AIG, CDS, Suits, and Geeks
By Arnold Kling
The Washington Post is in the middle of a three-part series on AIG and credit default swaps. A lot of the focus is on corporate infighting.
A Brooklyn College graduate, the 42-year-old [Joseph] Cassano was not one of the “quants” who had mastered the quantitative analysis and risk assessment on which the firm had been built. He had no expertise in the art of hedging. But he had excelled in the world of accounting and credit — the “back office,” as it is known on Wall Street.
Cassano became head of the unit at AIG that did credit default swaps. Actually, I think that a strong back-office guy would be pretty good to have in that position. You don’t just have economic risk. You also have operational risk. It sounds to me as though Cassano would have been good at controlling operational risk.
The man with whom I identify in the article is Tom Savage, a geek who headed the financial products unit in the late 1990’s. He thinks that credit default swaps were highly profitable and low risk when they started, but seeing what ultimately happened, he regrets getting into them.
I feel that way about my role at Freddie Mac (although I was never a senior executive, as Savage was at AIG) in promoting credit scoring for mortgage underwriting. It seemed like a great idea at the time, yielding fewer errors and lower cost than traditional underwriting. But it helped pave the way for private securitization, because Wall Street came to treat FICO scores almost as a substitute for the guarantees of Freddie Mac and Fannie Mae. And, somehow, everybody forgot about the importance of borrowers putting up equity to buy homes, and the rest is history.
The Post story leaves more questions unanswered than answered. It refers to hedging strategies that the folks at AIG believed in prior to 2005 (when this part of the series ends. The next part picks up tomorrow.) What were those hedging strategies? Was it dynamic hedging, meaning that if your credit default swap started to go bad you would short similar securities?
Another question concerns the destruction of AIG’s chairman Maurice Greenberg by Elliot Spitzer. The article mentions a transaction involving “finite insurance,” which is something I have never heard of. The article suggests that it was an accounting trick, designed to dress up the balance sheets of both sides of the transaction. I want to know whether this was a “foot fault” (Greenberg’s term) or a serious fraud. Most importantly, I want to know who created the incentive to do this sort of transaction–was it insurance regulators in the first place?
Mostly, I am waiting (presumably this will be in the series finale tomorrow) to learn how AIG got into mortgage-backed securities and whether it was the suits or the geeks who got it wrong. That is, did the geeks under-estimate the risks, or did the suits run past warning signals flashed by the geeks?