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AIG: Res Ipsa Loquitur

AIG: Res Ipsa Loquitur

Courtesy of Roddy Boyd, The Financial Investigator 

Scales

Editor’s Note: A graf was added describing the signal contribution of The Wall Street Journal’s Serena Ng and Liam Pleven in explaining the Securities Lending unit in a February 5, 2009 article. Rather than fold it into the graf where I describe how Miles Weiss and Andrew Ross Sorkin advanced the story, I chose to break it out seperately. Accountability and transparency, to say nothing of accuracy, is central to enterprise reporting and when I fall short, I seek to immediately remedy the situation.

The Financial Crisis Inquiry Commission’s document release last Wednesday doesn’t offer the curious an answer to a question that hasn’t received much play since AIG’s collapse in September 2008.

The question is: “How Did AIG really collapse?”

Not: “How did they get in trouble?” Or: “Who is to Blame?”

But rather, what led to a firm that had a AA- rating, around $160-billion in market cap and $14-billion in profits–with real cash generation capacity to boot– in fiscal 2006 effectively go out of business in September 2008?

The answer is not Goldman Sachs.

It would be exceptionally easy–for no one more so than me since as I am in the process of writing a book on the collapse of AIG called Fatal Risk–if it had though.

The picture painted of Goldman Sachs, especially from legislators in Washington D.C. and the media–nowhere more so than the business desk of the New York Times–centers largely on the now infamous series of swaps that one of Goldman’s proprietary trading desks entered into with AIG as central to its collapse. In this view, Goldman’s meticulous enforcement of so-called credit support agreements and the billions of dollars in collateral calls forced upon AIG’s Financial Products unit is seen as fatal.

Yet months of investigation into the matter suggest a different answer: What killed AIG was much more likely the financial and managerial collapse within AIG Global Investment Corporation’s securities lending program.

The management of the unit, under Win Neuger, took a portfolio that had been throwing off about four basis points of profit since inception in the 1990s and in 2005 began imposing a 30-basis point profit target. Outside of the sheer impossibility of improving margins 7.5 times, the practical hurdles to obtaining creditworthiness and liquidity were formidable. So daunting, in fact, that creditworthiness and liquidity were tossed out and a naked grab for yield resulted. [It’s unclear whether the bogey was ever met but the growth of the portfolio--40% from 2004 to 2006--makes clear that Securities Lending had become a major economic factor for AIGGIC.]

Consider this chart, derived from AIG’s public filings.

Note the widening differential between assets and liabilities and then look at the trajectory of the program’s growth. That nearly $38-billion chasm between assets and liabilities from 2004 to 2008 was not–per AIGFP– a series of collateral postings representing the difference between the market value of an asset and the price AIGFP had contracted to guarantee.

It was the pure economic loss of capital in its most natural state. It represented the decline in value of assets AIGGIC purchased with the cash Wall Street’s banks and brokerages gave as collateral for borrowing stocks and bonds from its life insurance investment-management portfolios.

When Wall Street returned the securities and reclaimed its cash, AIGGIC was obligated to deliver the original sum in full.

The problem was, of course, that AIGGIC, instead of buying triple-A rated, highly-liquid  short-term agency or asset-backed securities bought longer-dated sub-prime mortgage-backed securities.

When AIGGIC saddled itself with sub-prime MBS into the tens of billions of dollars, the ability to exit a trade became compromised. After the collapse of Bear Stearns Asset Management’s pair of highly levered hedge funds in June of 2007, there was a massive decline in the liquidity of wide swaths of the ABS market, which in turn, prompted a sharp sell-off.

It became a vicious circle.

One after another, the sector’s that AIGGIC’s securities lending program had bought into, such as sub-prime, Alt-A, CMBS, began to see bids fade and then virtually cease altogether. In turn, with a lending program that was going full-bore–the desk chief, Peter Adamczyk, was a truly star-crossed sort, under direct orders to engage in the dangerous and absurd while loudly protesting to no avail–AIGGIC found itself hunting yield further down the underwriting quality curve.

The fruits of this gambit are seen in the $6.3-billion differential between assets and liabilities for 2007.

[As the Wall Street Journal's Serena Ng and Liam Pleven wrote in February 2009, this was hardly a series of unfortunate missed opportunities to reign in growth--Securities Lending was the centerpiece of a multi-year quest to boost unit profits to $1-billion. Moreover, it was hardly Neuger acting as a lone wolf, as the Journal noted that chief credit officer Kevin McGinn became an enthusiastic backer, and the effort recieved--presumably--the backing of global risk chief Bob Lewis. Both Lewis and McGinn remain key executives at AIG.]

This was not just an ill-considered trade however. Months after AIG Financial Products began to receive its first collateral posting requests from Goldman Sachs in the late autumn of 2006, the securities lending program continued to grow with the same profit bogeys in place. Indeed, the AIGFP counter-parties who were loudly demanding collateral were the same counter-parties to the securities lending program, a program that at the end of fiscal 2007 had become AIG’s biggest secret, representing seven percent of a one-trillion dollar balance sheet and 15% of the $502-billion bond portfolio.

The risk-management inferno continued: Unbeknownst to but a handful of AIGGIC senior management, AIG had become the largest proprietary securities lending portfolio on Wall Street, eclipsed only by State Street, which managed numerous portfolios on a “third-party” basis.

That this portfolio was not on anyone’s radar within AIG is an understatement. Dozens of interviews with senior AIG corporate and financial officials testify to the fact that prior to the summer of 2008 few in the company’s upper ranks had an awareness of the program, and if they did, it was unlikely they could speak with any confidence about its details.

In layman’s terms, AIG was the only player expanding in a field only a minority of the financially sophisticated knew even existed, using the bonds that were at the forefront of the credit collapse as the bricks and mortar of the foundation.

In fairness, hindsight is exceptionally clear. It is easy to forget that the bonds that dropped so violently in price and liquidity starting in mid-2007 had just several weeks prior been trading in blocks of $50-million and $100-million. Nor, in a culture like AIG’s where economic performance was ruthlessly demanded, would it have been a simple political matter to  shut down a program that was providing at its peak what we can estimate was perhaps $250-million in revenues.

A spokeswoman for AIG declined comment on the matter and both Neuger and Adamczyk, citing their separation agreements with AIG, also refused comment.

The nearly $38-billion hit AIG took in this program was simultaneous, of course. But the lion’s share of it–perhaps around $20-billion–created such an unanticipated chasm in September 2008 that when desperate negotiations were underway to sell key units in order to stave off bankruptcy and news broke of trouble in this area it led to a complete collapse of negotiations.

[Bloomberg News’ Miles Weiss was the first to break the news of the securities lending woes; Andrew Ross Sorkin’s Too Big To Fail provides the authoritative “tick tock” of how the sudden revelations of problems with Securities Lending effectively scuttled an 11th hour loan package.]

Though the subject is endlessly debated, the spreadsheet provides yet another reminder of the violent shift in managerial styles and corporate culture between the Maurice “Hank” Greenberg era and the reign of Martin Sullivan. Greenberg, who prided himself on publicly and privately second-guessing his most successful managers, had an extensive background with financial services; Sullivan, who by disposition was the anti-Greenberg in terms of his collegial and trusting relationships with his senior managers, was broadly understood to have no real experience with the securities market.

AIG’s public relations staff, when pressed, gamely try and paint Sullivan as a tragic figure, a brilliant property and casualty insurance executive who took over a company beset by regulatory woes on all sides, on the cusp of a remorseless civil war with its pater familias and concurrently, forced to manage in an epic financial crisis that may well have had no historical analogue.

All of which is largely true.

Yet the fact remains: With only his good nature and trusting in his long-time colleagues to guide him, Sullivan took over a company that in 2006 derived more than $16-billion in revenue and $6.5-billion in operating income from capital markets activities. By way of contrast, these figures–for operations that were far outstripped in economic relevance to its primary insurance lines– nearly doubled the output of Bear Stearns.

There is little in the record to suggest that he had the will or the skill-set to make unpopular decisions about the risk of these units, let alone seriously engage a makrkets veteran like Win Neuger. Greenberg, on the other hand, had a long track record of rearranging profitable units from the top-down when it suited his needs.

It should go without saying that there is no small amount of blame to go around for all parties involved when it comes to the near-death of AIG. Because of this, like a handy literary device, It is much easier to point to an unsympathetic player like Goldman Sachs than it is to spend the time humping through AIG’s filings and building a case about how a sleepy and ancillary business like securities lending became a disaster on the par of AIG Financial Products.

None the less, the numbers speak for themselves and they tell the tale that AIG, and the people who are investigating its collapse, appear more than willing to have you glide past.


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