William D. Cohan on Wall Street and Main Street.Tags:
The conventional wisdom has it that the final report of the Financial Crisis Inquiry Commission was a low-budget flop, hopelessly riven by internal political disputes and dissension among the commission’s 10 members. As usual, the conventional wisdom is completely wrong. Actually, the report — and the online archive of testimony, interviews and documents that are now available — is a treasure trove of invaluable information about the causes and consequences of the Great Recession.
For instance, on the exceptionally important but little understood role played by the increasingly lower prices Goldman Sachs placed on the complex mortgage securities on its balance sheet — which helped determine the fate of many of its shakier Wall Street brethren — the commission report, on page 237, is crystalline:
As the crisis unfolded Goldman marked mortgage-related securities at prices that were significantly lower than those of other companies. Goldman knew that those lower marks might hurt those other companies — including some clients — because they could require marking down those assets and similar assets. In addition, Goldman’s marks would get picked up by competitors in dealer surveys. As a result, Goldman’s marks could contribute to other companies recording “mark-to-market” losses: that is, the reported value of their assets could fall and their earnings would decline.
The first victims of Goldman’s decision in May 2007 to begin communicating its lower marks to the rest of the marketplace were the two Bear Stearns hedge funds that were heavily invested in complex and squirrelly mortgage securities. Although Goldman disputes the charge, the lower marks caused the two hedge funds to recalculate the funds’ net asset value, known in the business as N.A.V., and to re-issue to investors in June 2007 a far lower N.A.V. — down 19 percent, rather than down 6 percent. All hell broke loose. Soon enough, the funds’ investors were blocked from withdrawing their money, and by July the funds filed for bankruptcy and were soon liquidated. Investors lost much of the $1.5 billion they had invested. The liquidation of the two hedge funds led to the collapse of Bear Stearns nine months later.
In late July 2007, Goldman started a nearly 17-month dispute with A.I.G. Financial Products, a subsidiary of American International Group, the giant insurer, about the value of $23 billion of complex mortgage securities that Goldman had insured through the subsidiary by paying some $100 million in premiums. Goldman’s agreement with the A.I.G. Financial Products allowed Goldman to demand collateral payments from the firm under two conditions. First, if A.I.G., the parent company, lost its AAA credit rating, which it did in March 2005. And, second, if Goldman believed the value of the underlying securities being insured had fallen, which by mid-2007 Goldman thought — correctly — had occurred. But the consequences of Goldman’s collateral disputes with the financial products subsidiary were profound for A.I.G., and contributed mightily to the government takeover of the insurer after pumping some $180 billion into it.The Financial Crisis Inquiry Commission report, buried by critics, is actually a must-read for those who want to understand the collapse.
The crisis commission report is chock-full of the details of how the dispute developed and progressed. On July 27, 2007, Goldman sent a $1.81 billion collateral call to A.I.G. Financial Products to make up for what Goldman — pretty much alone at that point — thought represented the decline in the value of the securities. “The $2bn margin call is driven by a massive remarking by Goldman Sachs of the underlying [mortgage] securities (down from – 6 pts to – 20-25 pts in some cases), ahead of all other dealers in the street,” Goldman’s Nicholas Friedman wrote in an internal e-mail the day before the collateral call.
When Joseph Cassano, the chief executive of A.I.G. Financial Products, first heard about Goldman’s collateral call, he was blown away and thought that it came “out of the blue,” he said in a five-hour, June 2010 interview released late last week by the crisis commission. “What in the world had changed between yesterday and today?” he wondered, to prompt the “whopper” of a collateral call from Goldman. Goldman’s marks were consistently lower than those of other Wall Street dealers — as Goldman itself admitted — and Cassano was incredulous about their accuracy. “I didn’t believe the numbers,” he said. “These aren’t real numbers. The markets had seized up.”
For the next two weeks, Cassano’s firm disputed Goldman’s valuations and its collateral call. It “was unusual to have disputes” with Goldman, Cassano told the commission. “Goldman Sachs is a business partner of ours and an important relationship.” During that time, Goldman reduced the collateral call to $1.6 billion, then to $1.2 billion and then to $600 million. “That told me something was up with their numbers,” Cassano said. “This market is so difficult, the markets are roiling to say the least. Even Goldman Sachs — a pretty good outfit — was having a hard time getting the numbers themselves.”
Before Cassano left for a late August cycling vacation in Germany and Austria, he suggested paying Goldman a “good faith” $300 million deposit. Goldman countered with a demand for a $450 million deposit, which Cassano agreed to provide on Aug. 10. In a side letter that same day, A.I.G. Financial Products and Goldman further stipulated that the $450 million did not resolve the collateral dispute between the two firms. The payment was a way for everyone to “chill out,” an A.I.G. executive wrote.
After Labor Day, Cassano said, he initiated a meeting with Michael Sherwood, co-chief executive of Goldman Sachs International — whom he described as being “a very practical guy” — to discuss how to resolve the ongoing collateral dispute. Cassano pointed out to Sherwood that something must have been amiss because Goldman’s original collateral call of $1.8 billion got reduced in two weeks time to $450 million. Cassano says that Sherwood admitted to him that Goldman’s bankers “didn’t cover ourselves in glory during this period.”
Things quieted between Goldman and A.I.G. Financial Products until Sept. 11, when Goldman asked for another $1.5 billion in collateral based on its marks. This was the beginning of the end. On Nov. 2, Cassano said, Sherwood gave him a “heads up” that Goldman was increasing its collateral call to $2.8 billion, in addition to the $450 million it already had. “We’re not going to pay that amount,” Cassano said he told Sherwood, and that the latter replied, “Yea, I didn’t think you would.” And, according to the crisis commission report, Cassano soon faced other problems: by Nov. 14, both Société Générale, a large French bank, and Merrill Lynch had asked the A.I.G. subsidiary to post collateral to them as well, in the amounts of $1.7 billion and $610 million, respectively, based largely on the Goldman precedent.
On Nov. 23, A.I.G. Financial Products agreed to give Goldman another $1.55 billion in collateral, bringing its total posted to $2 billion. Cassano told the crisis commission that he decided to make the payment “to avoid airing dirty laundry” in the market about the disputes. A week later, based on his firm’s calculations and other market input, Cassano phoned Sherwood and demanded the money back from Goldman. Cassano recalls that Sherwood said he would think about it — but the money was never returned.
The dispute continued into January. Cassano eventually spoke with David Viniar, Goldman’s chief financial officer, to try again to get the money back. “We may have been ahead of the market,” Cassano said Viniar told him, “but the market is coming our way.” Cassano was again incredulous, and wondered if Goldman was “driving the market” down to benefit the short position it had started taking in December 2006 against the mortgage market. “There is nothing trading,” Cassano said. “You can’t even trade by appointment.”
That was Cassano’s last conversation with Goldman. By March, he had been relieved of his executive duties and became a $1 million a month consultant until the government takeover of A.I.G. Over the years, A.I.G. Financial Products had paid him more than $300 million in compensation. The Goldman collateral calls continued until the bitter end, by which time it had been paid $12.9 billion and the government had poured some $40 billion into the financial products subsidiary as part of the overall rescue of A.I.G. Cassano told the commission that if he had not been relieved of his duties, he would have continued to dispute the collateral calls with Goldman rather than agree to pay them.
As the Financial Crisis Inquiry Commission report makes convincingly clear, Goldman has to finally admit publicly the important role its marks played in exacerbating the financial woes of its competitors. The other lesson is that these kinds of complex securities, and the derivatives tied to them, should in the future be traded on public exchanges, where prices can be far more easily agreed upon between buyers and sellers. The 2010 Dodd-Frank financial reform law calls for the latter, but it hasn’t happened yet. Contrary to the critics, the commission report is the strongest argument we have to get those regulators moving.
