Michael Lewis on AIG
By Arnold Kling
Compelling, as usual. I’ll post some excerpts below the fold, but I recommend reading Lewis’ whole piece.
Lewis writes it very much as a suits-vs.-geeks story. He portrays the head of AIG financial products, Joseph Cassano, as a suit who did not listen to the warnings of the geeks until it was too late. In fact, I worry that because Lewis’ sources are geeks, his story may be one-sided.
One small quibble is that Lewis does not want to get into the details of structured finance. He talks very loosely about “risks” being passed around, and he makes it sound as if AIG was taking on all the risk, leaving everyone else risk-free. I think that’s an exaggeration.
Also, it is noteworthy that AIG backed out of the market late in 2005. Lewis says that the suckers who came in to take AIG’s place were Wall Street firms. But one should not overlook Freddie Mac and Fannie Mae, which had lost market share in 2004 and 2005, but which jumped in big time in 2006 and 2007.
What Lewis hints at, but does not spell out clearly enough in my opinion, is that the “AIG bailout” did not benefit AIG nearly as much as it benefited Goldman Sachs and other large financial firms, foreign and domestic, who are not necessarily deserving recipients.
The incentive system at A.I.G. F.P., created in the mid-1990s, wasn’t the short-term-oriented racket that helped doom the Wall Street investment bank as we knew it. It was the very system that U.S. Treasury secretary Timothy Geithner, among others, had proposed as a solution to the problem of Wall Street pay.
At the end of 2001 its second C.E.O., Tom Savage, retired, and his former deputy, Joe Cassano, was elevated. Savage is a trained mathematician who understood the models used by A.I.G. traders to price the risk they were running–and thus ensure that they were fairly paid for it. He enjoyed debates about both the models and the merits of A.I.G. F.P.’s various trades. Cassano knew a lot less math and had much less interest in debate.
In a normal economy, when interest rates rise, consumer borrowing falls–and in the normal end of the U.S. economy that happened: from June 2004 to June 2005 prime-mortgage lending fell by half. But in that same period subprime lending doubled–and then doubled again. In 2003 there had been a few tens of billions of dollars of subprime-mortgage loans. From June 2004 until June 2007, Wall Street underwrote $1.6 trillion of new subprime-mortgage loans and another $1.2 trillion of so-called Alt-A loans…The subprime sector of the financial economy clearly was responding to different signals than the others–and the result was booming demand for housing and a continued rise in house prices.
The A.I.G. F.P. executives present were shocked by how little actual thought or analysis seemed to underpin the subprime-mortgage machine: it was simply a bet that U.S. home prices would never fall. Once he understood this, Joe Cassano actually changed his mind. He agreed with Gene Park: A.I.G. F.P. shouldn’t insure any more of these deals.
There is much more worth reading.