May 17, 2009
Joseph Cassano: the man with the trillion-dollar price on his head by Tim Rayment
The multimillionaire trader accused of bringing down the insurance giant AIG - and with it the world's economy. So is he a criminal, an incompetent or a scapegoat?
(PAUL VICENTE/SUNDAY TIMES)
Photo: Joseph Cassano leaves his Knightsbridge home
They were frightened for a long time, then suddenly they were angry. For millions of Americans, anxiety about a jobless, debt-laden future turned to disbelief when it emerged that AIG, the company at the centre of the world's financial crisis, was handing out £300m in bonuses. It was the superpower's Sir Fred moment. Just as Britain reacted with fury to the disclosure that Sir Fred Goodwin's pension pot had been doubled as his bank neared collapse, so the US was shocked. The death threats came soon after. "I want them dead!" said one of a stream of messages that caused AIG staff to travel in pairs, park in well-lit areas, and dial 911 if followed. "I want their spouses dead! I want their children dead! I want their children's children dead! I want the earth upon which they have walked salted so nothing will ever grow again!"
This was one of the greatest bailouts in history, after the biggest corporate loss in history, during the most serious challenge to world stability since the 1962 Cuban missile crisis. And here was AIG, the recipient of so much taxpayers' money that the cheques exceed the value of the gold reserves in Fort Knox, paying bonuses to the very people who engineered the catastrophe.
Protesters toured the posh houses on Long Island Sound, an estuary northeast of New York City, with letters for AIG executives describing the plight of homeowners. But they were in the wrong place. Because the man who knows most about AIG's troubles lives in a stucco-fronted house 3,000 miles away. Some call him Patient Zero: the virus that infected the world financial system was transmitted from a genteel square near Harrods. If you wait patiently in Knights-bridge you will see him, and he appears not to be a risk-taking type. He puts on his red crash helmet and cycles greenly off across the city, politely declining to comment on global calamities. This does not look like a person waiting at the curtains for the arrival of the FBI.
Can one man in London really be to blame for the collapse of capitalism?
Until now, the economic crisis has been seen as a giant intellectual error, and AIG's multimillionaire employees in England were simply the people who made the biggest mistakes. The first to own up to misjudgment was Gordon Brown's friend Alan Greenspan - once so revered in his role as America's central banker that to be photographed with him was as flattering as being seen now with President Obama. "I have found a flaw," said Greenspan, referring to his free-market philosophy, after the banks started falling over. "I don't know how significant or permanent it is. But I have been very distressed by that fact."
Others have repeated this innocent-sounding explanation for the wrecking of so many lives. "There is no fail-safe way to offset this human tendency to collective error," says Lord Turner, chairman of the Financial Services Authority (FSA). And it is true, of course. Now and again, historical forces come together in a way that is mutually reinforcing, and individual changes that are powerful in themselves become so strong that their effects are wrongly seen as permanent. If 150m people - 2Å times the British population - stop tilling the land and start making things, as happened in China between 1999 and 2005; if the Chinese recycle their export earnings into cheap credit; if interest rates stay low for reasons that seem important at the time (the millennium bug, the tech-stocks crash, 9/11); if new ideas allow you to spread financial risk... well, by now you know the explanations. It became easy to imagine that the world was growing rich because we understood the universe better than our ancestors, until we didn't.
There is, however, an alternative reading. This says that the furore over bonuses is a convenient distraction from the real causes of the crisis, which go to the heart of how the world is run. There is dishonesty in this collapse, on a scale that is almost too vast to comprehend. There are conflicts of interest in American finance and politics that make our own, dear House of Lords look like beginners. There are frauds so large, and so long-standing, that it can be hard to see them for what they are. And all these things were allowed to thrive in an intellectual atmosphere that tolerated no dissent. This reading is optimistic for those who believe in free markets, even if it is pessimistic for the US. "Capitalism has not failed," says Bernard-Henri Lévy, the French philo-sopher. "We have failed capitalism." The thesis can be tested through Patient Zero.
The official version is that Joseph Cassano, who occupies the stucco-fronted house near Harrods, brought down a safe and stable company - and by extension, the world - with incompetent gambles. "You've got a company, AIG, which used to be just a regular old insurance company," Obama explained during a recent TV appearance. "Then they decided - some smart person decided - let's put a hedge fund on top of the insurance comp-any, and let's sell these derivative products to banks all around the world." Ben Bernanke, the chairman of the Federal Reserve, adds: "This was a hedge fund, basically, that was attached to a large and stable insurance company."
Cassano, who ran AIG's financial-products division in London, "almost single-handedly is responsible for bringing AIG down and by reference the economy of this country", says Jackie Speier, a US representative. "They basically took people's hard-earned money, gambled it and lost everything. And he must be held accountable for the dereliction of his duty, and for the havoc he's wrought on America. I don't think the American people will be content, nor will I, until we hear the click of the handcuffs on his wrists."
This account is as satisfying as it is easy to understand. It treats the blowing up of the world financial system like a global version of Barings, the bank that collapsed in 1995, with Cassano in the role of Nick Leeson. Operating from the fifth floor of a polished white stone building in Mayfair, Cassano's unit sold billions of pounds of derivatives called credit-default swaps (CDS), allowing banks to buy risky debt without attracting the attention of regulators. AIG took the fees, but did not have the money to pay up if the loans went bad. By the time the music stopped, European banks had protected more than $300 billion of debt with this bogus "insurance". And that is just one corner of a web of risk extending to over 1,500 big corporations, banks and hedge funds. In a 21-page paper known as the Mutually Assured Destruction memo, AIG claims that if the bailouts stop and the company is allowed to go bust, it will take the world with it. Cassano must have played with handcuffs as a child: he is the son of a Brooklyn cop. Now he waits for the fallout.
But the official version overlooks many things, including episodes of fraud at AIG that go back at least 15 years. It fails to explain why Public Enemy No 1 was allowed to leave the company on generous terms, with a retainer of $1m a month and up to $34m (£23m) in bonuses. And it does nothing to tell us why other big companies, whose profits looked as smooth and certain as AIG's in the good times, are also fighting for survival.
When Forbes published its first list of the world's biggest companies in 2004, AIG ranked third, after Citigroup, the dying bank, and General Electric, the industrial giant now drowning in its own debt. If you can think of a risk to insure, AIG was there: the company even made plans to survive a nuclear holocaust. It was built into a behemoth by one of the 20th century's corporate titans, Hank Greenberg. Less famous than the other insurance legend, Warren Buffett, Greenberg gave shareholders a return of 14% a year, and was equally loved. "I just think you are the most stupendous, unbelievable person in the entire industry, the entire world," one investor told an annual meeting, without irony.
But Greenberg faced a problem. Insurance is not like iPods, where if you invent the market, growth comes fast. Over time, it performs in line with the economy. In 1987 he found an answer: AIG would enter a joint venture with Howard Sosin, a pioneer in the new "Frankenfinance" of derivatives trading. You can thank Sir Isaac Newton for Frankenfinance. By showing in the 17th century that the universe conforms to natural laws, he encouraged our age to see money as a branch of physics. Starting in 1952, two generations of economists worked to show that people are like molecules, whose behaviour can be predicted in ways that are stable over time. Science then infected everything, from how much capital banks need to protect themselves against insolvency, to the risk in credit-default swaps. But there was a flaw: the City's faux physicists never go back far enough in their analysis, because the data on the Bloomberg terminal cover a tiny period of history. "Real scientists tend to be much more sceptical about their data and their models," says William Janeway, an MD of the private-equity firm Warburg Pincus and a Cambridge University lecturer. "They had all of the maths, but none of the instincts of good scientists." There is also the 4x4 effect: if you give people a safer car (read, a safer world through financial innovation), they tend to drive faster. But we are getting ahead of ourselves.
To start with, AIG trod carefully in the new, scientific universe. Sosin's idea was to buy financial risk from people who did not want it, then sell the risk to others in a series of "hedges" so that AIG kept the fees but not the risk. If a big organisation wanted to lock in an interest rate, for example, AIG would promise to pay the difference in costs if rates rose, then pass the risk to other parties in separate contracts. Sosin supplied the nerds and the models, AIG supplied the reassurance of its AAA rating, and for a long time the alchemy worked. AIG Financial Products (AIGFP), a unit with 0.3% of AIG's 116,000 employees, made over $1 billion in profits between 1987 and 1992, a vast sum at the time. But Sosin left. And so did his successor, a mathematician named Tom Savage. When Savage departed in 2001, Greenberg put in charge a man he saw as "smart, tough and aggressive": the unit's chief operating officer, Joseph Cassano. The new leader had no background in Frankenfinance; his degree, from Brooklyn College, was in political science. The cop's kid had ascended through what is called the "back office": his expertise was in supervising the contracts and running the lawyers and accountants. This did not matter, Greenberg thought. Underlings had the right maths, and besides, Greenberg's AIG held everyone, Cassano included, to account. The London team would be scrutinised. Which was just as well, as the huge intellectual error meant nobody else was in charge. "Why did no-one see it coming?" asked the Queen last November, on a visit to the London School of Economics. Well, they did, ma'am. Charles Bowsher, head of the US government's General Accounting Office, testified as long ago as 1994 that "the sudden failure or abrupt withdrawal from trading" of large dealers in derivatives "could cause liquidity problems in the markets and could also pose risks to others, including... the financial system as a whole". It took another 13 years, but that is exactly what happened.
One regulator tried to act on Bowsher's warning, but she was silenced. Brooksley Born, who monitored the futures markets, tried to extend her remit to unregulated derivatives. Alan Greenspan and Robert Rubin, the then Treasury secretary, persuaded Congress to freeze her already limited power, forcing her departure. Rubin had come into government from Goldman Sachs; when he left he went back to banking, and pushed for Citigroup to step up its trading of risky, mortgage-related investments. For his advice, he earned over $126m (£84m) and then, as Citigroup collapsed, became an adviser to Barack Obama. After Greenspan stepped down from the US central bank in 2006, he became a consultant to Pimco, the world's biggest bond fund, where his insights have been praised by his boss. "He's made and saved billions of dollars for Pimco already," said Bill Gross last year. Greenspan is also an adviser to Paulson & Co, a hedge-fund group that has made billions from the collapse in American housing.
The lightness of touch reached a level that defies belief. America has an Office of Risk Assessment, set up in 2004 to co-ordinate risk management for the main regulator, the Securities and Exchange Commission (SEC). Jonathan Sokobin, its director, says it is charged with "understanding how financial markets are changing, to identify potential and existing risks at regulated and unregulated entities". According to its website, it also helps to "anticipate, identify and manage risks, focusing on early identification of new or resurgent forms of fraud and illegal or questionable activities... across the corporate and financial sector". By early 2008, this office was reduced to a staff of one. "When that gentleman would go home at night," says Lynn Turner, the SEC's former chief accountant, "he could turn the lights out. We had gotten down to just one person at the SEC responsible for identifying the risk at all the institutions." The $596-trillion market in unregulated derivatives, including $58 trillion in credit-default swaps, was being watched by one person. That's when he wasn't looking at the rest of the corporate world, of course.
We are in a hotel in London, sitting on cracked red leather sofas. The interview is with one of the finest analysts of financial statements on the planet. Where you or I see pages of numbers, he sees a narrative. Sometimes the theme is a company's potential for growth. Sometimes it is the prospect of self-destruction. And at times the story does not make sense, because the figures are hiding a fraud. Charles Ortel, managing director of Newport Value Partners - a firm that provides research to professional investors - is explaining the potential for fraud in insurance. Insurers share their big risks with others. Imagine it is September 12, 2001, and you get a report on the previous day's terrorist attacks. You don't know your loss, because it takes time for victims to come forward and costs to be calculated. You decide it's $12 billion and do a deal with another insurer: I will write you a cheque now for $9 billion, and we agree my liability is capped at $12 billion. If the eventual losses are higher, the second insurer will pay. In the meantime, it is free to invest the $9 billion. Insurers make much of their money from investing premiums while they wait for a claim.
The second insurer can book some of the $9 billion as income. It shouldn't, because it is exposed to risk. But there's flexibility in how the numbers can be treated. If the second insurer is not having a good year, the flexibility creates the temptation to book phantom earnings, illegally supporting the share price. In the past, AIG has admitted episodes of improper accounting.
One question has not been answered. Was Cassano's team simply the dumbest in the room, betting on an ever-rising housing market against the likes of Goldman Sachs? Or was the world financial system brought down by fraud - a fraud made possible by the gradual but relentless takeover of public life by the insiders' club of finance?
In 2001, with AIG trading at $85 on the New York Stock Exchange, The Economist decided to commission some research on the company's true value, and chose the little-known firm Seabury Analytic to do it. This was deliberate. The magazine's New York bureau chief, Tom Easton, had been around long enough to know that nobody on Wall Street ever says "sell", except perhaps when a market is about to go up, and that the big security firms could not be trusted to give a candid view of AIG.
The research, which took five months, was the work of a team led by Tim Freestone, who is speaking here for the first time. Most analysts are upbeat: their colleagues' bonuses depend on fees from the company under scrutiny. But Freestone's firm (now called Crisis Economics) is independent. He judged that AIG was highly overvalued, and he would later realise that its shares were supported by an ability to stifle criticism. In his report for The Economist, however, he was tactful. To justify the share price, he said, "it would have to grow about 63% faster than [its] peers for the next 25 years. If investors believe that AIG can sustain this type of performance for that period of time, then AIG is properly valued". Any investor who believed that would need to be certified.
After the article came out, researchers from the big banks contacted him, incredulous that he had dug deeper than the industry norm and dared to release the findings. They seemed to be in awe, and at the same time jealous; nobody breaks the rules like this - not without paying a price. A delegation from AIG arrived at his office and presented him with a letter that seemed to renounce the story and to condemn its distortion of his research. He was intrigued to see the author's name at the end of the letter - why, it was his name, and the AIG contingent was awaiting his signature. The company also sent its executives on a private plane to The Economist headquarters in London to demand a retraction. Legal threats followed.
"I assumed AIG was attempting to railroad us out of business," says Freestone, who did not sign.
Greenberg was forceful when it came to his share price. He was often on the phone to Richard Grasso, the head of the New York Stock Exchange, with expletive-laden threats to move AIG to the Nasdaq unless the exchange did a better job. Grasso would then be seen on the floor of the exchange, talking to the market-maker for the stock. Grasso says he never asked the market-maker to bid the shares higher, which is just as well: both men could have gone to jail.
What does all this have to do with Joseph Cassano? Seabury Analytic's research suggests that when Cassano took over the Frankenfinance unit, the parent company was in trouble. "Its ‘distance to default' was much closer than anyone realised," says Freestone, whose models would later identify AIG and three peers - Lehman Brothers, Merrill Lynch and Bear Stearns - as insolvent when the markets saw everything as fine. He is not alone in his view. Another authority believes that as the man in Mayfair wrote his credit-default swaps, AIG was already doomed. "AIG's foray into CDS was really the grand finale," says Christopher Whalen, managing director of Institutional Risk Analytics, an expert on banking who has testified before Congress. Towards the end, it looked much like a Ponzi scheme, "yet the Obama administration still thinks of AIG as a real company that simply took excessive risks". In other words, there was never a chance AIG would honour its contracts: its income was nowhere near enough to cover the payouts.
Whalen has a reputation to protect: he is global risk editor of The International Economy magazine, co-founder of the Herbert Gold Society, a group of current and former employees of the US Treasury and the Federal Reserve, and regional director of the Professional Risk Managers' International Association. His assertion is not an impulse. It comes from months of talking to forensic specialists such as Freestone, insurance regulators "and members of the law-enforcement community focused on financial fraud". As evidence of dishonesty, Whalen points to AIG's occasional habit of using secret agreements to falsify financial statements - either its own or those of other companies. In 2005, a former senior executive at the insurer General Re pleaded guilty to a conspiracy to misstate AIG's finances, after General Re paid $500m in premiums for AIG to reinsure a nonexistent $500m risk. The transaction was a sham; the only economic benefit to either party was the $5.2m fee paid by AIG for Gen Re's help.
When the $500m in loss reserves were added to AIG's balance sheet in 2000 and 2001, Greenberg was able to claim an increase in reserves, when in fact they had declined. "They'll find ways to cook the books, won't they?" John Houldsworth, the former executive, said in a recorded phone conversation with Elizabeth Monrad, his chief financial officer. She observed that "these deals are a little bit like morphine; it's very hard to come off of them".
Similarly, in 2003 AIG was fined $10m for helping a telecoms company, Brightpoint, hide $11.9m in losses with a "non-traditional" insurance product that AIG offered for "income statement smoothing". Brightpoint paid $15m in premiums, and AIG refunded $11.9m in fake insurance claims. The ruse allowed Brightpoint to spread its loss over three years, overstating its 1998 net income by 61%. And in 2005, AIG restated five years of financial statements, admitting that they had exaggerated its income by $3.9 billion.
Whalen believes that at some point between 2002 and 2004, AIG concluded that the game was up for secret agreements, and that other methods of enhancing revenue were needed. "The thing I haven't satisfactorily answered," Whalen adds, "is whether AIG was so unstable coming out of 2000, 2001, that Cassano was trying to cover up a wounded, dying beast. Was he doubling up, to try and hit a home run and save the house? It looks like it, because otherwise it was just greed on his part, and he was writing as much of this crap as he could to inflate his bonus." If he is right, the implications are profound. Any bank that thought it was protected by credit-default swaps with AIG would have been exposed from the start, putting taxpayers at risk. The banks' credit traders would - or should - have realised that AIG was never likely to pay out. "The key point that neither the public, the Fed nor the Treasury seems to understand," says Whalen, "is that the CDS contracts written by AIG were shams, with no correlation between fees paid and the risk assumed. These were not valid contracts but acts to manipulate the capital positions and earnings of financial companies around the world."
The investigation into the General Re affair prompted AIG to oust Greenberg in 2005. He has always denied wrongdoing. In fact, he is suing AIG, claiming his successors abandoned risk controls and destroyed the firm. The old man's departure meant the brakes were off for Cassano; the new CEO, Martin Sullivan, had risen through the "property and casualty" side of the business. As he is fond of pointing out, he is not an accountant. Who would scrutinise the financial-products team now? The pace of CDS deals suddenly accelerated, until Cassano halted them for ever, all in the space of a few months. He had realised that sub-prime mortgages accounted for an increasing proportion of his trades, and that the underwriting standards were shocking. No model, however carefully constructed, can protect you from that. It was too late: the bomb on AIG's books was ticking.
For the world to go truly insane, leading to what the Bank of England has called "possibly the largest crisis of its kind in human history", two things are needed. The first is the intellectual capture of the Establishment, so that everyone - politicians such as Gordon Brown, regulators such as the SEC and the FSA, and academic and media commentators - is persuaded that a new way of thinking is in the public interest. The second step is when vested interests exploit the intellectual capture and take it to extremes.
Alpha males such as Cassano push at boundaries. You could say it is their evolutionary purpose. That is one reason we need governments, to protect us when male ambition reaches too far. But our governments were mesmerised by our bankers. "From 1973 to 1985," says Simon Johnson, a former chief economist at the IMF, "the financial sector never earned more than 16% of [US] corporate profits. In the 1990s, it oscillated between 21% and 30%, higher than it had ever been in the post-war period. This decade, it reached 41%." The whole point of financial companies is to allocate your savings to those who can use the money best. If they are taking 41% of the profit in an economy, something is out of balance. These figures reveal an enormous transfer of wealth.
Which brings us back to bonuses. In August 2007, as the financial crisis broke, Cassano claimed everything was fine. "It is hard for us, and without being flippant, to even see a scenario, within any kind of realm or reason, that would see us losing $1 in any of those transactions," he told investors, as his CEO listened in on the call. But it seemed to be a different story inside AIG. The company had hired Joseph St Denis, a former SEC official, as part of an effort to improve its internal controls. Cassano shut him out. "I have deliberately excluded you from the valuation of the super seniors [a type of debt] because I was concerned that you would pollute the process," St Denis recalls Cassano saying. The auditor resigned in protest, yet the minutes of AIG's audit committee show no sign of concern.
In the final three months of 2007, AIG lost over $5 billion. Under the terms of the bonus scheme, top executives should have had their pay cut for poor performance. When the compensation committee met in March 2008 to award bonuses, however, the Essex-born CEO urged it to ignore the losses. The board approved the change, even though losses were growing by the month, and Sullivan pocketed $5.4m. He was also awarded a golden parachute worth $15m. He was out of the company three months later, with a severance package worth $47m (£31m). That is $39,500 (£26,000) for every day he was in charge. Pension funds and other savers holding AIG shares lost $58.4m (£39m) a day during his tenure.
In seven years, the 400 employees in Cassano's division were paid $3.5 billion. Cassano received $280m. When the losses became public, AIG parted company with him immediately. But he wasn't fired: he "retired", with a contract paying him $1m a month for nine months, and protecting his right to further bonus payments. "Joe has been a very valuable member of the AIGFP senior management team for over 20 years," said Sullivan, who was soon to leave the scene himself. "He has had a great career with us, and we wish him the very best in the future."
Cassano's division then imploded. As house prices fell, credit ratings were cut and bankers began to panic, AIG posted the biggest quarterly loss in corporate history: $61.7 billion. This is equivalent to losing $28m (£19m) an hour, every hour, for the final three months of 2008. But by now, the company's problems were the property of the American taxpayer, creating extraordinary new conflicts of interest. Hank Paulson, the Treasury secretary in the outgoing Bush administration, was an ex-CEO of Goldman Sachs. He received tax benefits of about $200m (£133m) for taking on a government role. When the US decided to bail out AIG, the chief beneficiary of the rescue was... Goldman Sachs, which received $12.9 billion of public funds via the insurer. The new CEO, Edward Liddy, whose task is to wind down the company and to close $1.6 trillion in trades that are still outstanding from the Cassano era, is ex-Goldman Sachs. He even has $3.2m in the bank's shares.
AIG tried to keep secret its payments to Goldman Sachs and others, somehow imagining you could have $182.5 billion of taxpayers' money and not say how you were using it. And so the task facing Obama is even greater than we imagine. Intellectually, the president might see what is required, but execution still depends on the very club that helped bring about the collapse in the first place. "It is not outright fraud that has caused the most damage to the market," says Tim Freestone, the analyst first to see AIG's troubles. "It is the suppression of information, wittingly or unwittingly, by most of the market's players." A rush to regulation is not the answer, he adds: each new rule creates a minimum target for compliance, with unintended results. The challenge is to confront the keiretsu, the interlocking relationships that give insiders such an advantage.
Bankers and politicians like to blame the catastrophe on this or that cause, which swelled into a tsunami nobody could have foreseen. But as Simon Johnson points out, each reason - light regulation, cheap money, the promotion of homeownership - has something in common. "Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector."
AIG's early trades showed genuine brilliance; their later CDS deals, many of which were not even "hedged", were as foolish as can be. Was it fraud? Yes, in the widest sense - but it was fraud as wilful ignorance, in which a whole industry is based on false assumptions, and each participant has little reason to question the system as long as it continues to make him rich. "There is no need to have an overt conspiracy, or to be incompetent," says a thoughtful internet poster called Anonymous Jones. "Unfortunately, those ultimately bearing the risk - savers, taxpayers - did not have as strong a personal incentive to keep watch over the system, and those in charge of the financial sector ran roughshod over the entire enterprise, extracting profits far in excess of any value generated by their actions. When there are enormous incentives for each participant to cheat, the efficiency of any market breaks down."
In recent weeks, Cassano has grown a beard and changed his crash helmet, which is no longer red but silver. The disguise might not be enough; prosecutors are said to be close to criminal charges. They think he misled investors, an easier case to make than that of knowingly risking the financial system. "To date, neither AIG nor AIGFP is aware of any fraud or malfeasance in connection with the underwriting and creation of the multi-sector CDS portfolio," says AIG, referring to the trades under scrutiny, "as opposed to what, with hindsight, turned out to be bad business decisions."
If they were bad decisions, they had a context. "Once people who push boundaries understand that the police don't want to issue tickets," says Charles Ortel, "they start pushing. ‘If you're not going to arrest me for going 10 miles over the speed limit, well, I'll try 20. If I can do 20, I'll try 30. And then I'll try flying a plane on a road.'"