One failing of at
least some of those who inhabit the academic world is a
relentlessly popular and hopelessly arrogant delusion that human
behavior can be reduced to formulas that others can or should rely on.
finance experts seem especially guilty in this respect, having dreamed up
models that regularly fail to predict anything that might be of value to
those who must make decisions about what the future holds.
One of the funniest
example of analytical incompetence is hearing some of these so-called experts
explain away equity, commodity, credit and other bubbles as if they were
"exceptions" -- or didn't really exist at all.
In my view,
any economist who claims, for example, that there was never a bubble in
housing -- and plenty of these deniers exist -- should be stripped of
their credentials and sent to live in one of those down-and-out
communities where foreclosures are rampant for a bit of reality training.
Along similar lines,
today's Wall Street Journal
features a report by Carrick Mollenkamp, Serena Ng, Liam Pleven and
Randall Smith, entitled "Behind AIG's Fall, Risk Models Failed to Pass Real-World
Test," that helps explain how reckless academics and
their bogus theories contributed to the collapse of what was once the
world's largest insurer.
Gary Gorton, a
57-year-old finance professor and jazz buff, is emerging as an unlikely
central figure in the near-collapse of American International Group Inc.
Mr. Gorton, who
teaches at Yale School of Management, is best known for his influential
academic papers, which have been cited in speeches by Federal Reserve
Chairman Ben Bernanke. But he also has a lucrative part-time gig: devising
computer models used by the giant insurer to gauge risk in more than $400
billion of devilishly complicated deals called credit-default swaps.
AIG relied on those
models to help figure out which swap deals were safe. But AIG didn't
anticipate how market forces and contract terms not weighed by the models
would turn the swaps, over the short term, into huge financial liabilities. AIG
didn't assign Mr. Gorton to assess those threats, and knew that his models
didn't consider them. Those risks have cost AIG tens of billions of dollars
and pushed the federal government to rescue the company in September.
The global financial
crisis is studded with tales of venerable financial firms failing to protect
themselves against the unexpected. In the case of AIG, as with many other
firms, the financial horrors were hidden in the enormous market for
credit-default swaps, which are a form of insurance against defaults on all
sorts of debts.
A close look at AIG's
risk-management operations, and the rapid-fire chain of events that crippled
the firm, raises questions about the run-up to the financial crisis: Did
firms like AIG plunge into lucrative but perilous new markets without
thoroughly understanding the pitfalls? Had the sheer complexity of the
financial products made it all but impossible to fully calculate the risk? And
did firms put too much faith in computer models to assess dangers?
The turmoil at
AIG is likely to fan skepticism about the complicated, computer-driven
modeling systems that many financial giants rely on to minimize risk. As
chief executive of Berkshire Hathaway Inc., which owns insurance companies,
Warren Buffett has been sounding the alarm about the issue for years. Recently,
he told PBS interviewer Charlie Rose: "All I can say is, beware of geeks...bearing
Last December, at a
meeting with investors, Martin Sullivan, then AIG's chief executive officer,
told investors concerned about exposure to credit-default swaps that models
helped give AIG "a very high level of comfort." Mr. Gorton explained
at the meeting that "no transaction is approved" by the chief of
AIG's financial-products unit "if it's not based on a model that we
Now, a federal
criminal probe in Washington is examining whether AIG executives misled
investors at that meeting, and whether any of its executives misled its
outside auditor last fall. AIG itself has been forced to post about $50
billion in collateral to its trading partners, largely to offset sharp drops
in the value of securities it insured with the credit-default swaps. These
payments have continued to balloon after the bailout -- raising the specter
that the government will eventually have to lend more taxpayer money to AIG.
This account of AIG's
risk-management blunders is based on more than two dozen interviews with
current and former AIG executives, AIG's trading partners and others with
direct knowledge of the firm, as well as internal AIG documents, regulatory
filings and congressional testimony. Mr. Gorton, who continues to be a paid
AIG consultant, referred questions about his role to AIG. Mr. Sullivan
declined to comment.
credit-default-swaps operation was run out of its AIG Financial Products
Corp. unit, which had offices in London and Wilton, Conn. In essence, AIG
sold insurance on billions of dollars of debt securities backed by everything
from corporate loans to subprime mortgages to auto loans to credit-card
receivables. It promised buyers of the swaps that if the debt securities
defaulted, AIG would make good on them. AIG executives, not Mr. Gorton,
decided which swaps to sell and how to price them.
The swaps expose AIG
to three types of financial pain. If the debt securities default, AIG has to
pay up. But there are two other financial risks as well. The buyers of the
swaps -- AIG's "counterparties" or trading partners on the deals --
typically have the right to demand collateral from AIG if the securities
being insured by the swaps decline in value, or if AIG's own corporate-debt
rating is cut. In addition, AIG is obliged to account for the contracts on
its own books based on their market values. If those values fall, AIG has to
Mr. Gorton's models
harnessed mounds of historical data to focus on the likelihood of default,
and his work may indeed prove accurate on that front. But as AIG was aware,
his models didn't attempt to measure the risk of future collateral calls or
write-downs, which have devastated AIG's finances.
The problem for AIG
is that it didn't apply effective models for valuing the swaps and for
collateral risk until the second half of 2007, long after the swaps were
sold, AIG documents and investor presentations indicate. The firm left itself
exposed to potentially large collateral calls because it had agreed to insure
so much debt without protecting itself adequately through hedging.
The credit crisis
hammered the markets for debt securities, sparking tough negotiations between
AIG and its trading partners over how much more collateral AIG should have to
post. Goldman Sachs Group Inc., for instance, has pried from AIG $8 billion
to $9 billion, covering virtually all its exposure to AIG -- most of it
before the U.S. stepped in.
continued after the government bailout. AIG already has borrowed $83.5
billion from the Federal Reserve, a little more than two-thirds of the $123
billion in taxpayer loans made available to AIG so far. In addition, AIG
affiliates recently obtained from the government as much as $21 billion in
short-term loans called commercial paper. Much of the $83.5 billion has been
used to meet the financial obligations of the financial-products unit. If
turmoil in the markets causes prices of many assets to fall further, the
government might have to cough up more money to help keep AIG afloat. Cutting
it off would risk renewing the market upheaval the policy makers have
struggled to tame.
Mr. Gorton, the son
of a Phoenix psychiatrist, took a circuitous route to academia. He studied
Mandarin, considered becoming an actor and briefly drove a cab in Cleveland, where he carried a gun for protection, he later told acquaintances. Eventually,
he collected multiple degrees, including a Ph.D. in economics, and joined the
faculty of the Wharton School of the University of Pennsylvania.
He drove an old
Volkswagen Beetle, lived in a gritty North Philadelphia row house and
accumulated a vast trove of jazz records, which he would cue up at night on
two turntables to keep the music coming, recalls his wife at the time, Rachel
He was passionate
about mathematics, engaging in late-night conversations with fellow teachers,
says Ms. Bliss. One of his academic interests was how banks could unload risk
and sell loans to investors.
In 1987, AIG launched
its financial-products unit with Howard Sosin, a math expert and former
Drexel Burnham Lambert executive. Among his hires were Joseph Cassano, a
former Drexel colleague. After Mr. Sosin left, Mr. Gorton joined as a
consultant in the late 1990s. Mr. Cassano later took over the unit.
Early on, Mr. Gorton
billed AIG about $250 an hour, which likely would have netted him about
$200,000 a year, says a former senior executive at the unit. Eventually, his
pay was far greater; another former colleague estimates it at $1 million a
Mr. Gorton collected
vast amounts of data and built models to forecast losses on pools of assets
such as home loans and corporate bonds. Speaking to investors last December,
Mr. Cassano credited Mr. Gorton with "developing the intuition"
that he and another top executive had "relied on in a great deal of the
modeling that we've done and the business that we've created."
selling credit-default swaps around 1998. Mr. Gorton's work "helped
convince Cassano that these things were only gold, that if anybody paid you
to take on these risks, it was free money" because AIG would never have
to make payments to cover actual defaults, according to the former senior
executive at the unit. However, Mr. Gorton's work didn't address the
potential write-downs or collateral payments to trading partners.
AIG became one of the
largest sellers of credit-default-swap protection, according to a Moody's
Investors Service report last week. For years, the business was extremely
lucrative. In a 2006 SEC filing, AIG said none of the swap deals now causing
it pain had ever experienced high enough defaults to consider the likelihood
of making a payout more than "remote, even in severe recessionary market
AIG charged its
trading partners a fraction of a penny a year for every dollar of credit
protection. The company realized, of course, that it might have to post
collateral if the market values of the underlying securities declined. But
AIG executives believed that such price moves were unlikely to occur,
according to people familiar with AIG's operation.
As the debt
securities created by Wall Street became more complicated, so did the swaps
AIG offered. Around 2004, it began selling swaps designed to provide
insurance on securities called collateralized-debt obligations, or CDOs, that
were backed by securities such as mortgage bonds. Merrill Lynch & Co.,
then a major seller of the CDOs, was a big client.
CDOs, in particular, were exceptionally complex, involving more than 100
securities, each backed by multiple mortgages, auto loans or credit-card
receivables. Their performance depended on tens of thousands of disparate
loans whose value was hard to determine and performance difficult to
systematically predict. In assessing their risk, Mr. Gorton constructed
worst-case scenarios that factored in the probability of defaults on the
In late 2005, senior
executives at the unit grew worried about loosening lending standards in the
subprime-mortgage market. AIG decided to stop selling credit protection on
multisector CDOs, partly due to "concerns that the model was not going
to be able to handle declining underwriting standards," Mr. Gorton told
investors last December. But by the time it stopped, in early 2006, its
exposure to multisector CDOs had ballooned to $80 billion.
By mid-2007, as the
housing slump took hold, the subprime mortgage market was weakening and many
mortgage bonds were sinking in value. Ratings agencies began downgrading many
mortgage securities, a departure from the historical pattern, Mr. Gorton
later explained to investors. Concern began mounting about AIG's
credit-default swaps, even though AIG didn't have large exposures to
subprime-mortgage bonds issued in the worst years of 2006 and 2007.
partners were worried. Goldman Sachs held swaps from AIG that insured about
$20 billion of securities. In August 2007, Goldman demanded $1.5 billion in
collateral, arguing that the assets backing the securities were falling in
value. AIG argued that the demand was excessive, and the two firms eventually
agreed that AIG would post $450 million to Goldman, this person says.
Late last October,
Goldman asked for even more collateral, $3 billion. Again, AIG disagreed, and
it ultimately posted $1.5 billion. Goldman hedged its exposure by making a
bearish bet on AIG, buying credit-default swaps on AIG's own debt, according
to one person knowledgeable about this move.
When AIG's outside
auditor, PricewaterhouseCoopers LLP, learned about Goldman's demands, it
reviewed the value of the swaps, according to a Pricewaterhouse official
cited in minutes of a meeting of the audit committee of AIG's board. Last
November, when AIG reported third-quarter results, it took its first major
write-down on the swaps, lowering their value by $352 million.
That same month,
collateral calls came in from Merrill and Société
Générale SA, says the person familiar with AIG's finances. It's
not clear how much those two banks asked for, or how much they got.
AIG decided to talk
to investors last Dec. 5 about the financial-product unit's exposure to the
mortgage market. A Pricewaterhouse official said his firm told AIG's
then-CEO, Mr. Sullivan, and a deputy six days before the event that AIG might
have a "material weakness" in its risk management, according to
minutes of a Jan. 15 meeting of AIG's audit committee. Pricewaterhouse
declined to comment.
In his presentation
to investors, held at New York's Metropolitan Club, Mr. Sullivan praised the
unit's models as "very reliable" in analyzing many mortgages,
saying they had helped give AIG "a very high level of comfort."
Mr. Gorton was
introduced. "The models are all extremely simple," he said. "They're
highly data intensive." He said he didn't rely on the default-risk
predictions of credit-rating services, and instead came up with his own
estimates of what was safe enough for AIG to insure.
Mr. Cassano, the
unit's head, told investors: "We believe this is a money-good
portfolio....As Gary said, the models we use are simple, they're specific and
they're highly conservative."
But the collateral
calls kept coming. By the end of 2007, at least four other banks that had
purchased swaps from AIG -- UBS AG, Barclays PLC, Credit Agricole SA's Calyon
investment-banking unit and Royal Bank of Scotland Group PLC -- had asked for
money, according to people familiar with collateral calls. Deutsche Bank and
Canadian banks CIBC and Bank of Montreal also have demanded collateral at
various points, a person familiar with AIG's finances says.
In February, AIG
disclosed that Pricewaterhouse had found a "material weakness" in
its accounting controls. Late that month, AIG announced a $5.3 billion
fourth-quarter loss, its largest ever, driven largely by write-downs on the
swaps. It also said it was "possible" that actual losses on the
swaps could be material.
Mr. Sullivan told
investors that Mr. Cassano, the unit's head, was retiring. He remained a
consultant, receiving, until recently, $1 million a month, according to a
document later released by Congress.
In May, AIG announced
another record quarterly loss, of $7.8 billion, largely driven by write-downs
of the value of the swaps. That same month, Yale's School of Management announced it had hired Mr. Gorton away from Wharton.
Mr. Sullivan was
ousted in June. As of July 31, AIG had handed over $16.5 billion in
collateral on its swaps, according to a regulatory filing.
By August, AIG had
increased its estimates for what it might ultimately lose on the swaps in the
case of defaults to as high as $8.5 billion. (The estimates are distinct from
potential losses on write-downs and collateral calls.) That same month, Mr.
Gorton attended the Federal Reserve Bank of Kansas City's annual gathering in
Jackson Hole, Wyo. He presented a 92-page paper, "The Panic of
2007," which explained how the financial markets came unglued after a series
of unexpected events, such as when clients of financial firms suddenly sought
to reclaim assets put up as collateral. "It is difficult to
convey," he wrote, "the ferocity of the fights over
worsened in late August and September, and AIG's trading partners demanded
additional collateral. When Lehman Brothers Holdings Inc. filed for
bankruptcy protection on Sept. 15, bond markets essentially froze. That same
day, rating agencies slashed AIG's credit ratings. Company executives figured
the downgrade would require AIG to post more than $18 billion in additional
collateral to its trading partners, according to a person familiar with the
matter. Worried that a bankruptcy filing could roil markets world-wide, the
government stepped in with a bailout.
The rescue didn't
stop the collateral calls, which have eaten up much of the government's
initial $85 billion loan commitment, which on Oct. 8 it boosted to $123
On a rainy morning
last week, Mr. Gorton briefly discussed with his Yale students how perplexing
the struggles of the financial world have become. About 30 graduate students
listened as Mr. Gorton lamented how problems in one sector caused investors
to question value all across the board. Said Mr. Gorton: "There doesn't seem
to be a fundamental reason why."
Michael J. Panzner
J. Panzner is a 25-year veteran of the global stock, bond, and currency
markets and the author of Financial Armageddon: Protecting Your Future from
Four Impending Catastrophes, published by Kaplan Publishing.