This book is the opposite of the book Interest Rate Markets, where bond markets were described, but there was no math.  This book was written by an academic who has done many seminars for bond professionals so that they could understand the math behind bonds.

The math rarely transcends algebra, except where he used calculus to briefly explain duration and convexity.  Perhaps he could have consulted with actuaries who use discrete approximations.

One more virtue of the book is that if you use Bloomberg, which is common for bond professionals, the book explains the nuances of how Bloomberg does many of its detailed bond calculations.  It even explains why you have to interpret some of what you get from Bloomberg with caution, because it may use different assumptions than you would expect.

So if you want to learn the bond math, this book is a congenial way to do so.  I recommend it highly.

Quibbles

Now, the writer is an academic who has never managed bonds.  As such, he can’t help a great deal with bond selection or portfolio management issues.  But that’s not the main goal of the book… he’s here to teach us the math, and nothing more.

Who would benefit from this book:

Anyone who wants to learn the bond math would benefit from this book.  Go learn and conquer.

If you want to, you can buy it here: Bond Math: The Theory Behind the Formulas (Wiley Finance).

Full disclosure: I asked the publisher for the book and he sent me a copy.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

The rating agencies are the whipping boys of the market.  Like princes who had a whipping boy to take the hit for their transgressions, so the rating agencies take the hit that should go to the regulators, which delegated their  credit-risk responsibility to the rating agencies.  That works out well for all, in one sense: the rating agencies make money, and the regulators escape blame.  What could be better?

But now we face another situation with the rating agencies, where they will finally downgrade the US Government from AAA.  Long overdue, particularly when one looks at the entitlement promises.

But people put up all manner of objections to the rating agencies doing what they should have done ten years ago.  Here is the big one:

The rating agencies never get it right

Not true.  On corporate credit, their ratings are highly predictive, and even yield insights into the movement of stock prices.  Now, if you are talking about securitized credit, you have to understand one thing: no one gets a debt market right until it has been through a failure cycle.  The rating agencies use what little data exists, usually from loans that are held on-balance-sheet, and apply them to loans that are originated and sold.  Doesn’t work that well, but who had better data, because it was a new practice?  Everyone failed on securitization, and only a few of us questioned it in advance.

With government credit, the rating agencies have been right for the most part.  Why?  For the most part, rating agencies are honest dealers when it comes to credit.  To be otherwise would damage their reputation.

Other Objections

Others talk about what the US or the EU could do to muzzle the rating agencies, because the downgrades complicate their actions.  I would say that the Rating Agencies are late if anything — the agencies don’t have much impact on their own.  The big impact is that not enough cash will flow to service debt and other demands on cash at the right time.

If the rating Agencies were muzzled, it would not change the cash flows one whit, except that there would be greater distrust from lenders, because the referees were forcibly silenced.

So what happens if the US gets downgraded?

Not much.  As I have said before, the ratings don’t mean much, except to regulators.  Yields shouldn’t move much, and if there is a sovereign ceiling at Aa2/AA, that will be the benchmark for all US yields, and corporate/municipal/securitized yields won’t shift much, because the economic reality hasn’t changed much.

What will change are investment guidelines that require Aaa/AAA investments.  They will reflect the lower top category, and not force investors to buy foreign AAA dollar-denominated bonds.

What happens if the debt ceiling isn’t raised?

Not sure.  There are lots of things that can happen:

• Prioritizing payments
• Not paying principal or interest on bonds (not likely)
• Issuing scrip (haven’t heard it yet, but who can tell, states have done it)
• Martial law is declared, and the Constitution is null and void (again, not likely)

A genuine full default by the US Government would have many ugly consequences, and should be avoided.  Prioritizing payments would be ugly, but could force our government to do the hard questioning that it has avoided for a long time — what are the priorities of our government?  What would we spend money on if we were deciding on priorities today, rather than the dead ideas of the past?

What, Me Worry?

I have concern over a lot of things, but the debt ceiling does not make it for me.  The bigger entitlement issues have been ignored for 40 years, and I have covered them for 20 years.  This is not the end, but the beginning of debates over where the resources of the US go, and how much is extracted from the populace.  The real test will come when Medicare is reduced, and how well the voters accept that.

I am sure that I will write more on this topic, should I live so long.  My contentions are:

• Securitization does not create liquidity, it only redirects it.
• The Fed does not create liquidity, it only redirects it.
• The Treasury does not create liquidity, it only redirects it.

When I wrote this, one reader asked me to expand on this.  Let’s start with the simple one, securitization.  Take a bunch of loans.  How easy is it to trade them?  Not that easy.  The buyer will want to re-underwrite the whole thing.  It will take time, and time is the opposite of liquidity.

But when you securitize, the last loss pieces are very liquid.  After all, they are AAA/Aaa.  But that comes at a cost.  The lower-rated pieces are less liquid for two reasons.  1) the tranches are small. 2) in a bad situation, the principal could be wiped out in entire.

Securitization does not improve liquidity in aggregate, but it shifts liquidity to the AAA securities.

But what of the Fed and the Treasury?

They don’t create liquidity, as much as steal liquidity from savers.  The Fed creates liquidity through low interest rates, redirecting economic value from savers to debtors.  it is even more transparent in liquidity facilities they create and in quantitative easing, where they put the solvency of the central bank at risk.

Practically, the Treasury and Fed are a unit — think of the Fed as the commercial paper issuing arm of the treasury, though their commercial paper bears no interest, and is redeemable instantly.  We call them dollar bills.

The Fed and Treasury can redirect liquidity to their favorites, but it leaves the rest of the market starved.  The market will heal over time, but it is no credit to the Fed or Treasury.  The market finds ways to heal in spite of the actions of governments.

There are many people out there following aggressive investment strategies, but they want to be covered if things go wrong.  Why not sell down the positions a little and buy some high quality short-to-intermediate-term bonds?

What!?! Give up the upside?!  They would rather buy some insurance — something that will pay off big if things go bad.

But think of the other side of the trade.  What does the one offering you insurance have to do?  It depends if they are scrupulous or unscrupulous.

Scrupulous: Set aside money or high quality assets in reserve, and treat the premiums as part of the the return on a high-yield money market fund, albeit with the possibility of a severe loss.

Unscrupulous: Don’t set anything aside.  Write as many contracts as you can.  It’s free money because there won’t be any crash.  And if there is a crash, declare bankruptcy.  After all, many others will be doing the same thing — you will have company.

Even if the contracts in question are exchange-traded, with margin posted, still the one writing the contracts and taking the risk should be ready to pay the whole wad in the disaster scenario.  Maybe the exchange will make up a few small defaults, but even exchanges can go broke if the situation is severe enough.

In order for tail risk to be mitigated fairly, someone must keep a supply of slack high quality assets.  Rather than the insurer doing that, why not have the investor do so?  The insurer brings along his own cost structure.  Why not self insure and bring down the risk level directly.  Someone has to hold high-quality assets to mitigate risk; let the investor be that party; embracing simplicity and enjoying reduced risk without the possibility of counterparty failure.

Quaint, huh?  And it doesn’t involve a single disgusting derivative, unlike those that would create a “Black Swan” ETF.

I am a firm believer in “you can’t get something for nothing.”  So it is when a new derivative is proposed.  Either there are natural counterparties to take up the exposure (reducing their risk), or speculators must be encouraged to take the risk (more likely).

So, with longevity derivatives, the risk is people living too long leading to more pension payments in future years.  The proposition is: find a party that is willing to make more payments if mortality is better than expected, and offer him a payment, or series of payments, as an inducement to enter the transaction.

Let’s think for a moment, what entities benefit from a rise in longevity?  I can think of one: life insurers.  But there is a problem: anti-selection.  People who buy life insurance tend to be sicker than those of the general population, who tend to be sicker than annuitants.  Annuitants live the longest, and their lifespans improve the most on average.  Life insurers would find taking on longevity risk to be a dirty hedge at best for their life insurance books.  In general there have been few reinsurance agreements for longevity risk for immediate annuity portfolios, but then, that would be a really small component of the life insurance industry at present.

Even when terminal funding was permitted (back in the 1980s to early 90s) — where plan sponsors could buy annuities from insurers to free themselves from their pension obligations, it typically wasn’t a big business, and what did get done transferred credit risk from the plan sponsor to the participant.  Life insurer insolvency means the pension is at risk, subject to the limits of the state guaranty funds.  An acquaintance of mine, who was an actuary, who partially lost a pension on such an insolvency, said the solution wasn’t that hard — allow a lump sum as an option to those for whom the obligation was being transferred from plan sponsor to insurer.

The terminal funding business ceased because of changes in IRS regulations because a few companies realized gains out of terminating their plans.  That sat ill with Congress, especially past the era of corporate raiders, so an excise tax dramatically reduced the business.

So, even when pension plans were able to use insurers to reduce/eliminate their liabilities, there were issues.  There will be issues for longevity derivatives as well.

A swap agreement could point to a “reference portfolio of lives” chosen from some neutral database, or could point to the actual lives that the plan sponsor is trying to hedge.  The first requires less underwriting, and can be more generic, the second has less basis risk, and solves the actual problem, but requires messy underwriting.

Swap agreements could be long or short, but if I were a plan sponsor, I would have a hard time deciding whether to do a long or short swap.  Long swap: counterparty risk.  Short swap: little risk relief.  And to me, long would be 30 years or more and short would be ten years or less.  On short swaps if I ended up on the winning side of the trade, I would probably find few new takers for swaps when the time period was up.

That leaves me with one idea that might work: use a long (~30 years) cat-bond-type structure, where the principal adjusts down as deaths occur.  But we still have the counterparty issue.  If it is the obligation of a operating corporation, there is credit risk.  If it is its own bankruptcy remote Special Purpose Vehicle (SPV – no recourse to a parent company), then there is the risk that the assets in the SPV might not earn the returns necessary over the long haul to pay the interest and redeem the principal.

Calling Ajit Jain.  This is one of those contingencies that yearns for a Buffett-like investor who has a strong balance sheet and can invest for the long haul with above average returns, and thus absorb the volatility of aging annuitants.

But such balance sheets and investors are few.  So I would submit the idea that if you could not get Berkshire Hathaway to issue longevity bonds through such a structure as I have described, you’ll have a hard time issuing long dated longevity bonds anywhere.

Short-dated structures are cute, but don’t offer the relief that pension plans need.  So, I look at this market and do not expect much from it.  Credit risk and longevity risk are at odds with one another, and can be solved by the “magic man” who can earn returns superior to any excess longevity, or unsolved, leaving a larger problem in his wake, by the charlatan that delivers subpar returns.

That said, if you know the “magic man,” the pension fund should disintermediate and hire him.  Problem solved.  Now, where is this genius?

When currencies do not serve as a long-term store of value, economic actors search for ways to preserve future purchasing power, which often mean purchasing commodities. But most commodities are not cheaply storable over long periods, so actors get forced into the few that do: gold, silver, etc. There is a problem here, stemming from dumb money. When dumb money shows up for purchase of generic “commodities” distortions follow: backwardation, large storage demand, and warped market incentives.

Eventually overproduction catches up, but the volatility when it breaks can be huge and self-reinforcing, with c0unterparties raising margin to protect themselves.  Extreme volatility causes exchanges to raise margin requirements substantially, which reveals which side of the trade is inadequately financed, which typically is the side that was winning, which leads to a reversal in price action.  The dumb money is revealed.

Now after a washout, the dumb money often assumes that powerful entrenched interests colluded against them to deny them their long-deserved free ride to prosperity through speculation.  The exchanges are in cahoots with the other side.  Well, no, the exchanges have two interests, which are solvency and transaction volume, which drives their profits.  Solvency is a more primary goal for an exchange, because the second goal can’t exist without it, and exchanges are not thickly capitalized.

Many different types of financial systems are subject to these risks.  Think of AIG: they were rendered insolvent by rising margin requirements as their creditworthiness was downgraded, largely because the rating agencies concluded they were going to lose a lot of money off of their many bets on subprime residential credit.  Think of all of the mortgage REITs that got killed as repo haircuts rose on all manner of mortgage-backed securities at the time that values for the securities were depressed.  Alternatively, think of Buffett, who entered into derivative trades where he received money and bore the risk, but his agreements limited the margin that he would have to post.

Commodity-linked exchange traded products serve four functions:

1. Allow sponsoring financial institutions to get cheap financing through exchange traded notes.
2. Allow sponsoring financial institutions to inexpensively hedge their commodity risks.
3. Allow commodity producers to have cheap financing of their inventories via backwardation.  (And indirectly allow more clever speculators to earn extra profits from gaming the rolling of futures contracts.)
4. Allow retail speculators who cannot access the futures market to make or lose money.  Scratch  that, that should probably read “lose money in aggregate.”

Wall Street does not exist to do small investors/speculators a favor.  It exists to make money off of the issuance of securities, and their trading in secondary markets.

As Buffett put it, “What the wise man does in the beginning, the fool does in the end.”  Yes, there is monetary debasement going on.  We should expect gold, crude oil, and other commodity prices to rise to reflect that.  But rises can overshoot, particularly in smaller markets like gasoline and silver.

So in answer to the question, “Which came first – the margin call or the commodities mayhem?” my answer is simple: The cause of the bust is found in the boom, not in the bust.  The boom happened because of loose monetary policy, which led many people to adjust their risk posture up, whether in commodity speculation, or in high yield debts.  (Oh wait, there are ETFs for that now too.)  Eventually self-reinforcing booms have self-reinforcing busts.  The elites think they can tame this, but they can’t, because you can’t change human nature, which means you can’t change the boom-bust cycle.

James Grant, at a recent meeting of the Baltimore CFA Society said that we had exchanged a “gold standard” for “Ph. D. economist standard.”  And indeed, the value of our currency is manipulated by that intellectual monoculture at the Fed, who pass Einstein’s test of insanity: doing the same thing over and over again and expecting different results.  I say that because the Fed thinks that it can produce prosperity by reducing interest rates.  All that their policy does is produce an asset bubble, or price inflation in goods and services.

The Fed drove us into this liquidity trap through increasing application of an easy money policy.  It will take different ideas and different people, and a lot of pain to get us out, because the Fed is blinded by their bankrupt theories.

There are five factors for systemic risk.  Here they are:

1. Asset size of the institution, including synthetic exposures.
2. Degree of leverage of the institution, including synthetic exposures.
3. Asset-Liability mismatch, particularly financing long assets with short liabilities (including derivatives and margin agreements — think of AIG, or mortgage REITs on repo).
4. Degree to which the institutions owns financial companies equity or debt, or vice-versa, where other financial companies have claims on the institution in question.
5. Riskiness of the assets owned by the institution in question.

Contributing to the risks include easy monetary policy, which can lead/has led  to the neglect of risk control.  Personally, if I were a regulator of systemic risk, I would throw my effort at companies that fit factors 1 and 2, and analyze them for the other three factors.

Systemic risk is layered levered credit risk. A lent to B, who lent to C, who lent to D, who financed a bunch of bad mortgages.

#5 is underwriting risk

#4 is connectedness risk

#3 is liquidity risk

#2 is financial risk

#1 is risk to the economy as a whole.

So when I read articles like this, or books about systemic risk by academics that are so bad that I don’t want to review them (set them to work picking fruit, it would be more valuable than what they currently do), I simply say systemic risk is easy.  Look at my five points.  You can eliminate systemic risk by:

• Breaking up the big banks. (1)
• Disallowing banks from owning the equity of other financials and vice-versa. (4)
• Forcing strict asset-liability matching at banks, and  (3)
• Sizing capital to the riskiness of loans made. (2,5)
• Move to double liability on banks — they can’t be limited liability corporations.  Investors and managers must have their net worth on the line for any losses.

This isn’t hard, but the banks will scream.  Let them scream, and let the stocks of the banks fall.  Banks take risks beyond what they ought to because of poor regulation.  They should be regulated well, and have lower returns on equity as a group.

Before I start this evening, I just want to say that as a day progresses, if I find a good topic, I prepare for it. If I don’t, I plan on doing a book review. As it is, I have 15 books that I have read and not reviewed. The majority of them are poor. It is tough to do a bad book review, but I guess I will do a bunch of them.

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My review of this book was shaped by its coverage of my own industry.  I am an investment advisor, and a small one.  I learned far more from other sources regarding what I needed to do to comply with Dodd-Frank than this book did.  If I had had only this book to help guide me in my regulatory work, I would have been sunk.

Now, as I read through the book it struck me as being a perfunctory summary of the law, without a lot of insight.

The structure of the book is this:

• Introduce the Act
• Explain the history and main goals
• Go through the Titles (main divisions) of the Act, and give brief explanations of the main points.
• Explain how various institutions are affected at a high level.
• Then talk about how the various studies that the Act demands will be done, and how regulatory rules will be created.
• How it affects all existing agencies, and the new agencies that are created by the Act.
• What impact it has globally (not much)
• How it affects various financial professions
• How it interacts with SOX and Basel (not much)

I found the book to be weak, given what I know about my industry, and other financial industries.  It read like someone went through the Act and excerpted it.

Quibbles

I have no quibbles, I only have objections.  This book was put out too fast, and with too little thought.

Who would benefit from this book:

Better you should read the act; it is bad, but not that bad, as Washington goes.  The act is long, so if you are looking for an easy introduction to the act this book could be helpful, but you could probably clip the highlights of the act yourself.  It is only a question of the value of your time.

If you want to, you can buy it here: Essentials of the Dodd-Frank Act (Essentials Series).

Full disclosure: They asked me if I would like to get this book, and I said yes.  What a disappointment.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Unconstrained strategies for bonds are hot now with yields so low.  But wait. Let’s take a step back.  What do we mean by a constrained strategy?

A constrained strategy is one that limits the investments one can engage in either through:

• Specifying an index that the manager is charged with beating
• Specifying percentage limits for investments, split by categories such as credit quality, interest rate sensitivity, asset subclasses (ABS, RMBS, CMBS, Corporates, Agencies, etc.), and other variables
• Barring investment in more funky fixed income instruments such as preferred stock, trust preferreds, junior debts, CDOs, ABS, RMBS, CMBS, etc.
• Or some combination of the above.

There have been unconstrained strategies in fixed income before — they just weren’t called that.  Many value investors in the old days didn’t care what the legal form of the investment was — they only looked for an adequate margin of safety.  Their portfolios were a hodgepodge of debt and equity instruments.  Specialization in only doing debt instruments wasn’t common.

Most debt-only investments were constrained, particularly those from bank trust departments.  Of course, this was an era where investing in junk debt was not respectable for all but the most intrepid of investors.

With the advent of the 1980s we had two innovations: junk bonds and bond index funds.  The first took the world by storm with the demand for yield; I experienced that at the first insurance company that I worked for — they overloaded on junk bonds.  This was before the regulators began regulating bond credit quality more strictly.

The second took a longer time to germinate.  The first bond index fund came into existence in 1986 at Vanguard.  They couldn’t call it a bond index fund, because they could not exactly replicate the index.  There were too many bonds that were illiquid, and they could not buy them at any reasonable price.  Instead, they took an approach that we would call “enhanced indexing” today.  Match the interest rate sensitivity of the index, and the credit quality, but choose bonds that had more potential than the bonds in the index.

In that sense, though the SEC allows bond funds to be called index funds today, all bond index funds are enhanced index funds because there is no way to source all of the bonds.  And from my own days as a corporate bond manager, I learned that bonds in major indexes always trade rich.  From my piece, The Education of a Corporate Bond Manager, Part IX:

There was another example where I crossed bonds where it was legitimate — if it was done to help a broker in distress.  One day, someone offered me a rare type of Capital One bonds at a normal level, and I asked whether the bonds in question were the ones that were in a major bond index, without saying that per se.  After figuring that out, I bought them at the level, and called a broker that was likely to be short the bonds to see if he wanted them.  He certainly did, and offered them at a three basis point concession to where I bought them, as opposed to ripping the eyeballs out (as the technical term went).

The whole set of two transactions took 15 minutes, and made $15,000 for my client.  What was funnier, was that my whole family came to visit me that day, my wife and at that time, seven kids.  They heard the two transactions, though I had to explain it to them later. To the second broker, I had each of the kids say “Hi,” ending with the then three-year old girl who squeaked “Hi.”  He said something to the effect of, “I knew you had a large family, but it only really struck me now.”

That three-year old is now a beauty at twelve, and bright as anything, but I digress.  (They grow so fast… the nine-year old girl is cute as a button too.)

Bond management was once unconstrained by those who looked for total returns in the old days, and constrained in the old days by those who looked for yield.  (Many managers would not buy bonds that traded at a premium.)  Then the bond indexes became popular as a management tool.  In one sense, it freed bond management, because rather than hard constraints, they matched credit and interest rate sensitivities of the index.

But what that constrains is credit policy and interest rate policy.  One managing to beat a benchmark index has limited options.  What if you want to position for:

• Widening credit spreads
• Narrowing credit spreads
• Rising interest rates
• Falling interest rates
• Yield curve steepening
• Yield curve flattening
• Outperformance/underperfomance of a given sector

Any sort of directional bet could go wrong, and more often than bonds that fit the idea of replicating the index parameters, but are special in ways that the index does not appreciate.  So rather than going “whole hog” with the bet, you merely lean toward it, such that if you are wrong, you won’t destroy the outperformance versus the index.

But in this modern world where derivatives are widely accepted as fixed income instruments, a la Pimco, fixed income managers can do a lot more.  There is more freedom to make or lose a lot of money.

The unconstrained strategy can be thought of  in two ways: always trying to earn a positive return with high probability (T-bills are the benchmark, if any), or being willing to accept equity-like volatility while the bond manager sources obscure bonds, or takes large interest rate or credit risks.

I prefer the first idea, because it is more conservative, and fixed income management should aim for safety on average.  As I have said before, I only believe in taking risks that are well-compensated.

But here’s a hard one.  With the yield curve so wide, shouldn’t a bond manager with an unconstrained mandate put a little into long bonds or long zeroes?  I would think so, but I wouldn’t put a lot there unless the momentum started to favor it.

I like the concept of the unconstrained strategy; indeed, it is what I am doing for clients, but it is of the first variety, try to make money for clients in all markets, and not just be a wild man in search of yield or total return.

I find the move to unconstrained mandates to be a return to what value managers did long ago, but in a more complex fixed income environment.  I wonder though, as to whether the future failures will invalidate the idea for most.  It is tough to manage any asset class while adjusting the risk level to reflect what should not be done in a given era, whether in equities or debt.  The danger comes from trying to maintain yield levels that are higher than what is sustainable.

I don’t often do a Q&A with book authors, but I appreciated my dealings with Roddy Boyd, the author of Fatal Risk.  It’s official publication date is tomorrow, but it is now available at Amazon.  If you want to buy it, you can find it here: Fatal Risk: A Cautionary Tale of AIG’s Corporate Suicide.

Full disclosure: This book was sent to me by the author, unsolicited.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

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1) What impressed you most about your interview(s) with M. R. Greenberg?

To begin, his utter and consuming passion for AIG. He does not distinguish between AIG and himself, at least in any appreciable sense. What happened to AIG thus happened to him and vice versa. He will never forget anything and he will never forgive anything. Nor, for that matter, will he concede very much. The other issue is that per David Schiff’s observation, Greenberg never stops, he is “Always running.” Since his obsession is work, then everything else in his life can be elegantly understood: The foreign policy stuff, bringing his sons into the business, the travel schedule of a foreign diplomat, the boards and foundations. Since AIG was everywhere and doing everything so was Greenberg.

2) If you could have gotten others to talk with you, who would they be, and what questions would you want them to answer?

It’s a tie between Win Neuger and Martin Sullivan. I’d want to ask Sullivan if he really saw events per his Congressional testimony on the fall of 2008, where he laid much blame for the collapse at the feet of mark-to-market accounting. This is akin to Morgan Stanley’s John Mack complaining about short-sellers at the same time–a complete abdication of all intellectual responsibility. I’m guessing Sullivan has a lot more to say than just stuff about accounting. Regardless, no one at AIG had much to say about mark-to-market accounting in 2005-2007, when they had billions of dollars in unrealized gains from their sundry portfolios.

With Neuger, I would want to start at the very beginning of the expansion of the securities lending portfolio, which tracks to around the very minute of Greenberg’s departure. It’s easy to take shots after a crash but I wouldn’t do that; I’d want to know how he thought AIG was going to have a different end than the number of other securities lending portfolios that extended duration during low rate cycles and modest volatility. I’d also want to know when HE realized there was trouble, that you can’t always unload $150 million worth of mortgage-credit paper on the bid side. That conversation might get interesting.

3) AIG Financial Products had three eras, with three different managements, strategies, and interactions with AIG parent company.  Why wasn’t AIG able to manage AIGFP to keep it sound?

In a word: competition. In 1987 the only limits to what FP could do was what they could dream up. They dominated the landscape with a virtual monopoly. Come 1996, every I-bank and commercial bank was in rate swaps in a big way and, in the case of Gen Re and Credit Suisse, had their own Financial Product units seeking to do “bespoke” transactions. By 1999, Goldman was actively leveraging its corporate finance relationships to do custom transactions. Hedge funds, by the early parts of last decade, are competing with them on the asset finance side and on every sort of complex short-term trade FP entered, they were competing against the prop desks of Goldman, Merrill, J.P.Morgan and the like.

There is also the intellectual drift common to every enterprise. A founder comes in and designs a business in a certain fashion; By the second or third generation of management, it’s highly unusual to have the same rigid adherence to the founder’s goals. For an (extreme) example, look at the Ford Foundation and its role within the Liberal firmament and then look at who Henry Ford was. The divergence of mission usually occurs obliquely. For instance, Joe Cassano would have looked askance at a speculative bet directly on the mortgage market via Freddie or Fannie passthroughs. Instead, FP wound up long the mortgage market via writing insurance coverage they were told would never be impaired.

4) Are there any areas/subsidiaries inside AIG that you would want to look more closely at after writing Fatal Risk?

Not really.

5) What do you think the last moment was that AIG still had control of its own destiny was?

Maybe late 2006 or early 2007. Assuming some visionary philosopher King rode in with a mandate to hedge all risk, with total operational control and the budget to see it through, they would have had the ability to go out and buy a fair amount of coverage in the ABX indices for FP (and maybe structure some custom swap with a large bank) and begin an immediate “run-off” at the Securities Lending portfolio. It would have cost them billions of dollars and they still would have taken some bitter losses in the autumn of 2008. Still, I can see a $10 billion “investment” across FP and Securities Lending going a long way to preserving autonomy. It should be noted that I asked this question at every interview and no one said anything like it was even considered. FP executives say they never considered buying CDS on the CDS they were writing since it would have completely eliminated the “profits” from premiums. Go figure.

6) What would it have taken for AIG to be properly managed after Greenberg’s departure?

There was a massive gap in the knowledge base of the men who stepped in after the departure of Greenberg, Ed Matthews and Howie Smith; Martin Sullivan and (CFO) Steve Bensinger knew enough to run AIG in a bull-market. Their greatest weakness was in not having a suitable understanding of the downstream, or long tail, risk of derivatives, particularly in the reference securities. They were almost childlike in their trust in systems and processes: If PWC or a big law firm looked at something, that was good enough. The problem was that it isn’t. This isn’t to indict them: A guy like Steve Bensinger was a solid Treasurer but the CFO job at AIG required the ability to be an accounting whiz plus having equals parts risk guru and legal eagle–I’m thinking of a David Viniar sort–and he wasn’t any of those things.

Part of this problem has to do with the fact Greenberg/Matthews/Smith had seemingly been there forever and so a bright, truly talented next generation CFO or COO never bloomed. How could it have? Any ambitious 40 something would conclude that the AIG executive suites were permanently closed. So there was no backbench to hand and as I explain in the book, a post-Greenberg transition plan was not something Hank thought much of as a concept. Practically speaking, Sullivan was never remotely suited for the role since he had zero financial management experience. Moreover, his trusting, amiable disposition insured that when his former peers like Joe Cassano ran into hot water, he didn’t have a skeptical or questioning bone in his body. That’s a big risk to run when you have a Financial Services unit embedded in your company that is larger than Lehman Brothers and many times as complex. Greenberg, on the other hand, had little fear of conflict and had a track record of asserting himself over his trading desks.

7) Did AIG management err in moving so aggressively into areas that exposed them to the credit cycle and equity markets?  Do you think Greenberg could have been happy running a smaller insurance enterprise that would have a hard time growing profitably with moderate risk?

Part one: That’s the core challenge of AIG’s entrance into “The Kingdom of Money” as I put it. As conceived, its financial units were never supposed to have this risk; that was what the asset management units were for. Per question #3 however, FP inevitably had its advantages competed away and was forced to seek profits in areas that had long been frowned upon, like getting long fixed income risk.

Part two: No. Handsome and steady profits were attractive to Greenberg but growing them were what he was all about.

8 ) What were the shortcomings from Greenberg being an autocrat at AIG, even if he was one of the most talented CEOs ever?

In AIG under Greenberg the single-minded focus on profits, new opportunities and growth that he instilled obviously facilitated a period of expansion and wealth creation that has a bare handful of rivals in history. However, given time and the law of averages, profit opportunities began to fade (the returns on assets tell this story) so they had to go farther out on the risk curve to sustain income growth. There is the same end to this story every time. Secondly, autocratic organizations tend to have weak leadership benches. At the unit level, AIG was shot through with talented people from top to bottom. The person who could run the company post-Greenberg, however, arguably didn’t exist at the company. For a talented executive, in retrospect, AIG was a company that you either came to understand that you were never going to go any farther than where Greenberg saw you going or you left. A lot of people chose the latter but over time, many of them “went along,” and didn’t speak up at key junctures. For instance, in the securities lending debacle, the global investment unit’s senior leadership seemed fine with things but it was a pair of rank-and-file portfolio managers, Mike Rieger and another guy, who spoke up. They were roundly ignored.

9) What aspects of AIG’s culture overall helped lead to the eventual failure?

A problematic trust in process over actual insight and investigation. Time after time, “A law firm signed off on it” was considered actual risk management; it’s not. There was also just abysmal risk management, not only in the obvious things like writing $73 billion of super-senior CDO tranche protection and the Securities Lending debacle, but in the minutiae. It appears no one even looked at the credit support annexes, which were standard in all swaps. Moreover, FPs valuation systems were completely inadequate in getting real market prices for the underlying CDOs. There is an element of the “The Wizard of Oz” to AIG–”So that’s what is behind the curtain?”

10) Do you think AIG got sloppy in the early 2000s as business got more complex, and the need to meet earnings estimates grew more difficult?  (Gen Re, PNC, Brightpoint, etc.)

Yes. They were all very different transactions but yes. Gen Re should have been caught by a mid-level risk analyst or lawyer in the general counsel’s office around the second week it was under construction. Brightpoint and PNC were separate but had at their core the manipulation of earnings. The odd thing is that the PNC transactions had been done several times in Japan with the same ill intent and were thoroughly blessed by regulators there, who were apparently happy to do anything to suggest that the nightmarish balance sheets of Japanese banks were improving. They had not a concern in the world that the deals were totally abusive to the investor.

11) At the end, AIG had subprime risk in their life insurers (through securities lending), mortgage insurers, at American General Finance, and at AIGFP.  Was it a mere coincidence that they had it everywhere?

No. AIG was a corporation whose ethos was a ceaseless hunt for earnings. When you are a AAA, or AA+ and fund at Fannie/Freddie levels, the carry trade is a very obvious place to capture some seemingly risk free spread. Given that AIG’s risk management was highly passive–relying on what others said about risk (as opposed to doing their own work)–trusting the rating agencies to get it right came easy. What was interesting is that Securities Lending and the mortgage insurance company continued to add exposure months after the market started to turn but American General Finance and FP examined the market in-depth, had a heart attack and immediately ceased those lines of business. The best thing? No one said a word to each other. AIG, in this sense, resembles a large and dysfunctional family, where no one shared anything with anyone, even Mom and Dad. Under Greenberg, big decisions like that invariably resulted in long, detailed phone calls where the decision was hashed out with Greenberg and Matthews. They would abide the decision but would want to know every reason why it was made.

12) Did it ever dawn on anyone at AIGFP that they were the big patsies insuring subprime securitizations prior to them stopping the practice in entire in 2005?  Or that the Street were patsies for relying on one insurer? (Forget that the US bailed them out in the bailout of AIG.)

Not as laid out in your question, no. An FP executive named Gene Park has become a minor celebrity because of media accounts that have him as a “Voice in the Wilderness,” decrying abusively structured mortgage credit. Park certainly hated the sector and let it be known but his effect was limited in that Cassano disliked him with varying degrees of intensity. A guy named Andrew Forster, who ran the asset-finance group out of London and had ultimate authority over the swaps, was much more methodical and cautious. Park certainly communicated his dislike to him but Forster took months to flesh out his concerns. It doesn’t appear that the concerns over the swaps were ever put in terms of systemic risk but rather as just something that had higher than expected likelihood of default. It is difficult to overemphasize how incurious many at FP were.

13) What area in the AIG parent failed to note that AIGFP could call upon resources inside AIG upon downgrades, forcing a posting of collateral?  Treasury? CFO?  That had to be signed off on by someone at the AIG parent, no?

Every area. No one really looked at the absolute risk levels of the insurance FP was writing, no one looked at the CSAs, there were no autonomous risk procedures for determining valuations, no one modeled corporate cash flows in the event these swaps became a problem and it goes on. In July of 2007, when there was the first collateral demand from Goldman, much of the senior management of AIG was unaware this product line existed. That’s a problem.

14) Tim Geithner was supposed to be the Fed’s point man on derivatives.  How could he miss something this large? How do you think derivatives should be regulated?

Let me combine these two questions. Geithner missed it because he didn’t know enough to look for it, but I interviewed a number of senior Fed officials who had not missed AIG’s rapid balance sheet expansion, the leverage of the banks and brokers to each other and, ultimately, everyone to structured products. Their response was that the Fed (in New York) only analyzed bank holding companies, or the entities that owned the big banks. They fully acknowledged the financial filth going on but said it was at the operating units, where they had no ability to do anything. That was the purview of the Office of the Comptroller of the Currency, another federal regulator with minimal funding and difficulty retraining an experienced analyst corps. I’ll bet you can figure out how it went from there.

The only regulation that really, truly, deeply matters in pondering the credit crisis is the repeal of Glass-Steagall. Once banks were able to throw themselves and their funding capacities into market-making and underwriting full bore, nightmares could only result. To that end, the only regulation that matters in reframing a regulatory apparatus is the reimposition of Glass-Steagall in some form or shape. Commercial banks, all joking aside, have usually been pretty good at making loan decisions; conversely, when investment banks dominated the marketplace, risk was a function of how much capital a firm was willing to lose at one time. For all the mania’s and fads that come and go in the markets, from the mid 1930s onward, Wall Street did a decent job of keeping its insanities form effecting the economy too much.

It would be optimal if we got back to that.

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Many thanks to Roddy Boyd for the answers.  He want above and beyond again.