All the Devils Are Here by Bethany McLean

Author:Bethany McLean [McLean, Bethany]
Language: eng
Format: epub
Publisher: Penguin Group
Published: 2010-10-19T21:00:00+00:00

The blind spot was AIG-FP’s credit default swap business. Ever since that original BISTRO deal with J.P. Morgan, FP had created a profitable niche by taking on the risk of insuring the super-senior tranches of CDOs. These were the top-tier, triple-A tranches, the ones that got hit only if all the lower tranches got wiped out. Although it had been a sexy little business in the beginning, with innovative deals and healthy margins, it had become fairly humdrum. For the first four or five years, the credit default swap business was focused primarily on corporate credits—first writing protection against the possibility that a particular company’s debt might default, and then insuring the super-senior tranches of CDOs that were primarily made up of corporate loans. But as competitors entered the business, the spreads narrowed and the profits dwindled. Soon, FP’s traders were looking for new ways to use credit derivatives to make money.

FP found several things. It created a business aimed at helping banks—primarily European banks—evade their capital rules. AIG-FP sold credit default swaps to banks that held a variety of highly rated paper; the FP wrap, as it was called, allowed them to decrease their capital. There was nothing illegal about this; seeking “capital relief” had become widespread ever since the adoption of risk-based capital standards. Nor did FP hide what it was doing. It called the business—appropriately enough—“regulatory capital.” By the time of the financial crisis, AIG-FP had insured around $200 billion of highly rated bank assets.

And in 2004, AIG-FP began selling credit protection on triple-A tranches of a new kind of CDO, called a multisector CDO. In this, AIG-FP was following the evolution of the CDO business itself, which had gone from BISTRO—a CDO made up of one bank’s corporate loan portfolio—to CDOs that consisted of disparate corporate credits, to this new multisector CDO. Multisector CDOs were “highly diversified kitchen sinks,” as one FP trader put it, that included everything from student loans to credit card debt to prime commercial real estate mortgage-backed securities to a smattering of subprime residential mortgage-backed securities. The theory, as always, was that diversification would protect against losses; the different asset classes in a multisector CDO were supposed to be uncorrelated. A Yale economist named Gary Gorton was hired to work up the risk models, which showed—naturally!—that the possibility of losses reaching the super-senior tranches was so tiny as to be nearly nonexistent. To FP’s executives, wrapping the super-seniors felt like free money.

The executive who marketed credit default swaps for AIG-FP was Al Frost. Many FP executives were wary of him, viewing him as someone who had a way of shoehorning his way into businesses started by others. But he was a Cassano favorite and a member of the boss’s inner circle. Like everyone else, he feared Cassano’s temper. “He was more worried about Joe’s temper than about bringing him straight information,” says someone who worked with him.

Frost was a glad-hander, with friends up and down Wall Street. As these new multisector CDOs

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