Today, the Financial Crisis Inquiry Commission (FCIC) held the first of two days of hearings related to the role of derivatives in the financial crisis, and specifically through the prism of two companies, American International Group (AIG) and Goldman Sachs. FCIC Chairman Phil Angelides noted that the “sheer size of the derivatives market is as stunning as its growth,” citing an over-the-counter (OTC) derivatives market with a notional value of $684 trillion in 2008.
The FCIC heard testimony from various witnesses in three separate sessions today, and asked the witnesses several questions regarding their testimony.
Session 1: Overview of Derivatives
- Michael Greenberger, Professor, University of Maryland School of Law
- Steve Kohlhagen, former Professor of International Finance, University of California at Berkeley and former Wall Street derivatives executive
- Albert “Pete” Kyle, Charles E. Smith Chair Professor of Finance, University of Maryland
- Michael Masters, Chief Executive Officer, Masters Capital Management, LLC
The witnesses in Session 1, mainly academics, provided differing views as to the role that the OTC derivatives market played in causing the financial crisis. Professor Greenberger and Mr. Masters both emphasized that the deregulation of the derivatives market as a result of the passage of the Commodity Futures Modernization Act in 2000, and the creation of a regulatory blackhole, contributed to the 2008 economic downfall. Professor Greenberger focused specifically on the role of credit default swaps (CDS), stating that the “CDS market heighted substantially risks posed by securitization,” and that there were no clearing requirements ensuring that CDS commitments were adequately capitalized and no exchange trading requirements providing market transparency. Mr. Masters noted that unregulated credit derivatives contributed largely to creating systemic risk, while unregulated commodity derivatives created excessive volatility in commodities prices. He described the “interlocking web of very large exposures between the major swaps dealers” which created the potential for a domino effect because swaps dealers did not know the exposures of other players. He further explained that the non-existence of a requirement that swaps dealers post margin collateral to insure their bets also contributed to the increased systemic risk.
On the other side of the argument, Professor Kohlhagen argued that OTC credit derivatives and CDS specifically had “absolutely no role whatsoever in causing the financial crisis,” and rather played a role in delaying the crisis by propping up the housing bubble. He pointed to the push on home ownership throughout this decade as the main cause of the overvaluation and eventual collapse of the housing market.
Session 2: American International Group, Inc. and Derivatives
- Joseph J. Cassano, Former Chief Executive Officer, American International Group, Inc. Financial Products
- Robert E. Lewis, Senior Vice President and Chief Risk Officer, American International Group, Inc.
- Martin J. Sullivan, Former Chief Executive Officer, American International Group, Inc.
In response to questioning as to how the amount of AIG’s derivatives exposure was allowed to triple after 2005 to approximately $78 billion, Mr. Sullivan stated that he did not become aware of the specifics of the credit portfolio at AIG-Financial Products Division (AIG-FP) until 2007. Mr. Cassano noted that AIG-FP never compromised its underwriting standards, and determined in 2005 to stop writing protection on mortgage-backed subprime collateral debt obligations (CDOs). FCIC members focused on why AIG Investments, the company’s securities lending subsidiary, increased its exposure to mortgage-backed securities while AIG-FP was simultaneously making the decision to reduce its sub-prime exposure, and concluded that this was a failure of risk management on AIG’s part.
FCIC members focused most of their questions on the relationship between AIG-FP and Goldman Sachs Group (Goldman), one of AIG-FP’s most significant counterparties. In mid-2007, Goldman made its first collateral call of $1.8 billion on AIG-FP, and the FCIC members noted that Goldman had been very aggressive in getting collateral posted and marking down the underlying securities. Mr. Cassano noted the lack of incrementality of Goldman’s first collateral call, and then described how AIG-FP questioned Goldman’s valuations and negotiated the call down to $600 million by August 2007. Mr. Cassano attributed Goldman’s actions in continuing collateral calls to the opacity of the market and the difficulties in obtaining price discovery. He further stated that he regretted not volunteering, following his retirement in March 2008 from AIG-FP, to become the chief negotiator of collateral calls, because in periods of severe market disruption, he believed that he would have been able to use all available contractual rights to negotiate substantial discounts on collateral calls. He believed that if he had been able to stay on, AIG would have been able to preserve substantial amounts of cash that it could utilize during the events of September 2008, such that taxpayers would not have had to extend $40 billion to bail out AIG.
Session 3: Goldman Sachs Group, Inc. and Derivatives
- Craig Broderick, Managing Director, Head of Credit, Market and Operational Risk, Goldman Sachs Group, Inc.
- Gary D. Cohn, President and Chief Operating Officer, Goldman Sachs Group, Inc.
Mr. Broderick emphasized that Goldman follows an overall approach of prudent risk management, comprised of four main components: governance, information, people and active management of its positions. He noted that a central tenet of Goldman’s philosophy is to mark all of the firm’s positions to current market levels. He also noted that Goldman’s heavy investment in risk technology and that its management of derivatives risks is similar to that applied to other risks, such as applying disciplined fair value accounting, performing risk analyses, requiring strict collateral arrangements and managing counterparty exposures. Mr. Cohn provided Goldman’s perspective regarding its collateral calls to AIG and firmly denied that Goldman “bet against [its] clients.”
In response to additional questions and requests by the FCIC for further documentation regarding the breakdown of Goldman’s risk exposure, Mr. Cohn noted that risk was viewed in the aggregate, and that no operational report likely existed that segregated the risks resulting from derivatives activities from other activities of Goldman. The FCIC members also focused on Goldman’s perceived aggressiveness in making collateral calls and marking the value of the underlying to securities down consistently lower than other dealers in the marketplace. Mr. Cohn continually denied that Goldman intended to bring market valuations down, stating that Goldman used live trades to substantiate its pricing reference points, and used the same set of books with all of its counterparties, whether it acted as the buyer or seller of credit protection.