Why AIG Blew Up and Took Down the World

Vanity Fair has an article by financial writer Michael Lewis that looks deeply into the disaster inside the Financial Products (FP) group at AIG. The article is aptly named "The Man Who Crashed the World" and focuses on Joseph Cassano who ran the AIG FP group.

Here is the key bit:

The people still left inside A.I.G. F.P. like to list just how many things had to go wrong for their business to implode. Any one of a number of things might have sufficed to avert their catastrophe: our political leaders might have decided against the Wall Street argument not to regulate credit-default swaps; the ratings agencies might have resisted the Wall Street argument to rate subprime bonds AAA; Wall Street banks, in 2006 and 2007, might have declined to replace A.I.G. F.P. in the role of subprime risktaker of last resort; and on and on. Their list is mostly a catalogue of large, impersonal forces. But impersonal forces require people to conspire with them. Joe Cassano was the perfect man for these times—as responsible for a series of disastrous trades as a person in a big company can be. He discouraged the dissent of subordinates who understood them better than he did. He acted with the approval of A.I.G., but he also must have known that A.I.G. wasn’t able to evaluate his trades. Once he was persuaded to stop insuring subprime-mortgage bonds, the logical course of action was to reverse the deals he had already done. In 2006 he might have found a way to do this, if he had been willing to accept the costs involved, but he wasn’t. Had he been, the machine he helped to create would have kept running—by then it had a life of its own—and the losses would have simply wound up more concentrated inside the big banks. But he’d have saved his company.

But Michael Lewis' story has a lot more. It has a portrait of Jake DeSantis, a trader inside AIG FP who had nothing to do with the disastrous trades that brought down AIG and the world economy. But DeSantis became enraged when the mob wanted to take the bonuses away from the AIG people. DeSantis points out that he took a $1/year salary to clean up the mess with the understanding that he would get a big bonus (and admitted that the after tax bonus amount would be $742,006.40!). But when Congress started writing a bill to clawback 90% of the bonus, DeSantis quit AIG and published his resignation letter in the NY Times along with a statement that he was turning over his bonus to charity. (Even the villains seem to be good guys in this story!)

From reading the Vanity Fair article I now understand why the financial crisis became worldwide. As Lewis points out, the model that Casano built was adopted by others:

In a financial system that was rapidly generating complicated risks, A.I.G. F.P. became a huge swallower of those risks. In the early days it must have seemed as if it was being paid to insure against events extremely unlikely to occur—how likely was it that all sorts of companies and banks all over the globe would go bust at the same time? Its success bred imitators: Zurich Re F.P., Swiss Re F.P., Credit Suisse F.P., Gen Re F.P. All of these places were central to what happened in the last two decades; without them the new risks being created would have had no place to hide, but would have remained in full view of bank regulators. All of these places have been washed away by the general nausea now felt in the presence of complicated financial risks, but there was a moment when their existence seemed cartographically necessary to the financial world. And A.I.G. F.P. was the model for them all.

What is incredible is that this wasn't purely a few rogue traders, or just the domineering personality of Casano. The whole system was poisoned. As Michael Lewis points out, when AIG withdrew fromt his market in 2006 because it realized the risks were too great, other Wall Street firms stepped in and the fantasy went on:

A.I.G. F.P.’s willingness to assume the vast majority of the risk of all the subprime-mortgage bonds created in 2004 and 2005 had created a machine that depended for its fuel on subprime-mortgage loans. “I’m convinced that our input into the system led to a substantial portion of the increase in housing prices in the U.S. We facilitated a trillion dollars in mortgages,” says one trader. “Just us.” 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. When Gene Park informed them that A.I.G. F.P. would no longer do so—Hello, my name is Gene Park and I’m closing down your business—he became the most hated man on Wall Street.

The big 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, Bear Stearns, and the others were hundreds of billions in losses that might otherwise have been suffered by A.I.G. F.P. Unwilling to take the risk of subprime-mortgage bonds in 2004 and 2005, the Wall Street firms swallowed the risk in 2006 and 2007. Lending standards had fallen, property values had risen, and the more recent loans were thus far riskier than the earlier ones, but still they gobbled them up—for if they didn’t, the machine would have ceased to function. The people inside the big Wall Street firms who ran the machine had made so much money for their firms that they were now, in effect, in charge. And they had no interest in anything but keeping it running. A.I.G. F.P. wasn’t an aberration; what happened at A.I.G. F.P. could have happened anywhere on Wall Street … and did.

As recently as August 2007, A.I.G. F.P. traders were feeling almost smug: all these loans made in 2006 and 2007 were going bad, but the relatively more responsible 2005 vintage that they had insured didn’t look as if it would suffer any credit losses. They were, they thought, the smart guys at the poker table. Joe Cassano even went on an investor conference call and said, famously, “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 on any of those transactions.”

This whole story in literally incredible. It probably won't be fully understood for twenty years as researchers get to dig deeper into the story and its complexity is unraveled. It is a tragedy for all of us.

Ultimately, this is the price of capitalism. An inherently unstable system. But an enormously productive system. The trick that has to be learned is to tame it as best you can. Unfortunately, from 1980 until 2008 the ideology of the Right was rampant with their belief that the market could do no wrong, that all regulation is wrong, and that any government is too much government. This ideological blindness set the stage on which this tragedy has occurred.