How AIG FP brought down the world

By Felix Salmon
July 2, 2009

Michael Lewis is back in Vanity Fair, with a really good article about Joseph Cassano and AIG Financial Products. Or half of a really good article, at any rate — the second half of the story is fantastic, and gives by far the best English-language account of what happened at FP and how Cassano, by commission and omission, enabled it. (The piece isn’t online, just a précis — I do hope VF gives up this annoying habit soon.)

There’s a bit too much irrelevant throat-clearing at the beginning of the piece, though, and there’s also this very peculiar passage:

The public explanation of AIG’s failure focused on the credit-default swaps sold by traders at AIG FP, when AIG’s problems were clearly broader. There was the mortgage-insurance unit in North Carolina, United Guaranty, that had taken on all sorts of silly risks in the past two years, lost several billion dollars, and replaced their CEO. There were the fund managers at AIG, the parent company, who had blown nearly $50 billion in trades in subprime mortgages — that is, they had lost more than AIG FP, whose losses stood at around $45 billion.

Later on in the piece, after it starts getting good, Lewis explains how “if it hadn’t been for AIG FP the subprime-mortgage machine might never have been built, and the financial crisis might never have happened”. So doesn’t it make perfect sense for the public explanation of AIG’s failure to focus on FP? After all, as Lewis shows, FP literally had no idea what it was doing. He tells the story of Gene Park, who examined FP’s business at the end of 2005 and found that it was insuring deals which were 95% subprime:

Park then conducted a little survey, asking the people around AIG FP most directly involved in insuring them how much subprime was in them. He asked Gary Gorton, a Yale professor who had helped build the model Cassano used to price the credit-default swaps. Gorton guessed the piles were no more than 10 percent subprime. He asked a risk analyst in London, who guessed 20 percent. He asked Al Frost [FP's main liaison to Wall Street], who had no clue.

Cassano simply trusted the models (which were built with a lot of Gorton’s help), even when the models weren’t designed for subprime in particular, or even really for mortgages.

I guess the message of Lewis’s piece is that FP caused the global financial crisis, even if it didn’t necessarily cause the complete downfall of AIG — that AIG ended up buying in to the bubble created by FP, just companies like Citigroup and Bear Stearns did. Or, to put it another way, FP brought down the financial markets, and the crashing financial markets brought down AIG. You can blame the end of the world on Cassano, but there were a lot of people inside AIG but outside Cassano’s little group who ended up buying into the markets he helped to create and inflate.

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