Thursday, July 2, 2009

The Man Who Crashed the World

Teaser posted on Vanity Fair of an article by Michael Lewis:

Is it really possible for one man to precipitate a global economic catastrophe? In the August 2009 issue of Vanity Fair, contributing editor Michael Lewis, one of the most insightful Wall Street critics writing today, investigates the central role of A.I.G.’s Financial Products division in the subprime-mortgage and financial crises that necessitated a $182.5 billion taxpayer bailout out the insurance behemoth.

Following the public outcry over its bailout and bonus handouts, A.I.G. has become the company perhaps most associated with Wall Street greed and arrogance. But, as Lewis points out, its collapse has remained poorly understood. Talking to a number of A.I.G. F.P. traders, Lewis takes us deep inside the company to form a detailed history of who made what decision, when, and why—and what the consequences were.

A.I.G. F.P. was founded in 1987 by a group of mathematically gifted Wall Street traders who saw an opportunity to revolutionize credit markets through derivatives and computer models. It began as a limited and cautiously run enterprise, but its success, and the growing pressure for increasing profits, led it to grow and branch out into riskier types of credit-based derivatives. In 2001, Joe Cassano, a scrappy and ambitious longtime A.I.G. F.P. employee who lacked a mathematics background, was promoted to head the division. Under his watch A.I.G. F.P. would become increasingly immersed in credit-default swaps—insurance it sold on packages of corporate and consumer loans, including subprime mortgages, created by Wall Street. By the time the housing bubble burst, A.I.G. F.P. was on the hook for $450 billion in these credit-default swaps—enough to bankrupt A.I.G. many times over if even a fraction of this debt went bad.

In the article, “The Man Who Crashed the World,” Lewis explores:

• How A.I.G. F.P.’s decline began when Cassano took over and stifled its culture of healthy dissent with his autocratic leadership style: “A.I.G. F.P. became a dictatorship,” one trader from the division tells Lewis. “Joe would bully people around. He’d humiliate them and then try to make it up to them by giving them huge amounts of money.” Another trader confirms, “Under Joe the debate and discussion that was common under [previous A.I.G. F.P. C.E.O.] Tom [Savage] ceased.“

• How the bundles of loans that A.I.G. was insuring came to include not just relatively safe corporate debt but far riskier consumer debt—car loans, credit card loans, and, of course, subprime mortgages. As one A.I.G. F.P. trader explains to Lewis, “The problem is that something else came along that we thought was the same thing as what we’d been doing.”

• How A.I.G. F.P. became the first stop for Wall Street banks looking to insure the massive amounts of debt they were buying, packaging, and selling: “We were doing every single [credit-default swap] deal with every single Wall Street firm, except Citigroup,” says one A.I.G. F.P. trader. “Citigroup decided it liked the risk and kept it on their books. We took all the rest.”

• The failure of A.I.G. executives to realize just how much of the debt they were insuring was subprime-mortgage-related

• Joe Cassano’s initial refusal to scale back A.I.G. F.P.’s C.D.S. business when confronted with evidence of its unsoundness, and the decision he made that came back to haunt the company.

Pick up a copy of Vanity Fair's August issue—on newsstands in New York on July 1, and around the country on July 7—to read Lewis's entire article.

Posted on Reuters by Felix Salmon:

Lewis explains how “if it hadn’t been for AIG FP the subprime-mortgage machine might never have been built, and the financial crisis might never have happened”. So doesn’t it make perfect sense for the public explanation of AIG’s failure to focus on FP? After all, as Lewis shows, FP literally had no idea what it was doing. He tells the story of Gene Park, who examined FP’s business at the end of 2005 and found that it was insuring deals which were 95% subprime:

Park then conducted a little survey, asking the people around AIG FP 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 the piles were no more than 10 percent subprime. He asked a risk analyst in London, who guessed 20 percent. He asked Al Frost [FP's main liaison to Wall Street], who had no clue.

Cassano simply trusted the models (which were built with a lot of Gorton’s help), even when the models weren’t designed for subprime in particular, or even really for mortgages.

I guess the message of Lewis’s piece is that FP caused the global financial crisis, even if it didn’t necessarily cause the complete downfall of AIG — that AIG ended up buying in to the bubble created by FP, just companies like Citigroup and Bear Stearns did. Or, to put it another way, FP brought down the financial markets, and the crashing financial markets brought down AIG. You can blame the end of the world on Cassano, but there were a lot of people inside AIG but outside Cassano’s little group who ended up buying into the markets he helped to create and inflate.

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