When I was a kid, Americans disparaged Japan for its keiretsu, crony capitalism. During the 1997 Asian meltdown, Americans attacked Asia for its crony capitalism. But if you read the following, you will discover that America is in the grip of a crony capitalism:
There is dishonesty in this collapse, on a scale that is almost too vast to comprehend. There are conflicts of interest in American finance and politics that make our own, dear House of Lords look like beginners. There are frauds so large, and so long-standing, that it can be hard to see them for what they are. And all these things were allowed to thrive in an intellectual atmosphere that tolerated no dissent. This reading is optimistic for those who believe in free markets, even if it is pessimistic for the US. “Capitalism has not failed,” says Bernard-Henri Lévy, the French philo-sopher. “We have failed capitalism.” The thesis can be tested through Patient Zero.
The official version is that Joseph Cassano, who occupies the stucco-fronted house near Harrods, brought down a safe and stable company — and by extension, the world — with incompetent gambles. “You’ve got a company, AIG, which used to be just a regular old insurance company,” Obama explained during a recent TV appearance. “Then they decided — some smart person decided — let’s put a hedge fund on top of the insurance comp-any, and let’s sell these derivative products to banks all around the world.” Ben Bernanke, the chairman of the Federal Reserve, adds: “This was a hedge fund, basically, that was attached to a large and stable insurance company.”
Cassano, who ran AIG’s financial-products division in London, “almost single-handedly is responsible for bringing AIG down and by reference the economy of this country”, says Jackie Speier, a US representative. “They basically took people’s hard-earned money, gambled it and lost everything. And he must be held accountable for the dereliction of his duty, and for the havoc he’s wrought on America. I don’t think the American people will be content, nor will I, until we hear the click of the handcuffs on his wrists.”
This account is as satisfying as it is easy to understand. It treats the blowing up of the world financial system like a global version of Barings, the bank that collapsed in 1995, with Cassano in the role of Nick Leeson. Operating from the fifth floor of a polished white stone building in Mayfair, Cassano’s unit sold billions of pounds of derivatives called credit-default swaps (CDS), allowing banks to buy risky debt without attracting the attention of regulators. AIG took the fees, but did not have the money to pay up if the loans went bad. By the time the music stopped, European banks had protected more than $300 billion of debt with this bogus “insurance”. And that is just one corner of a web of risk extending to over 1,500 big corporations, banks and hedge funds. In a 21-page paper known as the Mutually Assured Destruction memo, AIG claims that if the bailouts stop and the company is allowed to go bust, it will take the world with it. Cassano must have played with handcuffs as a child: he is the son of a Brooklyn cop. Now he waits for the fallout.
But the official version overlooks many things...
But the official version overlooks many things, including episodes of fraud at AIG that go back at least 15 years. It fails to explain why Public Enemy No 1 was allowed to leave the company on generous terms, with a retainer of $1m a month and up to $34m (£23m) in bonuses. And it does nothing to tell us why other big companies, whose profits looked as smooth and certain as AIG’s in the good times, are also fighting for survival.
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...for a long time the alchemy worked. AIG Financial Products (AIGFP), a unit with 0.3% of AIG’s 116,000 employees, made over $1 billion in profits between 1987 and 1992, a vast sum at the time.
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“Why did no-one see it coming?” asked the Queen last November, on a visit to the London School of Economics. Well, they did, ma’am. Charles Bowsher, head of the US government’s General Accounting Office, testified as long ago as 1994 that “the sudden failure or abrupt withdrawal from trading” of large dealers in derivatives “could cause liquidity problems in the markets and could also pose risks to others, including… the financial system as a whole”. It took another 13 years, but that is exactly what happened.
One regulator tried to act on Bowsher’s warning, but she was silenced. Brooksley Born, who monitored the futures markets, tried to extend her remit to unregulated derivatives. Alan Greenspan and Robert Rubin, the then Treasury secretary, persuaded Congress to freeze her already limited power, forcing her departure.
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The lightness of touch reached a level that defies belief. America has an Office of Risk Assessment, set up in 2004 to co-ordinate risk management for the main regulator, the Securities and Exchange Commission (SEC). Jonathan Sokobin, its director, says it is charged with “understanding how financial markets are changing, to identify potential and existing risks at regulated and unregulated entities”. According to its website, it also helps to “anticipate, identify and manage risks, focusing on early identification of new or resurgent forms of fraud and illegal or questionable activities… across the corporate and financial sector”. By early 2008, this office was reduced to a staff of one. “When that gentleman would go home at night,” says Lynn Turner, the SEC’s former chief accountant, “he could turn the lights out. We had gotten down to just one person at the SEC responsible for identifying the risk at all the institutions.” The $596-trillion market in unregulated derivatives, including $58 trillion in credit-default swaps, was being watched by one person. That’s when he wasn’t looking at the rest of the corporate world, of course.
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One question has not been answered. Was Cassano’s team simply the dumbest in the room, betting on an ever-rising housing market against the likes of Goldman Sachs? Or was the world financial system brought down by fraud — a fraud made possible by the gradual but relentless takeover of public life by the insiders’ club of finance?
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What does all this have to do with Joseph Cassano? Seabury Analytic’s research suggests that when Cassano took over the Frankenfinance unit, the parent company was in trouble. “Its ‘distance to default’ was much closer than anyone realised,” says Freestone, whose models would later identify AIG and three peers — Lehman Brothers, Merrill Lynch and Bear Stearns — as insolvent when the markets saw everything as fine. He is not alone in his view. Another authority believes that as the man in Mayfair wrote his credit-default swaps, AIG was already doomed. “AIG’s foray into CDS was really the grand finale,” says Christopher Whalen, managing director of Institutional Risk Analytics, an expert on banking who has testified before Congress. Towards the end, it looked much like a Ponzi scheme, “yet the Obama administration still thinks of AIG as a real company that simply took excessive risks”. In other words, there was never a chance AIG would honour its contracts: its income was nowhere near enough to cover the payouts.
... As evidence of dishonesty, Whalen points to AIG’s occasional habit of using secret agreements to falsify financial statements — either its own or those of other companies. In 2005, a former senior executive at the insurer General Re pleaded guilty to a conspiracy to misstate AIG’s finances, after General Re paid $500m in premiums for AIG to reinsure a nonexistent $500m risk. The transaction was a sham; the only economic benefit to either party was the $5.2m fee paid by AIG for Gen Re’s help.
When the $500m in loss reserves were added to AIG’s balance sheet in 2000 and 2001, Greenberg was able to claim an increase in reserves, when in fact they had declined. “They’ll find ways to cook the books, won’t they?” John Houldsworth, the former executive, said in a recorded phone conversation with Elizabeth Monrad, his chief financial officer. She observed that “these deals are a little bit like morphine; it’s very hard to come off of them”.
... “The key point that neither the public, the Fed nor the Treasury seems to understand,” says Whalen, “is that the CDS contracts written by AIG were shams, with no correlation between fees paid and the risk assumed. These were not valid contracts but acts to manipulate the capital positions and earnings of financial companies around the world.”
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For the world to go truly insane, leading to what the Bank of England has called “possibly the largest crisis of its kind in human history”, two things are needed. The first is the intellectual capture of the Establishment, so that everyone — politicians such as Gordon Brown, regulators such as the SEC and the FSA, and academic and media commentators — is persuaded that a new way of thinking is in the public interest. The second step is when vested interests exploit the intellectual capture and take it to extremes.
Alpha males such as Cassano push at boundaries. You could say it is their evolutionary purpose. That is one reason we need governments, to protect us when male ambition reaches too far. But our governments were mesmerised by our bankers. “From 1973 to 1985,” says Simon Johnson, a former chief economist at the IMF, “the financial sector never earned more than 16% of [US] corporate profits. In the 1990s, it oscillated between 21% and 30%, higher than it had ever been in the post-war period. This decade, it reached 41%.” The whole point of financial companies is to allocate your savings to those who can use the money best. If they are taking 41% of the profit in an economy, something is out of balance. These figures reveal an enormous transfer of wealth.
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In the final three months of 2007, AIG lost over $5 billion. Under the terms of the bonus scheme, top executives should have had their pay cut for poor performance. When the compensation committee met in March 2008 to award bonuses, however, the Essex-born CEO urged it to ignore the losses. The board approved the change, even though losses were growing by the month, and Sullivan pocketed $5.4m. He was also awarded a golden parachute worth $15m. He was out of the company three months later, with a severance package worth $47m (£31m). That is $39,500 (£26,000) for every day he was in charge. Pension funds and other savers holding AIG shares lost $58.4m (£39m) a day during his tenure.
In seven years, the 400 employees in Cassano’s division were paid $3.5 billion. Cassano received $280m. When the losses became public, AIG parted company with him immediately. But he wasn’t fired: he “retired”, with a contract paying him $1m a month for nine months, and protecting his right to further bonus payments. “Joe has been a very valuable member of the AIGFP senior management team for over 20 years,” said Sullivan, who was soon to leave the scene himself. “He has had a great career with us, and we wish him the very best in the future.”
... And so the task facing Obama is even greater than we imagine. Intellectually, the president might see what is required, but execution still depends on the very club that helped bring about the collapse in the first place. “It is not outright fraud that has caused the most damage to the market,” says Tim Freestone, the analyst first to see AIG’s troubles. “It is the suppression of information, wittingly or unwittingly, by most of the market’s players.” A rush to regulation is not the answer, he adds: each new rule creates a minimum target for compliance, with unintended results. The challenge is to confront the keiretsu, the interlocking relationships that give insiders such an advantage.
Bankers and politicians like to blame the catastrophe on this or that cause, which swelled into a tsunami nobody could have foreseen. But as Simon Johnson points out, each reason — light regulation, cheap money, the promotion of homeownership — has something in common. “Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector.”
AIG’s early trades showed genuine brilliance; their later CDS deals, many of which were not even “hedged”, were as foolish as can be. Was it fraud? Yes, in the widest sense — but it was fraud as wilful ignorance, in which a whole industry is based on false assumptions, and each participant has little reason to question the system as long as it continues to make him rich. “There is no need to have an overt conspiracy, or to be incompetent,” says a thoughtful internet poster called Anonymous Jones. “Unfortunately, those ultimately bearing the risk — savers, taxpayers — did not have as strong a personal incentive to keep watch over the system, and those in charge of the financial sector ran roughshod over the entire enterprise, extracting profits far in excess of any value generated by their actions. When there are enormous incentives for each participant to cheat, the efficiency of any market breaks down.”
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