The Back Alley Archives

Confronted with the new development—his company was insuring not consumer credit generally but subprime mortgages—Cassano didn’t blink. He simply claimed that the fact was irrelevant: for the bonds to default, U.S. house prices had to fall, and Cassano didn’t believe house prices could ever fall everywhere in the country at once. After all, Moody’s and S&P still rated this stuff AAA!

Still, Cassano agreed to meet with all the big Wall Street firms and discuss the logic of their deals—to investigate how a bunch of shaky loans could be transformed into AAA-rated bonds. Together with Park and a few others, Cassano set out on a series of meetings with Morgan Stanley, Goldman Sachs, and the rest—all of whom argued how unlikely it was for housing prices to fall all at once. “They all said the same thing,” says one of the traders present. “They’d go back to historical real-estate prices over 60 years and say they had never fallen all at once.” (The lone exception, he said, was Goldman Sachs. Two months after their meeting with the investment bank, one of the A.I.G. F.P. traders bumped into the Goldman guy who had defended the bonds, who said, Between you and me, you’re right. These things are going to blow up.) The A.I.G. F.P. executives present were shocked by how little actual thought or analysis seemed to underpin the subprime-mortgage machine: it was simply a bet that U.S. home prices would never fall. Once he understood this, Joe Cassano actually changed his mind. He agreed with Gene Park: A.I.G. F.P. shouldn’t insure any more of these deals. And at the time it didn’t really seem like all that big of an issue. A.I.G. F.P. was generating around $2 billion year in profits. At the peak, the entire credit-default-swap business contributed only $180 million of that. He was upset, it seemed, mainly that he had been successfully contradicted.

What no one realized was that it was too late. A.I.G. F.P.’s willingness to assume the vast majority of the risk of all the subprime-mortgage bonds created in 2004 and 2005 had created a machine that depended for its fuel on subprime-mortgage loans. “I’m convinced that our input into the system led to a substantial portion of the increase in housing prices in the U.S. We facilitated a trillion dollars in mortgages,” says one trader. “Just us.” Every firm on Wall Street was making fantastic sums of money from this machine, but for the machine to keep running the Wall Street firms needed someone to take the risk. When Gene Park informed them that A.I.G. F.P. would no longer do so—Hello, my name is Gene Park and I’m closing down your business—he became the most hated man on Wall Street.

The big Wall Street firms solved the problem by taking the risk themselves. The hundreds of billions of dollars in subprime losses suffered by Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns, and the others were hundreds of billions in losses that might otherwise have been suffered by A.I.G. F.P. Unwilling to take the risk of subprime-mortgage bonds in 2004 and 2005, the Wall Street firms swallowed the risk in 2006 and 2007. Lending standards had fallen, property values had risen, and the more recent loans were thus far riskier than the earlier ones, but still they gobbled them up—for if they didn’t, the machine would have ceased to function. The people inside the big Wall Street firms who ran the machine had made so much money for their firms that they were now, in effect, in charge. And they had no interest in anything but keeping it running. A.I.G. F.P. wasn’t an aberration; what happened at A.I.G. F.P. could have happened anywhere on Wall Street … and did.

As recently as August 2007, A.I.G. F.P. traders were feeling almost smug: all these loans made in 2006 and 2007 were going bad, but the relatively more responsible 2005 vintage that they had insured didn’t look as if it would suffer any credit losses. They were, they thought, the smart guys at the poker table. Joe Cassano even went on an investor conference call and said, famously, “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 on any of those transactions.”

Here's the bit that caught my eye.

"Every firm on Wall Street was making fantastic sums of money from this machine, but for the machine to keep running the Wall Street firms needed someone to take the risk...

The Wall Street firms solved the problem by taking the risk themselves. The hundreds of billions of dollars in subprime losses suffered by Merrill Lynch, Morgan Stanley, Lehman Brothers, and the others were hundreds of billions of losses that might otherwise have been suffered by AIG. Unwilling to take the risk of subprime mortgage bonds in 2004 and 2005, Wall Street firms swallowed the risk in 2006 and 2007..."


OK, I need reader help here. Let's unpack this.

First, things went crazy in subprime in late 2005 and 2006. Those 5-6 quarters were when the most damage was done, the dreckiest paper in big volumes. Lew Ranieri said the paper got worse around then (not that it was great before, mind you). Even thought the paper was even more toxic in 2007, the volume fell off as subprime woes were coming into sharp focus. So understanding what happened in 2006 is important.

What does Lewis mean, exactly, by "take the risk?" AIG had written CDS against the bonds, or at least that's what the piece implies, as opposed, say, to CDOs that contained subprime mezz paper. Did the investment banks start writing CDS against subprime bonds? Their credit ratings weren't so high that that action would have accomplished much in the way of credit enhancement (or was everyone so punch drunk that any name would do?). Did they rely on overcollateralization and keep the equity layer? I haven't seen anything that would suggest that the big brokerage firms stepped up and did credit enhancement of subprimes, but it isn't impossible.

The reason I am a bit confused here is that the accounts of subprime writedowns at the big broker dealers (plus Citi, which apparently was happy to do deals without AIG guarantees, thank you very much) was that they took losses on subprime paper (I had presumed mortgages they held as trading inventory, plus perhaps also warehoused mortgages) and CDO paper. Merrill and Citi both had large exposures to the super senior layer. That ins't consistent with the story that they took the risk to get the deals done. For Merrill, it seemed as if the firm kept blindly originating deals even though the stuff was getting harder to place (the various AAA layers were 70-80% of the value of the whole CDO) and believed in the stuff enough to carry it. Really bad underwriting practice, in other words, Not as clear why Citi wound up with so much paper, but they had been putting some (a lot?) in SIVs, so as those got unwound, Citi may have taken them on balance sheet.

It is also useful to understand where the credit enhancement was occurring pre and post AIG. CDO volumes were exploding. The party that takes the risk of an equity layer in a CDO winds up eating a lot of the risk of the subprime paper that went into the CDO. Not sure how far that would have gone in supplanting AIG, but it could conceivably have gone a fair way.

But I was also under the impression that hedge funds pursuing credit oriented strategies were important buyers of the equity layer in CDOs. Did they come to play a bigger role in this period?