Money and Power (102 page)

Van Praag also warned Blankfein of an emerging conspiracy theory about the firm, which the
Times
article might broach. “The article references the extraordinary influence GS alums have—the most topical being
John Thain,” the former Goldman president and co–chief operating officer and former CEO of the
New York Stock Exchange who had, the previous week, agreed to become CEO of
Merrill Lynch in the wake of the firing of Stan O’Neal a few weeks earlier. “[B]ut [Bob] Rubin, Hank [Paulson], Duncan [Niederauer, who replaced Thain as CEO of the NYSE] et al[.] are all in the mix too. She hasn’t gone as far as suggesting that there is a credible conspiracy theory (unlike her former colleague at the
NY Post
). She does, however, make the point that it feels like GS is running everything.”

The twin ideas that Goldman was “running everything” and that there was a “credible conspiracy theory” involving the firm would, soon enough, be major public-relations nightmares for the firm but, at that moment anyway, Blankfein was far more concerned about the promulgation of the idea that somehow the firm had avoided the mortgage meltdown and made a bunch of money. “Of course we didn’t dodge the mortgage mess,” Blankfein wrote to van Praag. “We lost money, then made more than we lost because of shorts”—so the firm
did
make money, and what he had previously called a “hedge” he was now referring to as a “short.” In any event, his next thought made the most sense. “Also, it’s not over, so who knows how it will turn out ultimately,” he concluded. Unable to resist adding his two cents, Gary Cohn, who had been copied on the correspondence, chimed into the discussion with the thought that Goldman was “just smaller in the toxic products.”

But, increasingly, investors and the media wanted to know how Goldman had bested the competition, succeeding wildly where others had failed. To try to answer this question, and in preparation for Goldman’s fourth-quarter earnings release—scheduled for December 18—Viniar prepared a one-page PowerPoint slide titled “How Did GS Avoid the Mortgage Crisis?” and subtitled “Our Response.” As had Broderick before him, Viniar touched on familiar themes, reinforcing a number of Goldman verities. “We were actively managing our mortgage exposure throughout 2006, and towards the end of the year we became increasingly
concerned about the sub-prime market,” he wrote. “As a result we took a number of actions at that time and into early 2007 to reduce our risk. In the first quarter of 2007 we stopped our residential mortgage warehousing efforts, shut down our CDO warehouses, aggressively reduced our inventory positions, reduced counterparty exposure and increased our protection for disaster scenarios.”

He then launched into a particularly lucid analysis of how being honest with itself about the value of the mortgage securities on its books had made all the difference. No other Wall Street CFO could have made a similar claim. “Key to our ability to do this was our extremely robust mark to market philosophy,” he continued. “You simply cannot manage risk effectively if you don’t know what positions are worth. An accurate daily marking process makes difficult decisions considerably easier, as you tangibly feel the cost of inaction every day as the market declines. We have extensive price discovery and valuation resources and don’t subscribe to the notion that there are instruments that can’t be valued. So, we knew the value of what we had and managed our risk accordingly.… Given the complexity and diversity of risks in our business, we believe that it is critical to provide our teams with the confidence and support necessary to identify and escalate issues as soon as possible and to prioritize the interest of the entire firm over any individual objectives. In addition, we think it is important for senior leadership to be actively engaged in the business flows and decision-making process, in times of calm as well as crisis.”

N
ot only Bear Stearns but also
AIG, the international insurance behemoth, began to feel the effects of the aggressive way Goldman was marking its trading books. Which is not to say Goldman’s marks were wrong—quite the opposite actually—but only that they were not without serious financial and social consequences for others at ground zero of capitalism. In the aftermath of the global financial collapse, one of the reasons given for the historic decisions to rescue Bear Stearns and AIG was because of how “
interconnected” these institutions were to one another, according to Robert Steel, the former Goldman partner who had joined Paulson at Treasury as undersecretary for domestic finance.
Goldman’s marks were one of the ways firms became linked to one another. The consequences for the two Bear Stearns hedge funds—which likely would have collapsed anyway—were devastating and were exacerbated by Goldman’s marks; at AIG, the Goldman marks were equally momentous, especially since never before had the government saved an investment bank or an insurance company from bankruptcy.

If nothing else, Hank Greenberg, the longtime chairman and CEO of AIG, was a smart and ruthless businessman. He diversified AIG beyond simply writing fire and casualty insurance to become the world’s largest underwriter of commercial and industrial insurance. He was also an innovator. He created insurance for directors and officers of corporations to try to protect them against their own blunders. He created environmental protection insurance and coverage for those threatened by kidnapping. AIG “built a team of skilled underwriters who were capable of assessing and pricing risk,” he often proclaimed. Greenberg also knew that AIG’s AAA credit rating gave the company a valuable and differentiated advantage in the marketplace by allowing it to borrow money cheaply and then to invest it at higher rates of return, and to make money on the spread. If this kind of thing could be done outside the ken
of often onerous state regulations that blanket the insurance industry, even better.

To that end, in 1987, Greenberg created
AIG Financial Products, known as AIGFP, by hiring a group of traders from the investment bank
Drexel Burnham Lambert, led by
Howard Sosin, who supposedly had a “better model” for trading and valuing interest-rate swaps and for generally taking and managing the risk that other financial firms wanted to sell. The market for derivatives was in its infancy, but growing, and Greenberg determined that AIG could be at its forefront. According to Greenberg, the overriding strategy at AIGFP was for the business to lay off most of the risks it was taking on behalf of its clients so that AIG was not exposed financially in the event of huge market-moving events that could not be modeled or anticipated. Under Greenberg’s watchful eye, he says, the formula worked famously: from 1987 to 2004, AIGFP contributed “over $5 billion to AIG’s pre-tax income” and helped the company’s market capitalization increase to $181 billion, from $11 billion.

The business Sosin and his team created was nothing more than a hedge fund inside an insurance behemoth with the added benefit that their access to capital was seemingly unlimited and costless and instead of getting the typical “two and twenty” hedge-fund deal, AIGFP’s traders got to keep between 30 percent and 35 percent of the profits they generated. This sweet arrangement allowed many of the four hundred or so people who worked at AIGFP to become very proficient about taking risks with other people’s money and to get rich.

Things at AIGFP were humming along so well that when Sosin and Greenberg had a falling-out, in 1993, and Sosin quit—taking a reported $182 million in severance with him—the business didn’t miss a beat under his successor,
Thomas Savage, a mathematician who encouraged his traders to challenge him about the efficacy of the risks the group was taking. Savage retired in 2001 and was replaced by
Joseph Cassano. Cassano had been the back-office operations guy at both Drexel and AIGFP before becoming the CFO and then getting the top job. By then, AIGFP had started insuring—innocently enough, it seemed—the risk that corporations might default on the debt they had issued. By selling something that became known as “credit-default swaps” to nervous investors, AIG agreed to pay off the defaulted debt at 100 cents on the dollar. AIG got the premiums; investors got peace of mind. This was the kind of financial innovation Greenberg fancied, especially since AIG’s AAA credit rating made its cost of borrowing so low, a real competitive advantage. The biggest part—some $400 billion—of the AIGFP insurance book was written on behalf of European banks looking to take risk off their books as a
way of avoiding the need to raise additional capital to appease the European regulators. “This is a great irony,” explained a former AIG executive. “The European banks went out and were able to buy credit-default insurance on their assets so that they didn’t have to keep as much capital on their balance sheet. So here was an insurance company in the United States with essentially no liquidity, no equity and no reserves providing equity relief for European insurance companies. Talk about the house of cards.”

As the writer
Michael Lewis explored so elegantly in his August 2009 profile of AIGFP in
Vanity Fair,
Cassano was not a particularly benevolent leader. “AIGFP became a dictatorship,” one London trader told Lewis. “Joe would bully people around. He’d humiliate them and try to make it up to them by giving them huge amounts of money.” Needless to say, the camaraderie and openness of the Savage era was lost quickly in the savage Cassano regime. “Even by the standards of Wall Street villains, whose character flaws wind up being exaggerated to fit the crime, Cassano was a cartoon despot,” Lewis wrote. But none of that mattered particularly at AIG as long as Greenberg was running the show, since Greenberg was every bit Cassano’s match in ruthlessness, but a better and more astute businessman.

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.