naked capitalism

Michael Lewis has a generally very good piece in Vanity Fair on the AIG Financial Products mess, filing in some bits that were missing from the equation. He does go a bit overboard in saying nice things about Jake DeSantis, the man who wrote the New York Times “Dear AIG: I Quit!” op ed. To me, it was another case of Wall Street, and its co-conspirators not getting it. Anyone in a normal business knows if the company has massive losses or is bankrupt, you probably don’t have a job any more and whatever bonus you thought you might get just went poof. He got a very juicy retention bonus, over $700,000 after taxes. My dim recollection is that the partners at LTCM were paid $250,000 a year before taxes to clean up their mess, even adjusted for inflation, much less than what DeSantis was paid. As much as I take the LTCM “talent” story with a handful of salt, DeSantis is no Myron Scholes or Lawrence Hilibrand.

The story recounts how an AIG FP employee, Gene Park, was promoted at the end of 2005 to be the unit’s liaison with Wall Street subrprime desks. Park takes one look at the exposures and freaks out. The big boss, Joseph Cassano. tries to browbeat him into compliance but comes around to his point of view and stops writing guarantees on subprime.

Here’s the bit that caught my eye.

Every firm on Wall Street was making fantastic sums of money from this machine, but for the machine to keep running the Wall Street firms needed someone to take the risk…

The Wall Street firms solved the problem by taking the risk themselves. The hundreds of billions of dollars in subprime losses suffered by Merrill Lynch, Morgan Stanley, Lehman Brothers, and the others were hundreds of billions of losses that might otherwise have been suffered by AIG. Unwilling to take the risk of subprime mortgage bonds in 2004 and 2005, Wall Street firms swallowed the risk in 2006 and 2007,

OK, I need reader help here. Let’s unpack this.

First, things went crazy in subprime in late 2005 and 2006. Those 5-6 quarters were when the most damage was done, the dreckiest paper in big volumes. Lew Ranieri said the paper got worse around then (not that it was great before, mind you). Even thought the paper was even more toxic in 2007, the volume fell off as subprime woes were coming into sharp focus. So understanding what happened in 2006 is important.

What does Lewis mean, exactly, by “take the risk?” AIG had written CDS against the bonds, or at least that’s what the piece implies, as opposed, say, to CDOs that contained subprime mezz paper. Did the investment banks start writing CDS against subprime bonds? Their credit ratings weren’t so high that that action would have accomplished much in the way of credit enhancement (or was everyone so punch drunk that any name would do?). Did they rely on overcollateralization and keep the equity layer? I haven’t seen anything that would suggest that the big brokerage firms stepped up and did credit enhancement of subprimes, but it isn’t impossible.

The reason I am a bit confused here is that the accounts of subprime writedowns at the big broker dealers (plus Citi, which apparently was happy to do deals without AIG guarantees, thank you very much) was that they took losses on subprime paper (I had presumed mortgages they held as trading inventory, plus perhaps also warehoused mortgages) and CDO paper. Merrill and Citi both had large exposures to the super senior layer. That ins’t consistent with the story that they took the risk to get the deals done. For Merrill, it seemed as if the firm kept blindly originating deals even though the stuff was getting harder to place (the various AAA layers were 70-80% of the value of the whole CDO) and believed in the stuff enough to carry it. Really bad underwriting practice, in other words, Not as clear why Citi wound up with so much paper, but they had been putting some (a lot?) in SIVs, so as those got unwound, Citi may have taken them on balance sheet.

It is also useful to understand where the credit enhancement was occurring pre and post AIG. CDO volumes were exploding. The party that takes the risk of an equity layer in a CDO winds up eating a lot of the risk of the subprime paper that went into the CDO. Not sure how far that would have gone in supplanting AIG, but it could conceivably have gone a fair way.

But I was also under the impression that hedge funds pursuing credit oriented strategies were important buyers of the equity layer in CDOs. Did they come to play a bigger role in this period?

Any answers to these questions very much appreciated. Please feel free to ping me at yves@nakedcapitalism.com, but leave a comment if you are set up to do so. Thanks!