The major finance businesses—banking, lending, insurance, investing—did not lend themselves to the sort of explosive growth that created overnight billionaires. Sure, you could get wildly wealthy, but you had to be somewhat patient. But that wouldn’t do; these were the sort of folks who couldn’t be bothered even to wait for immediate gratification. The bankers needed some way to get to that next level now, to embrace the sort of models that would be game changers immediately.
They needed a Viagra.
The 100-year-old financial houses could never compete with that sort of growth. Well, at least not with their relatively staid old business models, their conservative approach to risk. Slow growth and modest profit margin was not how you got rich quick. So they leveraged up, embraced risk, and reinvented themselves as newfangled quants. “We’re engineers, too—financial engineers! We design derivatives and securitize debt! We have access to massive leverage! Hey, everybody, we’re all gonna get laid!”
How else can you explain CEOs going all in?
Financial engineering took care of the first problem, the killer app. Be it leverage or derivatives or securitization, the wizards of Wall Street had found their Viagra. At least, they thought they did. What they failed to consider was the cost of failure.
That was something that Silicon Valley had down to a science. In tech land, start-ups hit it big or fizzled. The cost of failure was minimal, and working at the right crashed-and-burned company was a badge of honor. During the post-2000 tech wreck, FuckedCompany.com was a favorite web site among the geek crowd.
Those who work at start-ups risk thousands of dollars of money from friends and family; they roll the dice with hundreds of thousands of angel investor cash. They gamble millions of venture capital dollars on new business ideas. And when it all goes kaput, hey, it was a long shot in the first place. They all pick themselves up, dust themselves off, and move on to the next project.
Not so with the finance gurus. When you are a 100-year-old company handling hundreds of billions of dollars, there is no easy exit. Big investment banks were not playing with venture capital money, where the expectation was that 99 out of 100 projects would return nothing. They were playing with the rent money and life insurance premiums and mortgages and 401(k) cash of their clients, businesses, and individuals alike.
These weren’t modest investments made by people who understood the long odds against them and allocated risk capital accordingly. This was blood money. They bet the house—and lost.
We’ve come a long way from the days when the man atop the organizational chart made 40 times what the person on the lowest rung earned. Over the past few decades, executive compensation has exploded, with some CEOs taking 200, 300, even 400 times the base pay at the company.
With so much of this compensation made via options-based incentives, the bosses had every reason to swing for the fences. The upside was all theirs, and the downside was the shareholders’—and taxpayers’.
But don’t for a moment think their terrible track record had a negative impact on their compensation. Despite their performance, these CEOs were paid as if they were enormous successes. The compensation figures that follow are enormous; that they were paid for such abject failure is a national embarrassment.
It is also an indictment of three major corporate governance issues that have not been discussed widely enough. The first is the crony capitalism that was rife in boardrooms across the United States. The cronyism of major corporate boards, especially those in the finance area, has become legendary. Rubber-stamp directors who rarely buck the chairman or challenge the CEO are unfortunately all too common. These boards did not serve either their companies or their shareholders well.
Also enabling this festival of greed are the large institutions that held the companies’ stock, most especially the big mutual funds that have been AWOL when it comes to policing the senior management. They have the time, expertise, and incentives to do so; it is beyond the capability of individual shareholders. Besides, it makes no economic sense for someone who owns 100 or 1,000 shares of stock to act as overseer and scold to corporate boards. But it was squarely in the interest of owners of 10 million shares and up to do so. Why the mutual fund complexes failed to protect their shareholders is hard to fathom. Perhaps when it comes to the finance sector, they feared missing out on syndicate deals and hot IPOs if they asked too many questions.
Then there are the so-called compensation consultants. They did a horrific disservice to the shareholders as well as the companies. The role of these primarily ethicless weasels was to give cover for these ridiculous compensation packages. I would love to see a review of the packages as written back then. If the compensation experts were members of an actual profession with standards and ethics, they would be drummed out of that profession. Instead, these people were merely tools used by the C-level execs to transfer vast sums of wealth from the shareholders to themselves.
Astonishingly, many of the corporate chieftains whose firms have been bailed out at taxpayer expense still maintain very significant net worths, courtesy of those now destroyed firms. Stan O’Neal left Merrill Lynch with $160 million. Ace Greenberg is reputed to have sold over $100 million in Bear Stearns stock. And Hank Paulson, who as both CEO of Goldman Sachs and Treasury secretary under President Bush, dumped nearly half a billion dollars’ worth of his Goldman Sachs stock (thanks to his new government job, it was tax defered, too!) Had they been running partnerships when their firms collapsed, they would have been left in a rather different financial situation.
That is how incentive pay is supposed to work—upside gains and downside risks as well. But that’s not at all what happened: 1,23• Lehman Brothers Chairman and CEO Richard Fuld Jr. made $34 million in 2007. Fuld also made nearly a half-billion—$490 million—from selling Lehman stock in the years before Lehman filed for Chapter 11 bankruptcy.
• Goldman Sachs always pays its top executives handsomely: Chairman and CEO Lloyd Blankfein got $70 million in 2007. Co-Chief Operating Officers Gary Cohn and Jon Winkereid were paid $72.5 million and $71 million, respectively.
• While Bear Stearns was rescued by a $29 billion Fed shotgun wedding to JPMorgan Chase, former chairman Jimmy Cayne received $60 million when he was replaced.
• American International Group CEO Martin Sullivan got $14 million in 2007 (he was thrown out in June that year). Robert Willumstad was handed $7 million for his three months at the helm (Edward Liddy took over as AIG’s chief executive in September 2008). So far, the tab for AIG’s bailout is $173 billion.
• Morgan Stanley Chairman John Mack earned $1.6 million plus stock in 2007. CFO Colin Kelleher got a $21 million paycheck in 2007. Morgan Stanley also received an expedited approval to become a banking holding company in 48 hours—a record.
• Founder and CEO Angelo Mozilo of Countrywide Financial, which was at the forefront of the subprime fiasco, cashed in $122 million in stock options in 2007; his total compensation over the years was over $400 million.
• Stan O’Neal, who steered Merrill Lynch into collapse before being deposed, was given a package of $160 million when he left his post in 2007. That package makes his successor CEO John Thain’s $17 million in salary, bonuses, and stock options in 2007 look like a bargain. (That may explain why Thain used $1 million of company—and shareholder—money, rather than his own, to redecorate O’Neal’s old office.)
• Bank of America CEO Kenneth Lewis brought home $25 million in 2007. Bank of America acquired Merrill and Countrywide in 2008 and has thus far received $45 billion of direct government bailout money and another $300 billion in asset guarantees.
• JPMorgan Chase & Company Chairman and CEO Jamie Dimon earned $28 million in 2007. JPM Chase acquired troubled investment house Bear Stearns in March 2008 with the Federal Reserve backstopping $29 billion in Bear assets to help get the deal done.
• Fannie Mae CEO Daniel Mudd received $11.6 million in 2007. His counterpart at Freddie Mac, Richard Syron, brought in $18 million.
In 2008, the federal government took over the firms’ combined $5.5 trillion mortgage portfolio, with Herbert Allison to serve as Fannie CEO and David Moffett the new CEO at Freddie.
• Wachovia Corporation Chairman and CEO G. Kennedy Thompson received $21 million in 2007. He was succeeded by Robert Steel as CEO in July 2008. Steel is slated to get a $1 million salary with an opportunity for a $12 million bonus, according to CEO Watch. Wachovia merged with Wells Fargo in late 2008 in a deal notable for its shocking lack of government involvement.
• Seattle-based Washington Mutual was scheduled to pay its new CEO, Alan Fishman, a salary and incentive package worth more than $20 million through 2009 for taking the helm of the battered bank. It was seized by the FDIC in the fall of 2008, and in October was acquired by JPMorgan Chase.
These compensation packages for miserable performance were little more than a massive wealth transfer from shareholders to C-level executives. It just goes to show you: In the world of crony capitalism, failure pays extremely well.
Chapter 17
Year of the Bailout, Part I: The Notorious AIG
Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.
—John Stuart Mill, 1867
September 2008 started with a bang: Fannie Mae and Freddie Mac were put into conservatorship on September 7, 2008. The following week, Lehman Brothers filed the largest bankruptcy in American history.
The repercussions of setting Lehman Brothers adrift on an ice floe were much worse than either Hank Paulson or Ben Bernanke had contemplated. The complications caromed throughout the financial world, causing panics on trading desks. The cascade quickly froze credit markets.
The month was barely under way, and it was already a September to remember. The same weekend Lehman began its long dirt nap, Bank of America hastily purchased Merrill Lynch for $50 billion. Before the month ended, the Treasury Department would guarantee money market funds; the Securities and Exchange Commission (SEC) would ban short selling; the Troubled Assets Relief Program (TARP) would be unveiled; Goldman Sachs and Morgan Stanley would convert to commercial banks, and Washington Mutual would be taken over by JPMorgan Chase.
Then there was American International Group (AIG).
Once Bear Stearns tumbled, traders’ immediate reaction was to identify analogous risk: Who else held similarly bad assets? What other firms had equivalent risk exposure? When Bear fell, the obvious answer was Lehman Brothers. Once Lehman went down, the next in line was AIG.
In 2000, AIG had a $217 billion market cap and was the world’s largest insurer.1 It had numerous divisions, but was in essence two companies under one roof. One was an insurer, the other a structured products firm.
AIG-the-insurer was well known to the public. It was in the Dow Jones Industrial Average, a select club with only 30 members. Regulated by each state’s insurance commission, well reserved for in case of loss, the company was a model corporate citizen. It was also a member of an even more select group, one of a mere handful of firms with a triple-A credit rating. The insurance company made consistent if unspectacular profits.
Hidden among the actuarial tables and staid regulated insurance services was an entirely different company: AIG’s Financial Products (FP) division, or as it came to be known, AIGFP. It was essentially a giant hedge fund, and like private investment firms, its managers kept a fat 32 percent of the profits it generated. Not surprisingly, FP made outsized bets on derivatives. Even though the firm’s CEO, Hank Greenberg, had negotiated the joint-venture agreement between AIG and Financial Products, aspects of the compensation arrangement troubled him. The Washington Post noted that FP received “its profits upfront, even if the transactions took 30 years to play out. AIG would be on the hook if something went wrong down the road.”2
Not, however, the Financial Products team. They were compensated immediately.
Financial Products had begun 20 years earlier with a handful of junk-bond traders from Drexel Burnham Lambert. From 1987 on, the division grew in both size and importance to AIG. From just 13 employees in 1987, FP ballooned to over 400 by 2005.3 “The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999,” Gretchen Morgenson observed in the New York Times. “Operating income at the unit also grew, rising to 17.5 percent of AIG’s overall operating income in 2005, compared with 4.2 percent in 1999.”4
It turns out there was no great secret to making all that money. What AIGFP did was simple: It assumed an enormous amount of risk. As of September 2008, FP had exposed AIG to over $2.7 trillion worth of swap contracts via 50,000 trades made with over 2,000 counterparties.5 In exchange for that massive potential liability, FP took in premiums of one-tenth of 1 percent of the exposure. By the time Nassim Nicholas Taleb’s book The Black Swan: The Impact of the Highly Improbable was published in 2007, it was already far too late for FP’s mathematicians and computer geeks. They were a (highly improbable) accident about to happen.
No matter how hard you try, there are too many people who simply refuse to learn the first law of economics: There is no free lunch. Amazingly, AIGFP actually had a product internally called “free money.” By 1998, FP was looking at a new kind of derivative contract: the credit default swap (CDS). Set all of the complexity aside, and at its heart any CDS is merely a bet as to whether a company is going to default on its bonds. According to AIGFP’s computer models, the odds were 99.85 percent against ever having to make payment on a CDS.
Tom Savage, the president of FP, summed up the free lunch mantra succinctly: “The models suggested that the risk was so remote that the fees were almost free money. Just put it on your books and enjoy.”6 And what of that 0.15 percent risk? According to the Washington Post, AIGFP figured “the U.S. economy would have to disintegrate into a full-blown depression to trigger the succession of events that would require Financial Products to cover defaults.”7
You know the rest.
Back in the markets following Lehman’s demise, it was shoot first, ask questions later. The chatter among traders was that AIG’s huge derivatives book must have been festooned with Lehman default swaps. Short sellers backed up the truck. The death of Lehman would be the last straw for AIG.
But that turned out not to be the case. AIG had treated Lehman debt derivatives the way any smart oddsmaker would: It had taken offsetting trading positions that canceled each other out. As far as Lehman CDS exposure was concerned, AIG was essentially flat.8
The greater concern was AIGFP’s massive derivatives book. My firm was short AIG’s stock long before Lehman collapsed. Our downside bet was motivated by its $80 billion derivative exposure related to subprime mortgages.9 This turned out to be a much larger problem for the insurance giant than Lehman’s face-plant. As AIG’s rapidly devaluing mortgage assets fell, their loss potential became unmanageable.10 The weekend before it became the next bailout recipient, Bloomberg put a dollar figure on AIG’s derivative risk: “$587 billion in contracts guaranteeing home loans, corporate bonds and other investments.” The more housing fell, the further these contracts plunged in value.11 The need for putting up billions in additional collateral was what would be the final straw.
Laughably, both Standard & Poor’s and Moody’s warned of potential downgrades to AIG’s credit ratings the further these mortgage assets fell. The absurdity of the situation appeared to be lost on the rating agencies’ analysts. FP’s losses were directly related to subprime mortgage securities—the ones these same agencies had previously rated AAA. Ironically, nearly everyone who relied on Moody’s or S&P’s ratings to invest in mortgage-backed securities (MBSs) ended up getting downgraded themselves.
The Naughty Child Index
For those who have a hard time conceptualizing the differences between Bear Stearns, Lehman Brothers, and AIG, consider the Naughty Child Index.
Lehman Brothers is like the little kid pulling the tail of a dog. You know the kid is going to get hurt eventua
lly, so no one is surprised when the dog turns around and bites him. But the kid hurts only himself and no one else. No one really cares that much.
Bear Stearns is the little pyromaniac—the kid who is always playing with matches. He could not only harm himself, but burn the house down and indeed burn down the entire neighborhood. The Fed steps in to protect not him, but the rest of the block.
AIG is the kid who accidentally stumbles into a biotech warfare lab and finds all these unlabeled vials. He heads out to the playground with a handful of them jammed into his pockets.
The decision to allow Lehman Brothers to go belly-up has been roundly criticized by many people as a mistake that cost AIG dearly. That turns out to be an incorrect conclusion, a classic correlation-versus-causation error. It is much more accurate to observe that the same factors that drove Lehman into bankruptcy also drove AIG to the brink.
It began with rates so low that everyone in the nation decided they wanted a house (and the bigger, the better). This included many people who could not afford one. So these folk applied for mortgages from a new kind of lender, one that operated with little regulation and even less supervision. These lenders were able to give loans to these people—bad credit risks, too little income, no equity—due to their unique business model. They could ignore traditional lending standards because they did not plan on holding these mortgages very long. They could specialize in higher-commission subprime loans because they were so-called lend-to-securitize originators. They made higher-risk loans, then flipped them to Wall Street firms, which repackaged them into complex mortgage-backed securities.
These same investment banks had too little capital and used too much leverage, but that didn’t stop them from buying too much of this paper from each other. It didn’t matter much anyway; since it was rated triple-A by S&P and Moody’s, there wasn’t anything to worry about. Underlying all of these transactions was the assumption that home prices in the United States never went down.
Bailout Nation Page 19