November 29: Eight thirty a.m. A week after Thanksgiving and four months after Goldman’s first collateral call, AIG’s top executives—among them Sullivan, Lewis, Dooley, and Steve Bensinger, the company’s chief financial officer—finally meet to talk, via a conference call, about the mounting problem. Cassano, Forster, and a third AIG-FP executive join them on the phone. Three auditors from PricewaterhouseCoopers, including Tim Ryan, the lead auditor of the AIG account, also participate in the meeting. Someone takes notes, which are later obtained by the investigators.
By the time that late November meeting took place, AIG’s top executives were well aware of the collateral calls. Prying the information out of Cassano, however, hadn’t been easy.21 In early August, about a week after the first one, AIG’s auditors had scheduled a meeting with Cassano and several other FP executives on another topic. One of the auditors mentioned, more or less in passing, that he had heard a rumor that FP had been hit with collateral calls. Cassano acknowledged that FP had received a collateral call from Goldman but pooh-poohed its significance, arguing that the market would come back once traders returned from vacation. The auditors accepted the rationale and moved on to their main topic.
Toward the end of August, AIG CFO Steve Bensinger also began picking up rumors that FP was getting collateral calls. He asked one of his deputies, Elias Habayeb, CFO for the AIG’s financial services division, to call Cassano and find out. Again, Cassano acknowledged the calls but dismissed their significance. Habayeb, having crossed swords with Cassano in the past, was not so quick to accept his say-so. Over the ensuing weeks—especially as the end of the quarter approached—Habayeb lobbed e-mail after e-mail into Cassano and his top deputies, trying to find out how the securities were being valued and to what extent the problems were. Cassano, annoyed by the e-mails, would assign one of his minions to respond.
At four thirty on October 8, for instance, Habayeb sent a lengthy e-mail to Cassano with a series of “follow-up questions” about valuing the super-senior portfolio, which FP needed to do quickly since the quarter had ended eight days earlier. “When should I expect to receive the valuation of the SS CDS (portfolios D & E) using the BET as of September 30, 2007?” was one question. (BET stood for binomial expansion technique, a methodology also used by the rating agencies, which FP was trying to quickly adopt.) “With respect to the valuations using BET, how are the effects of hedges reflected or not reflected in these estimates?” was another question. Habayeb concluded gently, “I understand that everyone is working hard … I further appreciate that this is not an easy exercise. However, as you can imagine, this has become the hottest subject at 70 Pine” (70 Pine was the Wall Street location of AIG’s headquarters).
Three hours later, Cassano forwarded Habayeb’s e-mail to his lieutenants. “More love notes from Elias,” he wrote. “Please go through the same drill of drafting answers… .”
Meanwhile, AIG’s auditors at PricewaterhouseCoopers had begun viewing the collateral calls as far more serious business than they had a few weeks earlier. Goldman Sachs, which was also a client of PWC, helped push it in this direction. At Goldman the collateral dispute was important enough that it was being discussed at the board level; its auditors sat in on those discussions. “It was a constant focus inside Goldman Sachs,” says a former partner. As the ongoing dispute with AIG worsened, several Goldman Sachs executives began asking their auditors how it could be that “you have one set of numbers for one firm and a totally different set of valuations for another firm?” The lead partner on the Goldman account—who had nothing to do with AIG—told the executives he would take it up with HQ. Which he did. It wasn’t long before PWC was bearing down on FP and AIG as well.
The essential problem FP faced as it grappled with how to value the super-seniors was that it had never really thought about liquidity risk. Its models had always measured one thing: credit risk. That is, what was the likelihood of a triple-A tranche defaulting, which would cause FP to have to pay off the bonds in their entirety? Cassano had always been fixated on that question because that is where he saw the risk. And since AIG’s risk models consistently showed there was virtually no credit risk, it always valued the securities at par.
But now, with the market in “a state of panic,” as Cassano described it, the only question that mattered was what they were worth today. What could they be sold for in the marketplace? If it was less than 100 percent on the dollar—as it clearly was—then AIG-FP had a contractual obligation to put up collateral. That was the liquidity risk: the risk that the continuing drip, drip, drip of collateral calls would drain AIG-FP of cash and ultimately create a run on the firm that would destroy it—in much the same way that the Bear hedge funds had been destroyed.
Incredibly, this was a form of risk that Cassano had apparently never considered, and therefore had never modeled for. It was also a risk that AIG executives like Habayeb had never accounted for, in large part because they hadn’t even known it existed. (That is why, too late, the company was now trying to adopt the BET methodology.)
In the short term, the problem was that the market for triple-A tranches of multisector CDOs was frozen. There was no way to use trading data to establish values for the securities because no one was trading the securities. Nobody knew what a CDO was worth anymore, nobody trusted anybody else’s marks, and nobody dared to make an actual trade to find out. It was as if everybody in the mortgage market, having enjoyed a long, drunken revelry, was finally sobering up. Looking in the mirror was not a pleasant experience.
Thus everyone on Wall Street had to rely on models to come up with new marks. There was no other way to do it. This is also why everyone’s marks varied so widely. Everyone had different inputs; the imperfections of quant-style modeling had never been so clear. Merrill Lynch was also marking down its securities. Its marks, however, were much higher than Goldman’s; as Cassano liked to point out, Merrill’s marks were around ninety cents on the dollar, while Goldman’s were in the sixties and low seventies. Because Goldman’s marks were so low, AIG-FP viewed them mainly as an example of “Goldman being Goldman,” taking undue advantage of the situation to inflict pain on AIG.22 But the fact that FP didn’t have its own valuation model made it difficult to refute Goldman’s marks.
Goldman would later insist that it was not trying to gouge AIG—that it alone was being realistic about its marks. One of its tried-and-true techniques, when counterparties objected to its marks, was to offer to sell at the low price to the counterparty. Not once did a counterparty accept the offer, which, to Goldman, was proof that its marks weren’t low enough. Goldman would also later point out that because it had used AIG to hedge trades, it did not pocket the cash it got from AIG, but handed it over to the counterparties on the other side of the trade. In other words, it had no motive for putting the screws to AIG because the money wasn’t going into its own pocket.
At that November 29 meeting, the one in which the top brass for FP and AIG finally met to hash out the situation, Cassano told the others that FP was already in the process of “going to ground” to create a new model that would allow it to value the super-seniors as quickly as possible. Yet at the same time, he once again downplayed the importance of the collateral calls. “Collateral calls are part of the business,” he shrugged, adding that he “does not see this as a material issue with GS or any of the other counterparties,” according to the notes of the meeting.
Then he was asked how the dispute might affect AIG’s profits for the upcoming quarter. “JC noted if we agreed to GS values could be an impact of $5bn for the quarter,” the notes read. “MS”—Martin Sullivan—“noted this would eliminate the quarter’s profits…. JC noted that this was not what he was proposing but illustrative of a worse [sic] case scenario.” Forster would later tell the Financial Crisis Inquiry Commission that, upon hearing the $5 billion figure, Sullivan said the number would give him a heart attack. (Sullivan later testified that he didn’t remember saying that.) And with that, the meeting end
ed.
Or so Cassano thought. In fact, after the FP executives got off the phone, the accountants stayed in the room with Sullivan and Bensinger to discuss what they had just heard. If the first part of the meeting had been troubling for Sullivan, this latter part was even worse.
One gets the sense, reading the notes of the meeting, that the Cassano conversation was the last straw for the accountants. PWC lead Tim Ryan was not nearly as calm about the collateral calls as Cassano had been; on the contrary, he was quite agitated. He could see, in a way the AIG executives themselves could not, how their poor risk management practices were creating problems. He listed some of the things that bothered him: The fact that FP had posted $2 billion in collateral without bothering to inform headquarters. The way FP was “managing” the valuation process of the super-seniors. The growing exposure at the securities lending program. And the fact that the risk managers had inexplicably allowed the securities lending program to increase its exposure to subprime securities at the same time that FP was reducing its exposure.
“While no conclusions have been reached,” Ryan told Sullivan and Bensinger, according to the notes, “we believe that these items together raise control concerns around risk management that could be a material weakness.” For Sullivan, there were no two scarier words than “material weakness.” If that wound up being the accountants’ conclusion, it would have to be disclosed to investors—and that would be devastating. He promised to do whatever he had to do to avoid such a declaration. And on that sobering note, the meeting finally ended.
AIG had a long-scheduled investors’ meeting set for Wednesday, December 5, 2007. The planned topic was the company’s life insurance and retirement services businesses. But as the rumors continued to swirl about AIG’s subprime exposure, Sullivan decided to change the focus. The company would talk instead about its credit default swap business, along with the rest of its exposure to the mortgage market.
It was a very long meeting. Sullivan began by noting AIG’s profitability over the past few years, its strong capital position and cash flow ($30 billion in the first nine months of 2007), and its lack of debt. “We have the ability to hold devalued investments to recovery,” he told investors. “That’s very important…. AIG-FP has very large notional amounts of exposure related to its super-senior credit derivative portfolio. But because this business is carefully underwritten and structured … we believe the probability that it will sustain an economic loss is close to zero.”
Over the course of the day (with a break for lunch), fourteen AIG executives made presentations—including Cassano, Forster, model expert Gary Gorton, and Bob Lewis. Every one of them said essentially the same thing: there was little or no chance that the tranches AIG had either insured (in the case of FP) or bought (in the case of other AIG divisions) could ever lose money. Of the fourteen, nobody said this more fervently, or more often, than Cassano. “[W]e have an extremely low loss rate in these portfolios and the underlying reference obligations have a relatively low downgrade migration from the rating agencies,” he said in a typical remark. “It is very difficult to see how there can be any losses in these portfolios.” (Four months earlier, during an earnings call, Cassano had made a similar remark: “It is hard for us, without being flippant, to even see a scenario … that would see us losing one dollar in any of these transactions.” That line would come back to haunt Cassano, as it was quoted ad nauseam in the aftermath of the crisis.) At least half a dozen times he rolled out all the explanations he had been using to push back against Goldman: The due diligence that had gone into assembling the subprime tranches AIG insured. The fact that it had little or no exposure to 2006 and 2007 vintages. The amount of subordination in the CDOs AIG insured, meaning that hell would have to come close to freezing over before any of AIG’s super-seniors defaulted. He acknowledged that FP was in disputes with counterparties over marks but described those disagreements as “parlor games.”
“There is a major disconnect in the market,” he claimed, “between what the market is doing versus the economic realities of our portfolio.” In other words, in Cassano’s view, the market was simply wrong. And since the market didn’t understand the strength of AIG’s underlying collateral, he was damned if he was going to begin marking it down in any meaningful way. (He did tell the gathering that AIG was writing down another $500 million in November, but that was a pittance in the grand scheme of things.) “If you ask me how I manage the business,” he said, “it’s the fundamental underwriting that is the first line of defense, the first line of protection, the first thing that gets you comfortable in this business.” Even now, months after the collateral calls began, Cassano still seemed unable to comprehend that the issue he was facing had nothing to do with the “fundamental underwriting” of the CDOs AIG insured. The issue was that the collateral triggers were putting the entire corporation at risk. AIG may have had plenty of capital, as Sullivan had suggested, but because it was an insurance company, that capital was strictly regulated and very little of it could be used to shore up AIG-FP as it faced the growing onslaught of collateral calls. The notion that FP was invulnerable because of its parent’s financial strength—a notion the market had accepted for years—was suddenly exposed as a giant illusion. It was just the opposite: FP’s sudden vulnerability to liquidity risk was endangering the larger company. That’s what Cassano didn’t understand.
When the time came for questions, most analysts seemed to accept Cassano’s version of reality. Several, however, did not. One investor—unidentified in the transcript of the meeting—while acknowledging to Cassano that “you’ve clearly demonstrated no economic loss,” asked what should have been an obvious question: “[W]hat if you did use the ABX index and the counterparties? What would your marks be?”
“It’s nonsensical,” Cassano replied curtly.
“But what would the nonsensical number—?”
“I don’t know,” Cassano cut him off. “It’s nonsensical.”
“Could it be north of $5 billion?” the investor pressed.
“You know I have no—Do you have any idea? I don’t know. Look, we’re in the business of going to the core of the fundamentals. The ABX is just not representative of the pool of business that we have.” And that was that.
A few minutes later, Josh Smith, an analyst at TIAA-CREF, the financial services giant, posed another important question. “I noticed that some of the underlying collateral has been replaced with ’06/’07,” he began. “I think people take a lot of comfort that you stopped writing the ’06/’ 07. Can you quantify the risk that the underlying collateral from the earlier vintages gets replaced with this ’06/’ 07 stuff, which isn’t as good?”
Here was something else almost no one had noticed before—either inside or outside of AIG. For all of FP’s pride in having ended its multisector CDO business in 2005, it simply was not true that the referenced securities didn’t include those terrible 2006 and 2007 vintages. A number of the CDOs that AIG insured allowed for the CDO manager to replace older subprime bonds with newer ones—bonds that would invariably generate higher yields precisely because they were riskier. AIG didn’t even have to be informed that the collateral was being swapped out.
Take, for example, the $1.5 billion CDO known as Davis Square III, which Goldman Sachs underwrote in 2004. The CDO manager, Lou Lucido, worked for the Los Angeles investment firm TCW Group. During much of 2006 and 2007, Lucido was busy boosting the yield on Davis Square III by putting in subprime bonds from later vintages and kicking out many of the bonds that had been in the CDO when AIG agreed to insure it. Bloomberg estimated that, by 2008, “Lucido’s team, following criteria set by Goldman Sachs, changed almost one-third of the collateral in Davis Square III.” By May 2008, Davis Square III had been downgraded to junk, costing AIG $616 million in additional collateral calls—which came, of course, from Goldman Sachs.
At the investor meeting, however, none of this was divulged. When asked point-blank what percentage of AIG’s collateral
was 2006 and 2007 subprime vintages, Forster—whom Cassano had kicked the question to—said he didn’t know.
Still, in the immediate aftermath of the meeting, the market seemed pleased. AIG’s stock had been around $58 a share in the week preceding the investor meeting; after the meeting, it got a nice little pop, to $61 a share. And the meeting seemed to have energized Cassano as well. Two days after the meeting, on December 7, FP sent Goldman a letter demanding the return of $1.5 billion in collateral. Goldman, of course, refused. Several of the new marks that AIG-FP provided showed FP valuing the securities at par. David Lehman would later tell the Financial Crisis Inquiry Commission that AIG-FP’s valuation was “not credible.” He was right.
Though he didn’t realize it, Cassano’s biggest problem wasn’t Goldman Sachs. It was Tim Ryan at PricewaterhouseCoopers. All through November and December, in meetings with management, with the audit committee, and with the full board of directors, Ryan continued to raise concerns about the way FP was valuing the super-seniors, about the way it was managing the process, and about the inability or unwillingness of AIG management to get involved. While Cassano was focused on fending off more collateral calls—by the end of the year counterparties were demanding $2.7 billion, of which $2.1 billion were demands from Goldman—Ryan was making the case that AIG could not continue to allow Cassano and his FP team to manage the situation themselves.
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