Taken for a ride: the man who sparked the meltdown
Joseph Cassano has been accused of single-handedly bringing down insurance giant AIG, but the inherent rot in the derivatives market reveals levels of greed, fraud and entitlement that demand scrutiny in much higher places
Tim Rayment
Updated on May 24, 2009
They were frightened for a long time, then suddenly they were angry. For millions of Americans, anxiety about a jobless, debt-laden future turned to disbelief when it emerged that AIG, the company at the centre of the world financial crisis, was handing out US$455 million in bonuses. The threats came soon after. "I want them dead!" said one of a stream of messages that caused AIG staff to travel in pairs, park in well-lit areas and dial 911 if followed. "I want their spouses dead! I want their children dead!"
This was one of the greatest bailouts in history, during the biggest challenge to world stability since the 1962 Cuban missile crisis. And AIG was paying bonuses to the very people who engineered the catastrophe.
Protesters walked the upmarket streets of Long Island Sound, an estuary northeast of New York City, in the United States, with letters for AIG executives describing the plight of homeowners. But they were in the wrong place. Because the man who knows the most about AIG's troubles is Joseph Cassano, the son of a New York City cop who lives in London, Britain. Some call Cassano "Patient Zero" and the deadly virus that he spread was incubated in a genteel square of stucco-fronted houses near Harrods department store. You can see him in Knightsbridge and he appears not to be a risk-taking type. He puts on his crash helmet and cycles off. He does not look like a person with reason to fear the arrival of the FBI.
Can one man really be to blame for killing off unfettered capitalism when it was in its prime?
Until now, the economic crisis has been seen as a giant intellectual error and AIG's multimillionaire employees were simply the people who made the biggest mistakes. There is, however, an alternative reading. This says that the furore over AIG and its bloated bonuses is a convenient distraction from the real causes of the crisis, which go to the heart of how the world is run. There is dishonesty in this collapse, on a scale almost too vast to comprehend. There are conflicts of interest in American finance and politics that make the corrupt local councillors of the mainland look like beginners. There are frauds so large and so long-standing, it is hard to see them for what they are. This reading is optimistic for those who believe in free markets, even if it is pessimistic for the US. "Capitalism has not failed," says Bernard-Henri Levy, the French philosopher. "We have failed capitalism."
Cassano, who ran AIG's financial-products division in London, "almost single-handedly is responsible for bringing AIG down and by reference the economy of this country", says Jackie Speier, a US congresswoman. "They basically took people's hard-earned money, gambled it and lost everything. I don't think the American people will be content, nor will I, until we hear the click of the handcuffs on his wrists."
This account is as satisfying as it is easy to understand. It treats the blowing up of the world financial system like a global version of Barings, the British bank that collapsed in 1995, with Cassano playing Singapore-based fraudster Nick Leeson. Cassano's unit sold billions of dollars of derivatives called credit-default swaps (CDS), allowing banks to buy risky debt without attracting the attention of regulators. AIG took the fees but didn't have the money to pay up if the loans went bad. By the time the music stopped, European banks had protected more than US$300 billion of debt with AIG's worthless "insurance". In a 21-page paper known as the "mutually assured destruction" memo, AIG claims that if the bailouts stop and the company is allowed to go bust, it will take the world with it.
But the official version overlooks many things, including episodes of fraud at AIG that go back at least 15 years. It fails to explain why Cassano left the company with a retainer of US$1 million a month and US$34 million in bonuses. And it doesn't tell us why other big companies, whose profits looked as smooth and certain as AIG's in the good times, are also fighting for survival. When Forbes published its first list of the world's biggest companies in 2004, AIG ranked third, after Citigroup, the dying bank, and General Electric, the industrial giant now drowning in its own debt. If you could think of a risk to insure, AIG was there: the company even made plans to survive a nuclear holocaust. It was built into a behemoth by one of the 20th century's corporate titans, Hank Greenberg. Less famous than the other insurance legend, Warren Buffett, Greenberg gave shareholders a return of 14 per cent a year and was equally loved.
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 "Frankenstein finance" of derivatives trading. You can thank Isaac Newton for Frankenstein finance. 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 derivatives. But there was a flaw: the City's faux physicists never went back far enough in their analysis because the data on the Bloomberg terminal covers only a tiny period of history.
"Real scientists tend to be much more sceptical about their data and their models," says William Janeway, from the private-equity firm Warburg Pincus and a Cambridge University lecturer. "The [economists] had all of the maths but none of the instincts of good scientists."
To start with, AIG trod carefully. 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 mathematicians 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 per cent of AIG's 116,000 employees, made more than US$1 billion in profits between 1987 and 1992, a vast sum at the time. But Sosin left. As 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 boss had no background in Frankenstein finance; his degree, from Brooklyn College, was in political science. His expertise was in supervising contracts and managing the lawyers and accountants. This did not matter, Greenberg thought. The London team would be scrutinised.
There were plenty of warnings that the system AIG and others were building was fatally flawed and one US regulator tried to act, but she was silenced. Brooksley Born, who monitored the futures markets, tried to extend her brief to include unregulated derivatives. Alan Greenspan and Robert Rubin, the then chairman of the Federal Reserve and Treasury secretary, respectively, 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 trading in risky, mortgage-related investments. For his advice, he earned more than US$126 million and as Citigroup collapsed, he became an adviser to US President Barack Obama.
The absence of regulation reached a level that defies belief. The US has an Office of Risk Assessment, set up in 2004 to co-ordinate risk management for the regulator, the Securities and Exchange Commission (SEC). By early last year, 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 US$596 trillion market in unregulated derivatives, including US$58 trillion in CDS, was being watched by one person. That's when he wasn't looking at the rest of the corporate world, of course.
Was Cassano's team simply the dumbest in a casino largely ignored by regulators, betting on an ever-rising housing market against the likes of Goldman Sachs? Or was the world financial system brought down by fraud - made possible by the gradual but relentless takeover of public life by an insiders' club of finance subjected to minimal supervision?
In 2001, with AIG shares trading at US$85 apiece on the New York Stock Exchange (NYSE), The Economist commissioned research into its true value and chose the little-known Seabury Analytic to do it. This was a deliberate move.
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 when a market is about to go up, and the big 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. Most analysts are upbeat: their colleagues' bonuses depend on fees from the company under scrutiny. But Freestone's company (now called Crisis Economics) is independent. He judged that AIG was highly overvalued and he would later realise 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 per cent 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 probably be certifiably insane.
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 renounced the story and condemned its "distortion of his research". He was intrigued to see the name of the author at the end of the letter - it was his and the AIG people were 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 didn't sign.
Greenberg was forceful when it came to his share price. He was often on the phone to Richard Grasso, head of the NYSE, with expletive-laden threats to move AIG to the smaller Nasdaq market 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.
What does it have to do with Joseph Cassano? Seabury Analytic's research suggests that when Cassano took over the Frankenstein finance unit, the parent company was already in trouble. "Its `distance to default' was much closer than anyone thought," says Freestone. His models would later identify AIG and three peers - Lehman Brothers, Merrill Lynch and Bear Stearns - as insolvent when the markets thought they were fine.
Another authority believes that as Cassano wrote his CDS, AIG was already doomed.
"AIG's foray into CDS was really the grand finale," says Christopher Whalen, managing director of Institutional Risk Analytics and an expert on banking who has testified before Congress. Near the end, it looked like a Ponzi scheme, "yet the Obama administration still thinks of AIG as a real company that simply took excessive risks". In other words, there was never a chance AIG would honour its contracts: its income was nowhere near enough to cover the payouts.
His assertion is not an impulse. It comes from months of talking to forensic specialists such as Freestone, insurance regulators "and members of law-enforcement focused on financial fraud".
Whalen points to AIG's occasional habit of using secret agreements to falsify financial statements - either its own or those of other companies. In 2005, John Houldsworth, a former senior executive at the insurer General Re, pleaded guilty to conspiring to misstate AIG's finances after General Re paid US$500 million in premiums for AIG to reinsure a nonexistent US$500 million risk. The transaction was a sham; the only benefit to either party was the US$5.2 million fee paid by AIG for General Re's help.
When the US$500 million in loss reserves were added to AIG's balance sheet in 2000 and 2001, Greenberg was able to claim an increase in reserves, when in fact they had declined. "They'll find ways to cook the books, won't they?" said Houldsworth in a recorded phone conversation with Elizabeth Monrad, his chief financial officer. She observed that "these deals are a little bit like morphine; it's very hard to come off of them".
Whalen believes that at some point between 2002 and 2004, AIG concluded the game was up for secret agreements and that other methods to enhance revenue were needed. "The thing I haven't answered," Whalen adds, "is whether AIG was so unstable coming out of 2000, 2001, that Cassano was trying to cover up a dying beast. Was he doubling up, to try and hit a home run and save the house? It looks like it, because otherwise it was just greed on his part and he was writing as much of this crap as he could to inflate his bonus."
If he is right, the implications are profound. Any bank that thought it was protected by CDS with AIG would have been exposed from the start, putting taxpayers at risk. It would be like a doctor telling patients they were being immunised with a vaccine when in fact they were being injected with live virus.
"The key point that neither the public, the Fed nor the Treasury seems to understand," says Whalen, "is that the CDS contracts written by AIG were shams, with no correlation between fees paid and the risk assumed. These were not valid contracts but acts to manipulate the capital positions and earnings of financial companies around the world."
The investigation into the General Re affair prompted AIG to oust Greenberg in 2005. He has always denied any wrongdoing. In fact, he is suing AIG, claiming his successors abandoned risk controls and destroyed the firm.
The old man's departure meant the brakes were off for Cassano; the new chief executive, Martin Sullivan, had risen through the "property and casualty" side of the business. As he is fond of pointing out, he is not an accountant. Who would scrutinise the financial-products team now? The pace of CDS deals suddenly accelerated. He had realised that subprime mortgages accounted for an increasing proportion of his trades and that the standards of underwriting were shockingly lax. No model, however carefully constructed, can protect you from that. It was too late: the bomb on AIG's books was ticking. Alpha males such as Cassano push at boundaries. You could say it is their evolutionary purpose. That is one reason we need governments, to protect us when male ambition reaches too far. But our governments were mesmerised by people such as Cassano.
"From 1973 to 1985," says Simon Johnson, a former chief economist at the International Monetary Fund, "the financial sector never earned more than 16 per cent of [US] corporate profits. This decade, it reached 41 per cent." The whole point of financial companies is to allocate your savings to those who can use the money best. If they are taking 41 per cent of the profit in an economy, something is out of balance. These figures reveal an enormous transfer of wealth.
Which brings us back to bonuses. In August 2007, as the financial crisis broke, Cassano claimed everything was fine. "It is hard for us, and without being flippant, to even see a scenario, within any kind of realm or reason, that would see us losing US$1 in any of those transactions," he told investors, as his chief executive listened in on the call. But it seemed to be a different story inside AIG. The company had hired Joseph St Denis, a former SEC official, as part of an effort to improve its internal controls. Cassano shut him out. "I have deliberately excluded you from the valuation of the super seniors [debt products] because I was concerned that you would pollute the process," St Denis recalls Cassano saying. The auditor resigned in protest, yet the minutes of AIG's audit committee show no sign of concern.
In the final three months of 2007, AIG lost more than US$5 billion. Under the terms of the bonus scheme, top executives should have had their pay cut for poor performance. When the compensation committee met in March last year to award bonuses, however, Sullivan urged it to ignore the losses. The board approved, even though losses were growing monthly, and Sullivan pocketed US$5.4 million. He was also awarded a golden parachute worth US$15 million. He was out of the company three months later with a severance package worth US$47 million. That is US$39,500 for every day he was in charge. Pension funds and other savers holding AIG shares lost US$58.4 million a day during his tenure.
In seven years, the 400 employees in Cassano's division were paid US$3.5 billion. Cassano received US$280 million. When the losses became public, AIG parted company with him. But he wasn't fired: he "retired", with a contract to pay him US$1 million a month for nine months and protect his right to more bonus payments.
Cassano's division then imploded. As house prices fell, credit ratings were cut and bankers began to panic, AIG posted the biggest quarterly loss in corporate history: US$61.7 billion. This is equivalent to losing US$28 million an hour, every hour, for the final three months of 2008. But by now, the company's problems were the property of the American taxpayer, creating extraordinary new conflicts of interest. Hank Paulson, the Treasury secretary in the outgoing Bush administration, was an ex-chief executive of Goldman Sachs. He received tax benefits of about US$200 million for taking on a government role. When the US decided to bail out AIG, the chief beneficiary of the rescue was Goldman Sachs, which received US$12.9 billion of public funds via the insurer.
AIG tried to hide its payments to Goldman Sachs and others, somehow imagining you could have US$182.5 billion of taxpayers' money and not say how you were using it.
The task facing Obama is even greater than we imagine. Intellectually, the president might see what is required but execution still depends on the bankers club that helped bring about the collapse in the first place.
"It is not outright fraud that has caused the most damage to the market," says Freestone, the analyst who first saw problems at AIG. "It is the suppression of information, wittingly or unwittingly, by most of the market's players." Although AIG's early trades showed genuine brilliance, their later CDS deals, many of which were not even hedged, were as foolish as can be. Was it fraud? Yes, in the widest sense - but it was fraud as wilful ignorance, in which an industry is based on false assumptions and each participant has little reason to question the system as long as it continues to make him rich.
"There is no need for an overt conspiracy, or to be incompetent," says an internet poster called Anonymous Jones. "When there are enormous incentives for each participant to cheat, the efficiency of any market breaks down."
In recent weeks, Cassano has grown a beard and changed his crash helmet, which is no longer red but silver. The disguise might not be enough; prosecutors are said to be close to criminal charges. They think he misled investors, an easier case to make than that of knowingly risking the financial system. "To date, neither AIG nor AIGFP is aware of any fraud or malfeasance in connection with the underwriting and creation of the multisector CDS portfolio," says AIG, referring to the trades under scrutiny, "as opposed to what, with hindsight, turned out to be bad business decisions."
If they were bad decisions, they had a context. "Once people who push boundaries realise that the police don't want to issue tickets," says Charles Ortel, managing director of Newport Value Partners, a firm that provides research to investors, "they start pushing. `If you're not going to arrest me for going 10mph over the speed limit, well, I'll try 20. If I can do 20, I'll try 30. And then I'll try flying a plane down the road.'"
The Sunday Times