Michael Lewis has big story on AIG in Vanity Fair. (See also Carney’s discussion of the story, and his link to old AIG ads that gave me the idea for the above picture, which I also have hanging on the wall of my office).
Some of Lewis's story deals with the finance of what crashed AIG, and threatened the rest of the financial world. I wrote about that last March:
AIG was supposedly insuring risky paper for both banks and money funds. AIG got fees, the banks and the money funds got to look better. The problem is that AIG's plan for covering the risk was to assume, along with everybody else . . . that real estate prices would only go up. In other words, everybody was living in a Pee Wee Herman-like fantasy world.
More specifically, AIG was, in effect, selling its AAA credit rating to help game regulatory capital requirements. See Joe Nocera's excellent article, also from last March.
Lewis’s article does break new ground in explaining in more detail why this happened. Lewis blames everything on Joe Cassano, head of AIG Financial Products, whom Lewis dubs “the man who crashed the world.” According to Lewis, Cassano was not a financial wizard – just a back office guy with “a real talent for bullying people who doubted him.” He became ascendant when the man who put him in power, and who could control him (Hank Greenberg), was forced to resign by Eliot Spitzer (so, hey, let's blame all this on Spitzer).
Cassano didn’t understand what a mistake it was to apply financial models based on corporate credit to consumer loans, and specifically subprime. Indeed, apparently nobody at AIG understood what a big part of its portfolio subprime was. By the time AIG figured this out and pulled the plug in 2005, the damage to financial markets and to AIG had already been done.
All this still leaves me with two questions: first, how did Cassano get away with essentially betting all of AIG’s billions on risks that nobody in the firm really understood? And, second, why did hedge funds largely avoid similar folly?
In my view, the questions and answers are related. Foolish people are ubiquitous, but incentive and control systems can be, and sometimes are, designed to constrain folly. These include, as I’ve repeatedly argued, the “uncorporate” structure of hedge funds, as contrasted with the corporate structure of firms like AIG.
Many commentators have gotten this general point, but they stress the wrong details -- the perversity of corporate executive compensation, and the vicarious partnership liability that Wall Street firms left behind when they incorporated in the 1990s.
These explanations never wholly convinced me. After all, many executives at firms like AIG, Bear and Lehman bet their personal wealth on their firms. This would seem to have gotten their attention much more directly than marginal accretions to wealth through compensation. The fact that they owned limited liability firms doesn’t necessarily undercut their incentives, since bankruptcy law essentially gives everybody limited liability – you can’t lose more than all you have. Perhaps vicarious liability investors would have paid more attention, but it's doubtful that would have caused them to figure out the problem.
What I find more convincing is this little excerpt from Lewis’s article:
The typical hedge fund or private-equity fund has to schlep around and raise money all the time, and post collateral with big Wall Street firms for all the trades they do. The traders at A.I.G. F.P. had essentially unlimited capital on tap from the parent company, along with the AAA rating, rent-free.
Hedge funds have to “schlep around and raise money all the time” because their investors, unlike corporate shareholders, do not give them permanent capital. While corporate shareholders can sell their shares to other investors at current market prices, sale prices are discounted by the market’s evaluation of current management. Hedge fund investors, by contrast, have rights to get their money back from the company.
In other words, it’s the “capital lock-in” of the corporate structure – which some commentators have credited for the rise of modern capitalism, that is to some extent responsible for its recent fall. For better or worse, corporate cash is stuck for all time, as the AIG ad suggests.
So what should happen now? Should all financial institutions be uncorporations (or owned by the government)? No, but markets have now learned more about the risks of having traditional corporations manage complex financial instruments. And, yes, markets do learn. Consider why, as Lewis observed, hedge funds have to post collateral for trades with their brokers: because they did learn a lesson from Long Term Capital Management.
Of course a new round of SOX-like financial regulation is likely to short-circuit that learning process. But that's another story.
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