Fatal Risk

A Cautionary Tale of AIG's Corporate Suicide

Roddy Boyd

• Publisher: Wiley
• Year: 2011
• Print ISBN:
  9780470889800
• Edition: 1
• eBook ISBN:
  9781118084298
• Topic: Business
• Subtopic: Finance
• Index: Business

Long-listed for the FT & Goldman Sachs Business Book of the Year Award 2011

The true story of how risk destroys, as told through the ongoing saga of AIG

From the collapse of Bear Stearns and Lehman Brothers, the subject of the financial crisis has been well covered. However, the story central to the crisis-that of AIG-has until now remained largely untold. Fatal Risk: A Cautionary Tale of AIG's Corporate Suicide tells the inside story of what really went on inside AIG that caused it to choke on risk and nearly brining down the entire economic system. The book

• Reveals inside information available nowhere else, including the personal notes and records of key players such as the former Chairman of AIG, Hank Greenberg
• Takes readers behind the scenes at the U.S. Treasury and the Federal Reserve Bank of New York
• Details how an understanding of risk built AIG, but a disdain for government regulators led to a run-in with New York State Attorney General Eliot Spitzer

Fatal Risk is the comprehensive and compelling true story of the company at the center of the financial storm and how it nearly caused the entire economic system to collapse.

Chapter 1

The (Noncorrelated) Dream Team

In May 1997, a young man armed with a keen mind and a desire to succeed got out of a taxi at a leafy office park on Nyala Farm Road in Westport, Connecticut. Despite its location across from the busy Connecticut Turnpike, it was a surprisingly serene locale. Visitors from the concrete canyons of Manhattan’s financial district always remarked that they couldn’t believe they were only an hour from Grand Central Terminal. In every sense of the word, it was the very embodiment of the phrase, “the nearest far-away place.”

Andrew Barber, a 25-year-old options trader who had recently joined Prudential Securities, was more thankful than most to be enjoying the scenery. The breeze whistling through the trees, the absence of packed streets, and the quiet all were a thankful break from a big New York trading floor’s steam-kettle life. Born and raised in a small western New York town not far from the Pennsylvania border, he loved getting out of the city and hoped eventually to move back there. For now, though, there was no small amount of work to be done. Heading up an embryonic trading desk in a securities trading outpost of a vast insurance colossus, he was grateful for the opportunity to get in front of some people he believed might know where he was coming from.

There was potential here, Barber thought, though he had no idea what sort of business he might plausibly drum up. The men he was going to see did not much care about Prudential’s ability to sell securities in dozens of different countries, its huge balance sheet, or its boilerplate about putting the needs of the client first. They had heard variations on that pitch for around a decade now, and from men who had been at this game far longer than he had.

No, thought Barber, as he walked in the doors of a company called AIG Financial Products, none of those things appeared to matter very much to this place at all. Still, he was there, and just maybe that was enough.

Things happen here, Barber thought. It struck him that just getting in the door at places like this was a victory.

There was no way for Barber to know it at the time but he had walked into a business that was arguably one of the most distinctive in the global financial landscape. Possessing no real corporate mandate—other than to make money without risking its gilt-edged, triple-A credit rating, the place, to Barber’s way of thinking, was the financial equivalent of the National Security Agency. You were aware of it, but you had no idea what they did or how they did it. AIG Financial Products simply did as it pleased, whenever people there felt it was opportune, dealing with whomever they chose to, in the pursuit of making a buck however they saw fit.

AIGFP, or simply FP, as employees called it, had to do precious little. They had no need to pick up the phones to the big trading desks in New York and demand bids and offers for blocks of stocks and bonds, they had no outside investors fretting over last month’s earnings numbers, and no corporate managements were seeking their advice on strategy. It is no understatement to say that you could have a pretty successful career on a Wall Street trading desk in the 1980s and 1990s and would never have once encountered AIGFP on the other side of a trade. As a number of its founders acknowledge, this was all part of their plan.

But with each passing month, it became more apparent to the observant that AIGFP was a very large player in parts of the financial landscape. Investment bankers would come down to the trading floor with puzzled looks, describing conversations they had just had with equally baffled public finance officials who were using AIGFP to manage their interest rate exposure. It seemed to the bankers—and their municipal clients—that AIGFP was somehow making a killing in offering towns and cities the ability to swap their fixed-rate debt costs out for an interest rate that floated as borrowing costs rose or sank. This swap idea was hardly new, but was rarely used since someone—and it was almost always the municipal borrower—invariably got killed when rates ran up and debt that had once been cheap became suddenly quite expensive. For an investment bank, it was a public relations headache, another example of the Street’s sharks preying on the unsuspecting.1 As the story went, though, AIGFP managed to hedge out its risk and was happily taking the other side of these trades. For a fee, it even helped the cities and towns hedge their exposure to this sort of volatility, minimizing costs from swings in interest rates.

In the early 1990s, bankers to technology companies began to tell their colleagues that their clients in the Silicon Valley and along Massachusetts’s Route 128 were using AIGFP to turn their large blocks of company stock and options into ready cash. Instead of taking out a cash loan from a UBS or J. P. Morgan against their equity stake (a strategy fraught with risk since the bank could demand cash collateral or even seize the executive’s stock when the value declined enough), AIGFP used options to help corporate executives raise cash from their holdings overnight without making investors worry over the message sent by the CEO’s stock sales, or incurring the wrath of the taxman, who fretted over whether the stock had truly been sold and risk transferred.2

That interesting and lucrative things were happening at AIGFP was evident to a certain type of curious Wall Streeter—the sort who asked questions about why things were really happening, or conversely, why they were not. It was just that no one outside of Westport had answers to these sorts of questions.

This is where Andrew Barber came in because, like any dream factory, AIGFP needed a constant flow of dreamers. In this case, they needed puzzled bankers from Wall Street’s transaction factories to make the pilgrimage to Westport and unpack their dilemmas. Usually, it was a client with a certain sort of problem not amenable to the typical Wall Street banker cure-alls: the issuance of stock or bonds, a merger or sale of a unit. Rather, bankers and corporate officials came to them with the thorniest of problems: an international corporation with huge tax liabilities in one currency and large tax benefits in another that needed to have its tax payments risklessly normalized and then converted into a third currency, a privately held company that needed to rapidly (and without the hassles of Securities and Exchange Commission [SEC] registration) turn its huge and profitable holdings in some publicly held companies into some ready cash without surrendering its equity stake. Wall Street, and thus the men and women who worked there, were the canvas for AIGFP to conjure up new ways to use AIG’s rivers of cash and its titanium balance sheet to reap profits where others could not or would not.

A bright and creative thinker, Barber was just the sort AIGFP liked to deal with in the 1990s: smart enough to be doing the type of highly quantitative trading and analysis that was the sine qua non of their daily life, yet honest enough to know its limitations. Despite his relative youth, Barber was trying to build a business and was willing to talk to most anyone to see if he could get something going. This entrepreneurial spirit was a virtual necessity, since Prudential Securities—though part of a massive insurance company—was in reality a second-tier player (at best) in a financial system where first-tier firms like Goldman Sachs, Morgan Stanley, and Merrill Lynch garnered the lion’s share of customer trades and investment-banking work. On a given day, Barber would trade, research his own trading ideas, peddle a few trades to his growing book of customers and then grab a quick sit-down with the corporate finance department to explain how options and other derivatives could factor into getting some corporate client business done. It was, he had come to realize, a job that was equal parts exhilarating and utterly thankless.

Word gets around quickly on Wall Street when someone’s thinking is fresh or different. Astute investors remember when a sell-side trader challenges their assumptions or gets them to frame an investment dilemma in a different fashion. Traders are too often depicted as aggressive rogues, using bravado and ample amounts of capital to reroute a whirlwind market and carve out profits. The precise opposite is more often true: they are content to (nearly risklessly) execute trades between clients with differing investment views and goals and to hopefully earn a few cents’ profit between the bid and offer prices. Many sell-side traders and sales staff are quite good at providing clients market intelligence but much less efficient at helping clients use current conditions to frame a sober view of the future. As such, rather than the proverbial “Masters of the Universe” stereotype, they are more akin to hot-dog vendors on a Manhattan street, competing in a ruthlessly efficient and crowded market, earning a precarious living on heavy volume and narrow margins.

Not Barber.

So when a marketer at AIGFP got wind of a guy who was looking at equity options and derivatives differently, a quick phone call was made and Barber happily hopped a train to Westport.

Passing through the doors, what struck Barber was what he didn’t see at the place that a generation of Americans has now come to view with varying degrees of infamy. There were no packed trading floors, nor was there any false bravado or bonhomie among the people he met there. People were courteous, not because they particularly wanted anything from him—and he was in no position to be granting much in the way of the expensive, wheel-greasing perks institutional investors favor, like sports tickets or travel junkets—but because they seemed decent.

In fact, the more Barber thought about his time there, the feeling he got was that this was the most intentionally designed place he had ever been to in his life. Very little expense had been spared to create the perfect anti–Wall Street feeling: the main trading room, if indeed that’s what it actually was, he thought, had been set up as a series of interconnected, but free-standing desks to intentionally avoid the institutional trading desk vibe. (To get a sense of what the place really was, he had to force his eyes to track the roughly congruent layout of stacked computers and Bloomberg terminals.)

The walls of the room contained row after row of books, from arcane academic works covering the mathematical shape of interest rate curves to works on admiralty law and even copies of the corporate tax code from the 1940s. They weren’t for show; they were bookmarked, haphazardly stacked, and dog-eared, Barber noticed, and freshly so. People here wanted to know everything about subjects he hadn’t much presumed existed, let alone seen as ripe for some money making.

There was a platoon’s worth of dutiful analyst types studying those books, taking notes, comparing and contrasting things between volumes and between the book and their computers. Barber assumed they were the paralegals, junior assistants, and first-year researchers that all financial firms seem to run on. He would, in short order, learn how wrong he was.

The flatness of the organization was apparent almost immediately. While speaking with Jake DeSantis, one of the young derivatives traders he had come to know, one of the few senior managers there ambled by and, unprompted, opened up about a series of ideas he had. People walked by and talked about land purchases and shale, leases, and tax credit. Others floated into the conversation, and senior people ducked in and then out.

Were these potential trades or deals he was talking about, or simply random musings? Was Jake being asked to look into something, or was this just FP’s version of water cooler talk? At FP, he would learn, these sorts of distinctions could be immaterial. The next trade or the next deal could come from anywhere, in any asset or market sector, so everyone was open to exploring anything.

Again, the contrasts between large Wall Street firms like Prudential (and PaineWebber, where he had started trading) were striking. At those places, you could occasionally have a rewarding conversation with a supervisor, but there were so many managers and so many different corporate and political distractions that it was easier and safer to limit your contact with them. Making solid money was the safest way to avoid becoming a casualty in some investment bank’s corporate restructuring or a boss’s ego power move, but even then, there were no guarantees. Wall Street, he was coming to learn, offered many ways to die.

There was an aquarium there—one of the largest freestanding saltwater tanks in the world—that contained a decent-sized shark. A remnant from a previous tenant, the tank and its shark soon disappeared; when Barber asked why, he was told simply, “It’s just not who we are.” FP was wholly detached from the cultural norms of Wall Street and its boxing leagues, after-work drinking and strip clubs at conferences. Everything that was important to Wall Street simply got in the way at FP.

Barber would come to learn that AIGFP worked because it had the precise opposite ethos of the Wall Street salesmen who courted its business. The hustlers could keep their quick one-eighth- and one-fourth-point profits on a deal, or the extra nickels and dimes they captured on the spread between interest paid and interest received; AIGFP told people like Barber they wanted the risk because it was so often mispriced. This was a nicer way of FP’s saying that they felt they had the brain and computer power to look five years down the road and make a profitable assumption about the likely range of a stock’s price. A company with balance sheet, talented people, and a creative bent could make handsome returns over time when an executive, wanting to turn his options grants into some cash, allowed FP to strip out the volatility component of his options grant in return for cash.3

The surpassing strangeness of all this would only occur to Barber years later. In über-competitive Wall Street, where everything to do with business was held to be a secret or some proprietary formula, a customer had happily told him he could keep short-term profits and then told him that they make money—real money, into the tens of millions per trade—because they value something entirely differently than he does. Then, to complete the through-the-looking-glass aspect of it all, they told him how they do it.

On the way back to Prudential after a visit in 1998, Barber reflected on it. Am I a customer of theirs, or are they a customer of mine? He would learn the answer during his first transaction with them, a convoluted deal involving a method to extract the value from a rich dot-com executive’s stock holdings without selling the stock or risking a decline in value or tax liability.

The answer was in their worldview: AIGFP had no customers, only counterparties. As cordial and engaging as everyone there was, as willing as they were to give away the things that everyone else on Wall Street valued, Barber quickly saw that they did not negotiate on the structure of a transaction. Ever. When Barber inquired about perhaps changing a minor point here or a detail there, the answer was a firm “no.”

Everything AIGFP did was a “principal” transaction because AIG’s balance sheet and credit were always theoretically at risk. In this environment, every deal is constructed to very exacting risk tolerances, and everything and anything was a possible threat.

He would see this utter aversion to risk in action. A dozen years later Barber says he is still astounded to recall it. There were conference calls with FP that spawned more conference calls, which in turn led to meetings and calls with tax lawyers who would ask the initial risk-review-type questions but from a tax-law precedent angle. After they were done, the corporate finance lawyers weighed in. Then accountants ran the numbers to scenarios that Barber viewed as more satire than fact—wholesale shifts in the tax code back to 1970s levels, huge swings in the stock market, total corporate disruption. After that, there were people who seemingly had no connection to the transaction but who had clearly studied the deal closely and had strongly held opinions. It never really ended. Line by line, word by word, the deal’s papers were gone through, with the FP people always asking, “Do you understand?” and “Will there be a problem here?”

They were modeling the deal, he surmised, to protect themselves in the event Prudential or its customer weren’t able to live up to their obligations for any reason known to man. This struck him as odd, since Prudential in 1998 had $200 billion in assets and their customer was, at least on paper, worth hundreds of millions of dollars. “How,” he would ask colleagues many months later, “do you even develop a worldview that could model a trade to make money if a $750 billion institution failed?”

With a vetting process like this, Barber concluded, AIGFP’s concern was the opposite of his—and thus the opposite of Wall Street—in that they did not fret over where revenue was going to come from; they fretted over whether they had properly analyzed and modeled the risk that everyone else supposedly did not understand. In the vernacular, Wall Street, and all of American business, looked at transactions and worried about “upside,” wondering where additional profits could come from. At FP, people cared only about “downside,” or what could go wrong, better known as “the fat tail.”4

As he got tired, the legions of FP people who flocked around one of the smaller deals they would do in that time frame gathered strength and revisited things that had been signed off as settled simply because they wanted to. An investment bank, given that much time, could presumably have merged the United States and Canada.

Someone with whom he had struck up a ...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Cast of Characters
• Introduction
• Chapter 1 : The (Noncorrelated) Dream Team
• Chapter 2 : Who Dares, Wins
• Chapter 3 : The Man with the Plan
• Chapter 4 : Changes
• Chapter 5 : The Dirt Below
• Chapter 6 : War by Another Name
• Chapter 7 : The Kids Are Alright
• Chapter 8 : In the Shipping Business
• Chapter 9 : The Preservation Instinct
• Chapter 10 : The Down Staircase
• Chapter 11 : Midnight in September
• Epilogue
• Notes
• Acknowledgments
• Index