All the Devils Are Here [208]
“There is a major disconnect in the market,” he claimed, “between what the market is doing versus the economic realities of our portfolio.” In other words, in Cassano’s view, the market was simply wrong. And since the market didn’t understand the strength of AIG’s underlying collateral, he was damned if he was going to begin marking it down in any meaningful way. (He did tell the gathering that AIG was writing down another $500 million in November, but that was a pittance in the grand scheme of things.) “If you ask me how I manage the business,” he said, “it’s the fundamental underwriting that is the first line of defense, the first line of protection, the first thing that gets you comfortable in this business.” Even now, months after the collateral calls began, Cassano still seemed unable to comprehend that the issue he was facing had nothing to do with the “fundamental underwriting” of the CDOs AIG insured. The issue was that the collateral triggers were putting the entire corporation at risk. AIG may have had plenty of capital, as Sullivan had suggested, but because it was an insurance company, that capital was strictly regulated and very little of it could be used to shore up AIG-FP as it faced the growing onslaught of collateral calls. The notion that FP was invulnerable because of its parent’s financial strength—a notion the market had accepted for years—was suddenly exposed as a giant illusion. It was just the opposite: FP’s sudden vulnerability to liquidity risk was endangering the larger company. That’s what Cassano didn’t understand.
When the time came for questions, most analysts seemed to accept Cassano’s version of reality. Several, however, did not. One investor—unidentified in the transcript of the meeting—while acknowledging to Cassano that “you’ve clearly demonstrated no economic loss,” asked what should have been an obvious question: “[W]hat if you did use the ABX index and the counterparties? What would your marks be?”
“It’s nonsensical,” Cassano replied curtly.
“But what would the nonsensical number—?”
“I don’t know,” Cassano cut him off. “It’s nonsensical.”
“Could it be north of $5 billion?” the investor pressed.
“You know I have no—Do you have any idea? I don’t know. Look, we’re in the business of going to the core of the fundamentals. The ABX is just not representative of the pool of business that we have.” And that was that.
A few minutes later, Josh Smith, an analyst at TIAA-CREF, the financial services giant, posed another important question. “I noticed that some of the underlying collateral has been replaced with ’06/’07,” he began. “I think people take a lot of comfort that you stopped writing the ’06/’ 07. Can you quantify the risk that the underlying collateral from the earlier vintages gets replaced with this ’06/’ 07 stuff, which isn’t as good?”
Here was something else almost no one had noticed before—either inside or outside of AIG. For all of FP’s pride in having ended its multisector CDO business in 2005, it simply was not true that the referenced securities didn’t include those terrible 2006 and 2007 vintages. A number of the CDOs that AIG insured allowed for the CDO manager to replace older subprime bonds with newer ones—bonds that would invariably generate higher yields precisely because they were riskier. AIG didn’t even have to be informed that the collateral was being swapped out.
Take, for example, the $1.5 billion CDO known as Davis Square III, which Goldman Sachs underwrote in 2004. The CDO manager, Lou Lucido, worked for the Los Angeles investment firm TCW Group. During much of 2006 and 2007, Lucido was busy boosting the yield on Davis Square III by putting in subprime bonds from later vintages and kicking out many of the bonds that had been in the CDO when AIG agreed to insure it. Bloomberg estimated that, by 2008, “Lucido’s team, following criteria set by Goldman Sachs, changed almost one-third of the collateral in Davis Square III.” By May 2008, Davis Square III had been downgraded to junk, costing AIG $616 million in additional collateral calls—which came,