Guest Post: The CDOs That Destroyed AIG: The Big Short Doesn't Quite Reveal What They Knew And When They Knew It
Submitted by David Fiderer
It's been eighteen months since AIG collapsed, and Congress has yet
to seriously focus on the most important questions: What did they know
and when did they know it?
"What" refers to the fatal flaws in the collateralized debt obligations, or CDOs, that AIG insured.
"They" are the bankers that structured and sold the CDOs, plus the
AIG executives who took on the credit risk, plus the rating agencies
that handed out AAA ratings.
"When" harkens back to 2005 and 2006, when those toxic CDOs were first issued.
Just before the backdoor bailout of AIG's banks actually closed,
Michael Lewis addressed what they knew and when they knew it in Portfolio. He explained why the CDO market was ground zero for Wall Street malfeasance that led to the meltdown:
The funny thing, looking back on it, is how long it took
for even someone who predicted the disaster to grasp its root causes...
[Fund manager Steve] Eisman knew subprime lenders could be scumbags.
What he underestimated was the total unabashed complicity of the upper
class of American capitalism. For instance, he knew that the big Wall
Street investment banks took huge piles of loans that in and of
themselves might be rated BBB, threw them into a trust [i.e. a CDO],
carved the trust into tranches, and wound up with 60 percent of the new
total being rated AAA.
?But he couldn't figure out exactly how the rating agencies
justified turning BBB loans into AAA-rated bonds. "I didn't understand
how they were turning all this garbage into gold," he says. He brought
some of the bond people from Goldman Sachs, Lehman Brothers, and UBS
over for a visit. "We always asked the same question," says Eisman.
"Where are the rating agencies in all of this? And I'd always get the
same reaction. It was a smirk."
The Disaster Created Under Hank Paulson's Watch
That collective smirk reflected more than the bankers' contempt for
the rating agencies' analyses. It was a way of maintaining deniability
about CDO investments that were obviously designed to become insolvent
at the time they were created. In The Big Short, Lewis expands on this point:
[T]here were large sums of money to be made, if you could
somehow get [triple-B mortgage bonds] re-rated as triple-A, thereby
lowering their perceived risk, however dishonestly and artificially.
This is what Goldman Sachs had cleverly done.
This all started at the end of 2004, when:
Goldman was in the position of selling bonds to its customers created by its own traders, so they might bet against them...
According to a former Goldman derivatives trader, Goldman would buy the
triple-A tranche of some CDO, pair it off with the credit default swaps
AIG sold Goldman that insured the tranche (at a cost well below the
yield of the tranche), declare the entire package risk-free, and hold
it off its balance sheet. Of course, the whole thing wasn't risk free:
If AIG went bust, the insurance was worthless, and Goldman would lose
everything. Today, Goldman Sachs is, to put it mildly, unhelpful when
asked to explain exactly what it did, and this lack of transparency
extends to its own shareholders. "If a team of forensic accountants
went over Goldman's books, they'd be shocked at just how good Goldman
is at hiding things," says one former AIG FP employee, who helped to
unravel the mess, and who was intimate with his Goldman counterparts.
The guy in charge of all this, Goldman's CEO, was Hank Paulson. When
he moved over to Treasury, Paulson acknowledged that the subprime
bubble, which he helped foment, was central to destabilizing the
markets. As he wrote exactly two years ago:
The turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for US subprime mortgages, beginning in late 2004 and extending into early 2007.
[Those are Paulson's italics, not mine.]
Goldman now says that it didn't manipulate anything; it simply
responded to market demand. Or as Lloyd Blankfein testified, "what we
did in that business was underwrite to  the most sophisticated
investors who sought that exposure." Of course, a lot of so-called
sophisticated investors were played for suckers. Just ask Bernie
According to Lewis, the guys at AIG who bought Goldman's deals had
no idea that they were so heavily exposed to subprime residential
mortgages. I still find this part of Lewis's story too weird to be
believable. Most of the deals disclosed investment schedules, like
Appendix B for Adirondack 2, which were pretty easy to eyeball.
But even smart people can be fooled by CDO terminology, which is Orwellian by design. Consider the super-senior tranches of high grade multi-sector CDOs
that AIG insured via credit default swaps. Where else in the
English-speaking world does "multi-sector" translate into "singularly
invested in risky real estate mortgages"? Where else are "super-senior"
tranches exclusively invested in deeply subordinated claims? And how is
it that "high grade" CDOs are differentiated their mezzanine
counterparts by a 2% sliver of capitalization, a virtual rounding error?
Lewis also writes that these CDO deals were never seriously
questioned by AIG's then-CEO, Martin Sullivan. In June 2008, Sullivan
was fired and replaced by Bob Willumstad, an outsider who had first
joined AIG's board in April 2006, after the AIG had decided to stop
insuring subprime CDOs.
In September 2008, the one thing that AIG had going for it was a CEO
who had no reason to defend the toxic CDO deals that closed in 2005 and
2006. Willumstad could look regulators and investors in the eye and
agree with Lewis's assessment:
Goldman created a bunch of multi-billion 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 the $20 billion would simply go poof.
So Paulson unilaterally replaced Willumstad, and installed a crony,
Goldman director Ed Liddy, who would never challenge the dodgy CDOs. In
On the Brink,
Paulson's lobotomized financial history, he goes after Willumstad with
a passive aggressive smear. He recounts a comment from a former Goldman
partner, billionaire investor Chris Flowers, at a meeting to discuss
financing options for Lehman, on Saturday, September 13, 2008:
As everyone got up to leave, Chris Flowers motioned me
aside and said, "Hank, can I tell you what a mess it is over at AIG?"
He produced a piece of paper that he said showed AIG's day-to-day
liquidity...Flowers told me that according to AIG's own projections the
company would run out of cash in ten days.
"Is there a deal to be done?" I asked.
"They are totally incompetent," Flowers said. "I would only put money in if management was replaced."
I knew AIG was having problems--its shares had been pummeled all
week--but I didn't expect this. In addition to its vast insurance
operations, the company had written credit default swaps to insure
obligations backed by mortgages. The housing market crash hurt AIG
badly, and it had posted losses for the past three quarters.
With his "I-didn't-expect-this" story, Paulson expects us to believe
that he was surprised to learn the exact problems that were laid out by
AIG to the Fed, which kept Treasury fully apprised at all times, 48
hours earlier. On September 11, 2008,
AIG approached the New York Fed, which simultaneously informed
Treasury, to inform all concerned that AIG was running out of cash
because it was facing a ratings downgrade that was caused by credit
default swaps on subprime mortgages. On that very day in that very
building, New York Fed employees were trying to determine if AIG's
bankruptcy would have presented an unacceptable systemic risk.
"I have been blessed with a good memory, so I almost never needed to take notes," writes Paulson, who also testified,
"I did not know -- I had no knowledge of the size of the [CDO] claim of
any bank." That must mean that the topic never came up during the 24
different phone calls he had with Lloyd Blankfein during the week that
AIG was bailed out. Apparently, the information was never conveyed by
his personal proxy, Dan Jester,
who "was calling many of the shots at the insurer between
mid-September, when the New York Fed decided to go ahead with the
bailout, and the end of October 2008, when Jester was replaced at
A.I.G. by another Treasury official because, according to The New York Times, of Jester's 'stockholdings in Goldman Sachs.'"
Paulson's little hit-and-run smear against Willumstad was intended
to distract us from the source of the mess and to conflate blame on to
those tasked with the cleanup. On the Brink never recounts
Paulson's personal role in role in destroying AIG, his decision to
replace Willumstad with Liddy, or his own analysis dated March 13,
2008. In typical "Who me?" fashion, Paulson decries the problems with
opaque CDOs, but never mentions Goldman's pivotal role in creating the
disaster. Lewis writes:
Goldman Sachs had 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...[I]t didn't require any sort of genius
to see the fortune to be had from the laundering of triple-B-rated
bonds into triple-A-rated bonds. What demanded genius was finding $20
billion in triple-B-rated bonds to launder...To create a billion-dollar
CDO composed solely of triple-B-rated subprime mortgage bonds, you
needed to lend $50 billion in cash to actual human beings. That took
time and effort. A credit default swap took neither.
Those synthetic CDOs, including the notorious Abacus CDOs, were not
sold by AIG to the New York Fed, which only financed securities holding
"real" assets. They remain on AIG's balance sheet, shrouded in secrecy.
The CDO Market Remains A Bunch of Black Boxes
The bankers and hedge fund managers who made billions selling these
toxic CDOs are still smirking. They made billions by shorting those
subprime bonds and CDOs, but almost all of their handiwork remains
hidden, concealed from public view. The Big Short, The Greatest Trade Ever and The Quants
never give us specifics. The authors never identify the particular CDOs
that Greg Lippman, John Paulson or Alec Litowitz bet against. Without
the actual details on the trades, we must rely on the hearsay
narratives of three journalists; we cannot examine the hard evidence to
trace through to what they knew and when they knew it.
CDOs are not like regular mortgage bonds, which may be scrutinized
via their initial prospectuses registered with the S.E.C. Bonds such as
GSAMP Trust 2005-HE4
are structured so that the mortgage pool is essentially fixed at
closing. What you see is what you get. Actual bond performance is
available, for a price, from ABSNet.
CDOs are different. Everything is concealed. Aside from a relative
handful of cases, the public has no access to the initial prospectuses.
Even if a CDO prospectus were retrievable through the Irish Stock
Exchange, that CDO's investment portfolio is still likely to be kept
secret. Unlike subprime mortgage bonds, these CDOs had no legitimate
business purpose. They neither financed the mortgages, which had been
financed through the bonds, nor did they add to liquidity in the
marketplace, since the CDOs were non-tradable black box investments.
You'll never figure out a CDO by reading a rating agency analysis,
which offers a few cryptic comments of substance buried amid the
In addition, the CDOs are set up so that the asset manager can do
all sorts of bait-and-switch maneuvers, within broad credit-rating
based parameters, after the deal closes. CDO performance cannot be
tracked, because the performance data is only accessible to CDO
Hundreds of billions of fatally flawed subprime CDOs were created,
but, with a handful of exceptions, we still do not know who bought what
under what circumstances.
That's why the investigation into AIG's CDO exposure is such an
important opportunity. For the first time in February, we had a
schedule where we could match up the CDOs with the relevant exposure
amounts with the insured counterparties. It sure looks like Societe
Generale "bought" CDOs for the sole purpose of acting as a front for
Goldman, which created most of the CDOs that AIG insured on SG's
behalf. When The New York Times pointed out the suspicious circumstances of SG's CDO positions, Goldman spokesman Lucas van Praag responded with a non sequitur denial:
NYT assertion: "In addition,
according to two people with knowledge of the positions a portion of
the $11 billion in taxpayer money that went to Societe Generale, a
French bank that traded with A.I.G, was subsequently transferred to
Goldman under a deal the two banks had struck."?
The facts: The assertion is false and misleading.
Goldman Sachs provided financing to many counterparties, but in that
role we would not have known whether a counterparty had obtained credit
default protection, let alone from whom or in what amount.
Neither van Praag, nor the Goldman lawyers who reviewed his statement, are confused. They simply want to confuse us. The Times
didn't allege that Goldman provided financing to SG; it alleged the
opposite--that SG provided financing to Goldman. By acting as the
middleman in two back-to-back transactions, SG bought the credit risk
from Goldman and simultaneously sold the same risk, in the form of a
credit default swap, to AIG. In other words, SG acted like the
character in the Edward Jones commercial who, after submitting the highest bid at an art auction, says, "I want to go ahead and sell it now."
The best way to start to get to the bottom of all this is to pass a
law that requires all performance reports of all private label mortgage
securitizations, past and present, be made public. Second, as I wrote previously,
there should be a national registry for every ownership claim,
including every derivative claim, on a mortgage securitization. We
won't get anywhere until these transactions are fully exposed to
So far, Neil Barofsky, the TARP Inspector General appointed by
Paulson, has shown no curiosity in finding out what they knew and when
they knew it. His report
on the backdoor bailout of the CDO banks ignores the subject
completely. The selective pursuit of evidence is a big topic for