The Financial Crisis: the FRONTLINE interviews
Money, Power, & Wall Street
sponsored by Duke Sanford School of Public Policy
So tell us about AIG. When do they figure out, "Oh, my God, we've got a problem with AIG as well," and how [do] they react?
Well, it's again quite stunning, and it really goes to the slow response, the slow-footedness of the response. It's really the weekend of the Lehman collapse that they become fully aware of the depth of AIG's problem. I believe it's the Friday night before Lehman collapses, Lehman files for bankruptcy, the beginning of Monday morning effectively, at the end of a very long and tortuous Sunday. And it's really that Friday, while problems at AIG had been on the screen, where the problems of AIG burst fully on the scene.
Here's this mammoth institution that turns out to have an enormous hole in it. And again, policy-makers just come to grips with the extent of the challenges and the problems days before its imminent collapse. And of course in the wake of Lehman, a decision is made to inject over $80 billion in AIG, which, of course, ultimately grows to $180 billion.
... Why were they so surprised at how big a problem AIG would become?
I think the surprise in the regulatory community about AIG was directly related to the lack of regulation of AIG Financial Products, which was not the only source of AIG's problems but was the most systemic source and I think truly the greatest source, just in terms of sheer magnitude of exposure.
It was an orphan in terms of regulation. ... Insurance tends to be very well regulated, particularly the big states have very strong insurance commissioners and departments and regulate well.
But it wasn't part of any of the insurance companies. It was stuck over in London. It was away from headquarters. The supervision, to the extent there was, went to the Office of Thrift Supervision, which had some very dedicated people, but almost no expertise in this area. ... So AIGFP was just off the radar screen for everyone.
Really had no regulator looking over the books.
No regulator with any expertise in the area. You didn't have the insurance commissioners, you didn't have the Fed, you didn't have the SEC [U.S. Securities and Exchange Commission]. ...
One of the other things that had come out of AIG afterwards that caused an enormous amount of anger when it was clearly understood was the fact that the counterparties weren't forced to take haircuts, that Geithner's plan was 100 cents on the dollar for Goldman and others. What's your view of why Geithner made that decision the way he made it? ...
... This was now in the midst of the worst part of the crisis. Lehman had failed. The Reserve [Primary] fund had failed. Fannie and Freddie had been in conservatorship. Here was AIG. Wachovia was in real trouble. So very decisive action needed to be taken, and decisive also means speed, by definition.
I assume the concern was that if Geithner had tried to negotiate -- and it wasn't Geithner's call alone; it was Treasury and the board of governors of the Federal Reserve system -- that some of the counterparties would have said no … and that there would have been then no rescue package.
The serious problem here was that AIGFP was guaranteed 100 percent by the parent company, so you couldn't let AIGFP go without the entire institution being in mortal danger. So I assume that was the reason. ...
Was the AIG bailout necessary in your view?
I still to this day question why they paid off all of those counterparties in full at par with government money. ...
Did you ask Geithner?
No. Again, we were not involved in that at all. ...
We have rules in terms of derivatives. We have the power to accept or repudiate derivatives contracts. And typically if they have enough collateral or more collateral than necessary, the counterparty, to protect their position, then we'll ask for continued performance.
But if they're under-collateralized, we tell them, "Fine, take your collateral and go and take your haircut and go." That's kind of the rule we follow, and they could have done that. ... They could have used that same kind of approach I think.
Because not only was it the right thing to do, but the optics of this, I think the insensitivity of how people on Main Street would view of all this was always troubling to me. ...
The argument would be that there was no time for that. At this point the world's financial markets were going to melt down on Monday morning if Lehman Brothers or if Bear Stearns failed.
That was the argument. But even if you had to make a decision in a nanosecond, require them to take a 10 percent haircut. Just tell them, "We're going to pay you off at 90 percent. If you don't like it, too bad."
But the government had no legal obligation to put money into AIG to bail it out. If the government hadn't intervened, those counterparties would have taken huge losses, so there was some leverage there. But at least tell them, "You're going to take 10 percent." That would have helped.
But there was just willingness to kind of throw lots of money at the problem. I think we threw more money at the problem than we needed to, absolutely. ...
… You guys grilled Goldman pretty well on the issue use of derivatives. Why? What was your attitude about that?
Well, first of all, what we did as a commission is, given the limited budget we had -- you know, we had about a $10 million budget, which I suspect is less than each of the major banks spent on attorneys trying to fight our efforts or make our life more difficult. But what we did is a series of case studies to really try to expose, you know, so the commission could understand and the public could understand how the derivatives market worked. And we chose to look at the relationship between Goldman and AIG and to try to unfurl that for the public, and so we could also get a good look.
So we did a set of case studies. And we chose Goldman and AIG because it was a fascinating relationship. Here was AIG, you know, writing these derivatives contracts, essentially backstopping what turned out to be woefully defective subprime securities. And here was Goldman on the other side of those deals. And when the subprime securities started to go down, here is Goldman pursuing AIG.
What was really striking about that is here was AIG writing essentially $80 billion of insurance. Now, it's not really like insurance, because if it had been insurance, it would have been regulated. If it had been insurance, there would have been reserves posted.
But here is AIG writing $80 billion of protection on subprime securities, of which Goldman was the largest holder. And not the CEO, not the chief financial officer, not the chief risk officer, none of the people heading AIG understood that if the value of subprime securities declined, they would have to post collateral payments to their counterparties like Goldman.
And of course what happens in the summer of 2007 is the subprime market begins to crater. Goldman knocks on AIG's door, and they say, "You owe us a couple of billion dollars." And they said, "For what?" "Well, for the protection you wrote." And that came as a complete surprise to the leaders of AIG. They had no sense that they had that obligation in their contracts. And of course ultimately that was what led to their downfall. …
... One of the things I think the administration is battling now in the election is that there is this perception out there that the banks were coddled and in ways that were unnecessary. One of the main ones that comes up was the plan about AIG, that the counterparties did not take a haircut for the money that went into AIG. ... Even in a case where the banks were expecting to take a haircut, they weren't. It was deemed that that was unnecessary.
... These really are battlefield decisions. The people who were making those decisions had to do so within basically 48 hours of finding out there was a problem, and it's a lot easier to sit in judgment months later and say, "Ah, you should have done this," but when you're in those seats and things are happening at lightning speed and you have imperfect information, you make the best judgments you can.
With AIG, here's a company that insures ... a huge percentage of businesses in this country. Those guarantees are what's called pari passu. They're equal in seniority to other creditors of the company.
So if you decide you're going to default to Goldman Sachs or someone that the public might want you to give a haircut to, you trigger a whole series of other outcomes which would have impacted not the Goldman Sachses of the world, but would have affected Main Street, small businesses, large businesses.
Again, think about being in those rooms when these decisions are made. You get as many facts as you can. You don't know which businesses are impacted; you just know that there are thousands of businesses, households that will be impacted if you trigger that set of events. So you swallow hard and you say this is going to be brutally painful, but what is the right thing for the economy?
But the billions and billions of dollars that went to Goldman Sachs, for instance, ... it was a hard one for the public to swallow.
Brutal, and nobody was happy about that. ...
You were there when it became public and the blowback came. Did Geithner talk about it? Was this maybe one of those decisions that in hindsight, if they had had more time, a different outcome might have been decided upon?
I don't know. You'd have to ask him. One thing we do know is the government did not have what was called "resolution authority." It had no authority to deal with the failure of an institution like AIG. There was no way to resolve it in a manageable fashion.
So one of the most important reforms, frankly, came in Dodd-Frank, and this is something that the secretary was adamant about, was that the government had to get what's called resolution authority, the ability to take apart these large, failing institutions. ...
But in that situation, you wouldn't have brought AIG down; you would have just given a haircut to the counterparties.
It's hard to speak hypothetically. I can't tell you what the resolution would have been. These are incredibly complex institutions, and any time anyone talks about "bringing one down," or "nationalizing one," or "taking one over," that's the sound bite. The substance behind it is, you have to drill down and figure out what you're going to do at every level of the organization. ...
One of the situations a lot of people got angry about also was [Secretary of the Treasury Tim] Geithner's plan to save AIG paid 100 cents on the dollar to the counterparties. What say you of that decision?
I think paying 100 cents on the dollar to the counterparties in AIG was unconscionable. ...
It was interesting that the Fed was so resistant to telling us where the money went. They resisted Congress. They resisted when Bloomberg asked for the information under the Freedom of Information Act. Bloomberg brought them to court [and] won in the district court. The Fed had the gall to appeal, to say: We're both government. We're not accountable. ...
When we got the information, we understood why they didn't want us to have it. The largest recipient was Goldman Sachs, and two or three of the other large recipients were foreign banks. If the foreign banks were at risk, then why not have the foreign governments rescue the banks? ...
But at that time there were no tools. As things started to fall apart, Bank of America was going with Merrill, Barclays wasn't a possibility, what was the feeling in the room? What was the conversation that you were having with Obama about "You know what? We're in some trouble here"?
I think when we chatted on Sunday, I think it was a call where it was kind of a wow call: "Listen, Senator, Barclays pulled out. The U.K. government said no for the most part. There was an uncomfortable feeling of taking something on as big as Lehman without knowing really what's under the hood and how would they fund it and how would this would impact Barclays and this general system." And I said to the president, then-senator, we were talking, and he goes: "Well, what does this mean? What happens at the open?"
And I think none of us felt good about the open. No one knew whether it would be contained or not contained. There was a feeling that at that point, we were kind of trying to make sure we got our own funding that we needed, and that we could open and get our repos done and get the things we needed to do. And I would say at midday it's kind of, it was almost like, "OK, let's make sure we're protecting our own castle and getting our operations ready for that Sunday night of something we've never gone through before."
But the senator was asking about, "OK, well, what do you think this means?" And we were talking about AIG. Sunday night, [he] and I talked about AIG, and what does this mean for AIG, considering everyone knew they were the big elephant in the room. He was asking what type of contagion this would have, and I was clear that, from my perspective, although we had never seen anything, "I think immediately we will see the markets and funding start to dry up, you'll see a lack of liquidity, and we're going to be in a situation of the unknown." And the one thing about Wall Street is we can do very well in the known. Good or bad, we do well with clarity. In the unknown, things tend to freeze.
And that's kind of what happened. The markets started to freeze. People were nervous about other firms. Our funding at our firm and other firms started to -- everyone started to get nervous. The overnight commercial paper market became very tenuous. So we had a situation that got a little nervous, no question.
And then soon thereafter, the president -- then-senator, excuse me -- we had a call that week about AIG. I remember that he put a call together for us to talk about AIG, because during that week, I think it was at that point [New York] Gov. [David] Paterson had an announcement that they're going to give a loan of $20 billion to AIG, but most of the market knew that that loan wasn't anywhere near the size needed. And all of a sudden you started having nervousness about a run on AIG, and what did that mean.
And the president put a call together. It was myself and Volcker and I believe Robert Rubin and Larry Summers, [both former Treasury secretaries under Clinton], where we were talking about, "OK, what would happen if the contagion starts in on AIG?" And then we started to have calls the next week on -- it may not have been the next week -- but on Fannie and Freddie and how does this hit the agencies that do a lot of housing. So what I would tell you is this president was engaged before Lehman, but once Lehman hit, I think he was all over it, thinking in a proactive and prospective way of how this was going to impact the economy and the election.
Your expert opinion as an economist as well as someone who saw it firsthand was that there was little alternative, that basically the path taken was what?
I think, number one, we, the Obama administration, attempted to put in as many tough conditions as we could, conditional on the view you can't put in so much that the whole thing still is going to fall apart, that people are going to try everything they can not to take part and take a risk that the system breaks down, because then the economy would be even worse. But that said, all pressures, in my view, we needed to and continue to need to put as much pressure to hold people accountable for the losses as we can.
So when this comes to a head in my mind is when the AIG guys, the very group that blew up and threatened to destroy the entire financial system, comes back and gets a bonus. And they hold up the firm, and they say, "Well, we're the only ones that know how to keep this from blowing up, so you give us our bonuses, or else we will blow up the world." And at that point somebody asked me, on the news, "Do you think they deserve a performance bonus?," and my answer was: "These guys deserve the Nobel Prize for evil. They don't deserve a bonus."
And they got back and they said, "You know, that was an overstatement." And yes, it was probably an overstatement. They at least deserved a nomination for the Nobel Prize for evil. And that, we're just dealing with that all the way around. It's not accurate and it's not fair to say that the administration just handed out money, didn't impose conditions and didn't think about it. That's not accurate. That's not true.
But you had Long-Term Capital happen. You had the Bear weekend go down where both times they were able to within Wall Street and with help from the Fed to save the day. Why was there no plan?
Well, I think a couple things, which is why we go to the Dodd-Frank, and really the key parts that they're trying to work out. One, just to go back, I think you may have had a different outcome if Sunday night was Merrill Lynch saved, a Lehman filing, but something about AIG as well. There was that big elephant in the room for those 72 hours that no one discussed, which was AIG. All of Wall Street knew AIG had problems. My guess is the regulators knew AIG had problems, but they didn't have a regulator that had control of AIG that was at that table, and they didn't have control, the Fed nor the Treasury, of AIG.
So I do think that in some ways, when you look at the Dodd-Frank bill and you look at the five silos of the Dodd-Frank bill, a systemic regulator, I think, is crucial for the future success of our industry, because you need to know more than what the bank holding companies are doing; you need to know what some of the large insurance companies are doing, and other financial services.
The second thing is a resolution authority is key. So how do you wind down a global interconnected financial institution that's in a myriad of countries that have all different jurisdictions? So a resolution authority is key.
So when the AIG creditors are bailed, what's Geithner thinking?
I don't know. Thumbing through the GAO report that was done on this I think, again, it was they didn't feel like they had enough time to figure it out. And so when time is pressed and information is imperfect, I guess the tendency is to be more generous not less generous. ...
When during the weekend is it clear that AIG was also going to be a huge problem?
It became clear by Saturday of the Lehman weekend that AIG was a huge problem, and that was, I believe, a total shock. ... Everybody was just thunderstruck by the demise of AIG.
... When was it clear just how damaging this could be? When did the credit markets start freezing over?
Because it was all happening together, it's somewhat difficult to distinguish what impact Lehman had, what impact AIG had. But certainly as word started to get around Saturday and Sunday about the depths of AIG's problems, that was having a huge impact.
If you even go back one week earlier when Fannie [Mae] and Freddie [Mac] failed and what, in my view, was probably the single-biggest error made in the whole crisis, to let the preferred stockholders be wiped out.
That also started to create a lot of deep concern in the credit markets, because the preferred stock was basically sold as the equivalent of debt, and if the preferred stockholders in Fannie and Freddie were going to be wiped out, then it was a baby step at most to wiping out debt holders elsewhere.
What was the role of the credit default swap in this machine?
The credit default swap became an important instrument because you could feel that you were actually insured against the loss, except for one problem: The insurance company was not really a good insurance company. It was gambling, so it didn't have the resource to back the insurance which it was riding. ...
The credit default swaps also had other functions in that they allowed, and CDOs allowed, the banks to do this outside of the view of regulators, even if one was assuming that the regulators would have been on top of it. ...
Lack of transparency and lack on understanding of what was going on was absolutely essential to the blowing up of our financial system. The regulators took at face value the insurance that was being written by AIG. AIG was effectively allowing the banks to print money willy-nilly. …
Did the regulators know generally where the credit default swaps were in the system, in other words, where the counterparty risk lay?
The way these over-the-counter credit default swap markets work is they are very non-transparent. In general, market participants could not see what was going on.
So if I were buying a share of Bank America or Citibank, there'd be absolutely no way that I could ascertain what was going on. There was no sense of market discipline, which is essential for the working of a market economy, no way that market discipline could be exercised.
We have really undermined the basic principles of capitalism, of a market economy. The regulators had the authority to demand that information, so in principle, they could have looked underneath this non-transparency. They could have said: You bought this insurance, but how do we know it's insurance? You claim it's insurance, but how do we know this company that you claim you have insurance from will be able to pay off?
In other words, is the insurer going to be solvent when there's a calamity?
Exactly, and that's why every state has regulations to make sure that insurance companies can pay off the insurance. It's a very regulated industry, because there's a long history of insurance companies taking advantage of people. ...
Well, what happened to this genius company [AIG] that went down so fast?
AIG is a rather interesting case for a whole bunch of reasons. The first is, it's an insurance company, and if you think about the business of insurance, it's about risk. So everybody sort of assumed that if anybody knew something about risk, an insurance company would.
... Under Hank Greenberg, the company had grown enormously into this trillion-dollar company -- it was like a country rather than actually a company -- but it basically had this one unit which was kind of the strange, mysterious things off-center, known as AIG Financial Products, which was completely different from the rest of the company.
... The magical moment for AIG was very early in the piece when AIG Financial Products pulled off a transaction involving the Republic of Italy. They had a billion-dollar swap, which is a derivative contract, and that netted round about $10 million in up-front earnings for AIG.
And AIG Financial Products targeted an area which other banks couldn't operate in. Because of their AAA rating, they could work with things like sovereigns, like countries. They could work with people like the World Bank, which was AAA-rated but didn't like dealing with banks unless they were AAA-rated.
So they carved out this little niche of very credit-sensitive companies and sovereigns, and they dealt with AIG Financial Products. And the other thing they did, because of the insurance company name and their rating, is they could deal with very long maturities, like 30 years, which most banks struggled with, and they were able to carve this out. And the basic business that they created was immensely profitable.
But then around about the late 1990s, early 2000s, a couple things happened to AIG Financial Products. [Founder] Howard Sosin left in very acrimonious conditions, and the company evolved. The company then started to enter into credit insurance contracts, and this is an interesting crossover into the world of securitization. ...
They thought this was like catastrophe insurance -- because they were used to taking risk in terms of insuring against hurricanes, earthquakes, all these sorts of things -- and they thought they understood credit risk, because what they were doing was taking the risk of loss on portfolios of mortgages, but the risk they were taking is basically only if the losses on that portfolio of mortgages was extremely high. And historically, house prices have already gone up; mortgage loss rates were extremely low.
So their modeling, done by their own internal people, showed this was like a 1-in-a-10,000, 1-in-a-100,000-year event which would never happen. But there was a fundamental difference between this business and the business they've done before. And that business was, essentially, if they couldn't model properly and they couldn't match the contract in some way or hedge it by a mixture of other contracts, they would never do it.
In the case of these credit insurance contracts, they just went ahead and did them, because they saw it more like an insurance business where they would set aside some money, but they would never really have to pay, because this event wouldn't occur. ...
In 2007, 2008, the problems started for them. ... As the mortgage markets started to melt down in the United States and these underlying mortgages were losing value, the potential amount of money ... on these contracts that AIG had written started to rise.
Amazingly, AIG had never even considered this issue of them having to pay us collateral, because they just assumed that they could never lose any money on these contracts and they wouldn't basically have to ever pay.
So what they were faced with as their counterparties -- these are investment banks and banks like Goldman Sachs, JPMorgan, Societe Generale -- would come to them and say, "Give me money." There were huge disputes between them, and ultimately what brought AIG to its knees was these persistent series of collateral calls based on the fact that these contracts, on paper at least, were deeply out of the money, showing deep losses to the tune of several billion dollars.
What killed AIG, or was the straw that broke the camel's back, is after having paid across already $10 billion in collateral to these various banks, they realized they had to make a payment of $18 billion to these banks. And that's because AIG was going to be downgraded below a trigger level, which was AA, which was the usual trigger put into these contracts. ...
The scale of the AIG debacle was astonishing, because it spread through the world. ...
So this is the company you said [took] $450 billion worth of bets? ... What's the sort of ratio of the debt they took versus the money they had?
... Basically they were holding minuscule amounts of reserves, or cash, against these contracts simply because they believed they would never have to pay. ... And they had completely ignored the risk that effectively, irrespective of whether or not these contracts required them to pay, if the market value of these contracts changed significantly, then what would happen is they might have to put up this surety amount. ... It was astonishing. ...
"The FRONTLINE Interviews" tell the story of history in the making. Produced in collaboration with Duke University’s Rutherfurd Living History Program. Learn more...
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