Hubris

The New York Times has a fantastic account of how a small unit at AIG, employing just a few hundred people, managed to decimate the entire company through its issuance of hundreds of billions of credit default swaps on CDOs. It was all supposed to be a safe way of making money, while generating tremendous income for the company and the unit's employees, the latter of which received an average of more than $1 million a year.  As the unit's chief says, in reassuring investors, “It is hard to get this message across, but these [credit default swaps] are very much handpicked.” 

The whole story clarifies for me a number of things: the pattern of human decision-making that led to AIG's downfall, the link between subprime mortgages and AIG's fortunes, and on a wider scale, the relationship between financial innovation and the growing inequality in earnings in recent years.

Comments

[Thorfinn]

This article is also interesting as it shows Goldman's exposure to A.I.G., and their role in shaping the Fed's decision to bail the firm out. How many of Paulson's decisions in this crisis reflect his personal interest in his previous employer? Would a neutral agent make the same decisions?

[Per Kurowski]

Gretchen Morgensen in “Behind Insurer’s Crisis, Blind Eye to a Web of Risk” writes “Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.”

This is just but another example of a direct consequence of the financial regulators having marketed and given creed to the ludicrous concept that credit rating agencies could measure vaguely defined risks, and always get it right, without turning themselves into a source of systemic risk.

Of course the financial markets were never free and the following two QandAs suffice as proof.

1st. Question: What led the financial markets to the land of lousily awarded mortgages to the subprime sector?

1st. Answer: 99% the credit rating agencies with their AAAs

2nd. Question: Who empowered the credit rating agencies, the governments or the markets?

2nd. Answer: 100% percent the governments.

Mr. Cassano of AIG is also quoted saying that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals” and Morgensen rightly concludes that “of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.”

As a member of the audit committee of one of the supranationals, 2002-2004 I begged over and over again for a complete revision of counter-party risks, just to be treated with so much condescendence that it would have been embarrassing for others with weaker egos. The following is but one of the many paragraphs that I wrote about this issue in my book Voice and Noise, 2006, where I discuss my experiences at the World Bank.

“I truly believe that the World Bank Group’s Financial Complex is staffed by very qualified professionals. That said it is precisely because they could become too good for our own good, falling into the very human traps of complacency and excess of confidence, that I frequently made some comments, if only to pinch.

Phrases such as “absolute risk-free arbitrage income opportunities” should be banned in our Knowledge Bank. From what I have read and seen, I believe there is a clear possibility that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

[jsalvati]

Er, ok, that is connected to fast rising incomes at the top of the scale, but isn't it sort of unrelated to lagging incomes at the bottom/middle of the scale? Does more of this type of success at the top of the income scale translate into less success at the bottom? That seems unlikely to me, but maybe you have a mechanism you want to share.

[Gillian]

Another NYT article http://www.nytimes.com/2008/09/28/business/28lloyd.html?_r=1&scp=3&sq=goldman&st=cse&oref=slogin
helps answer one of my questions -- what have the survivors done right? Why did Bear Sterns go under while Goldman Sachs and JPMorgan survive? (Assuming they won't fail too.)

The article notes:

Goldman’s ability to sidestep the worst of the credit crisis came mainly because of its roots as a private partnership in which senior executives stood to lose their shirts if the bank faltered. Founded in 1869, Goldman officially went public in 1999 but never lost the flat structure that kept lines of communication open among different divisions.

In late 2006, when losses began showing in one of Goldman’s mortgage trading accounts, the bank held a top-level meeting where executives including David Viniar, the chief financial officer, concluded that the housing market was headed for a significant downturn.

Hedging strategies were put in place that essentially amounted to a bet that housing prices would fall. When they did, Goldman limited its losses while rivals posted ever-bigger write-downs on mortgages and complex securities tied to them.

The article also documents the link between Goldman and AIG, and notes the presence of Goldman execs in the Treasury meeting that decided to rescue AIG. And THAT may be another reason why Goldman has survived. What you know, how you operate, AND who you know.

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How many of Paulson's decisions in this crisis reflect his personal interest in his previous employer? Would a neutral agent make the same decisions?

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Goldman’s ability to sidestep the worst of the credit crisis came mainly because of its roots as a private partnership in which senior executives stood to lose their shirts if the bank faltered. Founded in 1869, Goldman officially went public in 1999 but never lost the flat structure that kept lines of communication open among different divisions.

In late 2006, when losses began showing in one of Goldman’s mortgage trading accounts, the bank held a top-level meeting where executives including David Viniar, the chief financial officer, concluded that the housing market was headed for a significant downturn.

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