Noam Scheiber: A new theory of the AIG catastrophe
What went wrong at AIG? Since the uproar over the firm's bonuses, it's become fashionable to distinguish between the masters of the universe at AIG Financial Products, the subsidiary that nearly torched the global economy, and the working stiffs at the rest of the company. So compelling is this dichotomy, in fact, that even the AIG basher-in-chief has invoked it. "You've got a company, AIG, which used to be just a regular old insurance company," President Obama explained during his recent "Tonight Show" appearance. "Then they decided--some smart person decided--let's put a hedge fund on top of the insurance company and let's sell these derivative products to banks all around the world."...
... it actually was pretty smart to put a hedge fund on top of an insurance company--at least for a while. For more than 15 years, the arrangement racked up big profits for AIG without exposing it to excessive losses. The real problem was more fundamental: Companies that deal in risk have a natural tendency to take on too much of it, whether they're arranging homeowner's policies or elaborate arbitrages. Over time, a steady march of profits desensitizes them to the dangers they once sweated; even institutional checks begin to weaken.
Which is why the difference between a successful risk enterprise and an unsuccessful one often has less to do with the complexity of its schemes than with its leaders' fanaticism about discipline. It was, among other things, the lack of such leadership at AIG in recent years that made the company a ward of the state.
AIG Financial Products began life in the mind of Howard Sosin, a Stanford-trained Ph.D. who once worked with junk-bond king Michael Milken at Drexel Burnham Lambert. In the mid-1980s, Sosin dreamt of leaving Drexel to start a company that would accept risk from people looking to unload it in exchange for a hefty fee. For example, a state government might pay Sosin's hypothetical firm to lock in an interest rate so as to avoid a potential increase down the road. (The contract, known as a "swap," would obligate Sosin to offset a higher interest payment, but allow him to pocket the difference if the interest payment fell.) Sosin would then turn around and unload the risk himself using a series of contracts called hedges, so that he would make money regardless of which way interest rates moved.
The only catch was that, in order to arrange all these contracts on favorable terms, Sosin needed the financial backing of an extremely reliable, deep-pocketed benefactor. When Sosin went looking for one, an associate put him in touch with former Connecticut senator Abraham Ribicoff--a friend of [AIG founder Hank] Greenberg's. Ribicoff brokered an introduction, and, in early 1987, the two men settled on a joint venture: Sosin would furnish the nerds and the algorithms, Greenberg would provide his company's triple-A rating, and the two sides would share the profits.
In the early days, many within AIG viewed Sosin's methods as something akin to alchemy. The AIG officials nominally overseeing his operation knew almost nothing about swaps, and they were dismissive of what they didn't understand. But, within months, AIG-FP was bringing in tens of millions of dollars. Suddenly, top AIG officials took notice. Worse, in light of all the revenue, it began to dawn on Sosin's AIG overseers that his terms were overly generous. "AIG probably thought, 'This thing--it's some Drexel wise guy. It'll make a little bit of money,'" recalls a former AIG-FP employee. "Instead, the thing was minting money. Suddenly ... [it was like]: 'You cut what kind of deal with him?...
Read entire article at New Republic
... it actually was pretty smart to put a hedge fund on top of an insurance company--at least for a while. For more than 15 years, the arrangement racked up big profits for AIG without exposing it to excessive losses. The real problem was more fundamental: Companies that deal in risk have a natural tendency to take on too much of it, whether they're arranging homeowner's policies or elaborate arbitrages. Over time, a steady march of profits desensitizes them to the dangers they once sweated; even institutional checks begin to weaken.
Which is why the difference between a successful risk enterprise and an unsuccessful one often has less to do with the complexity of its schemes than with its leaders' fanaticism about discipline. It was, among other things, the lack of such leadership at AIG in recent years that made the company a ward of the state.
AIG Financial Products began life in the mind of Howard Sosin, a Stanford-trained Ph.D. who once worked with junk-bond king Michael Milken at Drexel Burnham Lambert. In the mid-1980s, Sosin dreamt of leaving Drexel to start a company that would accept risk from people looking to unload it in exchange for a hefty fee. For example, a state government might pay Sosin's hypothetical firm to lock in an interest rate so as to avoid a potential increase down the road. (The contract, known as a "swap," would obligate Sosin to offset a higher interest payment, but allow him to pocket the difference if the interest payment fell.) Sosin would then turn around and unload the risk himself using a series of contracts called hedges, so that he would make money regardless of which way interest rates moved.
The only catch was that, in order to arrange all these contracts on favorable terms, Sosin needed the financial backing of an extremely reliable, deep-pocketed benefactor. When Sosin went looking for one, an associate put him in touch with former Connecticut senator Abraham Ribicoff--a friend of [AIG founder Hank] Greenberg's. Ribicoff brokered an introduction, and, in early 1987, the two men settled on a joint venture: Sosin would furnish the nerds and the algorithms, Greenberg would provide his company's triple-A rating, and the two sides would share the profits.
In the early days, many within AIG viewed Sosin's methods as something akin to alchemy. The AIG officials nominally overseeing his operation knew almost nothing about swaps, and they were dismissive of what they didn't understand. But, within months, AIG-FP was bringing in tens of millions of dollars. Suddenly, top AIG officials took notice. Worse, in light of all the revenue, it began to dawn on Sosin's AIG overseers that his terms were overly generous. "AIG probably thought, 'This thing--it's some Drexel wise guy. It'll make a little bit of money,'" recalls a former AIG-FP employee. "Instead, the thing was minting money. Suddenly ... [it was like]: 'You cut what kind of deal with him?...