erik lundegaard

Wednesday July 22, 2009

Global Financial Meltdown 101

Last May, in his essay “The Death of Kings” in The New Yorker, Nick Paumgarten, among other tasks, looked for the worst offender in the Global Financial Meltdown, a “sin eater,” he says, then writes:

So far, Bernie Madoff, John Thain, Dick Fuld, Joseph Cassano, and even Jim Cramer, to name a few who have been cast in the role, have proved insufficient.

Michael Lewis, author of “Liar’s Poker” back in the day, and “Moneyball in a more recent day, says not so fast. His piece on A.I.G. in the July Vanity Fair, “The Man Who Crashed the World,” not only offers one of the clearest pictures of this huge, vague mess, it offers up that worst offender: the aforementioned Joe Cassano, head of A.I.G. F.P. (Financial Products.)

Because of Lewis’ connection with Wall Street—as a trader for Solomon Brothers in the 1980s—he became (initially, an unwilling) confidante first to A.I.G’s Jake DeSantis, for whom Lewis opened the doors to the New York Times Op-Ed page, and then to a host of mostly anonymous A.I.G. F.P. employees. who gave him the inside story of A.I.G. F.P. in the 2000s. It’s a familiar story to almost anyone who’s had an idiot, micromanaging boss. The difference is in the damage this particular boss did.

Read the entire article. Lewis gives us a quick background on how A.I.G. became Wall Street’s designated insurer for what were still perceived to be fairly risk-free mortgage securities. He writes:

The risks it ran were probably trivial in relation to its capital, because the risks that the financial system wanted to lay off on it were, in fact, not terribly risky.

Then the clouds darken:

At the end of 2001 its second C.E.O., Tom Savage, retired, and his former deputy, Joe Cassano, was elevated. Savage is a trained mathematician who understood the models used by A.I.G. traders to price the risk they were running—and thus ensure that they were fairly paid for it. He enjoyed debates about both the models and the merits of A.I.G. F.P.’s various trades. Cassano knew a lot less math and had much less interest in debate...

But A.I.G. F.P. was a subdivision of A.I.G. How did the parent company allow someone who knew little about the product, wasn’t interested in debate, and punished those who didn’t agree with him come to power? The long answer is that they always do. The short answer is here:

A.I.G. F.P.’s employees for their part suspect that the only reason [A.I.G. Hank] Greenberg promoted Cassano was that he saw in him a pale imitation of his own tyrannical self and felt he could control him. “So long as Greenberg was there, it worked,” says one trader, “because he watched everything Joe did. After the Nikkei collapsed [in the 1990s], a trader in Japan lost 20 million. Greenberg personally flew to Tokyo and took him into a room and grilled him until he was satisfied.” In March 2005, however, Eliot Spitzer forced Greenberg to resign. And, as one trader puts it, “the new guys running A.I.G. had no idea.” They thought the money machine ran on its own, and Cassano did nothing to discourage the view. By 2005, A.I.G. F.P. was indeed, in effect, his company.

But almost every company has guys like this. You’ve probably worked for guys like this. And they’re not bringing down the entire financial system. Something else had to be going on:

The more subtle change inside A.I.G. F.P. occurred not long after Cassano assumed control. ... The banks that used A.I.G. F.P. to insure piles of loans to IBM and G.E. now came to it to insure much messier piles that included credit-card debt, student loans, auto loans, prime mortgages, and just about anything else that generated a cash flow. ... Because there were many different sorts of loans, to different sorts of people, the logic applied to corporate credit seemed to apply to this new pile of debt: it was sufficiently diverse that it was unlikely to all go bad at once. But then, these piles, at least at first, contained almost no subprime-mortgage loans.

Here’s the telling stat:

The combination of the dot-com bust and the 9/11 attacks had led Alan Greenspan to pump money into the system, and to lower interest rates. In June 2004 the Fed began to contract the money supply, and interest rates rose. In a normal economy, when interest rates rise, consumer borrowing falls—and in the normal end of the U.S. economy that happened: from June 2004 to June 2005 prime-mortgage lending fell by half. But in that same period subprime lending doubled—and then doubled again. In 2003 there had been a few tens of billions of dollars of subprime-mortgage loans. From June 2004 until June 2007, Wall Street underwrote $1.6 trillion of new subprime-mortgage loans and another $1.2 trillion of so-called Alt-A loans...

And here, to a certain extent, is why this was happening:

Perhaps the biggest reason for this [booming demand for housing and a continued rise in house prices] was that the Wall Street firms packaging the loans into bonds had found someone to insure against what turned out to be the rather high risk that they’d go bad: Joe Cassano.

A.I.G. F.P. ... went from being 2 percent subprime mortgages to being 95 percent subprime mortgages. And yet no one at A.I.G. said anything about it...

I like stories of the guys who figure it out early and who complain to deaf ears. Gene Park was one such guy:

He suspected Joe Cassano didn’t understand what he had done, but even so Park was shocked by the magnitude of the misunderstanding: these piles of consumer loans were now 95 percent U.S. subprime mortgages. Park then conducted a little survey, asking the people around A.I.G. F.P. most directly involved in insuring them how much subprime was in them. He asked Gary Gorton, a Yale professor who had helped build the model Cassano used to price the credit-default swaps. Gorton guessed that the piles were no more than 10 percent subprime. He asked a risk analyst in London, who guessed 20 percent. He asked Al Frost, who had no clue, but then, his job was to sell, not to trade. “None of them knew,” says one trader. Which sounds, in retrospect, incredible. But an entire financial system was premised on their not knowing—and paying them for their talent!

Eventually, thanks to Gene Park, Joe Cassano figured it out before most others and A.I.G. F.P. stopped insuring the risky sub-prime mortgage bonds. But it was already too late. Worse, in 2006 and 2007, Wall Street took on the risk themselves, resulting in hundreds of billions of dollars in losses there. Then the earlier, A.I.G.-insured subprime mortgages began to default, too.

The system was built on the premise that everyone wouldn’t, couldn’t default at the same time; then, to continue making easy money in down times, everyone went about making sure that this unlikeliest of scenarios became more and more likely.

Posted at 08:44 AM on Wednesday July 22, 2009 in category Business  
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