Behind Insurer’s Crisis, Blind Eye to a Web of Risk, September 27, 2008

“It is hard for us, 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.”

Joseph J. Cassano, a former A.I.G. executive, August 2007

The article quoted above came out in September, just a couple of weeks into the financial collapse of the economy. And while it’s well written and clear, I just couldn’t take it all in. At the time, I didn’t really even know what A.I.G. was and had never considered things like credit default swaps, arbitage, exotic derivatives, or complex financial instruments – terms we’ve come to know as code for economic rape. This article by Joe Nocera follows up on the former article and makes the mechanisms much clearer. The last article was "Who." This one is "How." "Why" is easy – greed. One has to read them several times to get it – and least I did.

Propping Up a House of Cards
By JOE NOCERA
February 27, 2009

^{Next week, perhaps as early as Monday, the American International Group is going to report the largest quarterly loss in history. Rumors suggest it will be around $60 billion, which will affirm, yet again, A.I.G.’s sorry status as the most crippled of all the nation’s wounded financial institutions. The recent quarterly losses suffered by Merrill Lynch and Citigroup — “only” $15.4 billion and $8.3 billion, respectively — pale by comparison. At the same time A.I.G. reveals its loss, the federal government is also likely to announce — yet again! — a new plan to save A.I.G., the third since September. So far the government has thrown $150 billion at the company, in loans, investments and equity injections, to keep it afloat. It has softened the terms it set for the original $85 billion loan it made back in September. To ease the pressure even more, the Federal Reserve actually runs a facility that buys toxic assets that A.I.G. had insured. A.I.G. effectively has been nationalized, with the government owning a hair under 80 percent of the stock. Not that it’s worth very much; A.I.G. shares closed Friday at 42 cents…}

^{“They were the worst of them all,” said Frank Partnoy, a law professor at the University of San Diego and a derivatives expert. Mr. Vickrey of Gradient Analytics said, “It was extreme hubris, fueled by greed.” Other firms used many of the same shady techniques as A.I.G., but none did them on such a broad scale and with such utter recklessness. And yet — and this is the part that should make your blood boil — the company is being kept alive precisely because it behaved so badly.}

^{When you start asking around about how A.I.G. made money during the housing bubble, you hear the same two phrases again and again: “regulatory arbitrage” and “ratings arbitrage.” The word “arbitrage” usually means taking advantage of a price differential between two securities — a bond and stock of the same company, for instance — that are related in some way. When the word is used to describe A.I.G.’s actions, however, it means something entirely different. It means taking advantage of a loophole in the rules. A less polite but perhaps more accurate term would be “scam”… As a huge multinational insurance company, with a storied history and a reputation for being extremely well run, A.I.G. had one of the most precious prizes in all of business: an AAA rating, held by no more than a dozen or so companies in the United States…}

^{To be sure, most of A.I.G. operated the way it always had, like a normal, regulated insurance company. But one division, its “financial practices” unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities. Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.}

^{These exotic instruments acted as a form of insurance for the securities. In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too. That was the ratings arbitrage. “It was a way to exploit the triple A rating,” said Robert J. Arvanitis, a former A.I.G. executive who has since become a leading A.I.G. critic. Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to A.I.G., and the AAA rating made the securities much easier to market. What was in it for A.I.G.? Lucrative fees, naturally. But it also saw the fees as risk-free money; surely it would never have to actually pay up. Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets — housing — could only go up in price.}

A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.

^{That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. And it didn’t. Its leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.}

^{The regulatory arbitrage was even seamier. A huge part of the company’s credit-default swap business was devised, quite simply, to allow banks to make their balance sheets look safer than they really were. Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed use their own internal risk measurements to set their capital requirements. The less risky the assets, obviously, the lower the regulatory capital requirement.}

^{How did banks get their risk measures low? It certainly wasn’t by owning less risky assets. Instead, they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., and the collateral triggers made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free” assets. This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began.}

^{At its peak, the A.I.G. credit-default business had a “notional value” of $450 billion, and as recently as September, it was still over $300 billion. (Notional value is the amount A.I.G. would owe if every one of its bets went to zero.) And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do. It’s not as if this was some Enron-esque secret, either. Everybody knew the capital requirements were being gamed, including the regulators. Indeed, A.I.G. openly labeled that part of the business as “regulatory capital.” That is how they, and their customers, thought of it.}

^{Here’s what is most infuriating: Here we are now, fully aware of how these scams worked. Yet for all practical purposes, the government has to keep them going. Indeed, that may be the single most important reason it can’t let A.I.G. fail. If the company defaulted, hundreds of billions of dollars’ worth of credit-default swaps would “blow up,” and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren’t so awful. I asked Mr. Arvanitis, the former A.I.G. executive, if the company viewed what it had done during the bubble as a form of gaming the system. “Oh no,” he said, “they never thought of it as abuse. They thought of themselves as satisfying their customers.” That’s either a remarkable example of the power of rationalization, or they were lying to themselves, figuring that when the house of cards finally fell, somebody else would have to clean it up.}

But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue. Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden.