All The Devils Are Here: Unmasking the Men Who Bankrupted the World (63 page)

On the other hand, Sullivan had so many other fish to fry that it was easy to leave Joe Cassano alone. By all the obvious measures, he seemed to be running a shop that was at the top of its game. In 2006, the division made nearly $950 million in profits, meaning it was not only helping AIG’s income statement but also minting millionaires, since the division still kept around a third of its profits as bonuses. (Cassano later acknowledged that he made around $300 million during his time at AIG-FP, although his lawyers claim that $70 million of that was deferred compensation that he lost when the AIG was bailed out by the government.)

As for the risks it was taking, no one could really see any significant problems on the horizon. The total notional value of AIG-FP’s derivatives business was $2.66 trillion. Of that, some $527 billion was in the credit default swap book. Of that, FP insured a “mere” $60 billion in multisector CDO tranches. FP’s subprime exposure, in other words, seemed like a relatively small piece of the business, around 3 percent of its total derivatives exposure. And no one at headquarters knew about the existence of the collateral triggers—including Dooley. When the risk managers at AIG headquarters ran FP’s various derivatives business through their risk models and stress scenarios, it got a clean bill of health. After the big 2005 restatement—which included significant changes in the way FP accounted for some of its hedges—the board told Sullivan that he should take tighter control of FP. He agreed. But it never happened, in part because Cassano wouldn’t let it happen. Sullivan kept telling the board he was moving in that direction, but there were always more immediate issues that took up his attention instead. And since FP was doing so well, nobody pressed the point.

By early 2007, the board of directors was beginning to get antsy about Sullivan’s management. It wasn’t just his unwillingness to get his arms around FP; there were lots of similar issues that the board wanted him to tackle but which he seemed to be avoiding. Sullivan was still resistant to the cultural
changes that were so clearly necessary. With the 2005 crisis now well in the past, the board wanted Sullivan to begin accelerating the pace of change.

“By the summer of 2007,” says a former AIG executive, “we were getting to the point where members of the board were saying, ‘We need to start setting some harder milestones.’ ”

Which, of course, was exactly when the collateral calls began.

September 11:
With everyone back from vacation, Goldman once again begins demanding collateral—$1.5 billion this time, in addition to the $450 million AIG has already posted. Société Générale, the big French bank, also demands collateral—$40 million—which AIG-FP executives immediately suspect has been instigated by Goldman, since Société Générale is a big Goldman client and its trades mirror Goldman’s trades. AIG-FP disputes the marks submitted by the two firms. Société Générale backs down. Goldman doesn’t.

September 13:
Goldman buys an additional $700 million worth of protection on AIG, bringing the total to $1.5 billion.

September 20:
Goldman announces its third-quarter results: profits of $2.9 billion, despite marking down its own subprime holdings. “Significant losses on nonprime loans and securities were more than offset by gains on short mortgage positions,” says the firm.

October 1:
AIG-FP accountant Joseph St. Denis, who had joined FP in June 2006, resigns. In a letter he would later write to congressional investigators, St. Denis says he became “gravely concerned” when he learned in September of the Goldman collateral calls—“as the mantra at AIG-FP had always been (in my experience) that there could
never
be losses” on the super-seniors. Cassano, he says, deliberately excluded him from meetings to discuss the valuation issue because, Cassano told him, “I was concerned that you would pollute the process.” On the morning he resigns, St. Denis tells AIG-FP’s general counsel that “I have lost faith in the senior-most management of AIG-FP.”

November 2:
Goldman ups its collateral demands to $2.8 billion. Yet again, AIG-FP disputes Goldman’s marks.

November 7:
AIG announces its third-quarter results: $3 billion in profits. But it also discloses that it has taken a $352 million write-down on “unrealized
market valuation loss” in the quarter, which ended in September. It adds that, in October, its portfolio took on an additional $550 million in losses, which could get better or worse, depending on what happens in the rest of the fourth quarter. During the ensuing conference call, the only thing the analysts want to talk about is AIG’s super-senior exposure.

November 8:
Goldman’s David Lehman e-mails Forster: “We believe the next step should include a line by line comparison of GS vs. AIG-FP prices…. Can we set aside 30 minutes to discuss live today or tomorrow?”

November 16:
Société Générale demands $1.7 billion on a portfolio of $13.6 billion. Merrill Lynch demands $610 million on a portfolio of $7.8 billion. “Their average price is 84.20 [cents on the dollar],” Forster tells Cassano in an e-mail. Goldman’s prices are much lower—in the high sixties.

November 18:
Goldman ups its credit default swap protection on AIG to $1.9 billion.

November 23:
AIG posts $1.5 billion in collateral, bringing its total to nearly $2 billion. Goldman’s demands rise to $3 billion.

November 27:
Cassano sends an e-mail to Bill Dooley at headquarters laying out, seemingly for the first time, all of AIG-FP’s counterparty exposures as well as the collateral calls that have come in so far. It is a sobering document. Merrill Lynch has bought protection on $9.92 billion worth of triple-A tranches from FP and is demanding $610 million. Bank of Montreal wants $41 million on its $1.6 billion portfolio. Calyon, the investment banking division of the French bank Crédit Agricole, is demanding $345 million on its $4.5 billion portfolio. UBS has a $6.3 billion portfolio; it wants $40 million from AIG. A half dozen other big banks have billions of dollars worth of super-seniors insured by AIG and haven’t yet made a collateral call—but obviously they could any day. And of course there’s Goldman Sachs, which has a total of $23 billion in super-senior exposure insured by AIG-FP. It is demanding not millions like everyone else, but billions.

November 29:
Eight thirty a.m. A week after Thanksgiving and four months after Goldman’s first collateral call, AIG’s top executives—among them Sullivan, Lewis, Dooley, and Steve Bensinger, the company’s chief financial officer—finally meet to talk, via a conference call, about the mounting problem. Cassano, Forster, and a third AIG-FP executive join them on the phone. Three auditors from PricewaterhouseCoopers, including Tim Ryan, the lead
auditor of the AIG account, also participate in the meeting. Someone takes notes, which are later obtained by the investigators.

By the time that late November meeting took place, AIG’s top executives were well aware of the collateral calls. Prying the information out of Cassano, however, hadn’t been easy.
^*
In early August, about a week after the first one, AIG’s auditors had scheduled a meeting with Cassano and several other FP executives on another topic. One of the auditors mentioned, more or less in passing, that he had heard a rumor that FP had been hit with collateral calls. Cassano acknowledged that FP had received a collateral call from Goldman but pooh-poohed its significance, arguing that the market would come back once traders returned from vacation. The auditors accepted the rationale and moved on to their main topic.

Toward the end of August, AIG CFO Steve Bensinger also began picking up rumors that FP was getting collateral calls. He asked one of his deputies, Elias Habayeb, CFO for the AIG’s financial services division, to call Cassano and find out. Again, Cassano acknowledged the calls but dismissed their significance. Habayeb, having crossed swords with Cassano in the past, was not so quick to accept his say-so. Over the ensuing weeks—especially as the end of the quarter approached—Habayeb lobbed e-mail after e-mail into Cassano and his top deputies, trying to find out how the securities were being valued and to what extent the problems were. Cassano, annoyed by the e-mails, would assign one of his minions to respond.

At four thirty on October 8, for instance, Habayeb sent a lengthy e-mail to Cassano with a series of “follow-up questions” about valuing the super-senior portfolio, which FP needed to do quickly since the quarter had ended eight days earlier. “When should I expect to receive the valuation of the SS CDS (portfolios D & E) using the BET as of September 30, 2007?” was one question. (BET stood for binomial expansion technique, a methodology also
used by the rating agencies, which FP was trying to quickly adopt.) “With respect to the valuations using BET, how are the effects of hedges reflected or not reflected in these estimates?” was another question. Habayeb concluded gently, “I understand that everyone is working hard … I further appreciate that this is not an easy exercise. However, as you can imagine, this has become the hottest subject at 70 Pine” (70 Pine was the Wall Street location of AIG’s headquarters).

Three hours later, Cassano forwarded Habayeb’s e-mail to his lieutenants. “More love notes from Elias,” he wrote. “Please go through the same drill of drafting answers….”

Meanwhile, AIG’s auditors at PricewaterhouseCoopers had begun viewing the collateral calls as far more serious business than they had a few weeks earlier. Goldman Sachs, which was also a client of PWC, helped push it in this direction. At Goldman the collateral dispute was important enough that it was being discussed at the board level; its auditors sat in on those discussions. “It was a constant focus inside Goldman Sachs,” says a former partner. As the ongoing dispute with AIG worsened, several Goldman Sachs executives began asking their auditors how it could be that “you have one set of numbers for one firm and a totally different set of valuations for another firm?” The lead partner on the Goldman account—who had nothing to do with AIG—told the executives he would take it up with HQ. Which he did. It wasn’t long before PWC was bearing down on FP and AIG as well.

The essential problem FP faced as it grappled with how to value the super-seniors was that it had never really thought about liquidity risk. Its models had always measured one thing: credit risk. That is, what was the likelihood of a triple-A tranche defaulting, which would cause FP to have to pay off the bonds in their entirety? Cassano had always been fixated on that question because that is where he saw the risk. And since AIG’s risk models consistently showed there was virtually no credit risk, it always valued the securities at par.

But now, with the market in “a state of panic,” as Cassano described it, the only question that mattered was what they were worth
today
. What could they be sold for in the marketplace? If it was less than 100 percent on the dollar—as it clearly was—then AIG-FP had a contractual obligation to put up collateral. That was the liquidity risk: the risk that the continuing drip, drip, drip of collateral calls would drain AIG-FP of cash and ultimately create a run on the firm that would destroy it—in much the same way that the Bear hedge funds had been destroyed.

Incredibly, this was a form of risk that Cassano had apparently never considered, and therefore had never modeled for. It was also a risk that AIG executives like Habayeb had never accounted for, in large part because they hadn’t even known it existed. (That is why, too late, the company was now trying to adopt the BET methodology.)

In the short term, the problem was that the market for triple-A tranches of multisector CDOs was frozen. There was no way to use trading data to establish values for the securities because no one was trading the securities. Nobody knew what a CDO was worth anymore, nobody trusted anybody else’s marks, and nobody dared to make an actual trade to find out. It was as if everybody in the mortgage market, having enjoyed a long, drunken revelry, was finally sobering up. Looking in the mirror was not a pleasant experience.

Thus everyone on Wall Street had to rely on models to come up with new marks. There was no other way to do it. This is also why everyone’s marks varied so widely. Everyone had different inputs; the imperfections of quant-style modeling had never been so clear. Merrill Lynch was also marking down its securities. Its marks, however, were much higher than Goldman’s; as Cassano liked to point out, Merrill’s marks were around ninety cents on the dollar, while Goldman’s were in the sixties and low seventies. Because Goldman’s marks were so low, AIG-FP viewed them mainly as an example of “Goldman being Goldman,” taking undue advantage of the situation to inflict pain on AIG.
^*
But the fact that FP didn’t have its own valuation model made it difficult to refute Goldman’s marks.

Goldman would later insist that it was not trying to gouge AIG—that it alone was being realistic about its marks. One of its tried-and-true techniques, when counterparties objected to its marks, was to offer to sell at the low price to the counterparty. Not once did a counterparty accept the offer, which, to Goldman, was proof that its marks weren’t low
enough
. Goldman would also later point out that because it had used AIG to hedge trades, it did not pocket the cash it got from AIG, but handed it over to the counterparties on the
other side of the trade. In other words, it had no motive for putting the screws to AIG because the money wasn’t going into its own pocket.