How did Joe Cassano — the man who brought down AIG, and with it, perhaps the entire global financial system, with those disastrous credit default swaps — talk about what his unit, AIG Financial Products, was up to?
We’ve been looking through a presentation that Cassano gave to a group of entrepreneurs and analysts in May 2007 — just as the extent of the collapse of the sub-prime market was becoming clear. In his speech (accessed by Nexis), Cassano detailed AIGFP’s various business lines, and, of course, painted a rosy picture of the unit’s future earning potential.
The entire performance has an almost poignant quality, looked at in light of the tumult that would soon befall AIGFP. (Less than nine months later, it would announce Cassano’s resignation after an $11.1 billion writedown of credit-default swaps.) But we’ve pulled out a few of Cassano’s comments that day that are particularly noteworthy…
“It’s Not By Any Stretch A Risky Business”
For instance, laying out how the presentation would go, Cassano said:
Pierre Micottis, who is the global head of our risk management function at AIG, will give a brief overview, and it needs to brief because we could spend hours on our risk management function. But he will be talking and giving an overview of the market credit and operational risk management function, and how that function at AIGFP integrates into the broader Enterprise Risk Management Group headed by Bob Lewis at the parent, and how we integrate all of those things into the parent.
Just in case we need to point this out: the level of risk taken on by AIGFP in its credit default swaps would, thanks to its exposure to the collapse of the sub-prime mortgage market, force the company to post billions in collateral to its trading partners, absorb billions in losses, and require a $180 billion rescue package from the US government to keep the company afloat. Cassano might have been able to “spend hours on our risk management function,” but that function was clearly flawed, to say the least.
Cassano would say a little more about risk — credit risk specifically — later in the presentation.
The other thing we’re all very proud of is that we have a very, very high credit quality in our company. Credit risk is the biggest risk our group has. It’s the single biggest risk that we manage. But with a AA plus/AA credit portfolio, there’s not a lot of risk sitting in there. And so while it is the largest risk, it’s not by any stretch a risky business.
You know the management at [AIG] liked the story, they were looking to enter into the financial services segment, and that began this long-term relationship that has really, I think, exceeded any of our expectations in many ways.
Because the novel notion was, gee, if we have a credit rating, because you’ve got to think of where we were, we were at Drexel where there was no credit rating, very, very little reach. We were making money, we were doing business with thrifts we were doing business with insurance companies that were buying high-yield bonds.
But boy if we had some breadth, couldn’t we really make some money and really, really do a good job at it? And maybe we could something as exotic as currency swaps and develop that segment of that market. So in 1987 the group was formed, we developed our business plans, we developed our systems capabilities, we developed our management of what we needed to do and we were off to the races basically.
“We Were Able To Catch That Wave”
Perhaps most interestingly, Cassano described the birth of AIG’s credit default swaps:
During this period, from about 1995 to ‘98, there was another business that was beginning to develop and it had some interesting notions to it, it was credit derivatives. We would use credit derivatives prior to 1998 as a way of hedging large risk that we had in our credit portfolio. So if we had any outstanding large risk we would bundle them up into a credit derivative, into a note and then sell them on to our investing clients. And this was a good business for us and we liked doing that.
But it was a watershed event in 1998 when JPMorgan came to us, who were somebody we worked with a great deal, and asked us to participate in some of their early what they called then bistro trades, and these trades were the precursors to what’s become the CDO market today, and the early movers in that.
And we were able to catch that wave of that business and were able to build on that platform. And you all read in the newspapers today, credit derivatives are one of the fastest growing segments in the derivatives markets and we’re a very large participant in a very specific niche, and that niche is in the super senior business and that’s one of the things that Andy will talk about during his segment.
We’ve written about JP Morgan’s role in bringing the CDS concept to AIGFP. What Cassano wasn’t saying there, was that, up until late 2005, it wasn’t just the “super senior” niche of the CDS market that AIGFP was insuring. It was derivatives based on sub-prime mortgages. And even though it reportedly stopped doing those deals at that time, it remained exposed, years later, to those subprime-based deals, which would ultimately bring it, and AIG proper, down.
No AAA Rating, No Problem
Cassano then went on to describe how, after a poor 2005 — thanks in part to the resignation of longtime CEO Hank Greenberg, amid allegations of accounting improprieties — AIGFP rebounded the following year.
But what I’m really pleased about is the way the business bounced back in 2006, because I think many people in the early days had questions about the sustainability of our platform, AIG Financial Products, if AIG was no longer AAA. I think there was a strong corollary that said, “Well AIG’s AAA so the team at Financial Products really benefits immensely from what’s going on with that AAA.”
And it’s bigger than that. The reason our relationship with AIG is in the soup, it’s everything about management’s activity and interest in what we’re doing, the crisp decision making about the way we can make decisions, the way we can bring resources to bear. Also all of our competitors are those people who would be our competitors in various segments, they themselves are only rated AA. So it really didn’t change that profile for us very much.
Of course, as subsequent reports have made clear, it was the loss of AIG’s AAA credit rating that kicked off the firm’s death spiral. The rating downgrade forced AIGFP to post far more collateral to its counter-parties on the credit default swaps than it otherwise would have had to — collateral it ultimately couldn’t come up with in full, triggering its first government bailout.
But maybe the most ironic — if that’s the word — pronouncement of the day came not from Cassano, but from his deputy, Andy Forster, who ran AIGFP’s global credit trading operation. Referring to the unit’s credit derivatives business — very much including the credit default swaps that would soon bring them down — Forster took complacency to a whole new level, declaring:
[A]ll of the business that we do, it’s very much assuming a worst case. So it’s never sort of thinking what might happen, it’s always sort of what’s the worst that could ever happen to me, what’s the worst recession that I can imagine and can I make sure that I can withstand all of that.
Looks like he learned from the master.