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PDFThe question is this: “How did AIG really collapse?” It is not: “How did the company get in trouble?” Nor is it this: “Who is to blame?”
Rather, the curious still want to know: What led a firm with a AA rating, around $160 billion in market value and $14 billion in profits – with real cash-generation capacity to boot – in fiscal 2006 to effectively go out of business two years later? The answer is not Goldman Sachs (NYSE: GS).
As the author of Fatal Risk, an upcoming book on the collapse of AIG, I would have found my job much easier if Goldman truly were the real culprit in this saga. The picture painted of Goldman, especially from Washington lawmakers and the media – particularly the business desk at The New York Times – focuses largely on the now-infamous serious of swaps that one of Goldman’s proprietary trading desks entered into with AIG as the central cause of the company’s collapse. Under this scenario, Goldman’s meticulous enforcement of so-called credit support agreements and the billions of dollars in collateral calls forced upon AIG’s Financial Products (AIGFP) unit look fatal to the company.
After months of investigation, however, I have reached a different conclusion: Chances are, the financial and managerial collapse within AIG Global Investment Corp.’s (AIGGIC) securities lending program killed the company instead.
Under the leadership of Win Neuger, that unit took a portfolio -- which had been throwing off about four basis points of profit since its inception in the 1990s – and began imposing a 30-basis point profit target in 2005. In other words, the unit suddenly faced the impossible task of posting margins that were 7.5 times those it had historically generated. As a result, the practical hurdles to obtaining creditworthiness and liquidity proved formidable – so formidable, in fact, that creditworthiness and liquidity were tossed out the window and a naked grab for yield resulted. (It remains unclear whether the unit ever met that bogey, but the growth of its portfolio – which expanded 40% from 2004 to 2006 – makes clear that securities lending had become a major economic factor for the division.)
Just look at the numbers in AIG’s regulatory filings. Note the widening differential between assets and liabilities, and then examine the trajectory of this program’s growth. From 2004 to 2008, the chasm between assets and liabilities climbed to almost $38 billion.
That change was not, per AIGFP, the result of a series of collateral postings that represented the difference between the market value of an asset and the price AIGFP had contracted to guarantee. No, it was the pure economic loss of capital in its most natural state. It represented the decline in the value of assets AIGGIC purchased with the cash that Wall Street banks and brokerage firms provided as collateral for borrowing stocks and bonds from its own life insurance investment-management portfolios.
Ultimately, when Wall Street returned the securities and reclaimed its cash, AIGGIC was obligated to deliver the original sum in full.
The problem, of course, was this: AIGGIC did not use that money to buy AAA-rated, highly liquid short-term agency- or asset-backed securities. Rather, it purchased long-dated subprime mortgage-backed securities instead.
Because AIGGIC had saddled itself with tens of billions of dollars worth of subprime mortgage-backed securities, the division’s ability to exit a trade became compromised. Following the collapse of two highly leveraged hedge funds at Bear Stearns Asset Management in June of 2007, the liquidity for huge swaths of the asset-backed securities market suffered a massive decline that in turn prompted a massive sell-off of such investments. At that point, a vicious cycle began.
One after another, the sectors that AIGGIC’s securities lending program had bought into -- such as sub-prime, Alt-A and CMBS -- began to see bids fade and then virtually cease altogether. Meanwhile, with its lending program still going full bore, AIGGIC found itself hunting yield further down the underwriting quality curve. (AIGGIC’s desk chief, Peter Adamczyk, looks like a star-crossed player in this saga. He was under direct orders to engage in the dangerous and absurd, while protesting to no avail.) The result of this strategy proved obvious, as evidenced by the $6.3 billion differential between assets and liabilities that had surfaced by 2007.
AIG did not simply engage in an ill-considered trade, however. Months after AIGFP began to receive its first collateral calls from Goldman in the late autumn of 2006, AIGGIC continued to grow with the same profit bogeys in place. Indeed, the AIGFP counterparties that were loudly demanding collateral were the same counterparties in a securities-lending program – a program that, at the end of fiscal 2007, had become AIG’s biggest secret – representing 7% of a $1 trillion balance sheet and 15% of a $502 billion bond portfolio.
From there, the risk-management inferno continued. Unbeknownst to all but a handful of AIGGIC senior management executives, AIG had become the largest proprietary securities lending portfolio on Wall Street – eclipsed only by State Street (NYSE: STT), which managed numerous portfolios on a “third-party” basis.
To say that this portfolio flew under the radar screen of those at AIG itself stands out as an obvious understatement. Dozens of interviews with senior AIG corporate and financial officials testify to the fact that, prior to the summer of 2008, few in the company’s upper ranks even knew about the program. Moreover, if they did, they could not speak with any confidence about the program’s details.
In layman’s terms, AIG was the sole player expanding in a field only a minority of the financially sophisticated knew even existed. And it used the bonds that were at the forefront of the credit collapse as the bricks and mortar of its foundation.
In fairness, hindsight is exceptionally clear. It is easy to forget that the bonds that dropped so violently in price and liquidity starting in mid-2007 had, just several weeks earlier, been trading in blocks of $50 million and $100 million. It is also easy to see that, given the ruthless performance-driven culture at AIG, this program – which provided an estimated $250 million in revenues at its peak – would have been no easy operation to shut down.
A spokeswoman for AIG declined to comment on this matter. Neuger and Adamczyk, citing separation agreements with AIG, refused to comment as well.
AIG took its $38 billion hit from this program all at once, of course. But the lion’s share of that hit – totaling perhaps $20 billion – helped trigger the rest. It created such an unanticipated chasm in September 2008 that, when desperate negotiations were underway to sell key units to stave off bankruptcy and news broke of trouble in this area, it led to a complete collapse of negotiations.
With the cause of AIG’s failure still endlessly debated, some have looked at the company’s violent shift in management style and corporate culture – under Maurice “Hank” Greenberg and then Martin Sullivan – for answers.
Greenberg, who prided himself on publicly and privately second-guessing his most successful managers, had an extensive background with financial services. Sullivan, who by disposition was the anti-Greenberg in terms of his collegial and trusting relationships with his senior managers, was broadly understood to have no real experience with the securities market.
AIG’s public relations staff, when pressed, gamely tries to paint Sullivan as a tragic figure. According to that portrait, Sullivan is a brilliant property-and-casualty insurance executive who took over a company that was bombarded by regulatory woes and on the cusp of a remorseless civil war with its pater familias, and was forced to manage through an epic financial crisis with no historical analogue.
To be fair, all of that is largely true. Yet this fact still remains: Sullivan took over a giant corporation – which derived more than $16 billion in revenue and $6.5 billion in operating income from capital markets activities in 2006 – with only his good nature and his trust in longtime colleagues to guide him. (By way of contrast, these figures – for operations that far outstripped the economic relevance of its primary insurance lines – nearly doubled the output of Bear Stearns.)
There is little in the record to suggest that Sullivan had the will or the skill set to make unpopular decisions about the risk of these units, let alone to seriously engage a markets veteran like Neuger. Greenberg, on the other hand, had a long track record of rearranging profitable units from the top down when it suited his needs.
It should go without saying that there is no small amount of blame to go around for all parties involved when it comes to the near-death of AIG. Because of this, it is much easier to point to an unsympathetic player – such as Goldman -- than it is to spend the time digging through AIG’s filings and building a case about how a sleepy and ancillary business like securities lending became such a disaster for the company.
Nonetheless, the numbers speak for themselves. And they tell a story that AIG and those investigating its collapse appear more than willing for the public to ignore.
