Greenberg: AIG’s Risky Subprime Activity ‘Exploded’ After He Left

October 10, 2008

American International Group’s (AIG) exposure to the subprime mortgage market that precipitated the government’s $85 billion bailout came as a result of business conducted after he left the company, according to Maurice “Hank” Greenberg, who was chief executive officer from the late 1960s until first quarter 2005.

Greenberg was at the helm in 1987 when AIG Financial Products was born and in 1998 when it started getting involved in credit default swap insurance. But Greenberg said in recent Congressional testimony that AIGFP was not involved in much subprime while he was in charge.

Greenberg left AIG in March 2005 in the wake of a probe into accounting practices at the company. Greenberg has denied any wrongdoing. He was AIG’s largest individual shareholder before the federal bailout.

Martin Sullivan, who succeeded Greenberg as CEO, suggested he was focused on other priorities including repairing AIG’s standing with customers and regulators, cooperating with several government probes and helping manage losses from Hurricane Katrina. His efforts succeeded, he said, as AIG enjoyed good years in 2006 and most of 2007.

“However as we now know, a different storm was gathering over the global financial markets,” Sullivan acknowledged.

The two told their tales in testimony given to the House Committee on Oversight and Government Reform. Sullivan appeared in person and submitted written testimony; Greenberg submitted written testimony only.

Robert Willumstad, the AIG board chairman who succeeded Sullivan as CEO on June 15, also appeared and submitted written testimony.

Greenberg recalled how AIGFP, the London-based office that grew the credit default swap business, got started.

“Our AAA rating was an asset that made it possible to create AIGFP in 1987 as part of AIG’s philosophy that generating earnings from diverse business lines would add to earnings stability if any particular business unit encountered a downturn,” Greenberg said of the company’s venture into financial products.

In 1987 the derivative market was small but growing. Greenberg said AIG’s approach was to conduct its business on a “hedged” basis, such that net profit should stem from the differences between the profit earned from the client and the cost of offsetting or hedging the risk in the market. “AIGFP would therefore not be exposed to directional changes in the fixed income, foreign exchange or equity markets,” according to Greenberg.

He said AIGFP reported directly to him and to AIG Senior Vice Chairman Ed Matthews and later to William Dooley, senior vice president.

According to Greenberg, there were management controls in place under his leadership to keep an eye on AIGFP and its risk portfolio.

“AIGFP was subject to numerous internal risk controls, including credit risk monitoring by several independent units of AIG, review of AIGFP transactions by outside auditors and consultants, and scrutiny by AIGFP’s and AIG’s Board of Directors. Every new type of transaction or any transaction of size, including most credit default swaps, had to pass review by AIG’s chief credit officer.”

Greenberg says the system worked. From 1987 to 2004, AIGFP contributed more than $5 billion to AIG’s pre-tax income.

However, he said AIG’s sales of credit default swaps “exploded” after he left the company in March 2005. He said AIGFP reportedly wrote as many credit default swaps in the nine months after he left than it did during the previous seven years combined and, he maintained, too much of its new business was tied to the subprime market.

“[U]nlike what had been true during my tenure, the majority of the credit default swaps that AIGFP wrote in nine months after I retired were reportedly exposed to subprime mortgages. By contrast, only a handful of the credit default swaps written over the previous seven years had any subprime exposure at all,” Greenberg said.

AIGFP exposure to multi-sector credit default swaps at June 30, 2008 was $80.3 billion, of which $57.8 billion contained subprime mortgage collateral. The mark-to-market loss on this was $24.8 billion, of which $21.0 billion related to sub-prime. The total mark-to-market loss on the AIGFP portfolio as of June 30, 2008 was $25.9 billion, according to Greenberg.

How did this over-exposure to the subprime market happen?

“I was not there, so I cannot answer that question with precision. But reports indicate that the risk controls my team and I put in place were weakened or eliminated after my retirement,” Greenberg said.

He said he has been told that the company halted weekly meetings for review of all AIG’s investments and risks, meetings that he used to stay abreast of AIGFP’s exposure.

Greenberg also suggested that the additional risk taken on through new credit default swaps “appears to have been entirely or substantially unhedged.”

But Sullivan denied that risk controls that were in place under Greenberg were watered down when he took over. He said the same controls remained and that, in fact, AIG invested in additional controls from the time he took over in March 2005.

Also, Sullivan said, AIG did heed signs that the credit quality and pricing were changing. He said AIGFP stopped writing the products after 2005 and during his tenure the situation was under control.

“Until I left, AIG had not suffered $1 of losses” on credit default swaps, he said.

Sullivan said that “unintended consequences” of one accounting rule was a major factor in AIG’s downfall. The FAS 157 accounting rule required AIG to mark its assets to market value even during a distressed market. “Companies must declare these values on their books even if they have no intention, or immediate need, to sell the assets, even if they have not realized any actual gain or actual loss,” he said.

AIGFP had intended to retain its interests in credit default swaps until they reached maturity but instead it was forced to mark them at fire sale prices. After Sullivan left, the company was forced to begin reporting billions of dollars of “unrealized losses” on the basis of the then-current market valuations.

Willumstad, who was CEO from June 15 when Sullivan was terminated to Sept. 15 when the government stepped in, had promised a liquidity plan for AIG by Sept. 25. But rating agencies would not wait for that.

There was a domino like series of repercussions following the writedowns. Rating agencies responded with downgrades of AIG’s credit rating, which in turn triggered billions of dollars in collateral calls, leading to the near bankruptcy and the government bailout. Sullivan said AIG got caught up in a “global financial tsunami.”

Rep. Mark Souder, R.- Ind., blasted Sullivan and Willumstad. “You took incredible risk,” he said. “You left your company exposed.”

Rep. Carolyn Maloney, D.- N.Y., criticized the executives for “running a great company into the ground” by what she said was essentially “gambling” in a credit default swap market that was totally unregulated.

“I wouldn’t refer to it as gambling,” said Sullivan, maintaining that the credit default swaps were “underwritten individually and very carefully.”

Sullivan pointed out that the company stopped writing credit default swaps after 2005.

Sullivan and Willumstad both agreed that the credit default swap market should be regulated going forward.

Some Congressional testimony suggested that AIG missed several warning signs that its AIGFP portfolio was in trouble. These included a report from its own internal auditor, PricewaterhouseCoopers, that found AIG to have a “material weakness” in its internal controls relating to AIGFP’s credit default swap insurance.

Also, a letter from the Office of Thrift Supervision on March 10, 2008, raised serious concerns as well.

Prior to that, in November 2007, Joseph W. St. Denis, an accountant hired to oversee AIGFP transactions, resigned because he said his efforts to determine the value of the firm’s default swap portfolio were blocked by Joseph Cassano, the president of AIGFP who drove the credit swap insurance business.

Sullivan said AIG legal and audit staff looked into the various warnings and into the St. Denis resignation and that the company had already been putting controls in place.

Rep. Mark Davis, R.- Fla., and Rep. Brian Bilbray, R.- Calif., suggested AIG also should have been paying attention to giant mortgage lenders Fannie Mae and Freddie Mac as they got deeper into subprime.

“Shouldn’t this have been noticed?” asked Bilbray.

Both AIG’s former CEOs said they were not aware of any exposure to Fannie and Freddie.

“I am heartbroken over what has happened,” said Sullivan, who worked for AIG for 37 years.

“I don’t believe AIG could have done anything differently. There was no private market solution,” said Willumstad.

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