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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