All the Devils Are Here [119]
The executive who marketed credit default swaps for AIG-FP was Al Frost. Many FP executives were wary of him, viewing him as someone who had a way of shoehorning his way into businesses started by others. But he was a Cassano favorite and a member of the boss’s inner circle. Like everyone else, he feared Cassano’s temper. “He was more worried about Joe’s temper than about bringing him straight information,” says someone who worked with him.
Frost was a glad-hander, with friends up and down Wall Street. As these new multisector CDOs were being developed, Frost was among the people at FP who soon realized there was a need for someone to wrap the triple-A tranches—a need that AIG-FP was uniquely capable of filling. AIG-FP by then was an experienced, trusted credit default swap counterparty that knew the ins and outs of swap contracts. And FP’s swaps were especially appealing to underwriters because they were backed by the parent company’s own stellar triple-A rating.
Or were they? Here was a question that no one at FP—or its counterparties—ever thought much about: What did it really mean to be backed by AIG’s triple-A rating? It most certainly did not mean that the parent company’s capital reserves were at FP’s disposal. AIG was an insurance company; there were severe limits as to how it could deploy its capital reserves. Says a former AIG executive: “We had capital, but it wasn’t mobile.” Much of AIG’s capital was walled off in the company’s insurance units, where it could only be used to shore up that particular division. Surprisingly little of it could be moved to FP, even in a crisis. In truth, despite being owned by the world’s largest insurance company, AIG-FP was really a stand-alone derivatives dealer. The parent company did not have its back.
“If you run a derivatives company,” says a former AIG-FP executive, “all you have to do is be wrong once, given the amount of leverage and the size of the book.” Hank Greenberg viewed AIG’s triple-A rating as critical to his business model, yet he never realized that the very existence of AIG-FP put that triple-A rating at risk.
That same uncritical belief in the strength of AIG’s triple-A was the reason FP never bothered to hedge its exposure to the super-senior tranches it was insuring. This was a sharp departure from the company’s usual practice. But AIG executives felt that because the deals were deemed to be riskless, “why would you hedge a riskless transaction? And if you did hedge,” says a former FP trader, “you would be getting protection from someone who was unlikely to be around, because it was a lesser entity.” In other words, any financial event powerful enough to cause losses to the super-seniors was also likely to bring down the counterparties.
Written into FP’s contracts were so-called collateral triggers, which allowed counterparties to demand that AIG put up collateral—that is, cold, hard cash—if certain events took place. One trigger was a drop in AIG’s credit rating to single-A. A second trigger was a downgrade of the super-seniors. And the third trigger was a decline in the market value of the securities AIG had wrapped—even if those securities retained their triple-A rating.
It is hard to know for sure if these triggers were there from the start. Frost ran his department like a little fiefdom; he tended to impart information on a need-to-know basis. (Through his attorney, Frost denies that he didn’t talk freely about what was going on in his business.) AIG-FP’s chief competitors in wrapping triple-A CDO tranches were the so-called