Michael Lewis has a generally very good piece in Vanity Fair on the AIG Financial Products mess, filing in some bits that were missing from the equation. He does go a bit overboard in saying nice things about Jake DeSantis, the man who wrote the New York Times “Dear AIG: I Quit!” op ed. To me, it was another case of Wall Street, and its co-conspirators not getting it. Anyone in a normal business knows if the company has massive losses or is bankrupt, you probably don’t have a job any more and whatever bonus you thought you might get just went poof. He got a very juicy retention bonus, over $700,000 after taxes. My dim recollection is that the partners at LTCM were paid $250,000 a year before taxes to clean up their mess, even adjusted for inflation, much less than what DeSantis was paid. As much as I take the LTCM “talent” story with a handful of salt, DeSantis is no Myron Scholes or Lawrence Hilibrand.
The story recounts how an AIG FP employee, Gene Park, was promoted at the end of 2005 to be the unit’s liaison with Wall Street subrprime desks. Park takes one look at the exposures and freaks out. The big boss, Joseph Cassano. tries to browbeat him into compliance but comes around to his point of view and stops writing guarantees on subprime.
Here’s the bit that caught my eye.
Every firm on Wall Street was making fantastic sums of money from this machine, but for the machine to keep running the Wall Street firms needed someone to take the risk…
The Wall Street firms solved the problem by taking the risk themselves. The hundreds of billions of dollars in subprime losses suffered by Merrill Lynch, Morgan Stanley, Lehman Brothers, and the others were hundreds of billions of losses that might otherwise have been suffered by AIG. Unwilling to take the risk of subprime mortgage bonds in 2004 and 2005, Wall Street firms swallowed the risk in 2006 and 2007,
OK, I need reader help here. Let’s unpack this.
First, things went crazy in subprime in late 2005 and 2006. Those 5-6 quarters were when the most damage was done, the dreckiest paper in big volumes. Lew Ranieri said the paper got worse around then (not that it was great before, mind you). Even thought the paper was even more toxic in 2007, the volume fell off as subprime woes were coming into sharp focus. So understanding what happened in 2006 is important.
What does Lewis mean, exactly, by “take the risk?” AIG had written CDS against the bonds, or at least that’s what the piece implies, as opposed, say, to CDOs that contained subprime mezz paper. Did the investment banks start writing CDS against subprime bonds? Their credit ratings weren’t so high that that action would have accomplished much in the way of credit enhancement (or was everyone so punch drunk that any name would do?). Did they rely on overcollateralization and keep the equity layer? I haven’t seen anything that would suggest that the big brokerage firms stepped up and did credit enhancement of subprimes, but it isn’t impossible.
The reason I am a bit confused here is that the accounts of subprime writedowns at the big broker dealers (plus Citi, which apparently was happy to do deals without AIG guarantees, thank you very much) was that they took losses on subprime paper (I had presumed mortgages they held as trading inventory, plus perhaps also warehoused mortgages) and CDO paper. Merrill and Citi both had large exposures to the super senior layer. That ins’t consistent with the story that they took the risk to get the deals done. For Merrill, it seemed as if the firm kept blindly originating deals even though the stuff was getting harder to place (the various AAA layers were 70-80% of the value of the whole CDO) and believed in the stuff enough to carry it. Really bad underwriting practice, in other words, Not as clear why Citi wound up with so much paper, but they had been putting some (a lot?) in SIVs, so as those got unwound, Citi may have taken them on balance sheet.
It is also useful to understand where the credit enhancement was occurring pre and post AIG. CDO volumes were exploding. The party that takes the risk of an equity layer in a CDO winds up eating a lot of the risk of the subprime paper that went into the CDO. Not sure how far that would have gone in supplanting AIG, but it could conceivably have gone a fair way.
But I was also under the impression that hedge funds pursuing credit oriented strategies were important buyers of the equity layer in CDOs. Did they come to play a bigger role in this period?
Any answers to these questions very much appreciated. Please feel free to ping me at yves@nakedcapitalism.com, but leave a comment if you are set up to do so. Thanks!
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I can think of two different alternative routes for super senior risk (subprime and other).
The first one was the other monolines such as MBIA, AMBAC or CIFG. They may have been well too happy to snatch some business from AIG-FP.
The second one was the "leveraged super senior" structure that was the craze then. Essentially, it meant that hedge funds or HNWI were able to write super senior protection by just putting a small amount of cash as collateral. When the fast market movements generated collateral calls and forced unwind of the positions, banks didn't find anyone to take the position again, and ended up with it.
Caveat : I was not in this particular business, so this is just an educated guess.
My recollection re: that fishead-end vintage subcrime mortgage paper, dim as is yours regarding whatl already seems like the fading history of another era, is that those shops SIV-ed large chunks of the equity tranches on what they wrote because nobody else would buy them. Those shops wanted to keep volume up—for the fees, read for the bonuses for the fees, natch—so they weren't about to swear off the junk. And 'they weren't exposed themselves' because the foetid liquefying Red Death zombie sputum was, putatively, not their legal responsibility and loss reserve liability, parked in quonset huts behind hurricane fencing in Nah Joisy. And, what the hey?, them equity tranches had sweeeeeeeett premium returns. When things might maybe be about to go a little wobbly, the notion was that the stuff could be sold off quickly, maybe at a bit of a loss but moved, 'because the paper was liquid.' Yeah, my recollection from various fragmentary public reportage was that they outsmarted themselves. Of course it hasn't been the subprime losses than killed most of them; Countrydied, yes, just maybe Merrill. The others had many, many other pallets of bad paper still chained to their ledgers when everything went very, very _illiquid_ and they found out just who the greater fool was in this game of theirs. None greater.
But I dunno, maybe Mikey the Lewis will pop up here and 'splain himself.
Hi Yves,
Haven't had time to read Michael Lewis's article, but the logic outlined in your post seems quite rational. From my understanding, AIG and the monolines were writing guarantees on the AAA tranches of the subprime securitisations. The mezz tranches were largely stuffed into CDOs for resecuritisation. Because the AAA tranches had credit enhancement in the forms of both subordination of lower-rated tranches and credit guarantees from AIG, they were easier to sell to investors. When AIG stopped providing the guarantees, the AAA tranches could only rely on subordination, and from all accounts, became harder to sell, so the banks retained the AAA tranches from 2006 onward. So, the banks took the risks because they held on to the AAA tranches without CDSs from the insurers. By saying "getting the deal done", it just means that they structured the deal, but they maintained large exposures.
AAA tranche investors are most concerened with correlation risk, where a large number of underlying assets default at the same time. This is what happened to subprime, where geographical diversification did not lower correlation. In any event, I believe all of AIG's subprime exposure was all to the AAA tranches.
I slurp up every bit of M Lewis that I can. He writes fabulous narative. But understand that his stories are first and foremost about villians and the rest of us. If you read his story closely, he admits that he is writing the story from the perspective of the insiders of AIG. I thank him for that, but never lost the point. Perspective is everything.
When you pick apart the point of whether the banks actually took the risks that AIG previously had taken in 2006, I did not perceive that as a statement of fact, rather the perspecitive of the AIG traders.
In reality, we know that a lot of paper was sold far and wide, to chumps who wanted to buy high yielding bonds. But the banks had a pipeline, and obviously got caught with a large bag of dreck too.
I thought the piece brought a lot of new perspective to the conversation, namely that Goldman made AIG post collateral on a downgrade. I also get the sense that far from dancing until the music stopped, players wanted to stop but were unable.
Hi Yves,
I'm a a great admirer of your blog. Well Done.
Your query about the dynamics of risk and responsibility around AIG and Wall St raises a different question for me.
You have consistently defended securitisation and disintermediation through this debacle. Yet with all your expertise, contacts, resources and time aplenty, you are unable to identify the breakdown of responisbility that underpinned the crisis.
This is not a criticism of you. It is part of an observation that securitisation is inherently opaque and overly complex. It has opacity and irreposibilty risk written into every split in the lending chain.
Is it not time for you to reconsider its rescue in favour of traditional, readily regulatable banking vis-a-vis Glass-Steagall?
David Smith
http://www.themarketstate.blogspot.com
David,
I'd like you to point out where I have defended securitization and disintermediation, much the less "consistenlty". Describing how it operated and why it took hold is not tantamount to defending it. You make a big leap and attribute it to me.
I've been hugely critical of the more extreme versions, CDOs, have said CDS should be abolished, and have pointed out ad nauseum how mortgage securitizations impede doing the right thing, namely one off mortgage mods when the borrower could be viable at a loss that is lower to the bank /trust than foreclosure.
Yves,
Investment bank retention of subprime risk post 2005 took two main forms. They often kept the residual risk in the underlying loan portfolios (through their ownership of the lenders or through warehouses) and they kept super-senior tranches of CDOs of RMBS. There are complications like Citi's infamous put options, which meant that a lot of risk they had seemed to have transferred ended up coming back on balance sheet when it mattered, but that was the bulk of it.
Previously, AIG and the monolines would write CDS on the super-senior stuff, supposedly removing the risk. When AIG stopped doing so, the banks tried to find other counterparties that seemed to make economic or regulatory capital sense, but where they couldn't they typically figured the risk was minimal so just kept it themselves.