Arnold Kling  

Michael Lewis on AIG

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Compelling, as usual. I'll post some excerpts below the fold, but I recommend reading Lewis' whole piece.

Lewis writes it very much as a suits-vs.-geeks story. He portrays the head of AIG financial products, Joseph Cassano, as a suit who did not listen to the warnings of the geeks until it was too late. In fact, I worry that because Lewis' sources are geeks, his story may be one-sided.

One small quibble is that Lewis does not want to get into the details of structured finance. He talks very loosely about "risks" being passed around, and he makes it sound as if AIG was taking on all the risk, leaving everyone else risk-free. I think that's an exaggeration.

Also, it is noteworthy that AIG backed out of the market late in 2005. Lewis says that the suckers who came in to take AIG's place were Wall Street firms. But one should not overlook Freddie Mac and Fannie Mae, which had lost market share in 2004 and 2005, but which jumped in big time in 2006 and 2007.

What Lewis hints at, but does not spell out clearly enough in my opinion, is that the "AIG bailout" did not benefit AIG nearly as much as it benefited Goldman Sachs and other large financial firms, foreign and domestic, who are not necessarily deserving recipients.

The incentive system at A.I.G. F.P., created in the mid-1990s, wasn't the short-term-oriented racket that helped doom the Wall Street investment bank as we knew it. It was the very system that U.S. Treasury secretary Timothy Geithner, among others, had proposed as a solution to the problem of Wall Street pay.
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.
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...The subprime sector of the financial economy clearly was responding to different signals than the others--and the result was booming demand for housing and a continued rise in house prices.
The A.I.G. F.P. executives present were shocked by how little actual thought or analysis seemed to underpin the subprime-mortgage machine: it was simply a bet that U.S. home prices would never fall. Once he understood this, Joe Cassano actually changed his mind. He agreed with Gene Park: A.I.G. F.P. shouldn't insure any more of these deals.
There is much more worth reading.

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COMMENTS (9 to date)
TA writes:

Here's what I don't get. The problem that came to be with subprime backed securities, and with subprime lending generally, wasn't really something you needed a geek to tell you about, or rating agencies doing their jobs properly, or anything else that fancy. It was that this lending clearly was based on an unlikely level and trend of house prices. It was like buying the S&P 500 index in early 2000, when the PE ratio was 30. You can talk to me all day about efficient markets, but I don't believe in a PE of 30. And I don't believe in house prices that have more than doubled in 8 or 9 years. Any good suit ought to be able to get that, without assistance from quants.

Publius writes:

The problem was deeper: rating agencies, FICO scores, LTVs "improved" by appraisal fraud, subordination levels that seemed sound at the time, geographic diversification (CA less than 20%, FL less than 10%, TX less than 10%, but who thought about Michigan?).

I didn't buy any, but I saw a lot and wondered what I was missing. The quantitative modeling was strong, and who knew that the ratings agencies had rigged the models?

Yes, yes, they had principal-agent issues, we all knew that. But nobody expected them to actually rig the models and then hide behind the first amendment to gain civil-immunity.

In any case, caveat emptor didn't work, because all these systems were coincident and no one expected housing prices to fall 70% in CA and 40% nationwide b/c the never had, at least in recorded history. Maybe along the Guilderkanal in Amsterdam, but that study hadn't been published in Journal of Finance or Risk.

Jesse writes:

Real estate in an obscure country called "Japan" dropped by about 50% in a remote historical era known as the "1990s."

Mike Rulle writes:

Per Jeffery Friedman's "A Crisis of Politics not Economics" (in which Arnold is thanked as a reviewer of the draft) he notes that the mortgage backed securities AAA tranches have still not defaulted to any material degree.

It is also my understanding that AIG's CDS experienced zero defaults. Obviously there were "marks". In the case of Goldman et al., they were allowed to unwind major portions of the CDS at the lower marks and lock in gains against taxpayer. They also helped drive the price of the CDS down by forcing collateral payments in the first place.

It has been my view since Sept '08 that any reasonable scenario analysis said the implied foreclosure rate in the market prices of the AAA tranches in the market and the CDS (of AIG--mostly on AAA securities) at the time of TARP was so high, that the panic to take over AIG was completely unwarranted. At the least, temporary "collateral forbearance" would have been prudent. It would have at least bought time to analyze instruments and even sell off the company.

Friedman says the fear factor of insolvency created the liquidity crisis. I believe that. Just like NASDAQ prices of 5000 implied double digit GDP growth (and therefore implausible), the prices of the AAAs implying foreclosure rates as high as 30% was equally implausible. But no one knew who had what. But couldn't the regulators take the time to determine that? Once the TARP speech of Bush was announced, every one was waiting to be bailed out--or at least have "the other guy" bailed out. Three weeks later no one needed bailing out. They had to force half the 300 bil of TARP preferred down the bank's throats.

While Friedman's essay is a fascinating description of a cascade of (potential) unintended consequences, Paulson and Bernanke unreasonably panicked in light of what was plausible (anything is possible). We are still feeling the consequences.

TA writes:

I think Mike Rulle's point is one you made a while back __ the Feds should have told Goldman (and others) to stuff their collateral calls.

Colin K writes:

@TC: What PE for the SP500 do you believe in over the next 10-20 years?

Over the past 50 years the average never exceeded 20 except at the peak of a couple bull runs until 91/92, and has only rarely retreated below that level. Even now PE is not running way below historic averages.

http://bespokeinvest.typepad.com/bespoke/2008/04/historical-sp-5.html

Tobin's Q isn't much better--it climbs for a decade or more before falling off a cliff and repeating.

http://en.wikipedia.org/wiki/Tobin%27s_q

House prices in many areas have trended steadily upwards for many years, particularly in highly-desirable cities and suburbs. Some places, like the Bay Area, saw such appreciation for several decades, with housing prices appearing to be "unaffordable" by conventional measures at almost any point in time. Those who waited for prices to level off ended up getting priced out.

The mistake was thinking this pattern would carry to marginal areas like South Florida or Phoenix, neither of which have the sort of economic foundation that exist in the big coastal metropolises. NYC and SFO were pretty ugly places during their rapid growth phases, and it didn't take too much rose tint in your goggles to think something similar was going on in the sun-belt cities.

FXKLM writes:

It's true that the AIG bailout effectively benefited the creditors of AIG rather than AIG itself or its shareholders, but it's not at all clear that Goldman was the real beneficiary. Goldman was much more aggressive than other Wall Street firms in securing collateral from AIG and Goldman had hedged a substantial portion of its exposure to AIG with credit default swaps. Although Goldman was one of AIG's largest creditors, it was in a much better position to survive an AIG bankruptcy than its competitors.

Everyone loves a Goldman Sachs conspiracy theory, but the truth is that Goldman did not particularly need or benefit from the AIG bailout.

Bill Drissel writes:

I used to listen to the radio in Dallas during my evening ride, "You don't need tax returns; just assert your income. We can put you in the house of your dreams!"

And we all know borrower fraud always ends up as investor fraud.

Everyone except "the smartest guys in the room."

Sigh

Thomas DeMeo writes:

I felt like Lewis promised some insight into what happened that he didn't deliver.

It seems strange that no one sees this as a fundamental problem of the dynamic effects of risk management. When you change the risk proposition, you change the way the market behaves.

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