Money and Power

by William D. Cohan

  The dominoes started falling differently than Greenberg planned on Valentine’s Day 2005, five days after AIG announced its 2004 earnings of $11.04 billion, a stunning 19.1 percent increase from the year before. That was when AIG revealed it had received subpoenas on February 9 from both New York attorney general Eliot Spitzer and the SEC related to their amorphous-sounding investigations about AIG’s accounting for various “non-traditional insurance products” and “assumed reinsurance transactions.” AIG said it would cooperate “in responding to the subpoenas.” A month later, on March 14, AIG announced that Greenberg would step down as CEO to become nonexecutive chairman of the board of directors and would be replaced by Martin Sullivan, who since 2002 had been AIG’s vice chairman and co–chief operating officer and a member of the company’s board. The company’s spin was that it had “implemented its management succession plan” by picking Sullivan, and since Greenberg was then seventy-nine years old the claim seemed plausible.

  But, in reality, Spitzer and the SEC were using the threat of a criminal indictment—which no financial company had ever survived—to put pressure on the board to dispense with Greenberg. It turned out that the regulators were investigating the accounting for two $250 million reinsurance transactions between an AIG subsidiary and General Re Corporation, the reinsurance behemoth and subsidiary of Berkshire Hathaway, in December 2000 and March 2001. “The entire AIG–Gen Re transaction was a fraud,” Spitzer later wrote in his civil fraud complaint against AIG, Greenberg, and another AIG executive. “It was explicitly designed by Greenberg from the beginning to create no risk for either party—AIG never even created an underwriting file in connection with the deal.”

  Spitzer filed a civil complaint in New York State Supreme Court on May 25, 2005—and later dropped it in its entirety. In March 2006, AIG paid $800 million to settle with the SEC and restated its shareholders’ equity by $2.26 billion for 2004. AIG also paid in excess of $800 million to New York State to settle charges against the company.

  Between the firing of Greenberg, the Spitzer investigation, and the potential accounting restatements, Standard & Poor’s, one of the three major ratings agencies, decided on March 30 that it would shoot first and ask questions later. Late that afternoon, S&P lowered AIG’s coveted AAA debt rating to AA+, for both its long-term counterparty credit and its senior debt. In making the downgrade from AAA—which was one of AIG’s most coveted assets—Grace Osborne, the S&P credit analyst, cited the delayed filing of AIG’s annual financial statement, known as a 10-K, with the SEC, and the uncovering of a “number of questionable transactions that span more than five years” that could result in a decrease of $1.7 billion to AIG’s reported shareholders’ equity. Without mentioning the downgrade, Martin Sullivan, the new CEO, wrote a letter to shareholders on April 4 where he acknowledged the various inquiries and how committed AIG was to cooperating with the company’s regulators to resolve any problems or concerns.

  Curiously, nowhere in Sullivan’s letter, S&P’s downgrade analysis, AIG’s announcements about Greenberg’s departure, or any of the various regulatory or internal investigations into AIG was the name “AIG Financial Products” even mentioned. Indeed, it is probably a safe bet that as of April 2005 very few people outside of 70 Pine Street, AIG’s world headquarters in downtown Manhattan, or much beyond AIGFP’s Wilton, Connecticut, and London, England, offices had even heard of AIGFP, or of its CEO Joseph A. Cassano, or even how it made increasingly large amounts of money for its parent, AIG. Needless to say, there was little, if any, disclosure to investors of the unprecedented risks Cassano was taking on either.

  According to Greenberg, Sullivan’s oversight of AIGFP and Cassano dissipated in the wake of Greenberg’s firing. “[R]eports indicate that the risk controls my team and I put in place were weakened or eliminated after my retirement,” Greenberg wrote in his October 2008 congressional testimony. “For example, it is my understanding that the weekly meetings we used to conduct to review all AIG’s investments and risks were eliminated. These meetings kept the CEO abreast of AIGFP’s credit exposure.” Not only did Cassano appear to be free of management scrutiny but, more important, it would turn out, the loss of AIG’s coveted AAA credit rating meant that the counterparties who had paid the premiums to and bought the credit protection from AIG could demand that AIG post collateral—in cash or securities—should the value of the debt being insured fall. This made sense, of course, in that an insured would want to know that its insurance company was good for the money. The posting of collateral in an escrow account makes the insured feel better but requires the insurer to have the cash around to put into escrow. It also required that the insured and insurer agree on how much collateral should be posted to make up for the loss of value in the securities being insured.

  At this moment, Greenberg said, Sullivan should have pretty much shut down the credit-default swap operation at AIGFP: “When the AAA credit rating disappeared in spring 2005, it would have been logical for AIG’s new management to have exited or reduced its business of writing credit-default swaps,” he explained. With little effort, Greenberg ticked off in rapid fire the litany of mistakes then made by Sullivan, Cassano, and company: Rather than curtailing the selling of credit-default swaps, AIGFP ratcheted up exponentially its issuance of them, and no longer just on corporate debt but on a whole new explosion of risk that Wall Street was madly underwriting through the issuance of increasingly risky mortgage-backed securities tied to so-called subprime and Alt-A mortgages. Then there were the credit-default swaps written on collateralized debt obligations, or CDOs, with huge exposures to subprime mortgages. And then there were the swaps sold to hedge the risk of CDOs of CDOs and of synthetic CDOs, where just the risk was bought and sold and there was no underlying security. AIGFP also wrote insurance for something called “multi-sector” CDOs, a collection of more than one hundred bonds ranging from those backed by residential mortgages to those backed by credit-card and auto-loan receivables.

  As of December 31, 2007, AIGFP had a portfolio of credit-default swaps totaling $527 billion, of which $78 billion were written on multi-sector CDOs, most of which had some exposure to subprime mortgages. Indeed, it has become widely accepted that without Joe Cassano and AIGFP around to insure the risk that Wall Street was taking in underwriting all these increasingly risky securities, the debt bubble might have deflated rather than exploding as it did in 2007 and 2008. In its defense—which shows up among other places in an August 2009 court filing by law firm Weil, Gotshal & Manges in a shareholder lawsuit—AIG argued first that it only wrote credit-default swaps on the “super senior” portion of the multi-sector CDOs, meaning, incredibly, that AIGFP believed it had very little real exposure “[b]ecause the super senior tranche has priority of payment ahead of even the AAA tranches, [and so] is regarded as having a better-than-AAA rating.” Additionally, AIG and Weil, Gotshal & Manges argued that in December 2005 AIGFP stopped writing new credit-default swaps on multi-sector CDOs that included subprime mortgages because “of concerns over deteriorating underwriting standards for subprime mortgages,” although AIGFP continued to insure the risks in both “prime” and “Alt-A” mortgages. Weil, Gotshal continued, “As a result, AIGFP’s exposure to multi-sector CDOs with more risky subprime mortgages and mortgage-backed bonds originating in 2006 and 2007 was limited, a fact which later provided additional comfort that losses suffered by other market participants would not spread to AIG.”

  While that last bit of legal spin is certainly debatable, what soon became crystalline—and a major problem for AIG—was that as the value of the toxic securities it had insured before 2006 fell and with the loss of its AAA corporate credit rating, AIG’s counterparties ratcheted up their demands for collateral from AIG.

  At the forefront of these increasingly strident collateral demands was none other than Goldman Sachs. Goldman had insured around $75 billion of these securities through AIGFP, and during the course of 2007, the displeasure with Goldman Sachs was becoming increasing
ly well known inside AIG. Goldman’s lower marks forced AIG to grapple—albeit with great reluctance—with its portfolio of insurance tied to the securities that Goldman kept insisting were worth less and less. “When the credit market seized up,” Sullivan testified before Congress, “like many other financial institutions, we were forced to mark our swap positions at fire sale prices as if we owned the underlying bonds even though we believed that our swap positions had value if held to maturity.”

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  ON JULY 10, the major credit-rating agencies—that for years were part of the problem through their chronic failure to exercise any independent judgment about the credit ratings they had slapped on a slew of mortgage-backed securities—began to get some religion (long after the fact) and downgraded hundreds and hundreds of residential mortgage-backed securities. The downgrades set off a chain reaction of worry, especially among some of the executives at AIGFP. The next day, in a telephone conversation with his colleague Alan Frost—a transcript of which was released by the Financial Crisis Inquiry Commission, or FCIC—Andrew Forster, the head of credit trading at AIGFP, expressed his dismay at the downgrades. “[E]very fucking … rating agency we’ve spoken to … [came] out with more downgrades,” he told Frost. “About a month ago I was like, suicidal.… The problem that we’re going to face is that we’re going to have just enormous downgrades on the stuff that we’ve got.… Everyone tells me that it’s trading and it’s two points lower and all the rest of it and how come you can’t mark your book. So it’s definitely going to give it renewed focus. I mean we can’t … we have to mark it. It’s, it’s, uh, we’re [unintelligible] fucked basically.”

  By late July 2007, in the wake of the downgrades and as a result of the trading it was seeing in the market, Goldman began putting pressure on AIG to pony up more collateral to cover the declining value of the mortgage securities AIG had insured. On July 26, Andrew Davilman, at Goldman, wrote Frost an e-mail telling him Goldman was making its first collateral call. Frost was on vacation. “Sorry to bother you on vacation,” Davilman wrote. “Margin call coming your way. Want to give you a heads up.”

  “On what?” Frost wrote back, eighteen minutes later.

  “[$]20bb of supersenior,” Davilman replied, just over a minute later. Frost never replied to Davilman’s e-mail. Instead, AIGFP decided that Forster, not Frost, would deal with Goldman’s requests for collateral payments.

  Goldman’s marks—and the subsequent collateral call to AIGFP based on them—were, understandably, not welcome news at AIGFP. But the marks were also the subject of some controversy within Goldman itself. “The $2bn margin call is driven by a massive remarking by Goldman Sachs of the underlying [mortgage] securities (down from −6 pts to −20 to −25 pts in some cases), ahead of all other dealers in the [S]treet,” Goldman’s Nicholas Friedman wrote in an internal e-mail the day before the AIGFP collateral call. Ram Sundaram, a Goldman managing director in proprietary trading, was also concerned about the Goldman marks. “After spending the past two days chasing dealers and internal desks for fresh marks,” he wrote some colleagues on July 26 at 11:09 p.m., “the result has been the need to call a significant amount of collateral from various counterparties. This is particularly concerning in that these stale marks were also being sent to clients by GS for their own valuation purposes (for example—[W]est [C]oast bonds were quoted at 99 yesterday by the GS trading desk and after we demanded a current bid they were bid at 77.5 today). The extent of the collateral calls being generated overnight is embarrassing for the firm ($1.9Bn from AIG-FP alone).” He urged caution and offered to make sure clients and others understood Goldman’s valuation methodology. At the same time, AIOI Insurance, a Goldman client in Tokyo, let the Goldman traders know how upset the company was about Goldman’s marks and the margin call that resulted. According to Shigeru Akamatsu, a Goldman vice president, “Suzuki-san,” at AIOI, believed Goldman’s marks were “more than twice as bad as others,” that the margin call was “totally unaccepted,” and “warned that he will strongly protest against us.”

  Goldman’s opening salvo against AIG had been fired. The next day, Goldman asked AIGFP for $1.81 billion in collateral; Goldman also purchased $100 million of insurance—by buying CDS—against the possibility that AIG would default on its obligations. (Eventually Goldman’s CDS purchase against an AIG default would reach a peak of $3.2 billion.) On July 30, an AIG trader told Forster that “[AIG] would be in fine shape if Goldman wasn’t hanging its head out there.” The July 27 margin call was “something that hit out of the blue, and it’s a fucking number that’s well bigger than we ever planned for,” Forster said later. He said the marks were all over the place and “could be anything from 80 to sort of, you know, 95” because of infrequent trading. He called Goldman’s marks “ridiculous.”

  When Cassano first heard about Goldman’s collateral call, he was blown away and thought that it came “out of the blue,” he said in a five-hour June 2010 interview with the FCIC. “What in the world had changed between yesterday and today?” he said he wondered, to prompt the “whopper of a [collateral] call” from Goldman. Goldman’s marks were consistently lower than those of other Wall Street dealers—as Goldman itself admitted—and Cassano was incredulous about their accuracy. “I didn’t believe the numbers,” he said. “These aren’t real numbers. The markets had seized up.” According to the January 2011 FCIC report, AIG’s models meanwhile showed “there would be no defaults on any of the bond payments that AIG’s swaps insured.” But, according to the report, “[t]he Goldman executives considered [the AIG] models irrelevant, because the contracts required collateral to be posted if market value declined.”

  Needless to say, the vast discrepancy in the way the two firms looked at the valuation of these securities did not make the negotiations between them any easier. Nor did it help that by the summer of 2007, Goldman would clearly benefit from a decline in the value of the mortgage securities—and had every incentive to convince the market the value had fallen—while AIGFP had an even bigger incentive to claim the value of the securities in the market had held up just fine. This was a zero sum game between the two financial powerhouses.

  The Goldman and AIGFP executives debated the matter in early August. In an August 2 e-mail, Thomas Athan, another AIGFP executive, wrote to Andrew Forster about a particularly difficult conversation he had had that day with Sundaram, the senior Goldman mortgage executive. “Tough conf call with Goldman,” Athan wrote to Forster. “They are not budging and are acting irrational. They insist on ‘actionable firm bids and firm offers’ to come up with a ‘mid market quotation’ ” as a way to determine how much collateral AIG needed to post.

  Athan did not want to put the details of his call with Sundaram in the e-mail but informed Forster that this needed to be escalated within AIGFP and then he needed to get back to Goldman by noon the next day. “I feel we need Joe to understand the situation 100% and let him decide how he wants to proceed,” Athan wrote. “I played almost every card I had, legal wording, market practice, intent of the language, meaning of the CSA”—a reference to the Credit Support Annex, which is a codicil to the ISDA Master Agreement that governs collateral calls in CDS transactions—“and also stressed the potential damage to the relationship and GS said that this has gone to the ‘highest levels’ at GS and they feel that the CSA has to work or they cannot do synthetic trades anymore across the firm in these types of instruments. They called this a ‘test case’ many times on the call. It seems Ram has put himself in a bind that the firm is watching him here to see how he works this out and anything other than getting collateral close to liquidation levels will be considered a failure. Someone (like Joe) might need to convince a senior person that there is an alternative way to look at this situation.” Athan suggested they all circle up and have a “halo”—a reference to a real-time Hewlett-Packard collaboration and meeting system—the next morning. “BTW,” Athan signed off, “[t]his isn’t what I signed up [for]. Where are the big trades
, high fives and celebratory closing dinners you promised?”

  For the next two weeks, AIGFP and Goldman disputed Goldman’s marks and its collateral call. It “was unusual to have disputes” with Goldman, Cassano said. “Goldman Sachs is a business partner of ours and an important relationship.”

  On August 9, Cassano told AIG’s investors on a conference call about AIGFP’s portfolio of credit-default swaps. “It is hard for us, and without being flippant, to even see a scenario, within any kind of realm of reason, that would see us losing one dollar in any of those transactions.… [W]e see no issues at all emerging. We see no dollar of loss associated with any of that business.” In reaction to Cassano’s bold assertion, on August 13, the Wall Street Journal reported in a front-page headline that “AIG Might Be Deceiving Itself on Derivative Risks.” According to writer David Reilly, “AIG might not want to whistle too loudly as it strolls past the subprime graveyard.” But Cassano pooh-poohed the story. “Hopefully people just ignore it,” he e-mailed Forster. “It is a real non-story.”

  Of course, it wasn’t. Instead, the questions intensified about whether AIGFP had the cash to meet mounting collateral calls from counterparties. The ratings agencies wanted to know, as did AIG’s outside auditors at PricewaterhouseCoopers and AIG’s internal auditors at 70 Pine. One of them, Elias Habayeb, the CFO of AIG’s financial services group who reported to AIG’s CFO, was particularly nettlesome to Cassano. For months, he had been pushing Cassano for more information about the value of the swaps AIGFP had written and about the collateral availability. “There must be something in the air or the coffee at 70 Pine,” Cassano complained in an e-mail to Habayeb on August 31 about the numerous inquiries he was suddenly getting from headquarters. He then went on to detail AIGFP’s sources of liquidity and urged Habayeb not to bother Forster and others with further questions. “We have taken many steps to insure our liquidity during this market disruption,” he wrote. “In many ways for us this is old hat stuff as we went through a similar shut off of the capital markets in 2005 during the compan[y’s] restatement horrors. We have been very careful about husbanding our liquidity resources and I am comfortable that we will be able to see this crisis through and come out the other side being opportunistic value buyers. If you have any other questions please direct them to me. As you can imagine Andy and his team have a big task on their hands keeping tabs on the markets, husbanding liquidity and managing their business. At times like this we all want them exclusively focused on their jobs. Cash is King.” (Despite his concerns, Habayeb had been AIG’s chief spokesman to the Journal’s August 13 story and had said everything was just fine.)