It wasn’t until the beginning of 2008 that headquarters finally got involved, but by then it was too late. In a mid-January meeting with the audit committee, according to the notes of the meeting, “Mr. Habayeb believes that he is limited in his ability to influence change, and the super-senior valuation process is not going as smoothly as it could.” Ryan responded, essentially, that this was not acceptable.
Meanwhile, Cassano was scrambling to come up with a value for the portfolio in time to report year-end results in early February. It was clear that there were going to have to be more write-downs. Using a theory he called a “negative basis adjustment,” Cassano estimated the write-down would be $1.2 billion. (Essentially, he was claiming that this adjustment reflected the difference between the way the swaps were priced and the way the underlying securities were priced.) Without this adjustment, the write-down would be $5 billion. The board—and the accountants—first learned about Cassano’s theory in a January board meeting. The auditors were not pleased, and they would have the final say. Over the next few weeks, Cassano attempted to convince the auditors that the negative basis adjustment was a legitimate valuation method. But Ryan wasn’t biting. It had no basis in accounting rules, he said.
In late January, Ryan dropped the hammer, declaring that AIG had “a material weakness in its internal control over financial reporting and oversight relating to the fair value of the AIG-FP super-senior credit default swap portfolio.” On February 5, AIG released the news of the material weakness in an SEC filing. The stock sank. Counterparties that had previously sat on the sidelines began demanding collateral. Cassano was furious. The “material weakness” announcement had “weakened our negotiation position as to collateral calls,” he wrote in an e-mail.
But it was over for Cassano. The board no longer trusted him and insisted that Sullivan fire him, something Sullivan was still reluctant to do, according to a former AIG executive. Cassano made it easy for him.
“Joe, we have these issues,” Sullivan said.
“Should I retire?” Cassano replied.
“Yes.”
“Joe was just worn out,” explains a former executive. A few weeks later, when the news was made public, Cassano was at AIG headquarters. Someone asked him if he had told his mother, who was in her eighties. “No,” he replied. “She doesn’t know what I do.” A few minutes later, the phone rang. It was his mother, who had just heard the news. “No, Mom,” Cassano could be heard saying on the phone. “I’m all right.” He left with $34 million in unvested bonuses and a consulting contract worth $1 million a month.
When the year-end results were finally announced, on February 28, 2008, the super-senior write-down wasn’t $1.2 billion, or even $5 billion. It was $11.47 billion. The following week, Goldman Sachs raised its collateral demands to $4.2 billion.
By June 2008, Martin Sullivan was gone as well. In May, the board forced Sullivan to remove Bensinger as CFO. At the same time, AIG managed to raise some $20 billion, which Sullivan—and everyone else—felt would be enough to carry the company through a possible crisis. But the collateral calls kept coming; by the end of the second quarter of 2008, AIG had posted $20 billion in cash to meet them. The securities lending problems continued to get worse. The PWC auditors continued to put pressure on management and the board to improve their internal controls. The value of the subprime securities FP insured continued to deteriorate. The Office of Thrift Supervision, which regulated AIG, got into the act, too. (AIG had purchased a small thrift in the 1990s, and when AIG, like the investment banks, needed a holding company supervisor because of requirements by the European Union, the OTS took on that role.) After the material weakness announcement, it began demanding that AIG improve the risk management on its credit default swap portfolio. “There was a sense that we were drifting,” says a former executive. “I wouldn’t say it was a crisis. But it wasn’t normal.”
However heroically he had performed during AIG’s 2005 crisis, Sullivan seemed increasingly lost as the situation worsened. When it became clear that the additional $20 billion in capital hadn’t restored confidence in AIG, the board finally—and belatedly—made its move. Several directors went to the chairman of the AIG board, Robert Willumstad, a former top Citigroup official, and asked him to step in as chief executive. Willumstad had only joined the board in 2006 and had recently started a private equity firm, which he would have to leave to take the AIG job. Reluctantly, he agreed to become the CEO. On June 15, Martin Sullivan left the company where he had spent his entire adult life.
Three days later, AIG-FP agreed to post $5.4 billion to Goldman Sachs—including cash to cover losses in five of the Abacus deals.
On his fourth day as CEO, Willumstad met with Larry Fink of BlackRock and asked him to evaluate the subprime exposure. He wanted to write down as much as he possibly could, as quickly as he could, and be done with it. He also thought a BlackRock imprimatur would finally give AIG the ability to fight back against the collateral calls. In August, he announced AIG’s second-quarter results—a $5.5 billion loss. He also announced that he was conducting a strategic review of the entire company, and would soon unveil his plan. He hoped the market would give him time to get through the review. He promised to present his new strategic plan to investors on September 26.
But by then, AIG had been rescued by its new majority owner, the United States government.
22
The Volcano Erupts
And what was Fannie Mae doing during that awful summer of 2007, as the mortgage market descended into utter chaos and decades of wrong-headed policies, craven behavior, foolish mistakes, and misguided beliefs had come together to create a financial volcano that was beginning to stir? Panicking, perhaps?
No, Fannie was plotting its comeback.
Fannie at that point held or guaranteed almost $2.7 trillion in mortgages; Freddie another $2 trillion. Unlike John Paulson or Andrew Redleaf, they had no ability to short the housing market. Their singular role, set out in the charter that had long given them their advantages over their market competitors, was to support the housing market and help the country’s citizens achieve the American Dream. Yet the fact that the housing market was in decline—instead of scaring the GSEs, as it should have—was a source of tremendous optimism. Subprime lenders were shutting down. Wall Street was afraid to securitize mortgages. Banks were reluctant to make new housing loans, since they could no longer sell them to Wall Street. Only mortgages guaranteed by the GSEs were viewed as safe enough to be sold and securitized. At long last, they were back in the driver’s seat. The country needed Fannie and Freddie—truly needed them—in a way it hadn’t in years. “I thought this was an opportunity for the GSEs to demonstrate their value to the world,” Fannie CEO Dan Mudd would later say.
Politicians, housing advocates, Washington think tank types—they were all suddenly rallying around Fannie Mae and Freddie Mac. Democrats like senators Charles Schumer of New York and Chris Dodd of Connecticut, both high-ranking members of the Senate banking committee, were pushing hard to expand the GSEs’ powers. Republicans weren’t far behind. “This is what you’re here for,” Mudd recalls legislators of both parties telling him. Even the Bush White House was backing away from its long-standing hostility toward the GSEs; no matter how much you might be ideologically opposed to Fannie and Freddie, it was hard to go after them when they were the only thing propping up the housing market. “The political environment was ‘We’re inviting you in! Come be part of the solution,’ ” Mudd later recalled.
By the end of August 2007, Fannie’s stock, which had dropped to a low of $48 in the spring of 2005, was almost back to its 2004 peak of $70. “Politics seems increasingly a plus for GSEs,” wrote Morgan Stanley analyst Ken Posner that fall. “Housing market stability is in the process of trumping the anti-GSE ideology that has held sway in recent years.”
That summer, Mudd drafted the company’s strategic plan for the next four years. He had stars in his eyes. He pointed out that over the last ten
years, Fannie Mae’s credit losses had amounted to $3.1 billion—compared to profits of $44.2 billion. “We have a great opportunity by taking more credit risk on the balance sheet.” He called on the company to go “deeper into segments where we only have scratched the surface”—meaning, of course, subprime mortgages.
Over the years, whenever Alan Greenspan and others had criticized the GSEs, it was the interest rate risk they worried about. Fannie and Freddie were so huge, they believed, that it would take only one big hedging mistake—and a sudden shift in interest rates—to bring about catastrophe. But they had never focused on credit risk—the risk that the mortgages Fannie and Freddie guaranteed or held would default. Maybe it was because they had been so blind over the years to all the credit risk in the system, from subprime originators to AIG, that they never saw it coming with Fannie and Freddie, either.
Thus it was that in 2007 Fannie and Freddie would add $600 billion in net new mortgage debt to their books, debt that would wind up being highly destructive. They would continue to buy and guarantee mortgages well into 2008. And thus it was that the GSEs would lumber, slowly but inevitably, toward a cliff they didn’t see. The financial crisis came on in fits and starts, and all the while Fannie Mae and Freddie Mac were accumulating the very mortgage risk that would cause the long-dormant volcano to finally erupt.
With all the problems he was facing, Fannie and Freddie were hardly high on Hank Paulson’s list of priorities. As Treasury secretary, he kept in close touch with all the Wall Street CEOs; he knew exactly what was going on. In his memoir, he describes a dinner in June 2007 with a handful of Wall Street chieftains, including Jamie Dimon of J.P. Morgan, Lloyd Blankfein of Goldman Sachs, and Chuck Prince, the CEO of Citigroup. “All were concerned with excessive risk taking in the markets and appalled by the erosion of underwriting standards,” he writes. Prince, he added, “asked whether, given the competitive pressures, there wasn’t a role for regulators to tamp down some of the riskier practices. Basically, he asked: ‘Isn’t there something you can do to order us not to take all of these risks?’”
Late July saw the German government bail out IKB. In early August, American Home Mortgage Investment Corporation, which was unable to sell its commercial paper, filed for bankruptcy. A few weeks later, Countrywide had to draw down that line of credit, signaling it was in trouble. On August 21, an auction of four-week Treasury bills nearly failed because the demand was so massive it overwhelmed the dealers. In mid-September, the British bank Northern Rock had to be rescued by the Bank of England.
The banks were all announcing huge write-downs while frantically trying to raise additional capital—something Paulson was pushing them to do. But the new capital was quickly overwhelmed by yet more losses. The SIVs that some banks had all used to off-load debt and lower their capital requirements were foundering as the money market funds began dumping their commercial paper. Treasury came up with a plan to create a “super SIV,” which the banks would fund, that would buy the assets from the individual SIVs. The plan fell through. Citi—which had been the most promiscuous user of SIVs—had to put the SIV assets back on its balance sheet, at exactly the wrong time, and they eventually contributed to its many billions of dollars in write-downs. Paulson and his staff were frantically busy, trying to come up with solutions and stave off disaster. His restless energy went into overdrive. Today’s idea wasn’t necessarily consistent with yesterday’s idea, but then, the problems were unprecedented. There was no manual for what to do when you’re the Treasury secretary trying to prevent a financial crisis. As the year wore on, he and his small team at Treasury began to joke that they felt like Butch Cassidy and the Sundance Kid: they were being pursued and cornered, and even though they’d come out with guns blazing, they couldn’t ever seem to get out in front of the problem.
Though he was a Bush appointee, Paulson had no patience for the White House’s “holy war”—his words—against the GSEs. Yes, they were flawed institutions that were far too big and, quite possibly, posed systemic risk. But Paulson was a pragmatist. He dealt with things as they were. Fannie and Freddie weren’t going away; they were a problem that needed to be managed. Besides, the GSEs were only partly to blame for the monsters they’d become. “This was created by Congress,” he’d say.
When he did focus on Fannie and Freddie, he didn’t gnash his teeth at the moral hazard they posed. Rather, he worked to reduce that moral hazard. One step was to get Fannie and Freddie a new regulator. It was no secret that OFHEO was outmatched; practically from the moment he was named Treasury secretary, Paulson had worked to push through legislation to create a new regulator that would have real authority to set capital requirements, conduct serious audits, and even—if it came to that—wind down the GSEs. To get such legislation, he had to compromise with Democrats. Paulson had no problem with that, but it was anathema to the White House staff. Paulson was perfectly willing to override them and go to President Bush directly, which he did. In 2006, he began working with the Democrats to get legislation that would create a better, tougher regulator. The effort ran into congressional roadblocks. Fannie’s enemies—including its White House enemies—started speculating that Paulson was in the tank for Fannie because it was a big client of Goldman’s. (Actually, it was a big client of every firm on Wall Street.) Goldman Sachs board member Jim Johnson, a typical charge went, had been the chair of the compensation committee when Paulson was CEO and had helped set his pay. And so on.
The second step Paulson took was to urge the GSEs to raise capital, the same way he was urging all the big firms to raise capital. He liked to say that he’d never seen a CEO of a financial institution get fired for having too much capital. And indeed, the GSEs did raise additional capital, selling a combined $13 billion in equity and preferred stock.
But $13 billion was a drop in the ocean for Fannie and Freddie. By 2008, the two companies held a total $84 billion in capital—less than 2 percent of what was, by that point, a combined $5.3 trillion in mortgages they owned or guaranteed. Even more than the banks, Fannie and Freddie could not afford major write-downs. There was absolutely no margin for error.
Yet Fannie and Freddie were taking write-downs. In February 2008, the GSEs announced their 2007 earnings: both lost money—$2.1 billion in the case of Fannie Mae, while Freddie Mac lost $3.1 billion, its first annual loss ever. The reason was deteriorating mortgages. Yet at the same time, they were taking on more and more risk—because nobody else could, or would. By early 2008, Fannie and Freddie were buying four out of every five U.S. mortgages, double their market share from two years earlier. In mid-February, President Bush signed a law that included a provision to raise the size of the jumbo mortgages Fannie and Freddie could buy, from $417,000 to $729,750 in high-cost areas—a stunning, unnecessary increase that was supported by both Democratic Speaker of the House Nancy Pelosi and Republican John Boehner, the House minority leader. (Paulson opposed the increase.)23 It was insanity. Jim Lockhart, a Yale fraternity buddy of Bush’s who had become the chairman of OFHEO, told Congress, “The GSEs have become the dominant funding mechanism for the entire mortgage system in these troubling times. In doing so, they have been reducing risks in the market, but concentrating mortgage risks on themselves.”
It was Bear Stearns that went first, in March of 2008.
If the failure of the two Bear Stearns hedge funds in July 2007 served as a kind of prologue to the financial crisis—a taste of what was to come—then the collapse of Bear Stearns itself was a rousing act one. There wasn’t much substantive difference between the two failures except in scale. Bear Stearns was awash in mortgage-backed securities of all sorts. It used them as collateral for its repo transactions. It had them on its balance sheet. It traded in CDOs and CDOs squared. Because it was both the smallest of the five major American investment banks and the most obviously exposed to mortgage risk, the market started asking questions about the value of its collateral. The answers didn’t really matter; the questions were all it took to kill the fir
m.
“The interdependent relationships between banks and brokerages and institutional investors strike most laymen as impenetrably complex, but a simple ingredient lubricates the engine: trust,” wrote Alan “Ace” Greenberg, former Bear Stearns chairman, in a memoir co-authored by Mark Singer. “Without reciprocal trust between the parties to any securities transaction, the money stops. Doubt fills the vacuum, and credit and liquidity are the chief casualties. Bad news, whether it derives from false rumor or verifiable fact, then has an alarming capacity to become contagious and self-perpetuating.”
Which is exactly what happened. On Monday, March 10—the beginning of its last week as an independent firm—Bear Stearns’s stock stood at around $70 a share. It had bank financing of about $120 billion and $18 billion in cash. But, recalled Greenberg, “some of our counterparties were expressing skepticism about our liquidity and were wary of dealing with us.” On Tuesday, Christopher Cox, the chairman of the SEC, told the press, “We have a good deal of comfort about the capital cushions at these firms.” It didn’t help. Bear’s cash fell to $15 billion as hedge funds began pulling their money out. One hedge fund withdrew all the securities it kept at Bear—“tens of billions of dollars’ worth,” wrote Greenberg. “Before the trading day closed, the Dutch bank Rabobank Group had told us that they weren’t renewing a $500 million loan due to mature at the end of the week and probably wouldn’t renew a $2 billion line of credit the following week.” On Wednesday, CEO Alan Schwartz went on CNBC, where he denied that Bear Stearns was having liquidity problems. If anything, that only made matters worse: going on TV to deny liquidity problems was likely to create liquidity problems, because it would spook lenders. Sure enough, repo lenders started refusing to roll over Bear’s commercial paper. By Thursday night, Bear was down to $5 billion in cash—though, notes Greenberg, “in light of the obligations that came due Friday morning, for all intents and purposes the figure was zero.” By Friday, the stock had dropped to around $30 a share. Bush was scheduled to give a speech at the Economic Club in New York that day. Already nervous at the beginning of the week, Paulson pressed Bush not to say there would be “no bailouts.”
All the Devils Are Here Page 46