by Matt Taibbi
So now you’ve got all this cash, and you don’t know when you’re going to have to take back those securities you lent out, but the understanding is that it could be anytime and will usually be in the near future. So say Borrower A takes a thousand shares of International Pimple from you and gives you that $10,000 as collateral—you have to be prepared to take those thousand shares back and give him his money back at any time. Because of this, you normally don’t want to invest in anything risky at all, anything that requires a long commitment. After all, why bother? You can take that money, buy U.S. Treasury notes with it, twiddle your thumbs, and make nice money basically for free—without any risk at all.
“The collateral shouldn’t be subject to market volatility,” says David Matias of Vodia Capital, who notes that more conservative sec lenders basically only put their collateral into short-term, ironclad safe investments like U.S. Treasuries, because there’s no reason not to. “Say you can make a fifty bps spread [i.e., one-half of 1 percent]. That’s enormous in this business. If you’ve got $100 billion in collateral and you can make a fifty bps on an annualized basis … that’s like a half-a-billion-dollar business right there.”
That’s the way it’s supposed to work. If Win Neuger and AIG had just taken the mountain of securities their subsidiary life insurance companies held, lent it out on the market, taken that collateral and invested it in the usual boring stuff—Treasuries, for instance—they would have made a small fortune without any risk at all. But that isn’t what Win Neuger did, because Win Neuger is a moron.
What Neuger did, instead, is take that collateral and invest it in residential-mortgage-backed securities! In other words, he took cash and plunged it into the very risky, not-really-AAA AAA-rated securities that bankers like Andy were cranking out by the metric ton, thanks to the insane explosion of mortgage lending.
This was par for the course during an era when you could never really be entirely sure where your money was or how safe it was. The high yields that these structured deals were offering to investors proved a monster temptation to people up and down the financial services industry. Larry Tabb of the TABB Group, a financial advisory company, gives an example.
“So take me,” he says. “I own a bank account. The money for my payroll, it either stays in my account or earns no interest … So what my banker says is, why don’t we, every night, we’ll roll that into an interest-bearing account. And then the next morning you’ll get it back, and we’ll give you interest overnight on it. And I’m like, ‘Okay, that sounds wonderful.’
“So along comes the credit crisis,” he says, “and, being in the industry, I say, okay, well, what are these guys putting my money into? So I called up my bank and I say, what are you guys putting my overnight money into? And the answer is like, agency and agency-backed securities.* And I’m like, oh, how much interest are they getting me? Oh, about one percent a year. So these are toxic securities that you’re putting me into, and you’re giving me one percent interest.”
“Great. And how much were they making?” I ask.
“Exactly,” Tabb says, explaining that in the end he was left with two options—go without any additional interest, or put all his money at risk while getting ripped off by other bankers.
Neuger’s scheme was a variation on the same business model. They were taking cash collateral in the billions from all the major investment banks on earth—Deutsche, Goldman, Société Générale—and plunging it into the riskiest instruments imaginable. What’s especially crazy about what he did is that the nature of his business dictated that he should have stayed away from all but the very shortest-term investments, because the people he was lending his securities to might at any time have decided they wanted their collateral back.
But Neuger did just the opposite. He borrowed short, taking collateral that technically he had to be prepared to give back overnight, and invested long, in instruments that take ten, fifteen, thirty years to mature. This was a business model that only worked if new business was continually coming in—and we all know what that’s called.
“It’s kind of a Ponzi scheme, actually,” says Matias of Vodia Capital. “If your business is growing, that point at which you have to pay it back is postponed into the future. As long as your business is growing, you have more collateral, not less. But as soon as your business contracts, your collateral starts to decrease and you actually have to make good on that collateral payback. They were betting the money as if they had years to ride through the market. But they didn’t.”
So within AIG in the period leading up to the total collapse of the housing bubble, you had two major operations running that depended entirely on the continued insane inflation of that bubble. On one hand, Joe Cassano was selling billions of dollars in credit default swap protection to banks like Goldman and Deutsche Bank without having any money to cover those obligations. On the other hand, Win Neuger was lending out billions of dollars of securities to more or less the same customers, then taking the collateral he was getting in return and investing it in illiquid, residential-mortgage-backed, toxic securities.
This was the backdrop for the still largely secret events that took place during the weekend of September 14, 2008, when the government stepped in to rescue AIG and changed the face of the American economy forever.
The CDS insurance Joe Cassano was selling started to show cracks as early as 2005. The reason Cassano could sell this insurance without putting up any money in the first place was that AIG, a massive financial behemoth as old as the earth itself, had a rock-solid credit rating and seemingly inexhaustible resources. When Cassano did deals with the likes of Goldman and Deutsche Bank (to say nothing of Miklos and his smaller Euro bank), all he needed in the way of collateral was AIG’s name.
But in March 2005, AIG’s name took a hit. The firm’s then-CEO, Maurice “Hank” Greenberg, was forced to step down when then–New York attorney general Eliot Spitzer charged Greenberg with a series of accounting irregularities. Those allegations, and Greenberg’s departure, led the major ratings agencies to downgrade AIG’s credit rating for the first time ever, dropping it from AAA to AA.
When that happened, it triggered clauses in the CDS deals Cassano was writing to all his counterparties, forcing the parent company to post collateral to prove its ability to repay—$1.16 billion, to be exact, in the wake of that first downgrade.
In 2007, as the housing market began to collapse, some of Cassano’s clients started to become nervous. They argued that the underlying assets in the deals had seriously declined in value and demanded that Cassano post still more collateral. Importantly, it was Goldman Sachs that freaked out first, demanding in August 2007 that AIG/Cassano fork over $1.5 billion in collateral.
AIG disputed that claim, the two sides argued, and ultimately AIG handed over $450 million. This was right around the time that Cassano was busy lying his ass off about the dangers of his portfolio. In the same month that he agreed to hand over $450 million to cover the depreciation in value of the assets underlying his CDS deals, Cassano told investors in a conference call that everything was hunky-dory. “It is hard for us, without being flippant, to even see a scenario within any kind of [rhyme] or reason that would see us losing one dollar in any of those transactions,” he said.
A month later, Cassano fired an accountant named Joseph W. St. Denis, who discovered irregularities in the way AIG valuated a target company’s hedge fund accounts; Cassano openly told St. Denis that he wanted to keep him away from his CDS portfolio. “I have deliberately excluded you from the valuation of the Super Seniors [CDSs] because I was concerned that you would pollute the process,” he says.
Then, in October 2007, Goldman Sachs came back demanding more money, this time asking for $3 billion. The two sides again argued and again settled on a compromise, as Cassano and AIG this time agreed to pony up $1.5 billion. This was a key development, because when AIG’s outside auditor (PricewaterhouseCoopers) heard about Goldman’s demands, it downgraded Cassano’s swap
s portfolio, writing down some $352 million in value that quarter.
Despite this very concrete loss of value, Cassano and his superiors at AIG continued lying their asses off. In yet another conference call in early December 2007, Cassano repeated his earlier position: “It is very difficult to see how there can be any losses in these portfolios.”
But it was too late to stave off disaster. By the time Cassano made that December statement, two other major counterparties, Merrill Lynch and Société Générale SA, had come knocking, demanding collateral to cover their deals. By late December, four more banks piled on: UBS, Barclays, Crédit Agricole’s Calyon investment-banking unit, and Royal Bank of Scotland Group. Deutsche Bank and a pair of Canadian Banks, CIBC and the Bank of Montreal, would join in later.
AIGFP by that point was, for all intents and purposes, dead. In February 2008, PwC, the auditor, found a “material weakness” in AIG’s books, and that quarter AIG announced an extraordinary $5.3 billion loss for the fourth quarter of 2007. Cassano was finally axed that same month, although, amazingly, he was still being paid a $1 million monthly retainer. Then, in May, AIG posted yet another record quarterly loss, of $7.8 billion. The company’s then-CEO, Martin Sullivan, was forced to step down in June. The nightmare was officially beginning.
And the collateral calls kept coming. By July 31, 2008, AIG had handed over $16.5 billion in collateral to Cassano’s clients. But some of them, in particular Goldman Sachs, were not satisfied. Goldman still had about $20 billion in exposure to AIG and it wanted its money. The management of AIG, however, disputed the amount it owed Goldman as per Cassano’s agreements. This was normal, but the lengths to which Goldman went to fight its cause were extraordinary.
“Collateral calls are somewhat subjective because they are based on the caller’s [i.e., Goldman’s] valuation of the CDS,” says one government official who would later be involved in the AIG bailout negotiations. “There may be a degree of negotiation, and since the called [AIG] has the money and the caller [Goldman] wants it, the called has a certain amount of power in the negotiations … This is what happened between AIG and Goldman.”
As is well known by now, these collateral disputes were a big part of the reason the government was ultimately forced to step in and take action to prop up AIG on the weekend of September 13–14, 2008. One of the key precipitating incidents, in fact, was the decision by the various credit agencies to downgrade AIG a second time. When AIG learned that Moody’s and Standard and Poor’s intended to downgrade them again on September 15, AIG knew it was in serious trouble, as the downgrade would trigger still more collateral clauses in Cassano’s crazy-ass deals. Already in a desperate fight to stave off Goldman and other clients that were screaming for the collateral ostensibly owed thanks to the last downgrade, AIG was now going to be on the hook to those same people for tens of billions more. It was this impending ratings holocaust that got the Treasury and the Fed scrambling, beginning Friday, September 12, to figure a way out for everyone concerned.
That part of the story is well known by now. What is less well known is the role that the other AIG crisis—the one caused by Win Neuger—played in the same mess.
Just a few months before, in late June and early July 2008, at roughly the same time Sullivan was stepping down and AIG was announcing a massive $7.8 billion first-quarterly loss, Neuger was announcing problems in his own unit. It seems that by July 2007 Neuger had lent out about $78 billion worth of securities and invested nearly two-thirds of the collateral he received in mortgage-backed crap. By March 31, 2008, the value of his portfolio had dropped to $64.3 billion. In late June, AIG made it public: Neuger, rather than make his “ten cubed” in profits, had actually lost $13 billion in the course of a year.
What is interesting about this is how the world came to find out about it. Neuger, remember, made his money by pulling securities out of the holdings of AIG’s subsidiary life companies, lending them out to Wall Street, then taking the cash put up as collateral and investing it. Unlike Cassano’s CDS deals, the securities he was lending were actually quite solid, so the parties he was lending them to—in large part the same people who were Cassano’s counterparties, i.e., Goldman, Deutsche, Société Générale, etc.—were in theory not at risk of taking great losses. After all, they were still holding the securities, the ordinary stocks and bonds in the portfolios of the subsidiary life companies, and those things were still worth something.
But a funny thing began happening in late 2007 and early 2008. Suddenly Neuger’s customers started returning their securities to him en masse. Banks like Goldman Sachs started returning huge chunks of securities and demanding their collateral back. In what quickly struck some regulators as a somewhat too convenient coincidence, many of these banks that started returning Neuger’s sec-lending cash were also counterparties to Cassano’s Financial Products division.
“Many of the counterparties who were involved with the securities-lending business, they were knowledgeable as to what was going on with [Cassano’s] Financial Products division,” says Eric Dinallo, at the time the head of the New York State Insurance Department. “You had people who were counterparties to the credit default swap side who were also able to pull cash out of [Neuger’s] sec-lending business.”
Early in that summer of 2008, Dinallo would chair a multistate task force charged with helping AIG “wind down” its crippled securities-lending business in such a way that AIG’s subsidiary insurance companies (and by extension the holders of policies issued by those companies) would not be harmed by any potential bankruptcy. The threat that a run on Neuger’s sec-lending business would result in these insurance companies getting bankrupted or seized by state insurance commissioners was like a guillotine that hung over the entire American economy in the summer of 2008—and, in ways that to this day remain unknown to most Americans, that guillotine would become a crucial factor in the decision to bail out AIG and AIG’s counterparties amid the implosion of September 2008.
Neuger had been borrowing from AIG subsidiary companies like American General, SunAmerica, and United States Life, companies that insured tens of thousands, if not hundreds of thousands, of ordinary policyholders and retirees. If enough of Neuger’s securities-lending clients demanded their money back at once, suddenly there was a real threat that the parent company AIG would have to reach down and liquidate the assets of these mom-and-pop insurance companies, leaving those tens of thousands of people out in the wilderness. All in order to cover Neuger’s colossally stupid and unnecessary bets on the mortgage market.
Faced with this terrifying possibility, the regulators in numerous states—led by New York but also including Texas, which contained many thousands of ordinary people with American General policies—suddenly took notice. It was little noted at the time, but when AIG announced that $13 billion loss, Texas insurance officials said publicly that they were not aware of the liabilities involved with Neuger’s portfolio. “We were aware of this portfolio, but we didn’t have transparency on what was in it because it was off-balance-sheet” in the company’s statutory accounting reports, said Doug Slape, chief analyst at the Texas Department of Insurance.
It was around this time, in June and July, that Dinallo and insurance officials from the states scrambled to step in and make sure that AIG had enough funds to cover the messes in the securities-lending business. The states had a mandate to make sure that no one would be allowed to take value out of these mom-and-pop insurance companies; before they would ever let that happen, they would step in and take the companies over.
They had the power to do that, but in July the officials were trying everything they could to avoid taking that drastic step. The situation was so serious that the federal government also stepped in to help convince the states not to seize any of the AIG subsidiaries if they could avoid it. “Treasury was calling the governors of the states and getting the governors to get their insurance commissioners to stay on board,” says Dinallo. “I was in the middle of these eleven-sta
te conference calls—eleven states being the number of states that had AIG subsidiary companies—and we were making sure that everybody was saying the same thing: that if we start seizing life or property insurers because they file for bankruptcy, it will be bad for everybody.”
In the end, the task force worked with AIG and got them to sign a “make-whole” agreement in which they pledged to put some money into the subsidiary pool and throw in another $5 billion or so to cover any potential future losses. The states thought this would be more than enough.
“As of June thirtieth, everything was still more or less fine,” says one state official involved in those negotiations. “It wasn’t the end of the world yet.”
But AIG and its subsidiary life companies were only “fine” up to a point. The garbage Neuger had invested in—and about a third of his portfolio was mortgage-based toxic crap—had plummeted in value, perhaps irreversibly. He couldn’t sell the stuff and he couldn’t really replace it in his portfolio with something safer. All he could do was hold on to his big folder full of worthless paper and hope it recovered its value. Meanwhile, he had to cross his fingers and hope his customers/counterparties wouldn’t start returning their securities and demanding their money back.
This, incidentally, was not an unreasonable expectation. Under normal circumstances a sec-lending business like Neuger’s wouldn’t have to deal with a lot of customers returning their securities (also called closing out their accounts) all at once. Normally the lender would lend out his securities on short-term contracts—say, sixty to ninety days—and at the end of that time the client would either renew the deal or else the securities would be lent to someone else. In either case the securities would remain lent out. This is called rolling the deal. Since the securities Neuger had lent out were still valuable, and the parties holding them didn’t have that much real risk of a loss, it was reasonable to expect that his clients would keep rolling them into the future.