All the Devils Are Here [199]
“What are you focused on?” Frost asked nervously.
“What are we focused on?” replied Forster, seeming incredulous at the question. “I’m focused on CDOs and subprime.”
“Yeah, obviously.”
“Nothing else,” Forster continued. “And spending most of my time answering questions of . . . AIG, you know, Sullivan, Lewis, all the rest of it.” Sullivan was Martin Sullivan, AIG’s CEO. Lewis referred to Bob Lewis, the company’s chief risk officer.
What Frost and Forster knew—and Sullivan and Lewis didn’t—was that embedded in AIG-FP’s swap contracts were those collateral triggers. AIG-FP’s counterparties, who had been paying it millions of dollars over the years to insure their triple-A tranches, had the right to demand what amounted to cash margin calls if one of three things happened: if AIG’s rating dropped to single-A or below; if the ratings on the super-senior tranches AIG was insuring were lowered by the rating agencies; or if the value of the tranches fell—even without a ratings downgrade. In all the time FP had been writing credit protection on multisector CDOs, no one could ever imagine any of these things ever happening. AIG was just too strong financially, and besides, the super-senior tranches FP insured had plenty of subordination; the default rate on the underlying mortgages would have to be almost unimaginably high to ever reach the tranches that FP insured.
Even after FP stopped writing the business in 2005—indeed, even after the parent company’s rating was dropped to double-A after Greenberg’s departure—the division executives remained convinced they had nothing to worry about. FP executives took solace in the fact that the 2006 and 2007 “vintages” of subprime mortgages were far worse than the 2005 vintage that FP had wrapped. Tranches with those later mortgages, they believed, would be hit long before any of the tranches that AIG insured. A government official who began poking around FP’s swap business in 2005, not long after Greenberg left, recalls looking at the collateral triggers and thinking, “This is a company with 9 percent tangible capital and an earnings stream to die for. It would truly take an Armageddon scenario. You’re thinking, ‘This is never going to happen.’ There’s risk, sure, but there’s also risk I could walk out the door and a brick could fall on my head.”
By the middle of 2007, however, Armageddon looked a lot closer than it had in 2005. And Forster was clearly worried that downgrades—and collateral calls—were coming. All he had to do was look at what had happened to the Bear Stearns hedge funds to know that the unimaginable was now a very real possibility.
“Every fucking one, every rating agency we’ve spoke to . . . every time they come out with more downgrades we have to go and . . . analyze all the exposures we’ve got in the rest of it. So, you know, it’s fairly time consuming,” Forster said. “The problem we’re going to face is that we’re going to have just enormous downgrades on the stuff that we’ve got. So you know, we sort of sit there with a $60 billion CDO book, and now we’re sort of sitting and saying, it’s super-senior. It isn’t going to be too much longer before we’re saying, we’ve got, you know, $20 billion of single-A risk. And that’s going to happen. There’s no doubt about it.”
“Do you think it’s going down that far, single-A?” asked Frost.
“Oh, yeah,” said Forster. “It’s going to get very, very, very ugly.”
The conversation turned to another potential problem: given what the market was doing, the value of the super-senior tranches was getting hit even without a ratings downgrade. How was AIG going to avoid marking down the value of the securities it insured—which would also result in collateral calls?
“Is there an event that could cause us to [lower our marks]?” asked Frost.
Forster replied that the rumbling of downgrades by the rating agencies would inevitably cause counterparties to focus on AIG’s marks, which were still at