Quiet conflict with Goldman helped push AIG to precipice
POSTED: Sunday, February 07, 2010
Billions of dollars were at stake when 21 executives of Goldman Sachs and the American International Group convened a conference call on Jan. 28, 2008, to try to resolve a rancorous dispute that had been escalating for months.
AIG had long insured complex mortgage securities owned by Goldman and other firms against possible defaults. With the housing crisis deepening, AIG, once the world's biggest insurer, had already paid Goldman $2 billion to cover losses the bank said it might suffer.
AIG executives wanted some of its money back, insisting that Goldman—like a homeowner overestimating the damages in a storm to get a bigger insurance payment—had inflated the potential losses. Goldman countered that it was owed even more, while also resisting consulting with third parties to help estimate a value for the securities.
After more than an hour of debate, the two sides on the call signed off with nothing settled, according to internal AIG documents and an audio recording reviewed by The New York Times.
Behind-the-scenes disputes over huge sums are common in banking, but the standoff between AIG and Goldman would become one of the most momentous in Wall Street history. Well before the federal government bailed out AIG in September 2008, Goldman's demands for billions of dollars from the insurer helped put it in a precarious financial position by bleeding much-needed cash. That ultimately provoked the government to step in.
With taxpayer assistance to AIG currently totaling $180 billion, regulatory and congressional scrutiny of Goldman's role in the insurer's downfall is increasing. The Securities and Exchange Commission is examining the payment demands that a number of firms—most prominently Goldman—made during 2007 and 2008 as the mortgage market imploded.
The SEC wants to know whether any of the demands improperly distressed the mortgage market, according to people briefed on the matter who requested anonymity because the inquiry was intended to be confidential.
In just the year before the AIG bailout, Goldman collected more than $7 billion from AIG. And Goldman received billions more after the rescue. Though other banks also benefited, Goldman received more taxpayer money, $12.9 billion, than any other firm.
In addition, according to two people with knowledge of the positions, a portion of the $11 billion in taxpayer money that went to Societe Generale, a French bank that traded with AIG, was subsequently transferred to Goldman under a deal the two banks had struck.
Goldman stood to gain from the housing market's implosion because in late 2006, the firm had begun to make huge trades that would pay off if the mortgage market soured. The further mortgage securities prices fell, the greater were Goldman's profits.
In its dispute with AIG, Goldman invariably argued that the securities in dispute were worth less than AIG estimated—and in many cases, less than the prices at which other dealers valued the securities.
The pricing dispute, and Goldman's bets that the housing market would decline, has left some questioning whether Goldman had other reasons for lowballing the value of the securities that AIG had insured, said Bill Brown, a law professor at Duke University who is a former employee of both Goldman and AIG.
The dispute between the two companies, he said, "was the tip of the iceberg of this whole crisis."
"It's not just who was right and who was wrong," Brown said. "I also want to know their motivations. There could have been an incentive for Goldman to say, 'AIG, you owe me more money.' "
Goldman is proud of its reputation for aggressively protecting itself and its shareholders from losses as it did in the dispute with AIG.
In March 2009, David A. Viniar, Goldman's chief financial officer, discussed his firm's dispute with AIG in a conference call with reporters. "We believed that the value of these positions was lower than they believed," he said.
Asked by a reporter whether his bank's persistent payment demands had contributed to AIG's woes, Viniar said that Goldman had done nothing wrong and that the firm was merely seeking to enforce its insurance policy with AIG. "I don't think there is any guilt whatsoever," he concluded.
Lucas van Praag, a Goldman spokesman, reiterated that position. "We requested the collateral we were entitled to under the terms of our agreements," he said in a written statement, "and the idea that AIG collapsed because of our marks is ridiculous."
Still, documents show there were unusual aspects to the deals with Goldman. The bank resisted, for example, letting third parties value the securities as its contracts with AIG required. And Goldman based some payment demands on lower-rated bonds that AIG's insurance did not even cover.
A November 2008 analysis by BlackRock, a leading asset management firm, noted that Goldman's valuations of the securities that AIG insured were "consistently lower than third-party prices."
To be sure, many now agree that AIG was reckless during the mortgage mania. The firm, once the world's largest insurer, had written far more insurance than it could have possibly paid if a national mortgage debacle occurred—as, in fact, it did.
Perhaps the most intriguing aspect of the relationship between Goldman and AIG was that without the insurer to provide credit insurance, the investment bank could not have generated some of its enormous profits betting against the mortgage market. And when that market went south, AIG became its biggest casualty—and Goldman became one of the biggest beneficiaries.
For decades, AIG and Goldman had a deep and mutually beneficial relationship and, at one point in the 1990s, they even considered merging. At around the same time, in 1998, AIG entered a lucrative new business: insuring the least risky portions of corporate loans or other assets that were bundled into securities.
AIG's financial products unit, led by Joseph J. Cassano, was behind the expansion. To reduce its own risks in the transactions, the company structured deals so that it would not have to make early payments to clients when securities began to sour. That changed around 2003, however, when AIG began insuring portions of subprime mortgage deals. A lawyer for Cassano said his client would not comment for this article. AIG also declined to comment.
Alan Frost, a managing director in Cassano's unit, negotiated scores of mortgage deals around Wall Street that included a complicated sequence of events for when an insurance payment on a distressed asset came due. The terms, described by several AIG trading partners, stated that AIG would post payments under two or three circumstances: if mortgage bonds were downgraded, if they were deemed to have lost value, or if AIG's own credit rating was downgraded. If all of those things happened, AIG would have to make even larger payments.
Frost referred questions to his lawyer, who declined to comment.
Traders loved Frost's deals because they would pay out quickly if anything went wrong. Frost cut many of his deals with two Goldman traders, Jonathan Egol and Ram Sundaram, who had negative or "bearish" views of the housing market. They had made AIG a central part of some of their trading strategies.
Egol structured a group of deals—known as Abacus—so that Goldman could benefit from a housing collapse. Many of them were actually packages of AIG insurance written against mortgage bonds, indicating that Egol and Goldman believed that AIG would have to make large payments if the housing market ran aground. About $5.5 billion of Egol's deals still sat on AIG's books when the insurer was bailed out.
"Al probably did not know it, but he was working with the bears of Goldman," a former Goldman salesman, who requested anonymity so he would not jeopardize his business relationships, said of Frost. "He was signing AIG up to insure trades made by people with really very negative views" of the housing market.
Sundaram's trades represented another large part of Goldman's business with AIG. According to five former Goldman employees, Sundaram used financing from other banks like Societe Generale and Calyon to purchase less risky mortgage securities from competitors like Merrill Lynch and then insure the assets with AIG—helping fatten the mortgage pipeline that would prove so harmful to Wall Street, investors and taxpayers. In October 2008, just after AIG collapsed, Goldman made Sundaram a partner.
Through Societe Generale, Goldman was also able to buy more insurance on mortgage securities from AIG, according to a former AIG executive with direct knowledge of the deals. A spokesman for Societe Generale declined to comment.
It is unclear how much Goldman bought through the French bank, but AIG documents show that Goldman was involved in pricing half of Societe Generale's $18.6 billion in trades with AIG and that the insurer's executives believed that Goldman pressed Societe Generale to also demand payments.
GOLDMAN'S TOUGH TERMS
In addition to insuring Sundaram's and Egol's trades with AIG, Goldman also negotiated aggressively with AIG—often requiring the insurer to make payments when the value of mortgage bonds fell by just 4 percent. Most other banks dealing with AIG did not receive payments until losses exceeded 8 percent, the insurer's records show.
Several former Goldman partners said it was not surprising that Goldman sought such tough terms, given the firm's longstanding focus on risk management.
By July 2007, when Goldman demanded its first payment from AIG—$1.8 billion—the investment bank had already taken trading positions that would pay out if the mortgage market weakened, according to seven former Goldman employees.
Still, Goldman's initial call surprised AIG officials, according to three AIG employees with direct knowledge of the situation. The insurer put up $450 million on Aug. 10, 2007, to appease Goldman, but AIG remained resistant in the following months and, according to internal messages, was convinced that Goldman was also pushing other trading partners to ask AIG for payments.
On Nov. 1, 2007, for example, an e-mail message from Cassano, the head of AIG Financial Products, to Elias Habayeb, an AIG accounting executive, said that a payment demand from Societe Generale had been "spurred by GS calling them."
Habayeb, who testified before Congress last month that the payment demands were a major contributor to AIG's downfall, declined to be interviewed and referred questions to AIG. The insurer also declined to comment for this article. Van Praag, the Goldman spokesman, said Goldman did not push other firms to demand payments from AIG.
Later that month, Cassano noted in another e-mail message that Goldman's demands for payment were becoming problematic. "The overhang of the margin call from the perceived righteous Goldman Sachs has impacted everyone's judgment," he wrote to five employees in his division.
By the end of November 2007, Goldman was holding $2 billion in cash from AIG when the insurer notified Goldman that it was disputing the firm's calculations and seeking a return of $1.56 billion. Goldman refused, the documents show.
In many of these deals, Goldman was trading for other parties and taking a fee. As the mortgage market declined, Goldman paid some of these parties while waiting for AIG to meet its demands, the Goldman spokesman said. But one reason those parties were owed money on the deals was that Goldman had marked down the securities.
Adding to the pressure on AIG, Viniar, Goldman's chief financial officer, advised the insurer in the fall of 2007 that because the two companies shared the same auditor, PricewaterhouseCoopers, AIG should accept Goldman's valuations, according to a person with knowledge of the discussions. Goldman declined to comment on this exchange.
Pricewaterhouse had supported AIG's approach to valuing the securities throughout 2007, documents show. But at the end of 2007, the auditor began demanding that AIG provide greater disclosure on the risks in the credit insurance it had written. Pricewaterhouse was expressing concern about the dispute.
The insurer disclosed in year-end regulatory filings that its auditor had found a "material weakness" in financial reporting related to valuations of the insurance, a troubling sign for investors.
A spokesman for Pricewaterhouse said the company would not comment on client matters.
Insiders at AIG bridled at Goldman's insistence that they accept the investment bank's valuations. "Would we call bond issuers and ask them what the valuation of their bonds was and take that?" asked Robert Lewis, AIG's chief risk officer, in a message in January 2008. "What am I missing here, so I don't waste everybody's time?"
When AIG asked Goldman to submit the dispute to a panel of independent firms, Goldman resisted, internal e-mail messages show. In a March 7, 2008, phone call, Cassano discussed surveying other dealers to gauge prices with Michael Sherwood, Goldman's vice chairman. At that time, Goldman calculated that AIG owed it $4.6 billion, on top of the $2 billion already paid. AIG contended it only owed an additional $1.2 billion.
Sherwood said he did not want to ask other firms to value the securities, because "it would be 'embarrassing' if we brought the market into our disagreement," according to an e-mail message from Cassano that described the call.
The Goldman spokesman disputed this account, saying instead that Goldman was willing to consult third parties but could not agree with AIG on the methodology.
TROUBLE GROWS AT AIG
By the spring of 2008, AIG's dispute with Goldman was just one of its many woes. Cassano was pushed out in March, and the company's defenses against the growing demand for payments faltered. By the end of August 2008, AIG had posted $19.7 billion in cash to its trading partners, including Goldman, according to financial filings.
Over that summer, AIG had tried, unsuccessfully, to cancel its insurance contracts with the trading partners. But Goldman, according to interviews with former AIG executives, would allow that only if it also got to keep the $7 billion it had already received from AIG. Goldman wanted to keep the initial insurance payouts and the securities in order to profit from any future rebound.
In addition to offering to cancel its own contracts, Goldman offered to buy all of the insurance AIG had written for several other banks at severely distressed prices, according to three people briefed on the discussions.
Negotiating with Goldman to void the AIG insurance was especially difficult, Federal Reserve Board documents show, because the firm did not own the underlying bonds. As a result, Goldman had little incentive to compromise.
On Aug. 18, 2008, Goldman's equity research department published an in-depth report on AIG. The analysts advised the firm's clients to avoid the stock because of a "downward spiral which is likely to ensue as more actual cash losses emanate" from the insurer's financial products unit.
On the matter of whether AIG could unwind its troublesome insurance on mortgage securities at a discount, the Goldman report noted that if a trading partner "is not in a position of weakness, why would it accept anything less than the full amount of protection for which it had paid?"
AIG shares fell 6 percent the day the report was published. Three weeks later, the U.S. government agreed to pour billions of dollars in taxpayer money into the insurer to keep it from collapsing.
The government would soon settle the yearlong dispute between Goldman and AIG, with Goldman receiving full value for its bets. The federal bailout locked in the paper losses of those deals for AIG. The prices on many of those securities have since rebounded.