Background. The Big Banks, their excesses, and the stories of their rapacious greed, are slowly receding into the rearview mirror of memory, like an Elm Street nightmare. We all know how it ended; the federal government bailed them all out to the tune of $445 billion. Some accepted the money begrudgingly, saying they were forced to take the medicine although they weren’t really sick.[1]
Clearly, the Big Banks have suffered huge reputational damage over the last few years – and rightfully so. But there was another player during these years that – except for those who have followed the story of the Financial Crisis – seems to have gone relatively unnoticed in the public eye; probably because the word “bank” is not found in its name. The company is American International Group, or “AIG”. Interestingly, the name and acronym give no hint of its core business. It is an insurance company! That’s right, insurance; quite possibly the world’s most boring, dry, unsexy and uninteresting profession, second only to statisticians.[2]
Reportedly, AIG is the third largest insurance company in the world as measured by assets. Now that commands some attention. So how is it that this behemoth got caught up in the Financial Crisis and Big Bank Bailout? Was it just bad timing? Wrong! Fate? Wrong! Victimhood? Wrong! Wrong! Wrong! Give up? It was stupidity mixed with ample doses of raw greed.
Counter-Party Wagers. To understand AIG’s role in the financial crisis requires one to understand risk. All of the Big Banks engage in wagering; some for their own account, called “market-making” or “proprietary trades” and some for their clients. These wagers are called credit default swaps, or “CDS.” In a 2010 article titled “How Credit Default Swaps Brought Down Wall Street”, author Kenneth Vereen, Jr. provides a good explanation[3]:
“To put it simply, CDS are a type of insurance contract. For example, assume Bank of America (BAC) buys a $1 million General Motors (GM) bond. When BAC buys this bond from GM, it is exposed to mainly two types of risk; interest rate risk and default risk. BAC can use a CDS to reduce the default risk associated with buying this GM bond. If BAC is worried about GM’s financial health and thinks that GM will default on its bond, BAC can buy a CDS to get insurance on the bond. BAC can buy a CDS from another financial institution, for example AIG. By selling a CDS to BAC, AIG is agreeing to insure BAC’s GM bond for a predetermined number of years in exchange for premium payments. In this transaction, BAC has transferred its default risk from the GM bond to AIG.
If GM defaults on its BAC bond, AIG agrees to make BAC “whole”. This means that AIG will pay the difference between what BAC can make on the bond by selling the bond and the bond’s value at the time when the CDS contract was enacted. In this example, if GM cannot pay back the full $1 million and BAC receives only $100,000 from GM, AIG is obligated to pay BAC $900,000 to make BAC whole. If GM is able to pay off the bond, BAC collects the bond money from GM, AIG does not have to pay BAC any money, and the CDS contract expires. This is the situation that AIG is hoping for because it will receive premium payments from BAC for insuring the GM bond but does not have to pay a lump sum to BAC to make it whole.”
To get closer to what actually happened to AIG, let’s substitute “RMBS” for “GM” in the above example. “RMBS” stands for “residential mortgage backed security” – those securitized bundles of toxic residential subprime, no doc, and liar loans that Wall Street investment banks sold to big investors, pension funds, and municipalities as “investment quality” i.e. safe, low risk bonds.[4]
But what is a boring mild-mannered insurance conglomerate with all the sex appeal of Clark Kent, doing dipping its toe into the exotic and fast moving stream of credit default swaps, anyway? Even the fast-talking brainiacs on Wall Street didn’t understand them. The now famous pillow-talk messages between Fabrice Tourre, aka “the Fabulous Fab,” a young hotshot Goldman Sachs trader sent over the company’s email system to his French girlfriend, puts a fine point on the issue:
“More and more leverage in the system, The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!” (sic)
Nevertheless, AIG, figuring that it knew more about calculating and insuring against risk than anyone, decided to dive into this business that reportedly was worth $45.5 trillion dollars. But the execs at the top all apparently failed to read the now-classic book, “Risk Diversification For Dummies.” Perhaps it was between printings. You know theme – the one about spreading risk across different industries and business sectors. Instead, they treated CDS risk the same as the rest of their general lines policies.
In standard insurance lines, if someone applies for an auto insurance policy, there are pre-existing statistics and algorithms that are used to measure the frequency of the risk and the expected range of claims paid. Premium pricing is developed based upon an understanding of these numbers; the insurance company charges a fee that reflects the risks insured against. In other words, it is a calculated risk – not an unknown or unknowable risk. And one thing is sure: Not all cars will be involved in a crash at the same time. The insurance company will never have to pay out on all of its accident claims at once.
But the AIG execs, being the smartest guys in the room, figured not only could they calculate the CDS risk, but that putting so many eggs in one giant RMBS basket would not be disastrous, because, like automobiles, everyone knew that all of the risk insured against could never crash at the same time. Hmmm. Did I suggest above that AIG was a victim of its own ‘stupidity’? Strike that. It was a victim of its own ‘insanity’.
The second part of AIG’s Big Bonehead Blunder was that it only took one side of the bet, i.e. that the residential housing and mortgage markets would not crash. Now, when it comes to wagering, the Big Banks know better than this. That is why they hedge their bets. When they gamble on one side of a CDS bet, they also gamble on the other side, as well. That way, a loss on one bet is a profit on the other. However, it appears that AIG treated the market for these exotic, complicated, and risky RMBS products the same as for auto, health and life insurance. Unfortunately, they had no actuarial knowledge of how bonds react when a few of them begin to lose value. As it turned out, in 2007-2008, the bonds, like lemmings, all went over the cliff together. The RMBS bond investors holding them lost money, the bonds lost value, and payoff demands began flooding in to AIG like the winners’ line at Churchill Downs. Much of this was due to the outsized impact the bond ratings agencies, Moody’s, S&P, and Fitch had on large institutional investment decisions. As explained in the September 28, 2009 issue of the New Yorker:
“The rating agencies’ role in inflating the bubble is well known. Less obvious is their role in accelerating the crash. Agencies have typically resisted changing their ratings on a frequent basis, so changes, when they occur, tend to be belated, widespread, and big. In the space of just a few months between late 2007 and mid-2008 (after the housing bubble burst), the agencies collectively downgraded an astonishing $1.9 trillion in mortgage-backed securities: some securities that had carried a AAA rating one day were downgraded to CCC the next. Because many institutional investors are prohibited from owning too many low-rated securities, these downgrades necessarily led to forced selling, magnifying the panic, and prevented other investors from swooping in and buying the distressed debt cheaply. In effect, the current system pushes many big investors to buy high and sell low.” [For a discussion of what the AAA and CCC ratings mean, see link here. – PCQ]
So Who Was AIG Insuring? Remember, a CDS wager takes two bettors. One, the insured, who is essentially “betting” the insured-against event will occur, and the insurer, in this case, AIG, is betting it won’t. Each bettor is called a “counter-party.” So in the story of AIG’s near death experience, which we’ll discuss shortly – I promise – who was betting against the success of these highly touted, highly rated and “safe”, investment grade RMBSs? If the ratings agencies are to be believed, the risk was as safe as, well, title insurance.[5] The answer to this question should have made AIG a tad nervous. The bettors wagering that the RMBS would fail were none other than the investment banks that packaged them up in the first place. This is akin to a chef taking out health and life insurance policies on his diners.[6] In fairness to the Big Banks, who have become the Rodney Dangerfield of the financial services industry, they did have a legitimate reason to buy CDSs; insuring against the risk of an investment failing meant they did not have to account for it in their capital reserves, thus freeing up more cash.
However, as discussed below, there is ample evidence that when these toxic securities were sold, the Big Banks already knew they were junk [Remember, the lower the loan quality, the higher the yield. To some investors this was like catnip to Tabby, especially since the ratings agencies were saying that what appeared to be straw and been spun into gold.] AIG appears to have been the “useful idiot” to the Big Banks, in taking bets on securities that had been compiled by the very banks betting against them. [For Vegas Vacation aficionados, AIG assumed the role of Clark Griswold in the Cheapo Casino scene, here.]
So, for the counter parties betting against the RMBS junk, the Big Banks were Big Winners. They received millions from the investors to whom they sold their toxic RMBS, and they received millions more when the RMBS failed… Correction: They stood to receive more, if AIG could pay off all of the claims coming at them at the same time. Something that, gasp, was never supposed to happen. You see, unlike the number of automobile crashes every year, which can be actuarially planned for, the RMBS all failed because: (a) They were doomed from the start, and (b) in 3Q 2007, the ratings agencies all had the same epiphany at the same time, i.e. the toxic junk was indeed, toxic junk. The bloom was off the rose and the lipstick was off the pig….
You see, the residential loans that backed the RMBS securities were largely made to borrowers who could not afford them. But the banks funding the loans didn’t care, since the mortgages were being sold as fast as they were made; they did not need to be carried on the lenders’ books. The long term health of the loans was the investors’ problem. To make this securitization process even more attractive, the Big Banks made money on the back end of these deals, as well, since they acted as the master servicers of the investment conduits called “REMICS”, to which the RMBS were supposedly transferred.[7]
So when the housing market began crashing, according to Reuters, AIG had reportedly $440 billion in CDS counterparty exposure. There was no way it could meet its obligations. There were two viable options: (1) Get a taxpayer funded bailout, or (2) File for bankruptcy protection. With the benefit of hindsight, we know what finally occurred; in September, 2008, AIG was bailed out to the tune of $182 billion. The money was loaned to the company in exchange for an approximately 80% equity stake in AIG. [The final remainder of the debt was paid back in December, 2012.]
Was AIG a “systemically important financial institution” whose survival was necessary for the U.S. and world economy? No, it wasn’t even a financial institution![8] Then was this bailout a gift to AIG? Nein. Nada. Nyet. The AIG bailout loan was a gift to the Big Banks that were AIG’s counterparties. And not only that, but fearing taxpayer fallout, the actual identity of the recipients of AIG’s borrowed funds was concealed from the American public for two years.
[To be continued.]
[1] In some instances, there was probably a grain of truth to this. The thinking was that if some banks partook and others did not, those that did would be viewed as being “in trouble,” and a run on that bank might occur.
[2] Q: What is a statistician? A: An accountant with no sense of humor. Q: How can you spot a statistician at a party? A: He’s the one that looks at his shoes when he’s talking. Q: What happened when four statisticians went deer hunting? A: Their shots all missed; two were high, two were low, but on average, they bagged a deer! Sorry, I couldn’t resist….
[3] Citations have been deleted.
[5] Subject only to limited exceptions, title “insurance” is a bit of a misnomer. Companies insuring the marketability of a homeowner’s title generally only insure against risks appearing on the public record. But before issuing the policy, an eagle-eyed title examiner pours over the public record at least twice – once when the policy is ordered, and again when the purchase is closed in escrow. Everything found on the public record is then listed as an exception to the homeowner’s insurance policy. So, in reality, title insurers are not so much insuring against “risk” – since that has been almost eliminated by listing the exceptions to coverage – but actually guaranteeing to their policy holders that they have disclosed in the listed exceptions, all of the relevant public record information about the subject property. Most title claims occur not because of some unknown risk occurring, but because the title examiner missed something on the public record that if found, would have been excluded from coverage. Loss ratios for the title industry are 10.00% [plus or minus] of what they are in the casualty insurance industry, such as auto policies. Nonetheless, title insurance is a necessary component in all real estate transactions, and provides invaluable services, often for free, to real estate lawyers such as myself.
[6] Does he know something the diners don’t? Will he profit if he puts way too much cayenne in the soup? And what ever happened to that box of rat poison in the kitchen, anyway?
[7] I say “supposedly” because: (a) There is substantial evidence that the promissory notes were never originally transferred into them as they should have been, and (b) when Big Banks were still doing non-judicial foreclosures in Oregon, I saw many MERS trust deed assignments back into these trusts when it became necessary to commence a foreclosure. If the trust deeds had been in the trusts all along, as promised in the securities offerings provided to investors, why would one need to transfer the trust deeds back? They should have been there all along.
[8] In Darwinian terms, some might say that after this sterling example of ‘Survival of the Dumbest’, AIG should have been permitted to sink slowly back to the muddy bottom of the gene pool.
