An AIG Atlas Shrugging

[musashi]

DEAR Mr. Liddy,

It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context:

I am proud of everything I have done for the commodity and equity divisions of A.I.G.-F.P. I was in no way involved in — or responsible for — the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage.

After 12 months of hard work dismantling the company — during which A.I.G. reassured us many times we would be rewarded in March 2009 — we in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials. In response to this, I will now leave the company and donate my entire post-tax retention payment to those suffering from the global economic downturn. My intent is to keep none of the money myself.

I take this action after 11 years of dedicated, honorable service to A.I.G. I can no longer effectively perform my duties in this dysfunctional environment, nor am I being paid to do so. Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid. Having now been let down by both, I can no longer justify spending 10, 12, 14 hours a day away from my family for the benefit of those who have let me down.

You and I have never met or spoken to each other, so I’d like to tell you about myself. I was raised by schoolteachers working multiple jobs in a world of closing steel mills. My hard work earned me acceptance to M.I.T., and the institute’s generous financial aid enabled me to attend. I had fulfilled my American dream.

I started at this company in 1998 as an equity trader, became the head of equity and commodity trading and, a couple of years before A.I.G.’s meltdown last September, was named the head of business development for commodities. Over this period the equity and commodity units were consistently profitable — in most years generating net profits of well over $100 million. Most recently, during the dismantling of A.I.G.-F.P., I was an integral player in the pending sale of its well-regarded commodity index business to UBS. As you know, business unit sales like this are crucial to A.I.G.’s effort to repay the American taxpayer.

The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money. I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of A.I.G.-F.P. because of those losses. In this way I have personally suffered from this controversial activity — directly as well as indirectly with the rest of the taxpayers.

I have the utmost respect for the civic duty that you are now performing at A.I.G. You are as blameless for these credit default swap losses as I am. You answered your country’s call and you are taking a tremendous beating for it.

But you also are aware that most of the employees of your financial products unit had nothing to do with the large losses. And I am disappointed and frustrated over your lack of support for us. I and many others in the unit feel betrayed that you failed to stand up for us in the face of untrue and unfair accusations from certain members of Congress last Wednesday and from the press over our retention payments, and that you didn’t defend us against the baseless and reckless comments made by the attorneys general of New York and Connecticut.

My guess is that in October, when you learned of these retention contracts, you realized that the employees of the financial products unit needed some incentive to stay and that the contracts, being both ethical and useful, should be left to stand. That’s probably why A.I.G. management assured us on three occasions during that month that the company would “live up to its commitment” to honor the contract guarantees.

That may be why you decided to accelerate by three months more than a quarter of the amounts due under the contracts. That action signified to us your support, and was hardly something that one would do if he truly found the contracts “distasteful.”

That may also be why you authorized the balance of the payments on March 13.

At no time during the past six months that you have been leading A.I.G. did you ask us to revise, renegotiate or break these contracts — until several hours before your appearance last week before Congress.

I think your initial decision to honor the contracts was both ethical and financially astute, but it seems to have been politically unwise. It’s now apparent that you either misunderstood the agreements that you had made — tacit or otherwise — with the Federal Reserve, the Treasury, various members of Congress and Attorney General Andrew Cuomo of New York, or were not strong enough to withstand the shifting political winds.

You’ve now asked the current employees of A.I.G.-F.P. to repay these earnings. As you can imagine, there has been a tremendous amount of serious thought and heated discussion about how we should respond to this breach of trust.

As most of us have done nothing wrong, guilt is not a motivation to surrender our earnings. We have worked 12 long months under these contracts and now deserve to be paid as promised. None of us should be cheated of our payments any more than a plumber should be cheated after he has fixed the pipes but a careless electrician causes a fire that burns down the house.

Many of the employees have, in the past six months, turned down job offers from more stable employers, based on A.I.G.’s assurances that the contracts would be honored. They are now angry about having been misled by A.I.G.’s promises and are not inclined to return the money as a favor to you.

The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats — even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.

So what am I to do? There’s no easy answer. I know that because of hard work I have benefited more than most during the economic boom and have saved enough that my family is unlikely to suffer devastating losses during the current bust. Some might argue that members of my profession have been overpaid, and I wouldn’t disagree.

That is why I have decided to donate 100 percent of the effective after-tax proceeds of my retention payment directly to organizations that are helping people who are suffering from the global downturn. This is not a tax-deduction gimmick; I simply believe that I at least deserve to dictate how my earnings are spent, and do not want to see them disappear back into the obscurity of A.I.G.’s or the federal government’s budget. Our earnings have caused such a distraction for so many from the more pressing issues our country faces, and I would like to see my share of it benefit those truly in need.

On March 16 I received a payment from A.I.G. amounting to $742,006.40, after taxes. In light of the uncertainty over the ultimate taxation and legal status of this payment, the actual amount I donate may be less — in fact, it may end up being far less if the recent House bill raising the tax on the retention payments to 90 percent stands. Once all the money is donated, you will immediately receive a list of all recipients.

This choice is right for me. I wish others at A.I.G.-F.P. luck finding peace with their difficult decision, and only hope their judgment is not clouded by fear.

Mr. Liddy, I wish you success in your commitment to return the money extended by the American government, and luck with the continued unwinding of the company’s diverse businesses — especially those remaining credit default swaps. I’ll continue over the short term to help make sure no balls are dropped, but after what’s happened this past week I can’t remain much longer — there is too much bad blood. I’m not sure how you will greet my resignation, but at least Attorney General Blumenthal should be relieved that I’ll leave under my own power and will not need to be “shoved out the door.”

Sincerely,

Jake DeSantis

[Petter Sandstad]

As far as I know, the traditional investment-parts of AIG are solid. Without the bailouts, these parts would be profitable by being bought by another corporation. The parts that have ruined AIG are the new, fancy, things. As mentioned here, credit default swaps &c. These parts deserve to be made extinct, but instead they are now destroying AIG's capital, as well as the barely enumerable bail-outs that it has received.

But the author here makes a serious error. The boom that he refers, only amounts to about 3 years of his service in the company. Since Sept 11 2001 the US has been in a bust, due to the weak-dollar policy that was initiated following the attack. When one is just speaking of this economic crisis as a bust, without including the cause of it, it is at best implied that the bust was caused by the boom (thus following keynesianism, austrian economics, &c).

[musashi]

The parts that have ruined AIG are the new, fancy, things. As mentioned here, credit default swaps &c. These parts deserve to be made extinct, but instead they are now destroying AIG's capital, as well as the barely enumerable bail-outs that it has received.

The derivatives are just another product being sold in the market place. IMO the real problem was ENRON – and the Sorbains-Oxley regulations that came about as a result of the ENRON collapse. I specifically refer to the “Mark to Market” requirement of asset valuation.

These credit default swaps had such a limited market, and each contract had such unidentifiable performance characteristics, that you had outfits like Blackrock and Berkshire picking them up for a song (like 5 and 10 cents on the dollar!). According to GAAP, public banks and insurance companies holding these default swaps had to take massive paper losses on the value of these assets.

[Petter Sandstad]

Yes, they are just another product being sold on the market. But they are unprofitable products, and they are the reason why AIG is doing so much worse than other comparative corporations. There certainly are many harmful regulations and political policies, but that is not an excuse of why AIG is being run so poorly.

[Raaz Satik]

AIG sold the tails. 99% of the time this is a great strategy, unfortunately the 1% of the time it isn't you blow up.

[Petyr Baelich]

AIG sold the tails. 99% of the time this is a great strategy, unfortunately the 1% of the time it isn't you blow up.

What are the "tails"? Surely not puppy dog and kitty cat tails!

[Petter Sandstad]

Credit default swaps are one of the many new fancy products that AIG has been offering. In strong contrast to the traditional products that they are offering. These products are complete failures, and can at best be viewed as extremely risky gambles. They are nowhere near to being certain bets, rather like 100 to 1.

[Raaz Satik]

AIG sold the tails. 99% of the time this is a great strategy, unfortunately the 1% of the time it isn't you blow up.

What are the "tails"? Surely not puppy dog and kitty cat tails!

When we talk about distributions (ie the normal distribution), we talk about the body and the tails, both right and left. Just like the mean tells you the center of a distribution, the standard deviation tells you about the width of the distribution, kurtosis tells you about the 'peakedness' of the body of the distribution and Skewness describes whether the distribution leans right or left.

When I said AIG sold the tails, I mean they made bets that a really rare occurrence wouldn't happen. In this case they sold credit instruments and the really rare occurrence they never thought would happen, happened! KABOOM.

[Raaz Satik]

Credit default swaps are one of the many new fancy products that AIG has been offering. In strong contrast to the traditional products that they are offering. These products are complete failures, and can at best be viewed as extremely risky gambles. They are nowhere near to being certain bets, rather like 100 to 1.

Why do you think they were complete failures?
But you are right, they like almost every form of insurance are an extremely risky gamble.

[Petter Sandstad]

Why do you think they were complete failures?
But you are right, they like almost every form of insurance are an extremely risky gamble.

From the fact that they did not make money on them. Because they are so much more risky than traditional insurance.

[musashi]

Why do you think they were complete failures?
But you are right, they like almost every form of insurance are an extremely risky gamble.

From the fact that they did not make money on them. Because they are so much more risky than traditional insurance.

It is a pretty complex situation, but I think AIG had exposure either way (with or without default swaps). One part of AIG was insuring lenders against losses associated with loan default. Another part of AIG was seeking to mitigate the risk associated with loss from loan defaults by selling these credit default options in the market place.

They created these products because they had limited access to funds by the traditional reinsurance routes. And as it turned out some of their reinsurance partners dropped them in the grease too, by not honoring their contracts once the deals soured.

In my mind the credit default swaps were just another free market option. There was a need. A product was created. Buyers and sellers formed a market place.

We write a lot about this specialized aspect of the insurance business. But what about the main stream part of the business that created the problem?

I mean in hindsight who would write a PMI policy on a mortgage with stated income (perhaps twice or three times greater than verifiable income streams); 100 to 110% of current market value; and interest only? The buyer has less than zero skin in the game. This is a “heads – you win, tails – I loose scenario” for the insurance company. PMI premiums should have been much, much higher.

[Raaz Satik]

Why do you think they were complete failures?
But you are right, they like almost every form of insurance are an extremely risky gamble.

From the fact that they did not make money on them. Because they are so much more risky than traditional insurance.

A financial product such as this is a zero sum transaction (excluding taxs etc). Yes AIG lost a lot of money on these CDSs but the counterparty to the transactions made a lot of money. Bad trade for AIG, good trade for most of the major investment banks in the world. (did you see who they paid /lost to?)

The only way this could be more risky than traditional insurance is if the risk/reward was out of line with the probability of the insured risk occuring. I'm not sure we're able to quantify whether that occured here. Real interesting article in wired magazine Recipe for Disaster last month discussing how correlation of default risk was severly underestimated in most cds models.

[Raaz Satik]

I mean in hindsight who would write a PMI policy on a mortgage with stated income (perhaps twice or three times greater than verifiable income streams); 100 to 110% of current market value; and interest only? The buyer has less than zero skin in the game. This is a “heads – you win, tails – I loose scenario” for the insurance company. PMI premiums should have been much, much higher.

Did you see Paul Wilmott's NYTimes Op Ed Bonus Babies on the heads I win, tails you loose scenario of Wall Street Bonus's.

[musashi]

Did you see Paul Wilmott's NYTimes Op Ed Bonus Babies on the heads I win, tails you loose scenario of Wall Street Bonus's.

I didn’t see it. But it does appear that the scenario described in Mr. Wilmott’s piece is just what hammered our shrugging Atlas, Jake DeSantis. If we take him at his word – his business unit made profit, and yet he’s out of a job sans salary & reward for a job well done.

I wonder if this is where we should draw the line at “too big to fail?” If the company is too big to be diversified, and thus become insolvent under a specific circumstance, then maybe it is too big. But how can any company consider every possible contingency, and then consider the impact of all these possible scenarios against each of its operations? It sounds really complicated to me.

[Uhlan]

Thanks to both musashi and Raaz Satik for both sources.

I know that I will never know the "facts" of Jake DeSantis employment contract. I am puzzled by his two statements regading his compensation for 2008 which according to him is not his only year of employment with AIG. (He wasn't hired from the outside to cleanup this mess.)

Jake DeSantis makes two statements about his compensation.

I take this action after 11 years of dedicated, honorable service to A.I.G. I can no longer effectively perform my duties in this dysfunctional environment, nor am I being paid to do so. Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid. Having now been let down by both, I can no longer justify spending 10, 12, 14 hours a day away from my family for the benefit of those who have let me down.

Seems clear so far. Later he says his compensation was:

On March 16 I received a payment from A.I.G. amounting to $742,006.40, after taxes. In light of the uncertainty over the ultimate taxation and legal status of this payment, the actual amount I donate may be less — in fact, it may end up being far less if the recent House bill raising the tax on the retention payments to 90 percent stands. Once all the money is donated, you will immediately receive a list of all recipients.

In my opinion his letter is well written and clearly not posted in a moment of rage.

I take no issue with his compensation (Seems like a lot to me!) but his statement of a salary of $1 a year, appears to me little more than President O'bama stating recently, that Republicans spend while he, the president's budget is investing. Either you received a $1 or you received $1 plus your retention bonus after taxes of $742,000! Seems to be a word redefinition gambit.........

What am I missing?

[musashi]

I take no issue with his compensation (Seems like a lot to me!) but his statement of a salary of $1 a year, appears to me little more than President O'bama stating recently, that Republicans spend while he, the president's budget is investing. Either you received a $1 or you received $1 plus your retention bonus after taxes of $742,000! Seems to be a word redefinition gambit.........

What am I missing?

I think that AIG and the media are mis-characterizing this situation. From the resignation, it seems AIG had cash issues 12 to 9 months ago. I can imagine a scenario where they approached the “Tall Trees” in the organization to work for $1, under a contract that provided payment a year later. This would resolve part of AIG’s cash flow issues and give them some political goodwill to make other unpopular decisions within the business – “Hey I know these changes are draconian, but your boss and I are only working for a dollar a year…” I don’t consider these payments a bonus anymore. It is deferred compensation.

[musashi]

Raaz I really enjoyed this article. I especially enjoyed the analogy of the binomial probabilities and the complexities of creating a copula. You know as a Quality Engineer I work with the binomial distribution (pass/fail) on a daily basis. It is refreashing to consider it in these circumstances.

As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A.

I really liked this statement… This is right where caveat emptor was abandoned. A bad investment was transformed into a good one.

In finance, you can never reduce risk outright; you can only try to set up a market in which people who don't want risk sell it to those who do. But in the CDO market, people used the Gaussian copula model to convince themselves they didn't have any risk at all, when in fact they just didn't have any risk 99 percent of the time. The other 1 percent of the time they blew up.

And this was a real gem too.