The Big Short_ Inside the Doomsday Machine - Michael Lewis [37]
Stage Two, beginning at the end of 2004, was to replace the student loans and the auto loans and the rest with bigger piles consisting of nothing but U.S. subprime mortgage loans. "The problem," as one AIG FP trader put it, "is that something else came along that we thought was the same thing as what we'd been doing." The "consumer loan" piles that Wall Street firms, led by Goldman Sachs, asked AIG FP to insure went from being 2 percent subprime mortgages to being 95 percent subprime mortgages. In a matter of months, AIG FP, in effect, bought $50 billion in triple-B-rated subprime mortgage bonds by insuring them against default. And yet no one said anything about it--not AIG CEO Martin Sullivan, not the head of AIG FP, Joe Cassano, not the guy in AIG FP's Connecticut office in charge of selling his firm's credit default swap services to the big Wall Street firms, Al Frost. The deals, by all accounts, were simply rubber-stamped inside AIG FP, and then again by AIG brass. Everyone concerned apparently assumed they were being paid insurance premiums to take basically the same sort of risk they had been taking for nearly a decade. They weren't. They were now, in effect, the world's biggest owners of subprime mortgage bonds.
Greg Lippmann watched his counterparts at Goldman Sachs find and exploit someone else's willingness to sell huge amounts of cheap insurance on subprime mortgage bonds and pretty much instantly guessed the seller's identity. Word spread quickly in the small world of subprime mortgage bond creators and traders: AIG FP was now selling credit default swaps on triple-A-rated subprime bonds for a mere 0.12 percent a year. Twelve basis points! Lippmann didn't know exactly how Goldman Sachs had persuaded AIG FP to provide the same service to the booming market in subprime mortgage loans that it provided to the market for corporate loans. All he knew was that, in rapid succession, Goldman created a bunch of multibillion-dollar deals that transferred to AIG the responsibility for all future losses from $20 billion in triple-B-rated subprime mortgage bonds. It was incredible: In exchange for a few million bucks a year, this insurance company was taking the very real risk that $20 billion would simply go poof. The deals with Goldman had gone down in a matter of months and required the efforts of just a few geeks on a Goldman bond trading desk and a Goldman salesman named Andrew Davilman, who, for his services, soon would be promoted to managing director. The Goldman traders had booked profits of somewhere between $1.5 billion and $3 billion--even by bond market standards, a breathtaking sum.
In the process, Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation. Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of subprime mortgage loans. Its logic was exactly that of the original mortgage bonds. In a mortgage bond, you gathered thousands of loans and, assuming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose. In a CDO you gathered one hundred different mortgage bonds--usually, the riskiest, lower floors of the original tower--and used them to erect an entirely new tower of bonds. The innocent observer might reasonably ask, What's the point of using floors from one tower of debt simply to create another tower of debt? The short answer is, They are too near to the ground. More prone to flooding--the first to take losses--they bear a lower credit rating: triple-B. Triple-B-rated bonds were harder to sell than the triple-A-rated ones, on the safe, upper floors of the building.