But Greenberg faced a problem. Insurance is not like iPods, where if you
invent the market, growth comes fast. Over time, it performs in line with
the economy. In 1987 he found an answer: AIG would enter a joint venture
with Howard Sosin, a pioneer in the new “Frankenfinance” of derivatives
trading. You can thank Sir Isaac Newton for Frankenfinance. By showing in
the 17th century that the universe conforms to natural laws, he encouraged
our age to see money as a branch of physics. Starting in 1952, two
generations of economists worked to show that people are like molecules,
whose behaviour can be predicted in ways that are stable over time. Science
then infected everything, from how much capital banks need to protect
themselves against insolvency, to the risk in credit-default swaps. But
there was a flaw: the City’s faux physicists never go back far enough in
their analysis, because the data on the Bloomberg terminal cover a tiny
period of history. “Real scientists tend to be much more sceptical about
their data and their models,” says William Janeway, an MD of the
private-equity firm Warburg Pincus and a Cambridge University lecturer.
“They had all of the maths, but none of the instincts of good scientists.”
There is also the 4x4 effect: if you give people a safer car (read, a safer
world through financial innovation), they tend to drive faster. But we are
getting ahead of ourselves.
To start with, AIG trod carefully in the new, scientific universe. Sosin’s
idea was to buy financial risk from people who did not want it, then sell
the risk to others in a series of “hedges” so that AIG kept the fees but not
the risk. If a big organisation wanted to lock in an interest rate, for
example, AIG would promise to pay the difference in costs if rates rose,
then pass the risk to other parties in separate contracts. Sosin supplied
the nerds and the models, AIG supplied the reassurance of its AAA rating,
and for a long time the alchemy worked. AIG Financial Products (AIGFP), a
unit with 0.3% of AIG’s 116,000 employees, made over $1 billion in profits
between 1987 and 1992, a vast sum at the time. But Sosin left. And so did
his successor, a mathematician named Tom Savage. When Savage departed in
2001, Greenberg put in charge a man he saw as “smart, tough and aggressive”:
the unit’s chief operating officer, Joseph Cassano. The new leader had no
background in Frankenfinance; his degree, from Brooklyn College, was in
political science. The cop’s kid had ascended through what is called the
“back office”: his expertise was in supervising the contracts and running
the lawyers and accountants. This did not matter, Greenberg thought.
Underlings had the right maths, and besides, Greenberg’s AIG held everyone,
Cassano included, to account. The London team would be scrutinised. Which
was just as well, as the huge intellectual error meant nobody else was in
charge. “Why did no-one see it coming?” asked the Queen last November, on a
visit to the London School of Economics. Well, they did, ma’am. Charles
Bowsher, head of the US government’s General Accounting Office, testified as
long ago as 1994 that “the sudden failure or abrupt withdrawal from trading”
of large dealers in derivatives “could cause liquidity problems in the
markets and could also pose risks to others, including… the financial system
as a whole”. It took another 13 years, but that is exactly what happened.
One regulator tried to act on Bowsher’s warning, but she was silenced.
Brooksley Born, who monitored the futures markets, tried to extend her remit
to unregulated derivatives. Alan Greenspan and Robert Rubin, the then
Treasury secretary, persuaded Congress to freeze her already limited power,
forcing her departure. Rubin had come into government from Goldman Sachs;
when he left he went back to banking, and pushed for Citigroup to step up
its trading of risky, mortgage-related investments. For his advice, he
earned over $126m (£84m) and then, as Citigroup collapsed, became an adviser
to Barack Obama. After Greenspan stepped down from the US central bank in
2006, he became a consultant to Pimco, the world’s biggest bond fund, where
his insights have been praised by his boss. “He’s made and saved billions of
dollars for Pimco already,” said Bill Gross last year. Greenspan is also an
adviser to Paulson & Co, a hedge-fund group that has made billions from
the collapse in American housing.
The lightness of touch reached a level that defies belief. America has an
Office of Risk Assessment, set up in 2004 to co-ordinate risk management for
the main regulator, the Securities and Exchange Commission (SEC). Jonathan
Sokobin, its director, says it is charged with “understanding how financial
markets are changing, to identify potential and existing risks at regulated
and unregulated entities”. According to its website, it also helps to
“anticipate, identify and manage risks, focusing on early identification of
new or resurgent forms of fraud and illegal or questionable activities…
across the corporate and financial sector”. By early 2008, this office was
reduced to a staff of one. “When that gentleman would go home at night,”
says Lynn Turner, the SEC’s former chief accountant, “he could turn the
lights out. We had gotten down to just one person at the SEC responsible for
identifying the risk at all the institutions.” The $596-trillion market in
unregulated derivatives, including $58 trillion in credit-default swaps, was
being watched by one person. That’s when he wasn’t looking at the rest
of the corporate world, of course.
We are in a hotel in London, sitting on cracked red leather sofas. The
interview is with one of the finest analysts of financial statements on the
planet. Where you or I see pages of numbers, he sees a narrative. Sometimes
the theme is a company’s potential for growth. Sometimes it is the prospect
of self-destruction. And at times the story does not make sense, because the
figures are hiding a fraud. Charles Ortel, managing director of Newport
Value Partners — a firm that provides research to professional investors —
is explaining the potential for fraud in insurance. Insurers share their big
risks with others. Imagine it is September 12, 2001, and you get a report on
the previous day’s terrorist attacks. You don’t know your loss, because it
takes time for victims to come forward and costs to be calculated. You
decide it’s $12 billion and do a deal with another insurer: I will write you
a cheque now for $9 billion, and we agree my liability is capped at $12
billion. If the eventual losses are higher, the second insurer will pay. In
the meantime, it is free to invest the $9 billion. Insurers make much of
their money from investing premiums while they wait for a claim.
The second insurer can book some of the $9 billion as income. It shouldn’t,
because it is exposed to risk. But there’s flexibility in how the numbers
can be treated. If the second insurer is not having a good year, the
flexibility creates the temptation to book phantom earnings, illegally
supporting the share price. In the past, AIG has admitted episodes of
improper accounting.
One question has not been answered. Was Cassano’s team simply the dumbest in
the room, betting on an ever-rising housing market against the likes of
Goldman Sachs? Or was the world financial system brought down by fraud — a
fraud made possible by the gradual but relentless takeover of public life by
the insiders’ club of finance?
In 2001, with AIG trading at $85 on the New York Stock Exchange, The Economist
decided to commission some research on the company’s true value, and
chose the little-known firm Seabury Analytic to do it. This was deliberate.
The magazine’s New York bureau chief, Tom Easton, had been around long
enough to know that nobody on Wall Street ever says “sell”, except perhaps
when a market is about to go up, and that the big security firms could not
be trusted to give a candid view of AIG.
The research, which took five months, was the work of a team led by Tim
Freestone, who is speaking here for the first time. Most analysts are
upbeat: their colleagues’ bonuses depend on fees from the company under
scrutiny. But Freestone’s firm (now called Crisis Economics) is independent.
He judged that AIG was highly overvalued, and he would later realise that
its shares were supported by an ability to stifle criticism. In his report
for The Economist, however, he was tactful. To justify the share price, he
said, “it would have to grow about 63% faster than [its] peers for the next
25 years. If investors believe that AIG can sustain this type of performance
for that period of time, then AIG is properly valued”. Any investor who
believed that would need to be certified.
After the article came out, researchers from the big banks contacted him,
incredulous that he had dug deeper than the industry norm and dared to
release the findings. They seemed to be in awe, and at the same time
jealous; nobody breaks the rules like this — not without paying a price. A
delegation from AIG arrived at his office and presented him with a letter
that seemed to renounce the story and to condemn its distortion of his
research. He was intrigued to see the author’s name at the end of the letter
— why, it was his name, and the AIG contingent was awaiting his signature.
The company also sent its executives on a private plane to The Economist
headquarters in London to demand a retraction. Legal threats followed.
“I assumed AIG was attempting to railroad us out of business,” says Freestone,
who did not sign.
Greenberg was forceful when it came to his share price. He was often on the
phone to Richard Grasso, the head of the New York Stock Exchange, with
expletive-laden threats to move AIG to the Nasdaq unless the exchange did a
better job. Grasso would then be seen on the floor of the exchange, talking
to the market-maker for the stock. Grasso says he never asked the
market-maker to bid the shares higher, which is just as well: both men could
have gone to jail.
