by Matt Taibbi
To simplify this even more: The rules say that banks have to have a certain amount of cash on hand. And if not cash, something as valuable as cash. But the system allowed banks to use home loans as their reserve capital, instead of cash, Banks were therefore meeting their savings requirements by … lending. Instead of the banking system being buttressed by real reserve capital, it was buttressed by the promised mortgage payments of a generation of questionable homebuyers.
Everyone and his brother starts getting offered mortgages. At its heart, the housing/credit bubble was the rational outcome of a nutty loophole in the regulatory game. The reason Vegas cocktail waitresses and meth addicts in Ventura were suddenly getting offered million-dollar homes had everything to do with Citigroup and Bank of America and AIG jettisoning their once-safe AAA reserves, their T-bills and municipal bonds, and exchanging them for these mortgage-backed “AAA”-rated securities—which, as we’ve already seen, were sometimes really BBB-rated securities turned into AAA-rated paper through the magic of the CDO squared. And which in turn perhaps should originally have been B-minus-rated securities, because the underlying FICO scores of the homeowners in deals like Andy’s might have been fakes.
Getting back to the story: So Miklos is buying AAA bonds. These bonds are paying his bank LIBOR plus fifty, which isn’t bad. But it becomes spectacular when he finds a now-infamous third party, AIG, to make the deal absolutely bulletproof.
“So I’m getting LIBOR plus fifty for these bonds,” he says. “Then I turn around and I call up AIG and I’m like, ‘Hey, where would you credit default swap this bond?’ And they’re like, ‘Oh, we’ll do that for LIBOR plus ten.’ ”
Miklos pauses and laughs, recalling the pregnant pause on his end of the phone line as he heard this offer from AIG. He couldn’t believe what he’d just heard: it was either a mistake, or they had just handed him a mountain of money, free of charge.
“I hear this,” he says, “and I’m like, ‘Uh … okay. Sure, guys.’ ”
Here we need another digression. The credit default swap was a kind of insurance policy originally designed to get around those same regulatory capital charges. Ironically, Miklos had once been part of a famed team at JPMorgan that helped design the modern credit default swap, although the bank envisioned a much different use for them back then.
A credit default swap is just a bet on an outcome. It works like this: Two bankers get together and decide to bet on whether or not a homeowner is going to default on his $300,000 home loan. Banker A, betting against the homeowner, offers to pay Banker B $1,000 a month for five years, on one condition: if the homeowner defaults, Banker B has to pay Banker A the full value of the home loan, in this case $300,000.
So Banker B has basically taken 5–1 odds that the homeowner will not default. If he does not default, Banker B gets $60,000 over five years from Banker A. If he does default, Banker B owes Banker A $300,000.
This is gambling, pure and simple, but it wasn’t invented with this purpose. Originally it was invented so that banks could get around lending restrictions. It used to be that, in line with the Basel Accords, banks had to have at least one dollar in reserve for every eight they lent; the CDS was a way around that.
Say Bank A is holding $10 million in A-minus-rated IBM bonds. It goes to Bank B and makes a deal: we’ll pay you $50,000 a year for five years and in exchange, you agree to pay us $10 million if IBM defaults sometime in the next five years—which of course it won’t, since IBM never defaults.
If Bank B agrees, Bank A can then go to the Basel regulators and say, “Hey, we’re insured if something goes wrong with our IBM holdings. So don’t count that as money we have at risk. Let us lend a higher percentage of our capital, now that we’re insured.” It’s a win-win. Bank B makes, basically, a free $250,000. Bank A, meanwhile, gets to lend out another few million more dollars, since its $10 million in IBM bonds is no longer counted as at-risk capital.
That was the way it was supposed to work. But two developments helped turn the CDS from a semisensible way for banks to insure themselves against risk into an explosive tool for turbo leverage across the planet.
One is that no regulations were created to make sure that at least one of the two parties in the CDS had some kind of stake in the underlying bond. The so-called naked default swap allowed Bank A to take out insurance with Bank B not only on its own IBM holdings, but on, say, the soon-to-be-worthless America Online stock Bank X has in its portfolio. This is sort of like allowing people to buy life insurance on total strangers with late-stage lung cancer—total insanity.
The other factor was that there were no regulations that dictated that Bank B had to have any money at all before it offered to sell this CDS insurance. In other words, Bank A could take out insurance on its IBM holdings with Bank B and get an exemption from lending restrictions from regulators, even if Bank B never actually posted any money or proved that it could cover that bet. Wall Street is frequently compared by detractors to a casino, but in the case of the CDS, it was far worse than a casino—a casino, at least, does not allow people to place bets they can’t cover.
These two loopholes would play a major role in the madness Miklos was now part of. Remember, Miklos was buying the AAA-rated slices of tiered bonds like the ones Andy was selling, and those bonds were paying LIBOR plus fifty. And then he was turning around and buying default swap insurance on those same bonds for LIBOR plus ten.
To translate that into human terms, Miklos was paying one-tenth of a percentage point to fully insure a bond that was paying five-tenths of a percentage point. Now, the only reason a bond earns interest at all is because the person buying it faces the risk that it might default, but the bonds Miklos was buying were now 100 percent risk free. The four-tenths of a percentage point he was now earning on the difference between the bond and the default swap was pure, risk-free profit. This was the goose that laid the golden egg, the deal of the decade. Once he bought the AIG default swap protection on his bonds, Miklos couldn’t lose. The only thing to compare it to would be a racetrack whose oddsmakers got stoned and did their math wrong—imagine if you could put a dollar on all twenty horses in the Kentucky Derby and be guaranteed to make at least $25 no matter who wins the race. That’s what it’s like to buy bonds at LIBOR plus fifty that you can credit-default-swap at LIBOR plus ten.
“So I’ve basically got forty basis points in my pocket,” Miklos recalls, giggling even now. “It’s free money. I mean, I’m getting those forty basis points running, for the life of the bond.”
Making matters even more absurd, the bonds Miklos was buying were already insured; they had, built in to the bonds themselves, something called monoline insurance. Monoline insurance refers to the insurance provided by companies like Ambac and MBIA. These companies, for a fee, will guarantee that the buyer of the bond will receive all his interest and principal on time. Miklos’s bonds contained MBIA/Ambac insurance; in the event of a default, they were supposed to cover the bond.
So Miklos’s bond deal was, in a sense, almost triple insured. It was AAA rated to begin with. Then it had the monoline insurance built in to the bond itself. Then it had credit default swap insurance from AIG. And yet there was that four-basis-point spread, just sitting there. It was bizarre, almost like Wall Street had reached into Miklos’s office and started handing him money, almost without his even asking. Perhaps not coincidentally, it was very much like the situation for ordinary homeowners, who around the same time found themselves suddenly and inexplicably offered lots of seemingly free money. It sounded too good to be true—was it?
Miklos’s bank thought so. “It was so unreal, my bosses wouldn’t let me book this stuff as profit,” he recalls now. “They just didn’t believe it could be true. I explained it to them over and over, but they wouldn’t mark it as profit.”
That didn’t mean, however, that they didn’t want him to do more of those trades. But no sooner had Miklos tried to buy more of the bonds than he found that another, much bigger party had di
scovered his little secret. “Suddenly someone is buying like five hundred million dollars of this stuff and getting the same swap deal from AIG,” he says. “I’m getting blown out of the water.”
Miklos starts hearing that the other party is one of the top five investment banks on Wall Street. And the rumor is that the money behind the deals is “partner money”—that the higher-ups in the Wall Street colossus had caught on to this amazing deal and were buying it all up for themselves, with their personal money, via the firm’s proprietary trading desk. “They started tagging AIG with all of this stuff,” he recalls. “And we got squeezed out.”
So here’s the question: why would AIG do this? Andy, though not involved with that deal, has a theory.
“The question is, were they stupid—or were they just never intending to pay?” he asks.
Before we get to the final part of the story—the part that involves a meeting of the very highest officials in government and heads of the most powerful financial companies in the world colluding on one final, unprecedented, grand-scale heist—we have to back up just a little and talk about another continent of Wall Street scams. Because what happened with AIG, what brought the financial crisis to a head, was really an extraordinary merger of the two different schools of cutting-edge Wall Street scammery, taking place under the one roof of AIG.
One school was the part we’ve already seen, the credit default scam that Miklos tapped into. This was the monster created by a pinhead American financier named Joe Cassano, who was running a tiny unit within AIG called AIG Financial Products, or AIGFP (FP for short). Cassano, a beetle-browed, balding type in glasses, worked for years under Mike Milken at the notorious Drexel Burnham Lambert investment bank, the poster child for the 1980s era of insider manipulations. He moved to AIG in 1987 and helped set up AIGFP.
The unit originally dealt in the little-known world of interest rate swaps (which would later become notorious for their role in the collapse of countries like Greece and localities like Jefferson County, Alabama). But in the early part of this decade it moved into the credit default swap world, selling protection to the Mikloses and Goldman Sachses of the world, mainly for supersenior AAA-rated tranches of the tiered, structured deals of the type Andy put together.
How you view Cassano’s business plan largely depends on whether you think he was hugely amoral or just really stupid. Again, thanks largely to the fact that credit default swaps existed in a totally unregulated area of the financial universe—this was the result of that 2000 law, the Commodity Futures Modernization Act, sponsored by then-senator Phil Gramm and supported by then–Treasury chief Larry Summers and his predecessor Bob Rubin—Cassano could sell as much credit protection as he wanted without having to post any real money at all. So he sold hundreds of billions of dollars’ worth of protection to all the big players on Wall Street, despite the fact that he didn’t have any money to cover those bets.
Cassano’s business was rooted in the way these structured deals were set up. When investment banks assembled their pools of mortgages, they would almost always sell the high-yield toxic waste portions at the bottom of the deals as quickly as possible—few banks wanted to hold on to that stuff (although some did, to disastrous effect). But they would often keep the AAA-rated portions of the pools because they were useful in satisfying capital requirements. Instead of keeping low-yield Treasuries or municipal bonds to satisfy regulators that they had enough reserves on hand, banks could keep the AAA tranches of these mortgage deals and get a much higher rate of return.
Another thing that happened is that sometime around the end of 2005 and 2006, the banks started finding it harder to dump their excess AAA tranches on the institutional clients. So the banks ended up holding on to this stuff temporarily, in a practice known as warehousing. Theoretically, investment banks didn’t mind warehousing, because they earned money on these investments as they held them. But since they represented a somewhat larger risk of default than normal AAA investments (although, of course, this was not publicly conceded), the banks often went out and bought credit protection from the likes of Cassano to hedge their risk.
Banks like Goldman Sachs and Deutsche Bank were holding literally billions of dollars’ worth of these AAA-rated mortgage deals, and they all went to Cassano for insurance, offering to pay him premiums in exchange for a promise of compensation in the event of a default. The money poured in. In 1999, AIGFP only had $737 million in revenue. By 2005, that number jumped to $3.26 billion. Compensation at the tiny unit (which had fewer than five hundred employees total) was more than $1 million per person.
Cassano was thinking one of two things. Either he thought that these instruments would never default, or else he just didn’t care and never really planned to pay out in the event that they did. It’s probably the latter, for things worked out just fine for Cassano; he made $280 million in personal compensation over eight years and is still living in high style in a three-floor town house in Knightsbridge in London, while beyond his drawing room windows, out in the world, the flames keep kicking higher. Moreover, reports have also surfaced indicating that the Justice Department will not prosecute him.
That’s what Andy means when he asks if, in offering guys like Miklos their crazy insurance deals, AIG was being stupid, or whether they were just collecting premiums without ever intending to pay. It would fit perfectly with the narrative of the grifter era if it turned out to be the latter.
That was one scam AIG had running, and it was a big one. But even as Cassano was laying nearly $500 billion in bets with the biggest behemoths on Wall Street, there was another big hole opening on the other side of the AIG hull. This was in AIG’s Asset Management department, headed by yet another egomaniacal buffoon, this one by the name of Win Neuger.
Semi-notorious in insurance circles for his used-car-salesman/motivational-speaker rhetorical style, Neuger is a sixty-year-old executive who came up in AIG in the mid-1990s and, much like Cassano, spearheaded a major new profit-seeking initiative within the traditionally staid and boring insurance business. Via the magic of an internal memo system he whimsically called “Neuger Notes,” the executive set out a target for his two-thousand-plus employees: they were to make “one thousand million” dollars in annual profit, a nice round number Neuger liked to refer to as “ten cubed.”
In quest of that magical “ten cubed” number, Neuger wasn’t going to brook any dissent. In his Neuger Notes back in December 2005, Neuger wrote, “There are still some people who do not believe in our mission … If you do not want to be on this bus it is time to get off … Your colleagues are tired of carrying you along.”
How was he going to make that money? Again, just like Cassano, he was going to take a business that should have and could have been easy, almost risk-free money and turn it into a raging drunken casino.
Neuger’s unit was involved in securities lending. In order to understand how this business makes money, one first needs to understand some basic Wall Street practices, in particular short selling—the practice of betting against a stock.
Here’s how shorting works. Say you’re a hedge fund and you think the stock of a certain company—let’s call it International Pimple—is going to decline in value. How do you make money off that knowledge?
First, you call up a securities lender, someone like, say, Win Neuger, and ask if he has any stock in International Pimple. He says he does, as much as you want. You then borrow a thousand shares of International Pimple from Neuger, which let’s say is trading at 10 that day. So that’s $10,000 worth of stock.
Now, in order to “borrow” those shares from Neuger, you have to give him collateral for those shares in the form of cash. For his trouble, you have to pay him a slight markup, usually 1–2 percent of the real value. So perhaps instead of sending $10,000 to Neuger, you send him $10,200.
Now you take those thousand shares of International Pimple, you go out onto the market, and you sell them. Now you’ve got $10,000 in cash again. Then, you wait for the sto
ck to decline in value. So let’s say a month later, International Pimple is now trading not at 10 but at 7½. You then go out and buy a thousand shares in the company for $7,500. Then you go back to Win Neuger and return his borrowed shares to him; he returns your $10,000 and takes the stock back. You’ve now made $2,500 on the decline in value of International Pimple, less the $200 fee that Neuger keeps. That’s how short selling works, although there are endless nuances. It’s a pretty simple business model from the short seller’s end. You identify securities you think will fall in value, you borrow big chunks of those securities and sell them, then you buy the same stock back after the value has plummeted.
But how does a securities lender like Neuger make money? Theoretically, with tremendous ease. The first step to being a successful securities lender is having lots and lots of securities. AIG had mountains of the stuff, through its subsidiary insurance companies, annuities, and retirement plans. An insurance company, after all, is just a firm that takes money from a policyholder and invests it in long-term securities. It then takes those mountains of securities and holds on to them as they appreciate over periods of years and years. The insurer makes money when the securities it buys with the policyholder’s money appreciate to the point that the company has something left over when it comes time to pay out policyholders’ claims.
It’s a good, solid business, but AIG wanted to make more money with those securities. So they formed a company that took those securities and lent them, en masse, to short sellers. From the point of view of the securities lender, the process is supposed to be simple and completely risk free. If you’re the lender, borrowers come to you for shares; you make money first of all because they pay you that 1–2 percent markup (called the general collateral, or GC, rate). You lend out a thousand shares, but the borrowers give you 102 percent of what those shares cost as collateral—that extra 2 percent is the GC rate, which you get really for nothing, just for having lots of securities to lend.