Back in November, Michael Lewis wrote a great story in Portfolio on the financial crisis, focusing on the traders who saw that the housing bubble was going to crash, bringing mortgage-backed securities down with it – and made lots of money betting on it. Now Lewis is back with his article in Vanity Fair on AIG Financial Products (FP) and its last head, Joseph Cassano. This time, though, it feels like it’s missing the usual Lewis magic.
Lewis sets out to tell the untold story of FP, based on extensive interviews with people who actually worked there. He starts by laying out the conventional wisdom about FP, which presumably he is going to debunk. The conventional wisdom, according to Lewis, is that the problem lay in credit default swaps: “The public explanation of A.I.G.’s failure focused on the credit-default swaps sold by traders at A.I.G. F.P., when A.I.G.’s problems were clearly much broader.” Indeed, Lewis implies that the government essentially framed FP: “Why were officials, both public and private, so intent on leading others to believe all the losses at A.I.G. had been caused by a few dozen traders in this fringe unit in London and Connecticut?
The problem is that, having actually paid for the magazine and read the article, it seems to me that Lewis only reinforces the case against FP and credit default swaps. He says that all of the FP people he talked to “were fairly certain that if it hadn’t been for A.I.G. F.P. the subprime-mortgage machine might never have been built, and the financial crisis might never have happened.” That sounds to me like a more damning case than I would have made.
In Lewis’s story, it was credit default swaps sold by FP that enabled banks to issue securities backed by subprime mortgages earlier this decade. He has evidence that the people at FP who were insuring these securities had no idea how much subprime debt was inside them. When Gene Park figured it out around the end of 2005, Joe Cassano actually agreed to stop insuring subprime-backed securities. Yet Lewis even holds FP responsible for what came later:
“A.I.G. F.P.’s willingness to assume the vast majority of the risk of all the subprime-mortgage bonds created in 2004 and 2005 had created a machine that depended for its fuel on subprime-mortgage loans. . . .
“The big Wall Street firms solved the problem by taking the risk themselves. . . . Unwilling to take the risk of subprime-mortgage bonds in 2004 and 2005, the Wall Street firms swallowed the risk in 2006 and 2007.”
This is somewhat plausible, but it’s a funny argument. Essentially it says that: (a) FP was responsible for subprime lending because, without insurance, investment banks wouldn’t have been willing to take on the risk of the securities in the first place (and demand from investment banks is what caused frontline lenders to originate these loans); but (b) when FP stopped insuring the securities, investment banks suddenly decided they were willing to take on the risk. I say it’s plausible because it could be that FP enabled a profit machine in 2004-05 and the banks were unble to shut it down in 2006-07 without torpedoing their earnings. But if that were the case, they would all have behaved like Goldman – shorting the mortgage-backed securities markets with one hand at the same time that they originated the stuff with the other. In 2006-07, most banks simply underestimated the risk of the stuff they were holding; that is FP’s fault only if you claim that FP made banks like Bear and Lehman stupid.
So when Lewis says, “A.I.G. F.P. wasn’t an aberration; what happened at A.I.G. F.P could have happened anywhere on Wall Street . . . and did” (ellipsis in original), I’m not sure which side he is arguing. Is he saying that FP is to blame for the crash? Or is he saying that FP caused the crash, but doesn’t deserve to be singled out because it “could have happened anywhere?”
The latter argument, to me, doesn’t make sense. The problem is better illustrated when Lewis describes the rise of credit default swaps in the 1990s:
“The traits required of this corporation were that it not be a bank – and thus subject to bank regulation and the need to reserve capital against the risky assets – and that it be willing and able to bury exotic risks on its balance sheet. There was no real reason that company had to be A.I.G.; it could have been any AAA-rated entity with a huge balance sheet. Berkshire Hathaway, for instance, or General Electric. A.I.G. just got there first.”
I don’t think anyone has ever argued that for some structural reason AIG was the only company that could have created the mess it did. AIG created the mess because it made stupid business decisions that other companies did not make. Other companies made other stupid decisions, but not the one to take a huge, one-sided bet, with no reserves, on the solidity of the housing sector and the entire economy.
Ultimately, I think Lewis is actually too harsh on FP. They made bad decisions, they essentially blew up all of AIG, and they required an enormous taxpayer-funded bailout to limit the collateral damage. But holding them responsible for the bad decisions at all the Wall Street investment banks seems a bit much.
By James Kwak
The Baseline Scenario 
That’s funny – my take from the article was that it could have happened anywhere, and it was only AIG that set it off because AIG got to the market first and most aggressively.
http://tauntermedia.com/2009/07/10/aig-again/
It’s a bit like the beginning of World War I. It was set in motion by the assassination of Ferdinand, but all of the underlying grievances had been there for years and would have found their release one way or another.
Once we had an interconnected finance system with extremely short-term money and essentially no reserve requirement, we were bound to sooner or later have a blowup we could not easily contain. That it was subprime housing and not currency crises or sovereign debt meltdowns was somewhat arbitrary.
Hmm, the way I understood it was that all the subprimes that were securitized were slapped with AAA ratings based on one strong loan within the bundle, which could explain some of the behavior of the investment banks?
Am I wrong, is there more detail I’m missing? Any explanation would be much appreciated.
Lewis is telling a story, not making an analysis or argument. His explanations, like most post hoc explanations of human behavior, don’t mean much. They are plausible, no more. On par with, “After yesterday’s runup, the market closed lower today on profit taking.” You can almost always make a plausible explanation for human behavior after the fact. “Young Jack stood his ground because he was cornered.” Or: “Young Jack collapsed on the ground because he was cornered.”
That’s actually similar to this: ““The big Wall Street firms solved the problem by taking the risk themselves. . . . Unwilling to take the risk of subprime-mortgage bonds in 2004 and 2005, the Wall Street firms swallowed the risk in 2006 and 2007.”
The big Wall Street firms had a problem in 2006 and 2007, because AIG was no longer willing to take the risk off their hands. The explanation that they had been “unwilling to take the risk . . . in 2004 and 2005” is post hoc, arguing that they did not because they had been unwilling. AIG had been willing to take the risk, and they had been happy to let AIG do so. If AIG had not done so at that time, we do not know what the firms would have done. Like “profit taking”, the firms’ “unwillingness” makes for a good story by connecting the dots. It should not be taken seriously.
“they would all have behaved like Goldman – shorting the mortgage-backed securities markets with one hand at the same time that they originated the stuff with the other”
But what Goldman did was basically double up on the swaps, right? Not exactly a solution to systemic failure caused by too many swaps, unless you have a Treasury Secretary who is willing to step in and pay on your swaps.
What I take from Lewis’s account is that people were blinded by money. When faced with the prospect of making less, or looking bad, the situation got out of hand at both FP and their customers.
I agree with Min that Lewis’s account isn’t predictive of the next crisis, but like his other work, should be taken as seriously as Lewis himself takes the rest of the world, which is with a grain of salt.
Traders were scared of Joe Cassano, because although he eagerly cut them checks for millions, he also made them say out loud that their bottled water was his bottled water. Wha?
There is no secret to what happened at AIG that we can learn from. I was pleased to see at least that somebody did recognize just how risky the business was, even if it was way too late.
I think Lewis makes the argument (that others have made — I think the WashPost detailed this in its December profile of AIG FP) that there was indeed a “structural reason AIG was the only company that could have created the mess it did”, namely that AIG had that perfect AAA credit rating? Okay, it’s not quite the only AAA company that could have launched something of this scale, but it does reduce the number of potential firms that could have done this to 2.5: AIG, Berkshire, maybe GE. But it’s not as if Microsoft or Exxon or J&J were ever going to do it.
Cassano came from Drexel. The guy who appointed him to his position, Savage, came from Drexel. Michael Milken came from Drexel.
(Are we seeing a pattern here?)
The Morgan Mafia gave them the gun and they used it.
Someone was using their already proven, healthy capacity for greed. Wonder who that someone could be. And what’s the endgame?
Did it go like this?
Lord Professor Droolington (LPD): Let’s have a little fun with those yanks across the pond, shall we?
Snivvles: What do you have in mind, midrool?
LPD: Find some bright young mathematicians over at the Fabian club and tell them they’re going on a long mission in the service of her majesty the queen.
Snivvles: Yes midrool. And what shall I tell them they will be doing?
LPD: Their task is to give the americans the tools they need to destroy themselves over a good twenty years. Shant be too difficult, and we’ll end up making a bloody fortune. First, they need to inflate a gargantuan credit bubble, then prick it, then deflate it until unemployment reaches, say, 40%. At that point they will need assistance in nationalizing everything. We shall be glad to oblige. Finally they will need some help in privatizing everything again, and we will once again stand by our american cousins.
True enough, but why continue to pay people who crushed and crashed all else? If the banks suddenly grew balls and agreed to take more risk, perhaps it was with some foreknowledge they had a scapegoat in hand and they themselves would be bailed out, and bonuses would continue to flow to the right people.
Actually Lewis’ account is not particularly new. Look at Gillian Tett’s book, Fool’s Gold. She tells the story from the perspective of the J.P.Morgan bankers who created the form of these derivatives. They were suspicious about mortgage-backed CDOs because of insufficient data about default and correlation risks, and in particular couldn’t understand how any bank could possibly load up its balance sheet with “supersenior” tranches of these securities once AIG stopped writing CDSs on them, ie, post 2005. It’s why JPM came through the crisis well.
I stopped mid way because I thought I was missing something and thought I’d come back to the article. Now I don’t have to.
I’m definitely not a Joseph Cassano fan, but as time has passed by I think Joseph Cassano has become too much of a convenient poster boy for PREVALENT problems throughout all of AIG’s leadership. And I guess AIG must love the way Michael Lewis seems to lay all the blame right there at Joe Cassano’s feet. If I were Cassano’s leaders I’d send Michael Lewis a “Thank You” note.
Interesting how they payed Cassano 1 million to sit and watch TV in the office. Do you think as AIG was showing Cassano the door out they may have been paying Cassano $1 million for OTHER reasons than to “consult”?? Lewis never seems to explore this question. Maybe Vanity Fair doesn’t pay enough for that?
It’s a great way for Lewis to tie a neat little bow around a very complex story. But I don’t think it shows the real problem at AIG. And I don’t think Lewis is doing his readers a service.
Well I guess with Michael Lewis, we have our modern day Tolkien, writing the tale of the one man who ruled them all…
The idea that all those Ivy MBAs who bought AIG CDSs were rooked somehow by one AIG guy – that Cassano had terrorized everyone at his firm into paralysis, allowing him to lead AIG and its merry band of followers down the road to ruin – that one man had the power and influence to crash the global economy is fiction of the first order.
Bravo for the careful reading, Min!
For me, from the beginning, regardless of who was responsible for CDS’s, AIG was the largest insurance company in the world, highly trusted. They could never have achieved what they did in insurance, if it were not for a deep understanding of following actuarilly established reserve requirements (capital held against potential losses). Insurers are not only prudent, but mostly forced to be that way be regulators. Although CDS’s were not catagorized as insurance products, they were only that (hedges against loss – which all insurance is ultimately). There were two problems, either the loss potential was essentially discounted to zero for the reason of an incredibly bad business decision, or they fraudulently failed to file with the insurance commissioners’ offices to have the product analysed and rated for loss potential and premium adjustment (no rate filing). Regardless of the cause, the failure was rooted in top-down mismanagement. There is simply no other possibility.
More and more these days, I have come to believe that if mismanagement is so severe that it results in major harm to many, it may be categorized as criminal negligence, whether intentional or not (regardless whether AIG’s managers failed to understand the loss poteniiality, or not. I know that Justice is heavily involved in prosecuting many involved in the collapse, but I would like to see part of the reform be the creation of criminal penalties for gross mismanagement.
I think maybe the point is that if AIG hadn’t gotten them hooked in 2004-2005 they might not have been so strung out on CDS in 2006-2007. But in the counterfactual it is always possible some other pusher might have relieved those CDS junkies of their money.
AIG didn’t make the banks stupid, it got them hooked, and by then they had been using so long that they no longer wanted to stop. That easy profit felt too good. Goldman is really the only one bank that went to rehab.
This is similar to my take – Lewis seems to be trying to find a scapegoat, implying that “everything would have worked out fine if we hadn’t promoted that Cassano above his competence!”
Of course, the idea that one person could be responsible for a systemic failure is, as someone put it: fiction. (I think last year there were some attempts to nominate Kerviel as Official Crisis Scapegoat, but they didn’t quite stick.)
Like any other quest for a pat answer, Lewis’ article just raises questions.
Why were the rating agencies giving tranches of garbage a AAA rating?
Why were AIG management not paying attention to what FP was doing?
Why did they buyers not examine what they were buying?
Why did the AIG quants not examine what they were modelling and pricing?
Why were the quants so addicted to money that they continued to work for what was obviously a trainwreck, or accepted Cassano’s abuse? (It’s not like these people couldn’t get jobs elsewhere or were not rich enough to retire.)
If Cassano is so rich and unemployed, what on earth is he doing in London? Can’t he take his money and live a decent live somewhere civilized, like Romania?
Uncle Billy: “Cassano came from Drexel. The guy who appointed him to his position, Savage, came from Drexel. Michael Milken came from Drexel.
“(Are we seeing a pattern here?)
“The Morgan Mafia gave them the gun and they used it.
“Someone was using their already proven, healthy capacity for greed. Wonder who that someone could be. And what’s the endgame?”
Yes, the importance of culture is important to understanding what happened. It is not just Wall Street vs. Main Street. Different corporate cultures are different. Ideas, attitudes, and practices migrate, compete, and change as people move between firms, and between industry and government.
bayardwaterbury: “Although CDS’s were not catagorized as insurance products, they were only that (hedges against loss – which all insurance is ultimately).”
It thought that they were more than hedges, that they could function as bets, like taking out fire insurance on a stranger’s house, and that it was the casino aspect that contributed to the enormous spread of risk. No?