calls began.

  September 11: With everyone back from vacation, Goldman once again begins demanding collateral—$1.5 billion this time, in addition to the $450 million AIG has already posted. Société Générale, the big French bank, also demands collateral—$40 million—which AIG-FP executives immediately suspect has been instigated by Goldman, since Société Générale is a big Goldman client and its trades mirror Goldman’s trades. AIG-FP disputes the marks submitted by the two firms. Société Générale backs down. Goldman doesn’t.

  September 13: Goldman buys an additional $700 million worth of protection on AIG, bringing the total to $1.5 billion.

  September 20: Goldman announces its third-quarter results: profits of $2.9 billion, despite marking down its own subprime holdings. “Significant losses on nonprime loans and securities were more than offset by gains on short mortgage positions,” says the firm.

  October 1: AIG-FP accountant Joseph St. Denis, who had joined FP in June 2006, resigns. In a letter he would later write to congressional investigators, St. Denis says he became “gravely concerned” when he learned in September of the Goldman collateral calls—“as the mantra at AIG-FP had always been (in my experience) that there could never be losses” on the super-seniors. Cassano, he says, deliberately excluded him from meetings to discuss the valuation issue because, Cassano told him, “I was concerned that you would pollute the process.” On the morning he resigns, St. Denis tells AIG-FP’s general counsel that “I have lost faith in the senior-most management of

  AIG
-FP.”

  November 2: Goldman ups its collateral demands to $2.8 billion. Yet again, AIG-FP disputes Goldman’s marks.

  November 7: AIG announces its third-quarter results: $3 billion in profits. But it also discloses that it has taken a $352 million write-down on “unrealized market valuation loss” in the quarter, which ended in September. It adds that, in October, its portfolio took on an additional $550 million in losses, which could get better or worse, depending on what happens in the rest of the fourth quarter. During the ensuing conference call, the only thing the analysts want to talk about is AIG’s super-senior exposure.

  November 8: Goldman’s David Lehman e-mails Forster: “We believe the next step should include a line by line comparison of GS vs. AIG-FP prices…. Can we set aside 30 minutes to discuss live today or tomorrow?”

  November 16: Société Générale demands $1.7 billion on a portfolio of $13.6 billion. Merrill Lynch demands $610 million on a portfolio of $7.8 billion. “Their average price is 84.20 [cents on the dollar],” Forster tells Cassano in an e-mail. Goldman’s prices are much lower—in the high sixties.

  November 18: Goldman ups its credit default swap protection on AIG to $1.9 billion.

  November 23: AIG posts $1.5 billion in collateral, bringing its total to nearly $2 billion. Goldman’s demands rise to $3 billion.

  November 27: Cassano sends an e-mail to Bill Dooley at headquarters laying out, seemingly for the first time, all of AIG-FP’s counterparty exposures as well as the collateral calls that have come in so far. It is a sobering document. Merrill Lynch has bought protection on $9.92 billion worth of triple-A tranches from FP and is demanding $610 million. Bank of Montreal wants $41 million on its $1.6 billion portfolio. Calyon, the investment banking division of the French bank Crédit Agricole, is demanding $345 million on its $4.5 billion portfolio. UBS has a $6.3 billion portfolio; it wants $40 million from AIG. A half dozen other big banks have billions of dollars worth of super-seniors insured by AIG and haven’t yet made a collateral call—but obviously they could any day. And of course there’s Goldman Sachs, which has a total of $23 billion in super-senior exposure insured by AIG-FP. It is demanding not millions like everyone else, but billions.