All The Devils Are Here: Unmasking the Men Who Bankrupted the World (39 page)

A few hours after Greenberg made his “foot fault” comment, Spitzer sent AIG a subpoena demanding documents relating to the Gen Re transaction. That evening, the New York attorney general happened to be the dinner speaker at a Goldman Sachs event. “Hank Greenberg should be very, very careful talking about foot faults,” he said. “Too many foot faults and you can lose the match. But more important, those aren’t foot faults.”

Not surprisingly, the board was fast losing faith in Greenberg. Even before the Spitzer subpoena, the independent directors had hired Richard Beattie, a high-priced lawyer with Simpson Thacher & Bartlett, who was well known for advising boards faced with difficult situations. Beattie had several dinners with Greenberg, hoping to persuade him to retire. At one point, right around the time of the earnings announcement, Greenberg had agreed to step down. But the next day he told Beattie he had changed his mind.

Once the Spitzer subpoena arrived, a special committee of directors began an internal investigation. AIG’s accounting firm, PricewaterhouseCoopers, was brought in to comb through the company’s books. “They were finding problems everywhere,” recalls a former AIG executive. It turned out that certain aspects of FP’s derivatives accounting were incorrect. Some reinsurance transactions had to be unwound. Deals that walked right up to the line—which PWC had once okayed—were now ruled out of bounds. And there was another problem: the company had promised to cooperate with Spitzer, and he wanted to depose Greenberg. The board wanted to know whether Greenberg was going to plead the Fifth Amendment. Greenberg said he wasn’t sure. How could the CEO take the Fifth and keep his job?

The climactic board meeting took place on March 13, 2005. It lasted all day, with the directors discussing among themselves whether to fire Greenberg and Greenberg, calling in from his boat and his airplane, arguing that he should keep his job. He had an odd way of going about it, though. “You people don’t know what you’re doing,” he berated them. “You don’t even know how to
spell
insurance.”

Toward the end of the meeting, the accountants from PWC told the board that it would no longer vouch for the firm’s books if Greenberg stayed as CEO. And that was that. Greenberg was allowed to stay on as chairman of the board, though that arrangement wouldn’t last long, either. His replacement as CEO was a bland AIG lifer named Martin Sullivan, who had spent his entire career on the insurance side of AIG. Although Sullivan had a
tremendous amount of insurance experience, because of the way Greenberg ran the company he knew very little about AIG-FP.
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Immediately after Greenberg’s departure, the rating agencies dropped AIG’s rating to double-A. Over the next few months, the intensity level inside the company was almost unbearable, as every subsidiary was turned inside out by swarms of accountants. “It was like a war zone,” says a former executive. In July AIG announced its restatement: the company would reduce its earnings by $4 billion covering the previous five years. In those five years, AIG had reported around $40 billion in profits; the new numbers lowered AIG’s profits by 10 percent. In other words, AIG didn’t really have to play games—$36 billion in profits would still have earned it plenty of respect. It’s just that Greenberg would have been seen as a mere mortal, instead of the great god of insurance.

Alain Karaoglan, a Wall Street analyst who had followed AIG for years, wrote several searing reports in the wake of Greenberg’s resignation. One in particular stands out. After taking a close look at the Foreign Life unit—the same subsidiary that was always said to be one of the crown jewels—he concluded that there were significant gaps “… between statutory earnings reported in the 10-K and our summation of statutory account principle (SAP) earnings for the operating entities.” In other words, try as he might, he could not make the earnings that AIG had reported for Foreign Life add up.

He also pointed out something that nobody had bothered to pay much attention to before. The rating agencies had consistently said that none of AIG’s operating subsidiaries would have merited triple-A ratings if they had been stand-alone companies. Only the guarantee from the parent company made them triple-A credits. Yet, he noted, “AIG, the parent, is just a holding company and its strength and only source of cash flow to bondholders and shareholders comes from its subsidiaries.” AIG’s vaunted triple-A, in other words, was a product of circular logic that broke down upon close inspection. As Karaoglan continued his analysis, he openly wondered whether the operating units deserved even a double-A rating.

Then he wrote this: “[W]e were all
to some degree complacent, and looked to some degree at the financials in a silo fashion and took comfort in the overall AIG whenever the silo could not stand on its own. In our view, we were all over-relying on Mr. Greenberg to sustain the company’s tremendous track record and ensure it was real. Now, with significant financial improprieties revealed by the company, we can no longer do that.”

Not long before Hank Greenberg was ousted, an FP executive named Gene Park got a call from an old high school friend who was trying to buy his first house. The price of the house was $250,000. The friend didn’t make a lot of money. Yet two mortgage originators had lined up to give him loans—one for the first mortgage, and the second for a loan to cover the down payment. The friend wanted to know if Park would lend him $5,000 to cover the closing costs, which he also didn’t have. Though a little startled by what he’d heard, Park loaned him the money.

Shortly before the closing, the man lost his job. He called Park again, worried that the deal would fall through. But it didn’t; when the friend told his mortgage broker that he was now out of work, the broker simply told him not to mention it. Sure enough, he closed on the house. Now Park was
really
startled.

A few months later, Park read an article in the
Wall Street Journal
touting the high dividend being paid by a hot mortgage company, New Century. He decided to take a closer look at the stock—and realized that New Century was a subprime lender that specialized in no-doc loans. He quickly dropped the idea of investing in it. Then a third data point popped up on his radar screen: in a trade publication somewhere, he read that multisector CDOs had very large concentrations of subprime mortgages.

By the spring of 2005, Al Frost was marketing a veritable assembly line of multisector CDO deals—FP had ten or fifteen in the pipeline at any given time. “It was almost mechanical,” says someone who was there. They were so routine, they got very little scrutiny from the risk managers or anyone else at AIG-FP. Every firm on Wall Street was going to AIG to buy credit default swaps on their super-senior tranches. Though the spreads remained small, the sheer volume of business made it a big profit center for FP.

Nor did the credit default swap deals slow down after Greenberg left. Although the business had its best quarter ever in late 2004, its second biggest quarter was in the spring of 2005, after Greenberg’s departure. From
$50 billion in 2004, the business ballooned to $110 billion by the end of 2005, according to the Congressional Oversight Panel. (By September 2008, when AIG was bailed out by the government, the exposure had been reduced to $60 billion.) Though it was still a small portion of AIG’s $2.7 trillion derivatives book (in notional value), the run-up was startling nonetheless. And Frost wasn’t the only one putting the pedal to the metal now that Greenberg was gone. The securities lending program also went into overdrive, and the mortgage insurance unit threw caution to the wind. The whole company, it sometimes seemed, was doubling down on subprime mortgages.

At both FP’s and AIG’s headquarters, the increasing number of multisector CDO deals was not viewed with alarm. On the contrary, Frost was seen as a hero. The downgrade to double-A had hit AIG-FP hard—it had to unwind billions of dollars worth of complicated transactions that had been dependent on the triple-A rating. A large part of the FP staff spent 2005 either unwinding deals or dealing with the restatements. Neither activity put money in the till. Frost’s multisector CDO business was something everyone else at FP could be happy about.

Which is also why Cassano decided in the fall of 2005 that the time had come to give Al Frost a promotion. At the same time, he decided to put Gene Park in charge of the multisector wrap business.

Park, however, wanted nothing to do with multisector CDOs. By then, he had done a little experiment. He had asked some people involved in the FP business to guess the percentage of subprime mortgage-backed securities in some of the recent CDOs that FP had wrapped. Most of them had guessed it was around 10 percent. Then he asked one of them to look up a few recent deals. What he found was stunning. The percentage of subprime securities in the CDOs wasn’t 10 percent—
it was 85 percent!
Without anybody at FP noticing, the multisector CDOs had become almost entirely made up of risky subprime securities.

Seriously worried, Park took his concerns to Andrew Forster, one of Cassano’s chief deputies in London, who had begun to have thoughts along the same lines. The two men then made the rounds of the Wall Street underwriters to better understand the collateral. What they heard was not comforting. The firms all acknowledged that the credit histories were not very good—but they all insisted it was okay because historically, housing prices only went in one direction: up. As long as that was the case, homeowners would be able to refinance and repay the debt.

Park and Forster both knew this was a terrible rationale. The collateral,
clearly, was unsound. The supposed diversification benefits of having a variety of credits in a multisector CDO had disappeared. They knew they needed to get out of the business.

And yet, how to break this news to Cassano without having him blow his stack? How to explain that this seemingly great business was exposing the firm to enormous risks that no one had been aware of? They couldn’t. Park himself never spoke to Cassano, but Forster decided that the best way to approach him was to say that the business had changed and the underwriting standards were deteriorating. “We’re comfortable with the portfolio today, but we’re not comfortable going forward,” Forster told Cassano, according to several former FP executives. “They were afraid to say they had made a mistake,” adds one of them. “They couldn’t admit to that.” After listening to Forster’s argument, Cassano agreed that, yes, they should stop writing new CDO business. But because nobody had been willing to tell Cassano how dire the situation really was, he—and AIG-FP—remained far too sanguine about the risks that remained on its books.

Park had wanted AIG not only to stop writing new business, but to begin hedging its exposure—and even to begin shorting securitized subprime mortgages. But that never happened. Most people at FP still couldn’t envision the possibility that their deals might ever go sour. At one point, Park spent about a month trying to work out a deal where FP would buy credit default swaps from one of its clients for some of its super-senior exposure. But the cost—20 basis points, or two-tenths of a percent—was considered too high for so unlikely an event. So Cassano and Forster vetoed the deal, according to several FP executives. (Cassano, through his lawyers, denies that he vetoed a hedging deal. Rather, he says, FP executives concluded that hedges were generally ineffective.)

In February 2006, Frost and Park went to the big annual asset-backed securities convention in Las Vegas. There were thousands of people in attendance; everyone who was anyone in the securitization business was there. They had meetings with all the firms they did business with. Frost introduced them to Park, and explained that AIG-FP “would be taking another look at the business.” Everyone knew what that meant. “During that period, he was not happy,” recalls someone who worked with Frost. “He thought Park was trying to undermine his business to make him look bad. He thought he was turning over the crown jewels. He personally took offense.”
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After the crisis, it would be revealed that FP did not completely turn off the spigot at the end of 2005, even though that is what the company later told the world. By the time 2005 had come to a close, the firm had a number of deals still in the pipeline. Not wanting to anger its clients, AIG-FP decided to close those deals, which meant it was continuing to insure multisector CDOs well into 2006. What’s more, under the terms of the swap contracts it wrote, CDO managers had the right to switch collateral to help maintain the yield—without having to inform AIG. As borrowers prepaid mortgages, for instance, the CDO managers would replace those earlier mortgages with mortgages that had been written in 2006 and 2007. Those latter mortgages, written as the housing bubble was reaching its peak, were far worse than even the mortgages written in 2005. And with Greenberg now gone, there was literally not a single executive at AIG’s headquarters who knew that a decline in the market value of the tranches AIG wrapped could trigger a collateral call.