Relevant and even prescient commentary on news, politics and the economy.

Random Notes, or, More Posts I Don’t Have to Write

Greg Mankiw presents Yet Another Reason to regret skipping the AEA this year, though somehow the word “intentional” was left out of the description.

Stan Collender, of all people, does the job I wished someone would do on Martin Feldstein’s WSJ op-ed. I may have beaten him by a day in calling it out, but there’s nothing so perfect as Collender’s conclusion:

Finally, something that’s not in the Feldstein piece: dollar for dollar, military spending doesn’t provide as much an economic return as domestic spending. Building an extra tank or missle that then sits idle because it’s not needed provides a one-time boost to the economy. But building a road, bridge, tunnel, sewer, or information superhighway that is needed continues to provide benefits as people, goods, and information travel faster, less expensively, and far more productively than would have otherwise been the case.

That means that starting with the headline, Feldstein was seriously mistaken.

Differences between now and 1992, positive version: In 1992, Dave Barry made a legendary appearance at the National Press Club. At some point during the Q&A, he declared that he was going to end all of his answers with the phrase “failed Clinton Administration.” (There may have been cheering.)

UPDATE: I was trying to think of a nice way to be rude about Tyler Cowen’s NYT piece on how “the seeds of the crisis” were planted by the resolution of the LTCM crisis.* () But Buce at Underbelly saves the day with a two-point takedown (not the three-pointer of Collender, but still aces) called Long-Term Confusion:

Tyler Cowan has an amazingly confused piece in this morning’s NYT arguing tht we owe our current plight in large part to the “bailout” (I use the term advisedly) ten years ago of Long-Term Capital Mangement (link). But the point of LTCM, as Tyler’s own piece acknowledges (but Tyler ignores) is precisely that LTCM was not a bailout, except perhaps in the sense that the Feds provided lunch.** Okay, and a little bit of arm-twisting. But I should think that would be on the approved list for even the most hairy-chested libertarian. The message was: look, we love ya, and we will work with ya, but we will not put skin in the game. [italics mine, but they could have been his]

In 2008, the NPC appearance of note is by Paul Krugman (h/t EconLib, again of all places), whose six part presentation and q&a session is available on YouTube and therefore easier to watch for the Internet-impaired than his Nobel Lecture.***

McMegan Wuz Robbed! Then again, that’s nothing compared to the abomination of this voting, where something that’s already remainder and long-forgotten appears to be winning.

And, finally, proof that it’s really TOUGH to live in Hoboken.

Happy New Year!

*If Robert Samuelson had published the same piece, Brad DeLong would not have been nice. As it is, we can just assume DeLong hasn’t read it yet amidst his globetrotting.

**Meaning in this case literally the food for the sixteen conversants, fifteen of whom anted up.

***Yes, I assume anyone who accesses YouTube from a non-networked machine has a downloading program. Also, am I the only one who just realised that YouTube is maintained on a Linux-based server?

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Oil, USD, Gold, GDP, Trade,….


Some are making predictions for 2009. How about you….send or leave some for 2009.

Update: I will archive these projections. Obviously the timing of some projections is pretty hard to nail down….but then look at Ken’s 2007 post below.

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Robert Waldmann

ended my last post 5 minutes ago wishing for part III of the saga and here it is !
The final act for AIG by Robert O’Harrow Jr. and Brady Dennis

The collapse was, of course, quick when it came. One interesting fact is that AIG Financial Products (AIGFP) stopped writing new CDSs in 2005. Another is that, until then, they had little idea what they were doing.

In fall 2005, Eugene Park was asked to take over Alan Frost’s responsibilities at Financial Products. Frost had done exceedingly well in marketing the credit-default swaps to Wall Street, and was getting a promotion. He would now report to Cassano directly on other strategic projects.

Park …was worried about the subprime component of the CDO market. He had examined the annual report of a company involved in the subprime business. He was stunned, he told his colleagues at the time.

What a fascinating new idea — how about examining the annual report of a firm whose securities one insures. I mean not all of them (what a bore) but just one.

From this passage it seems that AIGFP just assumed that mortgages were what they had been in the past. I mean it’s not their problem. The non bank mortgage lenders were loaning all they could, because they figured they could pass on the risk (well sometimes risk sometimes certainty of default) to people making CDOs who could pass it on to people buying CDOs who could pass it on to AIGFP which doesn’t seem to have wondered what they were insuring.

I give you a hint. If you tell the world that you are glad to bear all of some vaguely defined kind of risk, then it will get riskier.

AIG was a major factor in the market:

Financial Products had $2.7 trillion worth of swap contracts and positions; 50,000 outstanding trades; 2,000 firms involved on the other side of those trades; and 450 employees in six offices around the world.

That’s $ 6 billion in exposure per employee!

Obviously AIGFP had decided that to write CDSs on AAA rated securities was to get money for nothing. They couldn’t possibly examine the securities they were insuring. Notice how Frost’s role was described: “Frost had done exceedingly well in marketing the credit-default swaps to Wall Street.” You can do very well at selling something if you are charging too low a price.

I guess they can blame the credit rating agencies. In fact they do, but not for rating toxic sludge AAA but for rating them AA. The final words “There was no system in place to account for the fact that the company might not be a Triple A forever.”

In fact AIG hasn’t paid out on CDSs, they ran $150 billion short of ready cash, because they had to post collateral: ‘If additional downgrades occurred, either in AIG’s credit rating or in the CDO ratings, Financial Products would have to come up with tens of billions of dollars in collateral it did not have.’

AIG was downgraded from AAA to AA when Eliot “socks on” Spitzer caught him cooking the books.

On March 14, 2005, Greenberg stepped down amid allegations about his involvement in a questionable deal and accounting practices at AIG. The next day, the Fitch Ratings service downgraded AIG’s credit rating to AA. The two other major rating services, Moody’s and Standard & Poor’s, soon followed suit.

I guess that explains why he didn’t go after anyone with a pitchfork.

Back to my usual anti CDS rant after the jump.

I’d say that was crazy. Given AIGs exposure they shouldn’t have been rated AA. I ask for the nth time, what is the point of a CDS ? Why can’t AIG issue AIG bonds and use the proceeds to buy assets rather than insuring them ? I think it is clear. If AIG had issued 3 trillion in debt they wouldn’t be rated AA. CDSs written appear on the balance sheet at market value. This is nonsense. In the long run, the two actions (write a CDS on assets or sell debt and buy those assets) have the same impact on AIG’s book equity, in the short run the only difference is that AIG can be forced to post collateral (which can be seized in full even if it is in chapter 11 and mere bond-holders have to wait and get cents on the dollar) if it writes CDSs.

I think that it is strictly better for bondholders if AIG issues debt and buys assets than if it insures those assets (I am considering the premia paid on CDSs). I think the only reason to do it with CDSs is to trick regulators and ratings agencies about AIGs liabilities.

On a basically different topic, I cut some boring stuff out of one of my posts and put it here.

Now I think it is fairly likely that, if they they had stuck to CDSs on corporate bonds, AIGFP would have done very well just as they would have done issuing AAA bonds of their own and buying AA bonds.

My guess is that, at first, the money was there to be made because of excessively prudent rules and regulations. It is also there, because prudential regulations do not consider covariances so a diversified pool of AAA bonds is treated as if it is as risky as one AAA bond. This is necessary as there was no covariance rating agency which was worthy of the trust earned by the credit rating agencies. Thus the only variable which was independently estimated with some reliability (back then in 1998) was the risk of default of a single instrument.

My current view is that this would be a reasonable approach to prudential regulation if there weren’t firms like AIG financial products. The entities subject to the rules and regulations are large enough that they can diversify their portfolio at a very modest cost. They don’t bear risk for the fun of it. It is safe to assume that they will diversify without being specifically required to do so … unless there is a financial engineering industry which sets up special purpose entities with diversified portfolios and issues single securities whose ratings are high because of that diversification. This means that the diversification (by the SPE) suddenly relaxes the prudential requirement.

By pre-diversifying the financial engineers reduce the further reduction in risk available from diversification. The limiting case would be reached if all securities were put in a huge pool which was cut into tranches. At that point, the risk of default on any portfolio of, say all existing AA securities would be as high as the risk of default on a single security, because there would only be one AA security. Thus for the same prudential regulations, banks would be allowed to bear much more risk.

This is not socially useful. If prudential regulations are optimally adjusted to take into account the increased correlation of different assets, then nothing is accomplished. Otherwise the regulations are effectively changed by agents who can pocket the expected value of future public bailouts.

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GMAC Flashback

The whining has started, with most people (e.g., Chris Whalen at The Big Picture) making the obvious mistake of confusing GMAC with General Motors.

In the interest of history, I quote myself from the Dark Ages (March 2007) at Tom’s Place:

The next time GM explains that its pensioners need to take a hit, it won’t be because car sales have fallen.

It will be because of their subprime mortgage lending [original link expired]:

GMAC’s ResCap unit, which specializes in housing finance, reported $48 billion in subprime loans — about 76 percent of its mortgage portfolio as of year end.

ResCap increased its allowance for loan losses to 2.17 percent at year-end from 1.55 percent a year earlier and reported a spike in nonperforming loans to 10.5 percent of its mortgage portfolio.

GMAC said it earned $1 billion in the fourth quarter of 2006, compared with $112 million a year earlier. The results included a $791 million tax benefit from its conversion to a limited liability company.

Translation: that’s another $791 million that GM pensioners and others will have to pay into the general fund.

Loaning to the auto industry may be dicey, but it pales compared to a mortgage portfolio that was 76% subprime at the end of 2006.

GMAC may “need” to be bailed out, but that’s not because of its auto industry exposure.

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Robert Waldmann

The second of three parts of Dennis and O’Harrow’s series on the downfall of AIG introduces two new features—credit default saps and Joseph Cassano. Together the two managed to bring down AIG.

Thus far we have only read about how AIG got into the business of writing CDSs — it seemed too good to be true — money for nothing. My guess is that the first ones they wrote did amount to money for almost nothing. However such opportunities are few and if one considers one year’s money for nothing as the minimum acceptable profits for next year you will end up getting money for a while for destroying the world’s largest insurance company.

To me the interesting part is how they got into the CDS market

in early 1998: …

… a new kind of contract known as a credit-default swap. For a fee, the firm essentially would insure a company’s corporate debt in case of default. The model showed that these swaps could be a moneymaker for the decade-old firm and its parent, insurance giant AIG, with a 99.85 percent chance of never having to pay out.

The computer model was based on years of historical data about the ups and downs of corporate debt, essentially the bonds that corporations sell to finance their operations.

My guess is that the model was right and that returns on writing (less than 10 year) CDSs on corporate debt were huge while the risk was nothing that AIG couldn’t handle. This profit opportunity could exist because of binding prudential regulations — banks worried about capital requirements and managers of endowments and pension funds with rules requiring much of their assets to be AAA corporate debt or safer would be willing to pay much more than the actuarially fair premium for a CDS on, say, AA debt. Given the correlation of default on different AA bonds, writing CDS on a broad array of them is essentially money for nothing. The most likely value for payouts is zero and the expected value plus, say, 10 standard deviations would be less than the fees.

I have bolded the two factors which convince me that the model might have been reasonable when it was written. First this was corporate debt not new financial products so the ratings were based on decades of experience and not on, say, the assumption that the probability of a nationwide average house price decline is zero (an actual assumption made by Standard and Poor’s really). Second, I sure hope the “years” also amounted to decades including recessions and such. The use of sample frequencies to estimate probabilities is always risky, but if the sample size is a few years during an unprecedented house price boom, it is insane.

The problem is that once one has gotten money for nothing it is very hard to convince oneself that there is no more to be had.

The aim of this article seems to be to describe Hubris* — the pride that came before a fall. This is an old theme in drama — the oldest. I always read about it when I read stories of financial collapses. I suspect that it might be added, because it makes a morality play out of math. I suppose it might often be relevant because of human nature. However, I also think it is particularly relevant to finance.

The efficient markets hypothesis (adjusted for inflation) says you don’t find hundred dollar bills on the sidewalk. It is false. However, you don’t find a hundred dollar bill on the same concrete square day after day. It is possible for financial operators to find an anomaly and make a huge profit with moderate risk. At best they can find two or three. There don’t seem to be many of those who don’t conclude that they are geniuses who can find such profit opportunities year after year. A shining exception is Andrew Lahde who made a killing and cashed in. However, he isn’t in the business anymore.

I don’t see a solution to this problem. You have to put up either with people who think they are geniuses, because they have been very successful or who have something to prove. In particular, I think the replacement of Tom Savage by Joseph Cassano may have been very costly for AIG (Savage really retired according to all accounts). The huge profits made by Savage and Sosin (his predecessor) set a standard which Cassano was determined to surpass. It is very unwise to employ someone who considers finding hundred dollar bills on the sidewalk to be barely adequate.

It is also interesting that Cassano is not a quant:

A Brooklyn College graduate, the 42-year-old Cassano was not one of the “quants” who had mastered the quantitative analysis and risk assessment on which the firm had been built. He had no expertise in the art of hedging. But he had excelled in the world of accounting and credit — the “back office,” as it is known on Wall Street.

Now quants are clearly dangerous, but at least they know the silly assumptions they made when writing their models. In particular they must understand the fact that quantitative models require parameter estimates which are definitely not reliable unless based on large amounts of data. I don’t think someone who is good in the back office understands that estimates based on small samples are not just less precise but also have distributions which can’t be determined at all based on available data.

Anyway, the third article in the series should be bloody.

* I’m pretentious enough to use the word but I won’t spell it correctly as Brad does.

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Galbraith’s "Last Shovel"

To save us from Depression, Galbraith uses the last last shovel left, massive federal spending.

He sets out his specific proposals as if they were somehow innovative and daring. For me, they are nibbling at the edges, the stock answer U.S. capitalism always employs when its back is against the wall: Massive federal spending, massive federal debt consolidation. The title of his article admits as much.

Let’s look at the specifics and see how they work. Some of them actually move towards a more socialistic response to our problems; others, well, they simply perpetuate the problem.

Before I outline his solutions, know that I see our present predicament not only as specifically American but also global in nature. Galbraith does not look beyond our borders for solutions, a mistake, I suspect.

Galbraith’s Solutions:

  1. “Plug the tax gaps.” Problem: Local and state governments now have significant shortfalls in tax revenue. The crunch is hitting everywhere. Answer: “Revenue sharing.” By this he means, the U.S. will be writing checks on a massive scale, i.e., piling more debt on the federal government. He should have named it: Debt consolidation, moving the debt from states and localities to the federal government.
  2. “A National Infrastructure Fund.” Apparently the government will set up this fund and then use it to do the kind of capital investment that states and localities can no longer afford. While it will provide jobs and build infrastructure, we have to understand that we have simply postponed “repayment day.”
  3. “A Reconstruction Finance Corporation.” This Corporation is just a “National Infrastructure Fund” with a different set of clothes and a different task, i.e., addressing the industrial crisis, e.g., the auto industry and other industrial collapses. While it is laudatory in purpose, know again that we have just postponed “repayment day.” The national debt will explode; after deflation will come serious inflation–with all those unsupported dollars out there.
  4. “Reduce the age of Medicare eligibility to 55.” Again, Galbraith’s heart is in the right place, but this is certainly a tiny band-aid on a health care system that is bringing everyone down with it: from mighty corporations to lowly workers.
    Come on guys: Nationalize health care. Get serious. One national health care insurer: It set fees and schedules. Be bold. The time for petty tinkering is over. A privatized insurance system benefits only those with power and wealth. The powerful insurance and medical industry write the rules; the wealthy have no problems.
  5. “Home Owners Loan Corporation” that buys “back the mortgages through Fannie and Freddie,” turning “them over to a restructuring facility.” By this I think he hope he means that HOLC will actually own the mortgages and then restructure them. If so, good idea. If Fannie and Freddie still own the mortgages, expect those “semi-private” institutions to holler loud and long about how their investors are being hurt. After the present subprime wave expires, expect a new and equally large ARMS and Alt-F wave. This tsunami is not over.
  6. Raise benefits in Social Security. Good idea. I leave the how to others more knowledgeable than I in this area.
  7. Tax relief for working families “either directly or indirectly through remission of the payroll tax.” Again, Galbraith has his heart in the right place, but I still see the grinning piper entering the town. Who will pay?

What really distinguishes many of Galbraith’s solutions from Paulson’s initial response of rebate checks? Only the total bill is the difference. In many of his responses, the fundamental nature of the response is the same: More government debt. We are not drawing from some “rainy day” fund, using surpluses from good times to see us through. Some of my counters to Galbraith are blatantly socialistic (national health care, for example). I make no apologies for them. They are the way to go. We have listened to the siren song of pure privatization for far too long.

What to do? Here are three suggestions for starters:

  1. Create a national bank. Said bank will compete with private banks, even down to credit cards. Today’s banks will not lend, no matter how much money we pour into them. The credit crunch is real…and it will continue as the recession/depression deepens. In a sense, most of Galbraith’s suggestions do involve a kind of national lending facility. Well, make it official. A national bank. Why fritter around the edges, saving those banking and investment institutions that have brought us to ruin? Let them compete with a national bank.
  2. Institute a serious energy policy that makes us energy independent.
  3. Start seriously addressing our net trade imbalance and disastrous current account balance, which are the root cause of our difficulties. No nation can run our kind of net trade imbalance without imploding

This last point needs elaboration. American financial and economic power was(is?) enormous. When America sneezes, the rest of the world catches a cold. An old saw, but apt.

Capitalism, American style, is collapsing. And with it will fall the leeches who have feasted on it, i.e., China and others. How did they feast? By becoming export platforms to the U.S. We, of course, cooperated, by extending credit in every imaginable way. If we do not shake these totalitarian leeches–I call them for what they are–, then we will never get a handle on trade. Start thinking as a nation with national interests. If we do this, then we will get a handle on trade

Start thinking about a real amalgam of socialism and capitalism, welded together with freedom of thought and expression. Break the back of corporate power both in the House and in the Senate. National health care and a national bank will certainly be a step in this direction. If we disallowed any elected official from ever lobbying, we will begin to finish the job properly.

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Just wondering

by cactus

GW is on vacation. He’s certainly had a lot of these vacations. And yeah, I understand, he still gets his briefings and the like. (I note, most white collar workers I know take work home during their vacations and weekends too.)

I realize he doesn’t have a boss and he’s not accountable to anyone, but does he really need another vacation when he’s leaving office in less than a month? Is presidenting poorly such a tough job? (And no, I don’t think the fact that he’s on vacation reduces the odds of him screwing up yet another thing in the next few weeks.) Why did he take so many vacations?
by cactus

Update: rdan here….the Associated Press points to a coming Vanity Fair series on our President, through interviews with past staff.

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Once the smoke clears from the credit crisis


Movie Guy asks in comments:

I would prefer to read the risk assessment viewpoints of bankers and underwriters as they understand that subject matter far better than most. That’s the best starting point in my opinion. Whether their models were wrong or were simply ignored internally or by regulators is a question that hasn’t been adequately answered thus far.

I haven’t seen an active discussion of loan risk assessment models and actual display or links to existing risk assessment models on any key econ or financial blogs. If you have, please cite a few examples.

Once the smoke clears from the credit crisis, it will be interesting to learn whether economists, bankers, underwriters, and/or financial analysts were the driving force that caused bad investment and loan decisions. If existing U.S. trade policy is a related example, it’s possible that some economists – inhouse and Fed – made some bad predictions which, in turn, helped lead to the overall global credit crisis. In essence, I am saying that economists at various levels played active roles in the financial credit crisis. Thus far, I haven’t seen much noteworthy commentary on this matter, and certainly very little from U.S. economists or the econ blog community.

Are we to assume that banking and investment economists including those serving the investment houses, and Fed economists were ignored? I seriously doubt that was the case. So, where is that discussion?

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Robert Waldmann

Over at the Washington Post, Robert O’Harrow Jr. and Brady Dennis have a fairly interesting first of 3 articles on what went wrong at AIG. Of course, they tend to stress personalities and personal conflicts, but they do slip in some good points about economics.

I’d say the key bit was that AIG made a deal and only later noticed that they had made a suboptimal choice of incentive structures.

Under the joint-venture agreement, Financial Products received its profits upfront, even if the transactions took 30 years to play out. AIG would be on the hook if something went wrong down the road, not Sosin and his team, who took their pay immediately.

Could that cause problems ? Naaahh no way efficient markets imply that short term profits are just like long term profits (impossible).

The rest of my thoughts on the first third of the long sad story comes after the jump.

Greenberg was proud and protective of his company’s AAA credit rating, one of only a handful in the world.

The AAA, awarded after an examination by the bond-rating firms, sent a resounding signal to clients that they could always sleep well at night, that AIG was in no danger of failing. The more secure a company, the more cheaply it could borrow money — a fact that would be pivotal to Financial Products’ success.

This is, I think, a large part of the problem right there. An AAA rating is very valuable and any firm well into AAA territory has unused credibility which can be sold by borrowing at AAA rates and buying risky assets. The rating was just worth too much to leave sitting there, so it was destroyed.

Sosin and Rackson hoped that everyone would get rich, but they had their sights set on something more. They wanted to tear down walls they saw as impediments to innovation, the “fiefdoms” that were standard practice at other Wall Street firms. Their vision required a collaborative culture and a computer system that no one else had. For six months, the group worked on constructing “the position analysis and storage system,” or PASS. They called it simply “the system.”

It enabled Financial Products to bring a rare discipline to complex trades. By maintaining market, accounting and transaction details in one place, Sosin (Howard Sosin founder of “Financial products”which was a joint venture with AIG and eventually brought the firm down) and his people could track the constantly changing value of a trade’s components in a way no other firm could.

The advantages of this approach are clear — only by keeping track of such data in one place can a firm estimate the risk of its portfolio. The (by then long obsolete) very old approach effectively valued assets based on their own risk not their firm portfolio betal. However, the disadvantage should also be clear. An accounting “Fiefdom” mgiht also be called keeping the accountants independent from the traders. The unification elminates oversight. I can see how a trader might trust himself to manage risk too and consider separate departments a waste of resources. I can also see how Greenberg might agree as explained by O’Hara and Denis’s version of the negotiations with Sosin on the joint venture (their quotation marks)

Greenberg had little extra time for the nuts-and-bolts details that Sosin sought to negotiate. “I don’t really know much about this,” he told Matthews. “You go talk to these people.”

Greenberg did notice that he had a problem

Greenberg’s love of his joint venture’s revenue could not overcome his desire for greater control. He chafed at the deal, worrying that he had given Sosin too much freedom.

One detail in particular nagged at Greenberg. Under the joint-venture agreement, Financial Products received its profits upfront, even if the transactions took 30 years to play out. AIG would be on the hook if something went wrong down the road, not Sosin and his team, who took their pay immediately.

Ooops. This is just dumb dumb dumb. If the managers of “Financial Products” understand that the gap in the market which they discovered and monopolized is now full of competitors *and* see a bubble coming, the sharp thing to do is to ride the bubble getting short term profits safely in the bank. Paying based Mark to market profits is little better than paying on and mark to model (made up) profits. I think this mistake requires the influence of market fundamentalists who assume that there can’t possibly be bubbles.

The full argument is that bubbles are against investors rational self interest, and if asset prices are largely determined by delegated managers like Sosin, then contracts must have been written to align their interests with, in this case, AIGs shareholders so there is no need to worry that incentive contract encourage money managers to buy into bubbles because bubbles can’t exists because … Ah yes the argument is clearly circular nonsense.

So Greenberg broke with Sosin (who stopped being a genius when he didn’t have access to an AAA rating) and solved the problem by handling financial products (minus a 150 million golden parachute also).

Savage, a 44-year-old Midwestern math whiz, had just been named the new president of Financial Products. With the honor came explicit expectations, which Greenberg made clear: “You guys up at FP ever do anything to my Triple A rating, and I’m coming after you with a pitchfork.”

My advice ? Buy pitchfork futures.

“With a PhD from Claremont Graduate University in California, Savage”

Greenberg also wanted to change the way Financial Products’ employees divvied up its share of the profits. Under the previous arrangement, Sosin and his crew had the right to book immediate profits on the long-term deals. Greenberg thought there was a powerful incentive to go after millions of dollars in short-term gains while leaving AIG and its shareholders responsible for potential losses for years to come.

Savage agreed with Greenberg that Financial Products employees should defer half of their compensation for several years, depending on the length of the deals being done

Problem solved. Instant access to merely 15% of booked profits on megadeals couldn’t distort anyone’s incentives. I mean half of a gigantic conflict of interests is still a gigantic conflict of interests.

Savage said. “Hank Greenberg’s a great man. And I’m willing, when I talk to him, to say, you know, I’m in the presence of a great man and that’s worth something.”

I don’t want to know how much dealing with such a great financial genius was worth to Savage.

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