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1 1 2 FINANCIAL CRISIS INQUIRY COMMISSION 3 Official Transcript 4 5 Hearing on "The Role of Derivatives 6 in the Financial Crisis." 7 Wednesday, June 30, 2010, 9:00am 8 Dirksen Senate Office Building, Room 538 9 Washington, D.C. 10 11 COMMMISSIONERS 12 PHIL ANGELIDES, Chairman 13 HON. BILL THOMAS, Vice Chairman 14 BROOKSLEY BORN, Commissioner 15 BYRON S. GEORGIOU, Commissioner 16 SENATOR BOB GRAHAM, Commissioner 17 KEITH HENNESSEY, Commissioner 18 DOUGLAS HOLTZ-EAKIN, Commissioner 19 PETER J. WALLISON, Commissioner 20 21 Reported by: 22 PAGES 1 - 376 JANE W. BEACH, Hearing Reporter 2 1 Session 1: 2 MICHAEL GREENBERGER, Professor, 3 4 Overview of Derivatives University of Maryland School of Law STEVE KOHLHAGEN, former Professor of 5 International Finance, University of California 6 at Berkeley and former Wall Street derivatives 7 executive. 8 ALBERT "PETE" KYLE, Charles E. Smith Chair Professor of 9 Finance, University of Maryland 10 MICHAEL MASTERS, Chief Executive Officer, Masters 11 Management, LLC 12 Session 2: 13 Derivatives 14 JOSEPH J. CASSANO, Former Chief Executive Officer, Capital American International Group, Inc., and 15 American International Group, Inc. Financial 16 Products. 17 18 19 20 21 22 23 24 25 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. 3 1 Session 3: Goldman Sachs Group, Inc. and Derivatives 2 3 CRAIG BRODERICK, Managing Director, Head of Credit, 4 Market and Operational Risk, Goldman Sachs Group, 5 Inc. 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 GARY D. COHN, President and Chief Operating Officer, Goldman Sachs Group, Inc. 4 1 P R O C E E D I N G S 2 3 (9:06 a.m.) CHAIRMAN ANGELIDES: Good morning. Welcome to 4 the hearing of the Financial Crisis Inquiry Commission on 5 "The Role of Derivatives in the Financial Crisis." 6 to welcome everyone here today. 7 with a brief opening statement, and I will be followed by 8 Vice Chairman Thomas. 9 Good morning. I want I am going to start off As always, as we start the hearing 10 this morning I would like to thank Vice Chairman Thomas for 11 his partnership and his cooperative work with me and my 12 fellow Commissioners. 13 out and thank Commissioners Born, Hennessey, Thompson, and 14 Wallison for taking the lead on this hearing. 15 Today I want to particularly single Today we will be examining the role of 16 derivatives in the financial crisis. 17 despite 30 years in housing, finance and investment in both 18 the public and private sectors, I had little appreciation of 19 the tremendous leverage, risk, and speculation that was 20 growing in the dark world of derivatives. 21 22 23 I must say that, Neither, apparently, did the captains of finance nor leaders in Washington. The sheer size of the derivatives market is as 24 stunning as its growth. The notional value of over-the- 25 counter derivatives grew from $88 trillion in 1999 to $684 5 1 trillion in 2008. 2 the gross domestic product of all nations. 3 That is more than 10 times the size of Credit derivatives grew from less than a trillion 4 dollars at the beginning of this decade to a peak of $58 5 trillion by 2007. 6 our financial markets unseen and unregulated. 7 These derivatives multiplied throughout As I have explored this world, I feel a little 8 like I've walked into a bank, opened a door, and seen a 9 casino as big as New York, New York. Unlike Claude Rains in 10 Casablanca, however, we should be shocked, shocked that 11 gambling is going on. 12 As the financial crisis came to a head in the 13 fall of 2008, no one knew what kind of derivative-related 14 liabilities the other guys had. 15 participants have good information. 16 most, Wall Street and Washington were flying blind. Our free markets work when When clarity mattered 17 To be fair, derivatives have a legitimate purpose 18 to help hedge against risk, but much of what has been traded 19 in recent years, especially synthetic securities, is just 20 bet, upon bet, upon bet. 21 don't start a business. 22 securities may have been synthetic, but they destroyed real 23 people's real life-savings. 24 25 They don't build a factory. They don't add a job. They These One might think that financial reform legislation will take care of all of this, but it would be naive to 6 1 believe that a signature on a law, in and of itself, marks 2 the completion of financial reform. 3 beginning. 4 In fact, it is only the It took a good decade for New Deal reforms to be 5 put into action. 6 will be worked out in regulations. 7 already lining up to help write the rules. 8 depends on the will to make it happen, of regulators, of the 9 public officials who appoint them, and of the financial 10 The real nitty gritty of financial reform No wonder lobbyists are Real reform leaders who must live by them. 11 This Commission has already seen plenty of 12 instances of sensible regulations that went unenforced. 13 Sadly, we know that, while the soul may be willing, the 14 flesh is often weak. 15 financial crisis need to understand how we got into this 16 one. 17 All of us who want to avoid another That's the purpose of this Commission. In the case of derivatives, my fellow 18 Commissioners and I have seen something we've seen many 19 times in our investigation: 20 warning signs being ignored. 21 Risk, leverage, and early- In this instance, there were the reddest of red 22 flags. In 1994, Orange County, California, goes bankrupt in 23 a derivatives deal gone bad. 24 Management causes a near financial crisis. 25 Enron, knee deep in derivatives, explodes causing what is at In 1998, Long-Term Capital And in 2001, 7 1 the time the largest bankruptcy in U.S. history. 2 It's not as if no one warned us. Back in the 3 1990s, Commissioner Born, then Chair of the Commodities 4 Futures Trading Commission, saw the looming crisis and 5 argued strenuously for transparency and common-sense 6 regulation of derivatives. 7 earned her the John F. Kennedy Profile in Courage Award. 8 she had prevailed, I believe we would have had a safer 9 financial system. 10 Her prescience and tenacity If And so today we will look at derivatives and the 11 financial crisis through the prism of two companies: 12 Goldman Sachs and AIG. 13 derivatives, as indeed was all of Wall Street. 14 The two were linked through In June 2008, Goldman's derivatives book had a 15 notional value of $53 trillion, with over 1.2 million 16 contracts. 17 Chief Operating Officer, how his firm's derivatives' 18 dealings may or may not have contributed to the financial 19 crisis, and the economic crisis that followed. We will ask Gary Cohn, Goldman's President and 20 We will ask how it came to be that AIG, a once- 21 respected company that Americans looked to for traditional 22 insurance needs, found itself on the losing side of many 23 derivatives' transactions with Goldman and other companies 24 and had to be bailed out with a commitment of $182 billion 25 in taxpayers' assistance. 8 1 We will have questions for AIG's former CEO 2 Martin Sullivan, as well as the former head of its Financial 3 Products Group, Joseph Cassano, who is testifying for the 4 first time since the crisis. 5 Goldman-AIG connection, a multi-billion dollar strategic 6 relationship that ultimately turned contentious. 7 And we will explore the We will examine how the two financial giants 8 struggled over derivatives in the fateful weeks and months 9 leading up to the financial crisis, and whether their fight 10 fueled this crisis. 11 can shine a light on this dark world of derivatives. 12 13 Hopefully, over the next two days we And with that, I now turn the microphone over to my colleague, Vice Chairman Bill Thomas. 14 VICE CHAIRMAN THOMAS: Thank you, Mr. Chairman. 15 I do want to note for the record the absence of 16 two Commissioners. And frankly I'm surprised that we've 17 been able to maintain the full complement of the Commission 18 for as long as we have, given the resumes of the individuals 19 on the Commission. 20 Commissioner Murren and Commissioner Thompson, who I know 21 would want to be here. 22 this because we've been so pleased at the sacrifices the 23 Commissioners have made so that we could be in attendance. 24 But frankly, the real world sometimes cannot be overcome and 25 you've got to do what you've got to do. So I want to note the absence of And I wanted to make public note of So I want to 9 1 recognize them for their ongoing contribution, and they will 2 be with us at another time. 3 I also want to thank all of the witnesses once 4 again, and I want to underscore, Mr. Chairman, as you 5 mentioned we have two particular firms here. 6 done in the past, it isn't to focus on them and hold them 7 responsible, but rather to use them in an attempt to look at 8 some case studies. 9 players so that you have a better understanding of the way And as we have And you would turn to the biggest 10 in which relationships occurred, and I think by any standard 11 AIG and Goldman would be at least two of the principal 12 nominees in that discussion. 13 You mentioned the movie Casablanca. The movie 14 that I think of when we talk about derivatives, having begun 15 my Congressional career on the Agriculture Committee, is the 16 movie Trading Places with Dan Aykroyd and Eddie Murphy, and 17 their attempt to corner the orange juice futures market. 18 Because most people will think about derivatives in terms of 19 the classic pork belly, or oil, and the rest. 20 And so the frankly interesting history of how 21 derivatives came into play, at least in most people's 22 opinion, but especially the spinoffs of derivatives, a 23 significant role in what we have been statutorily charged 24 with investigating, the financial and the resultant economic 25 crisis, is one that most people do not understand. And the 10 1 more I listen to folk and read, apparently some of the 2 people who were the major players did not understand what it 3 was that they were dealing with, and especially the more 4 complicated financial aspects of being on one side or the 5 other of the derivatives. 6 So I mean even as late as today, in The New York 7 Times we continue to find out things that are behind-the- 8 scenes' exposes of what went on. 9 will probably get more of that. And as we go forward, we But today's hearing, 10 especially the first panel, I think will give us a quality 11 grounding in just exactly what we are talking about. 12 And I do hope--and I am going to try to keep my 13 eye on our primary statutory mission—and that is not get lost 14 in some of the intriguing stories, but to focus on what we 15 can do to determine the causes of the financial crisis and 16 the resulting economic crisis, and the role that the various 17 institutions and activities of those institutions played in 18 the resultant financial crisis. 19 So I look forward to today's testimony. And I 20 want to thank, once again, all the witnesses and look 21 forward to the hearing. 22 Thank you, Mr. Chairman. 23 CHAIRMAN ANGELIDES: Thank you, Mr. Vice 24 Chairman. Now we will begin the first session, and we have 25 four panels with us, four witnesses with us. This first 11 1 session is "An Overview of Derivatives" designed to give 2 both the Commission and the public a large-scale view of 3 this issue. 4 What I would like to do is ask if the witnesses 5 would please all rise and raise your right hand to do what 6 we customarily do, which is swear in all our witnesses in 7 our public hearings. 8 right hand. 9 So again, if you would raise your I will read the oath and you will affirm. Do you solemnly swear or affirm under penalty of 10 perjury that the testimony you are about to provide the 11 Commission will be the truth, the whole truth, and nothing 12 but the truth, to the best of your knowledge? 13 MR. GREENBERGER: 14 MT. KOHLHAGEN: 15 MR. KYLE: 16 MR. MASTERS: I do. I do. I do. I do. 17 (Witnesses sworn.) 18 CHAIRMAN ANGELIDES: Thank you, very much. 19 Gentlemen, we have received your written 20 testimony and we appreciate that. 21 of you to provide an oral statement of no more than five 22 minutes so that we can reserve the balance of the time, in 23 excess really of two hours, for questions and answers. 24 25 We are going to ask each So I would ask you also to not just repeat your written testimony, because we are good readers on this 12 1 Commission. 2 minute the yellow light will go on. 3 that you have one minute to wrap up. 4 You have in front of you a device that at one So that is your signal We will start and just go down in order with Mr. 5 Greenberger. 6 Greenberger, if you will commence your testimony, terrific. 7 8 We will end with Mr. Masters. WITNESS GREENBERGER: And, Mr. Thank you, Mr. Chairman, and thank you Members of the Commission: 9 I think Commissioner Thomas hit the nail on the 10 head. We often think of these products as being pork 11 bellies, or red wheat, and even in the regulated futures 12 market by the mid- to late-'90s it had expanded across a 13 wide array of instruments, financial instruments, 14 complicated financial instruments, that are part of the 15 derivatives package. 16 There will be much discussion when you deal with 17 this over the term "swaps," which is essentially what it's 18 called, an over-the-counter derivative, as a result of the 19 Commodities Futures Modernization Act, an unregulated 20 product. 21 Just quickly, the most common swap is a plain- 22 vanilla swap, interest rate swap. Someone has a loan. 23 They've committed to pay an adjustable rate. 24 worried that the adjustable rate will go above the fixed 25 rate. They're So they enter into a swap agreement with a swap 13 1 dealer--and there are five major swap dealers, major banks, 2 where the swap dealer will pay it the adjusted rate, or take 3 care of the adjusted rate, and it will pay the swap dealer 4 the fixed rate. 5 6 So it has swapped its adjustable exposure for fixed exposure. 7 Now of course the swaps dealers don't do that pro 8 bono. 9 and they themselves then lay off that risk with other swaps' 10 They pay a very hefty fee to put themselves at risk, parties. 11 The most classic thing I think we will be 12 discussing is the credit default swap, which many believe-- 13 including myself--was a major culprit in causing the 14 financial crisis. 15 That swap is the swap of a premium for the 16 guarantee in this case of an investment. 17 somebody owns a collateralized debt obligation, which is 18 essentially an investment, that subprime mortgages to 19 non-creditworthy individuals will be paid off and won't 20 default. 21 Theoretically They want an insurance against the very high risk 22 that people who can't afford a mortgage will not pay the 23 mortgage. 24 word $58 trillion, because this is a private, bilateral 25 opaque market I think estimates are just educated guesses. The calculus--I know, Mr. Chairman, you used the 14 1 The figures I put in my testimony is the credit default swap 2 market was at a minimum $35 trillion, a maximum $65 trillion 3 notional value. 4 And I've made clear in my testimony the 5 difference between notional value and amount at risk, and 6 I'm happy to discuss that. 7 We had an opportunity at one point where we 8 reached a fork in the road. Will these swaps' products that 9 look like futures--many people argued they were futures-- 10 would they be regulated as regulated futures? 11 be completely unregulated? 12 Or would they By virtue of the Commodity Exchange Act, if they 13 were futures they would be cleared--that is to say, some 14 strong financial institution would make sure that the 15 commitments were backed by adequate capital through the 16 collection of margin, and you wouldn't have situations like 17 September 15th, 16th, where AIG wakes up finding out all of 18 a sudden it owes $80 billion on its credit default swap 19 book. 20 That's the clearing aspect. And if it were regulated, it would be exchange 21 traded. 22 know. 23 there would be a market-driven price mechanism associated to 24 these products. 25 That is to say, transparent. The market would The regulators would know what is out there, and We had a fork. We could have either done that, 15 1 or we could do what Congress did in 2000, which was to 2 decide for their reasons that this market would be 3 completely unregulated. 4 That is to say, no clearing. 5 trading. 6 laws were preempted because of an understanding that this 7 was going to be a highly speculative market. 8 states, if they applied gambling laws, would interfere with 9 the market. 10 Preemption of state laws. No exchange Especially state gaming And the Not only was federal regulation what then- 11 Chairman Christopher Cox said, a regulatory black hole 12 overseeing this market, but the statute itself had a 13 provision in it that, to the extent the swaps violated the 14 statutes, they could not be rescinded or unenforceable. 15 In the end, what you have is a $600 trillion 16 notional value market that is completely unregulated and 17 dark. 18 there. Market observers don't know what's happening out 19 there. And that led to a belief that we needed to rescue 20 the entire market in the fall of 2008. 21 Therefore, regulators don't know what's happening out CHAIRMAN ANGELIDES: Thank you very much, Mr. 22 Greenberg--Greenberger, sorry, I just cut off that "er." 23 Mr. Kohlhagen. 24 Doctorates, I apologize. 25 Dr. Kohlhagen. WITNESS KOHLHAGEN: For all of you who have "Mister" is fine. 16 1 Good morning and thank you for inviting me here 2 and for letting me share my opinions with you. 3 basic points I want to make. I have five 4 The first is that interest rate derivatives, 5 currency derivatives, equity derivatives, and commodity 6 derivatives in my opinion did not cause, amplify, or 7 marginally spread--or materially spread the financial 8 crisis. 9 international community, corporations, and investors and In fact, they offered hedging opportunities to the 10 individuals, and were an enhanced global resource allocation 11 efficiency and had absolutely no material effect whatsoever 12 on the financial crisis. 13 Over-the-counter on credit derivatives, in 14 general, and credit default swaps in particular, had 15 absolutely no role whatsoever in causing the financial 16 crisis. 17 My second point is that credit derivatives in 18 general, and credit default swaps in particular, definitely 19 enabled the continuation of the bubble starting in March of 20 2005 when AIGFP sold a staggeringly large amount of credit 21 default swaps over about a 15-month period into the 22 marketplace. 23 The bubble started before that, and the crisis 24 would have happened if they had not done that. The crisis 25 would have come sooner if AIGFP had not been involved in 17 1 that market. 2 been somewhat less severe, but it still would have happened. 3 And it would have been--the crisis would have The causes--my third point is, the cause of the 4 financial crisis was quite simply the commitment by the 5 United States Government to bring home ownership to the next 6 group of people who previously had not been able to own 7 their own homes. 8 9 That did not necessarily have to lead to a crisis. There would be some cost to U.S. taxpayers, the 10 subsidies and guarantees, and was unknown. 11 that government program was implemented and the conduct of 12 the government-created, government-sponsored, and 13 government-managed program led to much higher costs than 14 people thought. 15 The way that In order for--my fourth point would be, the 16 amplification and spreading required enablers. And those 17 enablers, later when it turned into a bubble, what I call 18 "bubble enablers," included essentially everybody: 19 officers, lending institutions, the government's open-ended 20 and poorly supervised subsidies and guarantees of Fannie Mae 21 and Freddie Mac, those institutions that sold products that 22 were worth less than they were selling them to be, the 23 rating agencies, the Federal Regulators Liberalization and 24 Forbearance, and the Federal Reserve's easy monetary policy 25 in the face of it, and the BIS Capital Adequacy Rules that lending 18 1 gave an incentive to institutions and the whole AAA 2 securities invariant to their quality. 3 The fifth point that I want to make, and that I 4 would like to emphasize, that I have not seen anywhere in 5 the press or anywhere, is that the largest cause of the 6 over-valuation of the CDOs was miscommunication within the 7 firms on Wall Street that were creating them. 8 9 It takes two kinds of professional employees to create the CDOs that led to the crisis. The first are 10 mathematicians and technical experts that actually create 11 the models, that develop the models and develop the pricing. 12 Those people professionally have no concept whatsoever of 13 what's going on in the credit markets. 14 what's happening to underwriting standards in the credit 15 world. 16 They have no idea The second type of employee who does pay 17 attention to what's going on in the credit markets in 18 general had no knowledge at all of how these instruments are 19 priced. 20 silos did not communicate with each other. 21 credit guys were not telling the derivatives guys, if you 22 will, what was going on in the market. 23 I believe unknowingly, was off. 24 25 And in terms of corporate management, those two And so that the And so the pricing, The financial institutions that figured it out basically began hedging and began not underwriting these 19 1 securities. 2 middle of this that were fully equipped, that had both 3 skills and should have caught this, and those were the 4 rating agencies. 5 information and an obligation for discovery. 6 But there were a set of organizations in the They also had access to nonpublic When hedge funds and institutional investors 7 discovered the problem, they came to AIG. 8 know, it takes two to create a market: 9 And AIG basically sold into this market because they were a 10 And as all of you buyers and sellers. credible market participant. 11 I would like to add one thing, if I may please. 12 I believe that the writing of $80 billion of naked, unhedged 13 CDSs by AIGFP was an act of incredible corporate 14 irresponsibility on three grounds: 15 not appropriately manage their subsidiary; that AIGFP 16 executives went beyond their culture and their corporate 17 culture and did this activity; and thirdly, those 18 institutions who bought from them who never asked the 19 question, or at least didn't ask the question in time: 20 a minute. 21 they selling to other people? 22 23 If they're selling me this quantity, what are CHAIRMAN ANGELIDES: Thank you, very much. Professor Kyle. 24 25 that AIG executives did WITNESS KYLE: today. Thank you for inviting me here Wait 20 1 There are many, many culprits that have been 2 identified in causing the financial crisis. 3 derivatives trading is one culprit that has been proposed. 4 Its relatives: 5 tranching of risks are others. 6 OTC short-selling and the securitization and The list goes on. It includes: Poor risk 7 management at banks; the originate and distribute model of 8 banking; the credit rating agencies; the executive 9 compensation practices of large financial institutions which 10 allowed large bonuses to be paid; government mandates for 11 home ownership, and in particular mandates that Fannie Mae 12 and Freddie Mac purchase mortgages--backedby mortgages to 13 low-income home owners; and finally, unscrupulous banking 14 practices and greed. 15 I want to propose that there are different causes 16 of the financial crisis. 17 includes many things that are interesting to talk about in 18 the context of the crisis, but two other factors were the 19 most important ones and the ones that we should keep in 20 mind. 21 That list that I just went through The first of these is what I call "risk 22 shifting." 23 long as they were making profits. 24 taxpayer money when they were making losses. 25 The banks were playing with their own money as Banks were playing with So the what I call "risk shifting" is this idea 21 1 that a levered financial institution gets to keep the upside 2 but gets to dump the losses on taxpayers if it loses money. 3 Risk shifting was a big factor in the, lying behind the behavior of the 4 5 large banks. 6 The second factor I want to identify is what I 7 would call "irrational exuberance." 8 housing is a good investment and that everybody should own a 9 home, not only because they need a place to live but because 10 It's a belief that it's a good investment to own a home. 11 History shows that home ownership is not that 12 great of an investment, and it is very risky. 13 perfectly reasonable for people to be renters. 14 So it is Now when you think about risk shifting and 15 irrational exuberance as being the causes of the financial 16 crisis, I think the solution to the problem is relatively 17 straightforward. 18 for banks. 19 banks, then banks will be playing with their own money and 20 not playing with taxpayers' money. 21 We need much higher capital requirements If we have much higher capital requirements for And, we need less emphasis on home ownership as 22 an intrinsically desirable social goal undertaken for its 23 own sake. 24 So to explore risk shifting a little further, and 25 also to put derivatives into perspective, let's take a look 26 at three different, I'll call them case studies, but three 22 1 different situations that occurred during the financial 2 crisis which I think are very similar even though they look 3 different. 4 say about Bear Stearns probably applies to Lehman Brothers, 5 and I'll refer to Citigroup, and I'll refer to AIG. 6 And I'll call them "Bear Stearns," but what I Bear Stearns failed because--not because it had 7 huge losses on its derivatives book, but rather it just 8 owned huge quantities of mortgages that it financed with a 9 huge amount of leverage. And it was allowed to do this 10 because the SEC/CSE program, which was supposed to regulate 11 the investment banks, did not have really high capital 12 requirements and did not have a really strong liquidity 13 requirement that was good enough to keep Bear Stearns in 14 business. 15 Bear Stearns collapsed when they were not able to 16 finance their inventories of mortgages and securities backed 17 by mortgages in the market because the market lost faith in 18 the company. 19 The same thing happened to Lehman Brothers. Yes, 20 Bear Stearns had a derivatives book, but the main reason it 21 failed was because of its highly levered risky mortgage 22 positions. 23 Citigroup, it set up off-balance-sheet entities 24 which invested in very safe, seemingly safe securities 25 backed by mortgages. Citigroup was given almost an infinite 23 1 ability to leverage these investments because capital 2 requirements were so low. 3 or thought they were making a few basis points on the 4 transactions, those few basis points shows up as a really 5 high return on capital when it can be leveraged as much as 6 Citigroup was leveraging it. 7 investments were not so safe, Citigroup essentially 8 collapsed. 9 And even though they were making, When it turned out these And then there's AIG. AIG did the same thing, 10 but they used derivatives contracts. 11 default swaps essentially to insure very safe securities, 12 and they were only making a few basis points on the 13 transactions they thought. 14 they thought that they could make a lot of money on this. 15 They used credit But because of the leverage, In all three cases, the use of this leverage was 16 irresponsible and ultimately led to the collapse of the 17 institutions. 18 particularly Bear Stearns and Citigroup--if they hadn't been 19 playing with taxpayer money. 20 their own money, they would have engaged in better risk 21 management, which I may return to later. 22 23 24 25 But I don't think they would have done it-- If they had been playing with CHAIRMAN ANGELIDES: Professor Kyle. Thank you very much, Mr. Masters. WITNESS MASTERS: Good morning, Chairman, Vice Chairman Thomas, and Members of the Commission: 24 1 I welcome the opportunity to appear before you 2 today to testify on the very important topic of the role 3 played by over-the-counter derivatives in the financial 4 crisis. 5 Although a combination of factors caused the 6 financial crisis, unregulated derivatives played an 7 essential and uniquely dangerous role. 8 two-fold. 9 Their impact was First, unregulated credit derivatives were 10 largely responsible for creating systemic risk that turned 11 isolated problems into a system-wide crisis. 12 Second, speculation ignited by unregulated 13 commodity derivatives sparked excessive volatility in 14 commodities prices which further harmed an already stressed 15 economy. 16 Both of these problems could have been 17 significantly mitigated by requiring OTC derivatives to 18 clear through a central counterparty with novation and daily 19 margin. 20 the systemic risk inherent in a marketplace comprised of 21 opaque webs of interconnected and overleveraged 22 counterparties. This would have created transparency and precluded 23 Central clearing would have also made it possible 24 to enforce the aggregate speculative position limits which I 25 have proposed in previous Congressional testimony. 25 1 I will first discuss how derivatives created 2 systemic risk. 3 fostering excessive price volatility. 4 Then I will talk about their role in Unregulated derivatives set the following three 5 fundamental preconditions for the system wide financial 6 crisis. 7 First, a lack of transparency in derivatives' 8 markets made it difficult for counterparties to see when 9 individual firms were taking excessive risk before the 10 crisis, or to distinguish creditworthy firms from risky ones 11 once the crisis started. 12 Second, the interlocking web of very large 13 exposures between the major swaps' dealers created the 14 potential for a domino effect wherein the failure of one 15 dealer could lead to the failure of all dealers. 16 Third, losses do not have to be very high in 17 order to force the first domino to fall due to the extreme 18 leverage that characterized those positions. 19 was the result of requiring little or no margin collateral 20 to be posted to ensure other dealers bets. 21 This leverage Together, these three factors formed the 22 preconditions for a contagion between institutions as well 23 as between markets. 24 swaps' dealers spawned an interlocking web of very large 25 exposures among the 20 or so largest dealers. The large volume of trading between 26 1 When the supposedly highly credit-worthy Lehman 2 Brothers defaulted, swaps' customers, plus many of their 3 swaps' counterparties, immediately lost large sums of money. 4 Swaps dealers were forced to radically re-evaluate the 5 creditworthiness of all their counterparties, and question 6 who might be the next to fail. 7 The OTC derivatives markets came to a grinding 8 halt, jeopardizing the viability of every participant 9 regardless of their direct exposure to subprime mortgage- 10 backed securities. 11 Furthermore, when the OTC derivatives markets 12 collapsed, participants reacted by liquidating their 13 positions in other assets those swaps were designed to 14 hedge. 15 Markets witnessed a sell-off across all asset 16 classes. 17 market historically uncorrelated with financial assets prior 18 to the deregulation of OTC derivatives markets. 19 The sell-off even extended to commodities, a This brings me to the topic of excessive 20 volatility arising from the intrusion of OTC derivatives 21 into commodities markets. 22 Unregulated derivatives directly distort 23 commodity prices by facilitating excessive speculation. 24 Index speculation in particular is an especially dangerous 25 source of volatility. It is worth emphasizing that 27 1 derivatives' dealers thrive on volatility, while the rest of 2 the economy suffers because of it. 3 In my testimony before the Senate Agriculture 4 Committee last year I explained how the devastation caused 5 by the rapid deterioration of our credit markets, which 6 pushed our financial system to the brink, was greatly 7 exacerbated by the 2008 derivatives' driven rise and 8 collapse in food and energy prices. 9 In conclusion, I would like to reiterate that 10 during this crisis one single factor stood out in its 11 potential to destroy the financial system as a whole: 12 massive interlocking web of over-the-counter derivatives' 13 exposures among the biggest Wall Street swaps dealers. 14 Many financial institutions might have gone The 15 bankrupt or suffered severe losses from the crisis, but the 16 system as a whole would not have been imperiled were it not 17 for the propagation of unregulated derivatives' markets. 18 Thank you. 19 CHAIRMAN ANGELIDES: Thank you very much, 20 gentlemen, and we are now going to begin Commissioner 21 questioning. 22 and then the Vice Chair will follow me, and then the 23 Commissioners who led this investigation and hearing will 24 then follow. 25 And as is the custom, I will begin as Chair, Let me start with a couple of questions. I am 28 1 going to take a few of my questions now, and then defer the 2 balance to after the balance of the Commissioners have 3 spoken. 4 I want to ask a couple of you about the role that 5 derivatives played in accelerating, or perhaps enlarging, 6 amplifying, the creation, the issuance, the marketing of 7 synthetic collateralized debt obligations backed by 8 mortgage-backed securities? 9 Some have posed the fact that by the very nature 10 of having these derivatives, it accelerated the market, it 11 enabled the market. 12 amplified both the boom and the bust. 13 And therefore obviously in the end it So I would like to ask a couple of you to comment 14 on that. 15 comment on that: 16 amplified, accelerated the market. 17 couple of others the same question. 18 19 20 I'll start with you, Mr. Greenberger, if you would the extent to which credit default swaps WITNESS GREENBERGER: And I am going to ask a Well let me break it down into two answers. First of all, you have credit default swap 21 insuring real risk. 22 the subprime market and want to get insurance. 23 That is, people hold and investment in Just like we drive cars with comfort, even though 24 we may get into an accident, our insurance policy gives us 25 that comfort. People were investing in the proposition that 29 1 people without credit, or adequate credit, would pay their 2 mortgages. 3 That investment became much easier if you could 4 say, hey, I've got an insurance policy. 5 wasn't just AIG. 6 default swap. 7 importantly read “A Colossal Failure of Common Sense” by 8 Lawrence McDonald, a trader and officer within Lehman, who 9 blames credit default swaps for bringing Lehman down. 10 And, by the way, it All these institutions were issuing credit Read “House of Cards” by William Cohan, or most So, yes, if I've got insurance I'm going to take 11 more risk. 12 insurance policies, no collateral or capital had to be 13 posted. 14 Dinallo has said, and I know he will be before you, his 15 analysis of MBIA, the monoline which he was in charge of 16 trying to rescue, and AIG, was that for every real insurance 17 policy insuring risk, there were three to four that were a 18 gamble. 19 They didn't understand that, unlike most But the real villain of the piece here is, as Eric In other words, you could buy insurance on 20 somebody else's car, on somebody else's life, or in this 21 case on somebody else's CDO. 22 Goldman, leaving aside fraud--I don't want to talk about 23 fraud--but just look at that transaction. 24 played fantasy CDO. 25 picked out the most dangerous tranches. In the SEC case against John Paulson He went across a range of CDOs and He bet a billion 30 1 dollars those tranches would fail. 2 Some poor schnooks on the other side who thought 3 housing prices would always go up, took the opposite end of 4 that bet. 5 counterparties lost the billion. 6 rescued with taxpayer funds. 7 John Paulson made a billion dollars. The Many of them needed to be So the problem here is only in a small sense the 8 mortgage default. The real problem here is all the 9 gambling--don't forget, state gaming laws are preempted--all 10 the gambling on whether the defaults would occur, that had 11 nothing to do with the real economy. 12 warehouses got built. 13 medicines got discovered. 14 could do it legally, bet that non-creditworthy individuals 15 would not pay their mortgages. 16 As you said, no No manufacturing capability. No It was just Mr. Paulson, and he That blew a hole in the economy. Because of no 17 clearing requirements, the AIGs of this world never had to 18 post margin. 19 in the hole. 20 21 22 23 And they woke up on September 16th $80 billion CHAIRMAN ANGELIDES: All right. Mr. Kohlhagen, would you comment on my question, and perhaps pick up on-WITNESS KOHLHAGEN: I'm sympathetic to what Mr. Greenberger said, and I agree with your contention-- 24 CHAIRMAN ANGELIDES: 25 WITNESS KOHLHAGEN: "Question," but that's okay. I took it as a contention. 31 1 Okay. Then let me state what I believe. 2 I believe that credit default swaps did enhance 3 the bubble. 4 bubble started before credit default swaps. 5 They were a bubble enabler. I think that the I think one of the things people need to step 6 back from and realize is that in order for a market to work 7 you have to have sellers and buyers. 8 default swaps, once people figured out how to use credit 9 default swaps, there now was a new source of sellers that 10 hadn't existed before. 11 short the market. 12 And once the credit There was no way to actually sell or With the development and the rapid growth of 13 credit default swaps starting late in the bubble, there was 14 a whole new source of sellers, and there could be a whole 15 new source of buyers. 16 people making and losing money. 17 of this, what was going on in the United States' housing 18 industry and the subsidization of the guarantees by the 19 Federal Government of creating a whole new set of home 20 ownership, there were certain costs to the U.S. taxpayers 21 for that. 22 And so he's right that there were If you go back to the cause Nobody knew what it was going to be going in. 23 But once the bubble started, once you had enabled the 24 bubble--and I am agreeing with you that CDOs, synthetic CDOs 25 and credit default swaps enhanced the bubble in the latter 32 1 stage--you now not only have the cost to the U.S. Taxpayers 2 of the subsidies, but you now had gains and losses, as 3 Mr. Greenberger said, from the market. 4 So add to the cost to the U.S. Taxpayers the 5 losses the people saw. 6 ignore the billions in gains that he talked about. 7 And people see that as the cost and CHAIRMAN ANGELIDES: All right. Actually let me 8 pick up on this, and actually, Professor Kyle, I'm going to 9 pick up on your comments about what seems to be a common 10 thread. 11 No matter what device was chosen by the 12 institutions that failed, each device had extraordinary, or 13 each strategy, or lack thereof, had extraordinary leverage 14 associated with it. 15 What we have just heard these two gentlemen lay 16 on the table is in essence that you had this large betting 17 parlor. 18 fact that I'm someone who spent 30-plus years of my life in 19 the fields of housing, and investment as a practitioner, and 20 I was quite stunned to see the level of, in a sense, 21 leverage going on and betting going on with respect to these 22 securities. You know, in my opening remarks I referred to the 23 To what extent do you believe, or not believe 24 that these instruments allowed for the inflation of this 25 bubble? In other words, it may not have been the sole 33 1 cause, but were they the device-du-jour that allowed this 2 bubble to be amplified significantly? 3 WITNESS KYLE: So I think my view is the opposite 4 of the other panelists on this. 5 reasons we have derivatives and particular credit default 6 swaps is to allow short sellers to bet that a security is 7 overvalued by selling it short, and then profit if it goes 8 down. 9 I think that one of the There weren't really good vehicles for taking 10 short positions in mortgages or other securities backed by 11 housing finance instruments in the early stages of the 12 bubble. 13 more and more synthetic CDOs and credit default swap type 14 instruments that could be shorted in very significant 15 quantities. 16 But as the bubble progressed, you started getting If you don't have short sellers in a market, 17 there is a danger that asset prices will be over-valued; 18 that innocent, or unsophisticated investors will pay more 19 for a security than it's worth. 20 selling, only the people with bullish, or optimistic 21 opinions are heard. 22 opinions, the negative opinions to be heard in the 23 marketplace. 24 25 Because without short- It's kind of like I'm not allowing the So as instruments for shorting, subprime mortgages developed and became more commonplace in 2006 and 34 1 2007. My opinion is that the short sellers essentially came 2 into the party and turned off the lights a bit earlier than 3 the lights would have been turned off otherwise. 4 In other words, they helped prevent the bubble 5 from getting worse than it would otherwise have gotten by 6 damping down the values of these securities. 7 CHAIRMAN ANGELIDES: I am going to challenge that 8 a little in this sense. The fact is that because you 9 essentially had these highly levered bets, you know, the 10 CDS, as Professor Greenberger said, you had the ability for 11 example on all the Goldman Abacus deals for there to be, you 12 know, in a lot of these deals there might have been a $2 13 billion synthetic CDO where maybe there was $100 to $200 in 14 real money up. 15 was, you know, without being pejorative, it wasn't on a real 16 asset; it was referencing securities. 17 $1.9 billion that was extraordinarily levered. 18 And of course that was just a bet because it But you had perhaps You know, in essence Goldman, for example, paying 19 AIG $2.1 million a year on a bet that they could ultimately 20 win $1.7 billion. 21 Isn't the fact that there was this enormous 22 leverage available, didn't that just pump up the balloon? 23 And I will credit my Vice Chair with a question, which is, 24 instead of the balloon being filled with air, was it being 25 filled with helium? 35 1 2 3 WITNESS KYLE: Well, the big leverage of course is the homeowner who buys a home with no money down. CHAIRMAN ANGELIDES: Well, there are two points 4 of leverage, correct? I mean, you've got the homeowner 5 doing that, eroding lending standards, but now you have an 6 almost 100 percent bet on that bet. 7 WITNESS KYLE: Yes. So you have the homeowner 8 who is buying the home with essentially infinite leverage. 9 Then you have investors, or traders in the marketplace using 10 derivatives, and the derivatives are structured to 11 incorporate the ability to undertake a lot of leverage. 12 the tranching of the mortgage-backed securities, and in 13 particular some of the tranches that went into the Abacus 14 deal that you're going to be hearing about today, those 15 tranches were designed to package a lot of risk into a 16 small investment. 17 And And this enabled buyers of the collateralized 18 debt obligations to take on a lot of exposure to the 19 mortgages with a small amount of money. 20 of it--and the synthetic part of it, let me make it clear, 21 is the derivatives part of it--the synthetic part of it 22 serves the purpose of allowing a trader to take a short 23 position, and to take a short position as Mr. Paulson did 24 with a great deal of leverage. 25 The synthetic part So that synthetic portion, by allowing traders to 36 1 take a short position, tends to push the price of the asset 2 down rather than up. 3 synthetic CDOs had the effect of dampening down a 4 speculative binge that otherwise was propagating itself with 5 long positions, highly levered long positions, by investment 6 banks and hedge funds and even individual home owners that 7 had gotten out of control. 8 9 CHAIRMAN ANGELIDES: 12 13 14 All right, go ahead Kohlhagen, and then we will move on. 10 11 So I think that the creation of WITNESS KOHLHAGEN: Are we allowed to comment on that? CHAIRMAN ANGELIDES: I will allow you to comment. Would you, please, and then I have one observation to make. WITNESS KOHLHAGEN: The existence of leverage 15 that you both were discussing about, or both discussing, 16 does not necessarily lead to this outcome. 17 derivatives, interest rate derivatives, decades of 18 experience with highly leveraged books, of hedged books by 19 derivatives desks have never led to these kinds of problems. 20 21 22 23 So it's not a necessary outcome. I mean, currency It's not a necessary outcome of the leverage. WITNESS GREENBERGER: If I could take fifteen minutes, Mr. Chairman, I would just-- 24 CHAIRMAN ANGELIDES: 25 WITNESS GREENBERGER: Fifteen "minutes"? Fifteen seconds. 37 1 2 CHAIRMAN ANGELIDES: I only have thirteen minutes left. 3 WITNESS GREENBERGER: 4 (Laughter.) 5 WITNESS GREENBERGER: 6 I get confused between minutes. 7 short selling. 8 bet has to have the capital to pay it off. 9 Fifteen seconds. Like billions and millions, There's nothing wrong with You just have to have--the other side of the If it were in a clearinghouse, you would short 10 sell and know that AIG had the money to pay the bet off. 11 The American Taxpayer paid these bets off. 12 wrong with that short sale. 13 CHAIRMAN ANGELIDES: That's what's And that's one of the things 14 that strikes me, is that on a lot of these transactions 15 there was no skin in the game. 16 only skin came off the back of the Taxpayers. 17 At the end of the day, the You have these people who say it's a zero sum 18 game, but there were clear winners here and losers, and I 19 don't think it takes a math genius to know who the losers 20 were because of the bills that were paid. 21 WITNESS KOHLHAGEN: AIGFP had 20 years of 22 experience of running derivatives books, hedged derivatives 23 books with never a problem. 24 default swaps that they did with no hedging at all, just 25 writing them naked, that led to their problem. It was doing these credit 38 1 2 3 CHAIRMAN ANGELIDES: like to ask a question. Right. The Vice Chair would Go ahead. VICE CHAIRMAN THOMAS: Thank you. On that point, 4 Dr. Kyle, I understand your argument about the need for 5 short sellers, but I guess my biggest problem is in this 6 poker game I kind of like to watch it on TV because I always 7 get to see what everybody else has, and then watch the fool 8 get burned because he didn't know what the other guy had. 9 My worry is this whole business of transparency, 10 and an understanding of exactly what we thought were 11 sophisticated participants not being as sophisticated or 12 knowledgeable as we thought they were. 13 And I understand the clearinghouse concept, which 14 kind of helps it clean up, but in the situation we found 15 ourselves did you still think that short was good? 16 they simply betting on a hunch without having similar 17 information? 18 in one group, or one group thought they had a preponderance 19 of information and therefore did more because they thought 20 they could control the situation? 21 Or were And was there a preponderance of information It's this business of knowing and the failure of 22 transparency on both sides of this game that frankly has 23 just amazed me in terms of the bets they put down. 24 25 CHAIRMAN ANGELIDES: And by the way, just a technical matter here, Mr. Vice Chair, I'm actually done 39 1 with my time, so you can now roll. 2 3 VICE CHAIRMAN THOMAS: Okay, I used some of his, so now I'm on my time. 4 WITNESS KYLE: Okay, so--so I think I agree with 5 you. I believe that if you put more derivatives on 6 organized exchanges, if you standardized the contracts, if 7 you traded them in transparent markets, if you published 8 information about the positions that various parties have, 9 even if you encouraged discussion of how they're priced 10 which is helped by having the prices transparent, the people 11 who are going long and the people who are going short might 12 come to understand why they were disagreeing. 13 14 VICE CHAIRMAN THOMAS: Or especially those people who were going short with no chips on the table. 15 WITNESS KYLE: Well I think the people that went 16 short did have chips on the table. 17 billion dollars worth of chips on the table that he turned 18 into a large profit. 19 20 Mr. Paulson I think had a But the people that bought the--took the long positions-- 21 VICE CHAIRMAN THOMAS: Did you state that 22 accurately? 23 on the table going short, and then walk away with a billion 24 dollars. 25 He couldn't have had a billion dollars of chips CHAIRMAN ANGELIDES: Could I make-- 40 1 2 3 VICE CHAIRMAN THOMAS: Sure, on my time, you go ahead. CHAIRMAN ANGELIDES: On your time, my 4 understanding is, I believe from the work of our staff, is 5 that I think Mr. Paulson paid about a $15 million annual 6 payment, and I assume it was over probably about a two-year 7 period or so, or three-year period, until payoff. 8 was the ratio of leverage essentially. 9 VICE CHAIRMAN THOMAS: So that And the other concern, and 10 I'm jumping in the middle on a specific question, and 11 I'll go back to a broader approach in a second, was the idea 12 of leverage and the possibility that insurers--maybe AIG in 13 particular--didn't even understand the mechanism in terms of 14 their responsibility to put up real money if there's a 15 change in relationship of the value. 16 I mean that's a pretty fundamental rule of the 17 game that you would think insurance companies would 18 understand what it was that they were insuring against. 19 how the consequences of that policy would operate. And 20 WITNESS KYLE: Okay, so let me make two points. 21 Many people think that short selling is extremely 22 dangerous because your upside losses are kind of unlimited 23 if the price of the asset skyrockets. 24 25 VICE CHAIRMAN THOMAS: know and when you know it. It depends on what you 41 1 WITNESS KYLE: It does depend on what you know 2 and when you know it. 3 you're talking about individual stocks. 4 talking about taking a short position in a security that 5 everybody else deems to be AAA, or extremely safe, and it's- 6 - 7 8 And this is true in particular if VICE CHAIRMAN THOMAS: But if you're Well we'll get to that later about what AAA means. 9 WITNESS KYLE: --but if everybody thinks it's 10 AAA, the potential losses on taking a short position on such 11 a security are very small. 12 I mean, how much is the price of a security that 13 everybody trades if it's AAA going to rise and move against 14 you if you've taken a short position? 15 VICE CHAIRMAN THOMAS: If everyone thought it was 16 going to be a good bet, there would have been more with Mr. 17 Paulson, wouldn't there? 18 WITNESS KYLE: You would have thought so. So Mr. 19 Paulson in taking his position in credit default swaps was 20 not posing a risk to Taxpayers that he might lose money. 21 was paying a fee to buy insurance. 22 coming out of his pocket, or his hedge fund's pocket. 23 he stood to lose the money that he was paying for the 24 insurance. 25 catastrophe occurred in the debt markets for those That was his money But he stood to make a great deal if a And He 42 1 instruments, which indeed it did occur. 2 So I don't think he posed a risk to Taxpayers. 3 But certainly the people on the other side of the 4 transaction did pose a risk to Taxpayers. 5 CHAIRMAN ANGELIDES: Well, and again we're doing 6 a little duo here this morning. 7 we'd read all our materials. 8 interesting, we were unscripted because there was so much we 9 wanted to see where this goes, but that's a key point there. 10 We both said we came and There was so much, and so That of course Mr. Paulson was not systemically 11 important. 12 having institutions that turned out to be. 13 the size of the bets, the size of the betting does matter in 14 the end. 15 On the other side of the bet, you ended up And therefore And who does it matters in the end. WITNESS KYLE: Yes. And bond markets are 16 different from commodity markets in the sense that typically 17 in a commodity market when the price of the commodity starts 18 rising, things start getting more risky and more volatile. 19 When prices fall, typically things calm down. 20 In bond markets, it is just the opposite: 21 prices rise, bonds become safer; things calm down. 22 prices fall, things go haywire. 23 When When So in the case of the other side of Mr. Paulson's 24 bet, as prices fell volatility increased. These 25 collateralized debt obligations were structured in such a 43 1 way-- 2 VICE CHAIRMAN THOMAS: 3 WITNESS KYLE: --as to magnify the volatility if 4 prices fell. 5 profit from that as prices fell. 6 Margins. And Mr. Paulson knew that and was hoping to But back to your earlier question, there was 7 fundamental disagreement in the market between those who 8 thought that housing prices would go up forever and those, 9 like Mr. Paulson, who thought that housing prices would come 10 down. 11 And my experience, having debated with people 12 during the bubble, during this period, was that you could 13 share your opinions with people, but people would not change 14 their mind. 15 the various participants in the market, and this 16 disagreement occurred on Wall Street. 17 Main Street as you talked to people who thought it was a 18 good idea to buy a much bigger house than they needed 19 because it was a good investment. 20 There was some fundamental disagreement among VICE CHAIRMAN THOMAS: It also occurred on Just to respond to that, 21 you know economists are fond of saying that all of the 22 things being equal, and if the mortgage market looked like 23 it used to, 20 percent down, you get a statement of income, 24 what you've done, the rest of it, it wouldn't have been what 25 it was. 44 1 And so to a certain extent, there were people 2 assuming certain things. 3 diligence. 4 isn't what it used to be, but people were given assurances 5 that it was. 6 great deal of ignorance on people who should not have been 7 ignorant about the level of participation. 8 9 They didn't do their due And what it was that they had as a AAA-rated, it So to a certain extent, to me there was a And I would be much more concerned about those poker games I watch if my money was staking one of those 10 guys who keeps doing what he's doing and he ain't gonna be 11 at the table long. 12 Reaction? WITNESS KOHLHAGEN: Mr. Vice Chairman, I don't 13 want to comment on the poker game analogy, but I do want to 14 go back to something about two-and-a-half minutes-- 15 16 VICE CHAIRMAN THOMAS: you prefer that I use? 17 18 What gambling type would Roulette wheel? WITNESS KOHLHAGEN: I'll let you do the analogies. 19 (Laughter.) 20 VICE CHAIRMAN THOMAS: 21 WITNESS KOHLHAGEN: Okay. A couple of minutes ago you 22 asked a question. I want to make an important 23 clarification, if it's not understood by everyone. 24 an insurance company. 25 financially secure, best-run insurance company maybe in the AIG is It was in fact the strongest, most 45 1 history of the world. 2 3 VICE CHAIRMAN THOMAS: Somebody you wanted on the other side of your deal. 4 WITNESS KOHLHAGEN: Yes. AIGFP had nothing to do 5 with insurance. 6 still are a derivative subsidiary. 7 managed and ran AIGFP and worked at AIGFP knew nothing about 8 insurance. 9 They were a derivative subsidiary. They And the people who So it would be a mistake to view AIGFP as an 10 insurance entity. 11 responsible for managing the subsidiary, and clearly in this 12 case they failed. 13 The executives who ran AIG were VICE CHAIRMAN THOMAS: Okay. And that brings up 14 another whole series of questions about how it was handled 15 after the fact, and that particular segment. 16 been severed, and a whole bunch of other questions, which we 17 may get to. 18 Could it have Let me now start my time in terms of what I 19 usually do on my time. 20 being fairly frank and allowing us to get some degree of 21 different answers which will help us better understand and 22 we will do more of it. 23 First of all, thank you for already What I would ask of you is, not to stand but to 24 simply please say 'yes' to the question: If we have 25 information based upon your testimony, or we discover other 46 1 information as we continue to go forward, would you be 2 willing to respond to questions that we would put to you in 3 writing following this hearing? 4 (The witnesses nod affirmatively.) 5 VICE CHAIRMAN THOMAS: 6 She can't record head nods. 7 WITNESS GREENBERGER: 8 WITNESS KOHLHAGEN: 9 WITNESS KYLE: Yes. Yes. Yes. 10 WITNESS MASTERS: Yes. 11 VICE CHAIRMAN THOMAS: Thank you very much. You 12 know, some of us really did think if the rules of the game 13 would remain the same that house prices would go up. 14 creature of Southern California, and frankly no one who 15 didn't have to pay rent paid rent. 16 long time. 17 I'm a And it paid off for a And anyone looking at the Tax Code, if you had 18 the ability to buy a place that you could reasonably afford 19 and it fit into your three-times income, all of those little 20 calculations that people used to use, that it was usually 21 very, very rich people who didn't worry about trying to 22 build a nest egg in a way that seemed to be reasonable who 23 would rent. 24 25 So to what extent did the Tax Code play a role in moving us in the direction that we eventually went? Since 47 1 you mentioned renting versus buying? 2 WITNESS KYLE: I think that the deductibility of 3 interest and property tax payments encourages people to buy 4 homes. 5 ownership. It does make the rent/buy calculus favor home 6 On the other hand, if you compare the United 7 States with other countries, we have very high property 8 taxes. 9 largely offset by the high property taxes that we have in So I view the deductibility of interest as being 10 the United States and therefore view it as a kind of neutral 11 as to rent versus buy. 12 Like you, I used to live in California and I 13 talked to people a lot about the rent versus buy calculus. 14 So I went online a few years ago in the middle of the 15 bubble--I think it was about 2005 and 2006--and downloaded 16 about 40 or 50 rent versus buy calculators, and I learned 17 two things from those calculators, or three things. 18 First of all, they all gave a different answer. 19 Second of all, they all said you should buy a home. 20 third of all, all of them were wrong. 21 VICE CHAIRMAN THOMAS: 22 sponsored by realtors. 23 (Laughter.) 24 WITNESS KYLE: 25 And And they were all Most of them were sponsored by realtors, and realtors generally tell you to buy a home. My 48 1 experience sitting down with homeowners and actually trying 2 to get homeowners to go over the numbers was that homeowners 3 really hadn't figured out whether it was valuable for them 4 to rent or to buy. 5 yields traditionally--at least back in the 1980s--in many 6 periods have been very low. 7 rent. 8 9 And in particular, in California rent So it's an easy decision to VICE CHAIRMAN THOMAS: And you also haven't touched on the Tax Code provision, which concerned me from 10 the time that we didn't clear it up, having been on the 11 committee, was when we decided to not allow the deduction of 12 consumer interest; that we didn't insulate, isolate, and 13 protect the equity in your home from cleverly, and sometimes 14 not so cleverly, being utilized for consumer interest rather 15 than building up equity in the home. 16 WITNESS KYLE: I personally feel that the 17 decision to allow interest deductibility of home mortgage 18 interest but not allow the deductibility of credit card debt 19 interest undermined the integrity of the housing market. 20 VICE CHAIRMAN THOMAS: It certainly did, in terms 21 of producing a check for the equity that you gained every 22 month so that you could spend it, leaving people with no 23 margin after having lived in their home for years, of 24 protection that you would have thought ordinarily would have 25 been in the home. 49 1 WITNESS KYLE: And not only that, it of course 2 encouraged people to take their credit card debts and kind 3 of transfer them over to their mortgage effectively so that 4 they-- 5 VICE CHAIRMAN THOMAS: 6 WITNESS KYLE: 7 Sure, or the RV, or the-- --so that they could get the interest deductibility. 8 VICE CHAIRMAN THOMAS: 9 WITNESS KYLE: That was the problem. And it also encouraged banks to 10 think of home mortgages kind of like credit card debt, which 11 implies that the incentives to get let's say a good 12 appraisal on a house are undermined at the level of the 13 bank, because the bank is really in some sense making 14 something akin to a credit card loan to the homeowner and 15 not something that's your traditional mortgage that you 16 referred to earlier where the homeowner makes a 20 percent 17 down payment based on a legitimate appraisal and 18 verification of income. 19 VICE CHAIRMAN THOMAS: Well, and we'll go into in 20 some detail what my colleague from Las Vegas indicated to me 21 that there have now been 123 indictments in Las Vegas for 22 mortgage fraud. 23 that are clearly indicated. 24 that we had from the '80s simply seems like petty 25 misdemeanor based upon what occurred toward the end of the In even my own town we have several cases And obviously the discussion 50 1 session. 2 I am going to reserve my time because I want to 3 make sure that some of those who are very interested in the 4 narrow issue, which is the one in front of us, derivatives, 5 have maximum amounts of time to pursue that. 6 to come back near the end, Mr. Chairman, and ask this panel 7 if they would be willing to answer some questions based on 8 the fundamental concern we have, which is what are the 9 fundamental underlying causes of the financial crisis. 10 maybe we'll get to vote on some of them. 11 reserve my time. 12 13 CHAIRMAN ANGELIDES: Thank you. But I do want Thank you. And I And I am going to, as I said, reserve the balance of my time for the end. 14 Ms. Born. 15 COMMISSIONER BORN: Thank you very much, Mr. 16 Chair. 17 us explore the role of over-the-counter derivatives in the 18 financial crisis. 19 I appreciate all four of you appearing today to help We have experienced the most, and are 20 experiencing the most significant financial crisis since the 21 Great Depression, and it appears that regulatory gaps, 22 including the failure to regulate over-the-counter 23 derivatives may have played an important role in the crisis. 24 25 As a result of pressures from a number of the country's largest financial institutions who are and were 51 1 our largest derivatives dealers, Congress passed a statute 2 in 2000 called The Commodity Futures Modernization Act that 3 eliminated virtually all regulation over the over-the- 4 counter derivatives market. 5 Because of that statute, no federal or state 6 regulator currently has oversight responsibilities or 7 regulatory powers over that market. 8 and is often referred to as "the dark market." 9 It is enormous. The market is opaque As of December of last year, the 10 reported size of the market was almost $615 trillion in 11 notional amount, still more than 10 times the gross domestic 12 product of all the nations in the world. 13 While over-the-counter derivatives have been 14 justified as vehicles to manage risk, they in practice can 15 spread and multiply risk as well. 16 lack of price discovery, excessive leverage, lack of 17 adequate capital and prudential controls, and a web of 18 interconnections among counterparties have made this market 19 dangerous, and we will be examining the role that the market 20 has played in the financial crisis. Lack of transparency, 21 Warren Buffett has appropriately dubbed over-the- 22 counter derivatives "financial weapons of mass destruction." 23 And in a recent Commission hearing he said the time bomb is 24 still ticking. 25 Congress has just taken an historic and important 52 1 step toward closing this regulatory gap when the Conference 2 Committee on Financial Regulatory Reform decided on a bill 3 that would impose comprehensive federal regulation on 4 derivatives, including the requirement that most derivatives 5 must be traded on exchange and centrally cleared. 6 I look forward to its passage into law and its 7 full implementation in order to protect the public from the 8 systemic dangers posed by the market. 9 And as my first question I would like to direct 10 it initially to Professor Greenberger, and it concerns the 11 deregulation of these markets. 12 deregulation of the over-the-counter derivatives market in 13 any way contribute to the financial crisis? 14 would you explain how? 15 In your view, did WITNESS GREENBERGER: And if so, I believe it certainly did. 16 And just to go back to the AIG example, or the person who 17 took the opposite end of Mr. Paulson's bet--by the way, Mr. 18 Paulson made that bet with $15 million. 19 If he had lost the bet, he would have lost $15 million. 20 had absolutely no risk. 21 He got $1 billion. He AIG had complete risk. Now let's take AIG. Suppose we had had 22 traditional market controls. We have heard that the 23 management of AIG didn't understand what was happening. 24 we had had traditional market controls, the subsidiary would 25 have had to go to the holding company and say I've got to If 53 1 put collateral down. 2 $7 billion in collateral. 3 $80 billion probably would have been And when the adults in AIG understood that they 4 were insuring mortgages by non-creditworthy individuals, my 5 confidence is that they would have said: 6 We're not giving you $7 billion to run the risk of $80 7 billion. 8 9 Are you kidding? Then, Vice Chairman Thomas said, well, you know, there's no transparency here. If the exchange trading had 10 been involved, the regulators would have known that AIG was 11 buying these positions like crazy. 12 the CFTC, and probably state insurance regulators would have 13 said: 14 phenomenal risk. What are they doing 15 here? The Fed, the Treasury, They're running up this But we didn't have clearing. 16 to post anything. 17 these bets of $80 billion without putting a shekel on the 18 table. 19 They're AAA rating. So they never had They could make The holding company didn't know what was going 20 on. 21 all the regulated insurance subsidiaries, and on September 22 16th there was an $80 billion hole with the FP subsidiary. 23 When AIG failed, there was $20 billion in reserves of So if you have regulation, you have--as the value 24 of that bet declined minute by minute, AIG would have been 25 called up by its clearinghouse, post margin. Post margin. 54 1 And not wake up one day and find they were $80 billion in 2 debt. 3 And if they hadn't posted margin, the deal would 4 have been shut out. 5 would have seen what was happening. 6 have seen this phenomenal risk taking that was going on, and 7 I'm confident that somebody would have said: 8 Holy cow! 9 There are major fights over what the value of these 10 11 If it was on an exchange, everybody The regulators would Holy cow! And finally, we're not in the Lehman bankruptcy. instruments are. The creditors are saying they're worth a billion. 12 Lehman's saying they're worth $500 million. If you're on an 13 exchange, the market prices these things minute by minute. 14 You don't have these disputes. 15 the TARP assets because we didn't know what the price was. We couldn't rescue or buy 16 So if there was regulation, my view is these 17 crazy bets on bus drivers paying off $400,000 mortgages 18 would have never happened. 19 collateral that would have been called would have dampened 20 this market substantially. 21 would have alerted not only regulators but market observers 22 that craziness was going on here. 23 24 25 If they had happened, the The transparency of the exchange Let's head it off. And finally, we would have prices and not debates over prices. COMMISSIONER BORN: So one of the things we are 55 1 going to be looking at later today with AIG and Goldman 2 Sachs is the price disputes that they entered into about the 3 value of the underlying reference assets, or synthetic 4 assets for the CDS. 5 post enormous amounts of money. 6 And also, the need for AIG suddenly to What I am hearing you say is that, if this had 7 been trading on an exchange, there would have been price 8 discovery that showed what the values were, and what one 9 party would owe to another. 10 Is that right? WITNESS GREENBERGER: That's exactly right. We 11 can't have a debate over what the worth of an IBM stock is. 12 I can't tell you it’s worth a billion, and you can't argue 13 with me that it's $500 million. 14 by minute what an IBM stock is worth. 15 The market tells us minute The same is true with pork bellies that are sold 16 on exchanges. 17 market tells you minute by minute what the price is. 18 We can't argue over what the price is. The Because these were opaque, off-exchange, private 19 bilateral transactions, the only methodology for determining 20 a price is using crazy mathematical algorithms. 21 called mark-to-model. 22 That's So you get in these phenomenal disputes that 23 Lehman in its bankruptcy is now having with its creditors. 24 By the way, Lehman entered into 930,000 unregulated over- 25 the-counter derivatives; 6,000 of its creditors are in 56 1 disputes with it. 2 claim is worth a billion, and Lehman has sued them saying 3 it's an exaggeration by hundreds of millions of dollars. 4 5 One of the creditors is claiming its If you exchange trade, the free market tells you what the value is and you end all these disputes. 6 COMMISSIONER BORN: Well, and I also think I 7 understand you are saying that once the price is adequately 8 discovered through exchange trading, there is no big buildup 9 of indebtedness by one side of the contract to the other 10 because of the clearing mechanism? 11 WITNESS GREENBERGER: Absolutely. When AIG 12 entered into these bets, it didn't all of a sudden become a 13 bad bet. 14 risky, that bet became a more risky bet. 15 declined. 16 It gradually--as the housing market became more The value of it And in a clearing situation, the clearinghouse 17 twice a day would have gone back to AIG and said, hey, you 18 lost a million dollars today. 19 noon they would have done that. 20 million. 21 Post the margin. Maybe at At five o'clock, another And again, the adult supervision at AIG would see 22 all this margin going out. Why? Because the contract was 23 losing money. 24 crisis didn't build up overnight. 25 had to post no collateral, you get into these arguments Not all at one time. Day by day. This And instead, because they 57 1 between Goldman and AIG. 2 post collateral. 3 you have a fight over that. 4 All of a sudden Goldman is saying, How much collateral? We don't know. And In a clearinghouse, twice a day, based on the 5 minute-by-minute pricing, the clearinghouse tells you how 6 the market is going against you. 7 can't pay the margin, the clearinghouse closes you out right 8 then and there. 9 And by the way, if you The best thing that could have happened to AIG 10 was a couple of days into this crazy process they were 11 closed out by their clearinghouse. 12 COMMISSIONER BORN: Mr. Masters, can I ask you to 13 explain further your statement. 14 thought over-the-counter derivatives, particularly credit 15 default swaps, played a role in creating systemic risk that 16 made the financial crisis worse, and it indeed extended it 17 systemically. 18 You have said that you And as I understand it, you described the 19 interconnections between the large over-the-counter 20 derivatives dealers and other big financial institutions. 21 In fact, you have quite a wonderful chart in your testimony 22 that everybody should take a look at that illustrates maybe 23 just a few of the interconnections, since I believe there 24 were millions and millions of contracts outstanding. 25 Could you describe how these interconnections 58 1 created systemic risk? 2 WITNESS MASTERS: Sure. So the interconnections, 3 the problem with the interconnections not having these 4 trades on a clearinghouse of some form where everybody--the 5 clearinghouse was standing, to what Michael was saying, in 6 the middle of all these trades, was that no one really knew 7 who had what. 8 9 And so once you had one domino fall, which I was describing in my testimony, all the dominos could fall. 10 Because suddenly if you had CDS on let's say with Lehman 11 Brothers, and let's say you had CDS on a mortgage bond, or 12 you had it on some other bank's portfolio that you had 13 hedged, suddenly you didn't know if that CDS was good 14 anymore. 15 counterparty part of the contract. 16 17 18 Because embedded in every CDS contract is a credit So there's the bet. counterparty. And then there's the credit And the problem with that is that-- COMMISSIONER BORN: So when you say "credit 19 counterparty," you mean there's a credit risk as well that 20 the counterparty might not be able to pay you? 21 WITNESS MASTERS: Correct. And I think for a 22 long time people just sort of ignored this. They said, 23 well, you know, I've got this on with Goldman, or with 24 Lehman, or with AIG, or whatnot. 25 went down, people said, wait a minute. And suddenly when Lehman I've got all of 59 1 these over-the-counter credit default swaps on. 2 over-the-counter other instruments on. 3 I want to unwind all my bets. 4 I've got I want it all back. And the whole problem with that, having this 5 interconnectedness if you will, is it's the worry of what 6 does the other person have? 7 worried about what everybody else has, what they do is they 8 say, oh, well I just want all my chips back. 9 And so when everybody is And everybody collectively said: I want all my 10 chips back. 11 to one. 12 systemic risk was transferred. 13 other, but it was the fear of everybody's bets were bad. 14 And so you saw correlations in the markets go You had the very situation you had. And that's how It went from one, to the Because if Lehman wasn't going to pay off, then 15 what about AIG? 16 why AIG was toppling a few days later. 17 couldn't trust AIG, now what do you have to do? 18 further my belief that I think Treasury was going to let AIG 19 go until they realized that if AIG went, you know, everybody 20 else was going to go. 21 And in my view that was one of the reasons Because if you And it is And literally it was like dominos. COMMISSIONER BORN: So it was partly the 22 counterparty credit risk. That is, that if AIG defaulted on 23 its CDS, then its counterparties would be in a vulnerable 24 financial position themselves might then default on 25 their derivatives' obligations and even fail themselves, as 60 1 AIG did. 2 3 Is that right? CHAIRMAN ANGELIDES: Before you answer, I'll yield five minutes. 4 COMMISSIONER BORN: 5 WITNESS MASTERS: Thank you. That's right, Commissioner. 6 And so what you had was again this embedded credit bet, 7 within every bet one makes, when one is making a bet in the 8 over-the-counter market. 9 fails, what do you really have? 10 Because if your counterparty And so there was a massive switch after Lehman 11 Brothers went down to go to other counterparties to try to 12 replicate what other folks have, or to just take your bets 13 off overall. 14 pension funds and others. 15 want all our bets back. And we've talked to institutions about this-And suddenly they said, well, we 16 Well so now you've got a commodity index swap on. 17 And that's been fully collateralized, and you've got that on 18 with Goldman, or AIG, or whoever, and you say, well, I want 19 it back. 20 there's a chain reaction. 21 commodities that were in it. 22 Suddenly there's this huge disruption in the commodity 23 markets that's coming from the derivatives markets, really 24 the credit counterparty of the derivative markets. 25 Well as soon as you say I want it back, now Goldman has to sell the You get your money back. And again, that's how you saw the contagion from 61 1 one market to other markets. 2 COMMISSIONER BORN: So it's partly--this 3 uncertainty and fear of exposure to your counterparties led 4 to pulling out of contracts. 5 freeze up? 6 WITNESS MASTERS: Did the derivatives market The over-the-counter 7 derivatives markets freezed up. 8 the exchanges didn't. 9 counterparty centralized. One interesting thing is The exchanges where one had a There was no problem with the 10 exchanges. 11 market where you didn't know who your counterparty--you knew 12 them, but you didn't know if they were good anymore. 13 that's the real difference. 14 The only problem was with the over-the-counter COMMISSIONER BORN: And We had a hearing on the 15 shadow banking system and how there was essentially a run on 16 the investment banks through repo markets, through 17 commercial paper markets. 18 investment banks also a derivatives market run--a 19 derivatives counterparty run? 20 WITNESS MASTERS: Was part of the run on the big I don't think there's any 21 question that that was part of it. I mean, I knew plenty of 22 hedge funds that were, you know, trading with that, knowing 23 that, you know, if you had, you know, a $50 trillion 24 derivatives book that you didn't know if the counterparty was 25 good anymore. I mean, you know, nobody has $50 trillion of 62 1 capital. 2 And so it causes all sorts of other fears. I mean, people that own Goldman Sachs stock 3 suddenly say, you know what, I don't want to own it anymore. 4 I don't think there's any question that there was fear, and 5 legitimate fear, because I believe that had Treasury not 6 stepped in to save AIG, we would have lost all the 7 investment banks in a matter of time. 8 9 COMMISSIONER BORN: been a cascading of failures throughout the financial 10 system. 11 system itself have been? 12 So you think there would have What would the effect of that on the financial WITNESS MASTERS: Well you would have had--you lost 13 the shadow banking system, and to a large part that hasn't 14 come back to any extent. 15 of that part. 16 that was out there would have come back to affect the 17 regulated financial system. 18 more bank failures. 19 participants that would have gotten hurt, more so over a 20 period of time because the derivatives counterparty issue 21 was so much larger than the regulated area that it had a 22 very significant effect. 23 I mean, we've lost a lot of facets But you would have--the shadow banking leverage And you would have had many You would have had many other financial So that is how the systemic contagion started 24 with derivatives, and then led to markets really around the 25 world--not just here in the U.S. but in other countries. 63 1 COMMISSIONER BORN: Does this suggest that, or do 2 you feel that lack of regulation of the over-the-counter 3 derivatives market played any role in establishing a 4 fragility in the system that let it play this role in the 5 financial crisis? 6 WITNESS MASTERS: I don't think there's any 7 question. I mean, lack of regulation was one of the key 8 issues. 9 regulators what--for instance, a few years ago people said I mean, not having clearing--you know, you'd ask 10 what's the value of commodity derivatives out there? 11 they couldn't tell you. 12 they couldn't see the market. 13 Well And they couldn't tell you because In my view, with the benefit of hindsight the 14 Commodity Futures Modernization Act was an unmitigated 15 disaster. 16 I've ever seen with regard to the economy. 17 today we are trying to fix a big problem, but it's a long 18 battle. 19 20 21 22 It is one of the worst pieces of legislation that And, you know, I mean, it opened up all sorts of issues. Not having regulation in these markets is just not acceptable. CHAIRMAN ANGELIDES: Ms. Born, a couple more minutes, or-- 23 COMMISSIONER BORN: 24 CHAIRMAN ANGELIDES: 25 COMMISSIONER BORN: Sure. Okay, and then we'll-Let me ask you. Another area 64 1 that you touched on that the other witnesses did not is the 2 impact of derivatives on the commodity bubbles, or the role 3 that they caused in the energy and food bubbles in 2008 4 where, you know, the price of oil skyrocketed to over $140, 5 and then came back down to $33. 6 Could you comment on how derivatives, perhaps on 7 exchange derivatives, perhaps off-exchange over-the-counter 8 derivatives, played a role there? 9 WITNESS MASTERS: Well, so really for the last 10 decade, really, since 2003, commodities became sort of an 11 accepted, quote/unquote, "asset class" for institutional 12 investors. 13 And the way many of the large institutional 14 investors decided to allocate into commodities was via 15 commodity index swaps, or some other kind of commodity swap, 16 which allowed them-- 17 18 19 20 21 COMMISSIONER BORN: Let me ask you, who sold those commodity index swaps? WITNESS MASTERS: The large dealers: Goldman, AIG, JPMorgan, Lehman Brothers. And so when they marketed these, quote/unquote 22 "investments" to their clients, there was a significant 23 amount--I mean Wall Street, one thing they're pretty good at 24 is marketing--and there was a significant amount of money 25 flow that went into these derivative instruments that then 65 1 affected the price of these commodities. 2 allocate via price. 3 And markets So dollars went in and the price had to change to 4 account for that. 5 that was amplified by large institutional investors. 6 know, commodities may have gone up, but they probably 7 wouldn't have gone up anywhere near the levels they achieved 8 without this amplification, this inflow of large investment 9 dollars from institutional investors. 10 And so you had a very significant rise And then, when you had the credit crisis, when 11 you had the Lehman blowup, then suddenly again the 12 counterparties were where people were worried. 13 out. CHAIRMAN ANGELIDES: 15 COMMISSIONER BORN: Thank you. 16 WITNESS KOHLHAGEN: Can I-- 17 CHAIRMAN ANGELIDES: 19 this. Money came And prices came down just as fast. 14 18 You Thank you. Well, actually let's do Mr. Vice Chairman would like to make a comment. VICE CHAIRMAN THOMAS: Thank you. One of the 20 advantages of having a panel of experts is the interaction 21 between the panel of experts. 22 delay in time in response, it kind of loses the purpose. 23 And if there is a significant However, Commissioners control their own time. 24 And so I will, if necessary, periodically, since I saw him 25 being antsy out there, he wanted to say something, and it's 66 1 your time. 2 WITNESS KOHLHAGEN: Okay, thank you. Very 3 briefly, I would like to take the other side of what he just 4 said. 5 6 VICE CHAIRMAN THOMAS: Yes, but not in the same period of time. 7 (Laughter.) 8 WITNESS KOHLHAGEN: 9 VICE CHAIRMAN THOMAS: 10 WITNESS KOHLHAGEN: No. Okay. First of all, everything you 11 say about the--both you and Commissioner Born say about the 12 commodity markets is correct, but it did not contribute to 13 the financial crisis. 14 contribute, (a). 15 It did what it did, but it did not (b) To your point about the over-the-counter 16 derivatives market, I'm sorry I respectfully disagree. 17 did not freeze up. 18 your part. 19 government had not bailed out AIG that the over-the-counter 20 derivatives markets would have failed and crashed. 21 government did bail out AIG, and the over-the-counter 22 markets did not crash and they did not stop functioning. 23 24 25 It Those are speculative projections on I agree with you and Secretary Born that if the WITNESS MASTERS: But the I would just make the answer to that that-VICE CHAIRMAN THOMAS: Mr. Chairman, on somebody 67 1 else's time he can answer. 2 balance. 3 kind of an exchange can be helpful if it's advancing our 4 understanding rather than pushing an argument for the sake 5 of an argument. 6 I was just trying to get a But if we're willing to take a common pot, this CHAIRMAN ANGELIDES: If there is something 7 extraordinarily compelling, why don't we just, on common 8 time, just literally 15 seconds each, quick comments. 9 Kyle? Mr. Mr. Masters, yes. 10 WITNESS KYLE: A quick comment,, which I 11 agree that it is important for the CFTC or the government to 12 have good information about what is going on. 13 that information in real time. 14 of derivatives contracts move to organized exchanges where 15 the information in principle could be made available in real 16 time, the government and the public needs information about 17 what is going on in the OTC markets that hasn't gone to the 18 organized exchanges. 19 And they need And even if a large number So it is very important to get that information 20 collected. It is very important to get that information 21 stored and processed in a common form. 22 important for regulators to have access to it, and it is 23 very important for market participants to have access to 24 that part of it that is not too proprietary. 25 of Financial Research, which is part of the new bill, And it is very And the Office 68 1 actually is going to accomplish a lot of that. 2 But I don't think of it as a regulatory agency. 3 I think of it as an information collection agency. 4 going to be telling people how to run their business; it's 5 going to be providing information and transparency. 6 7 CHAIRMAN ANGELIDES: Mr. Masters, literally just quick. 8 9 It's not WITNESS MASTERS: Sure. I would just answer, you know, two issues with regard to commodities. You know, in 10 my view a speculative bubble in commodities has significant 11 consequences for the American public, and had significant 12 consequences with regard to furthering the financial crisis. 13 And then second, with regard to the derivatives 14 markets not freezing up, I was there during the period. 15 it didn't--you know, had we lost AIG, it would have totally 16 stopped. 17 as close as I would want to come to the markets freezing up. 18 19 But there was palpable fear out there. CHAIRMAN ANGELIDES: All right. If And it was Thank you. Mr. Hennessey. 20 COMMISSIONER HENNESSEY: Thank you, Mr. Chairman. 21 I want to see if I can try to clarify a few 22 things that are confusing me, because there's been a lot of 23 language thrown around in this debate and I think the 24 language sometimes gets sloppy, not from the four of you but 25 generally, and I think that sloppiness in language really 69 1 detracts from understanding what the problems are. 2 I am going to try and tackle a few things. 3 is, I think there is an assumption that math is evil, 4 because I think a lot of people don't understand it and 5 they're afraid of it. 6 One Two, is I have heard a couple of you say that 7 derivatives or credit default swaps were culprits. 8 think that derivatives and credit default swap are things, 9 and things can't be culprits any more than a hammer used in 10 a murder can be a culprit. 11 or misuses the hammer is the culprit. 12 And I The person who uses the hammer, And I am concerned that in a lot of cases what we 13 may be doing is confusing form, or the instrument, with the 14 actor who is using that instrument. 15 want to drill down into. That is kind of what I 16 Another is we've heard that credit default swap 17 are or were the cause of the crisis, and I want to explore 18 that a little bit. 19 talk about the question of whether or not side bets are bad. 20 And then I also want to, if I have time, I would just like to say, as a general matter I 21 am in favor of the capital requirements that we are talking 22 about, and generally for pushing things onto exchanges, and 23 for greater transparency. 24 25 But as I look at the different problems, first I want to start with CDOs, and then I want to go to the CDS 70 1 world. It seems to me that I can explain a lot of what 2 happened with some very simple assumptions. 3 So first, if we start with a collateralized debt 4 obligation, if I assume that two primary causes were, one, 5 people made a bad assumption about housing price declines. 6 And, two, people made really bad assumptions about the 7 correlation of housing price declines across different 8 regional markets. 9 It seems to me that those two errors can explain 10 all of the poor valuation of collateralized debt 11 obligations. Just general comments on that? 12 WITNESS KYLE: 13 COMMISSIONER HENNESSEY: 14 Yes. Mr. Kyle? I-Setting aside hybrids, which have CDS with them, which is a different-- 15 WITNESS KYLE: I agree that overly optimistic 16 assumptions about housing prices and overly low assumptions 17 about correlation are important. 18 also important. 19 But two other things are One is, when do homeowners default on their 20 mortgage? 21 percent? 22 kinds of assumptions are important in these valuations. 23 24 25 Do they default when they're underwater 20 40 percent? 50 percent? And so forth. Those Another assumption that is important is what are going to be the recoveries, given that a homeowner defaults? That depends in part on the ease with which a 71 1 creditor can foreclose on a homeowner. 2 time and the homeowner trashes the house, the recovery is 3 going to be much lower. 4 So I would add to your list-- 5 COMMISSIONER HENNESSEY: 6 WITNESS KYLE: If it takes a long Okay, good. Now-- --these additional issues, which-- 7 8 9 10 COMMISSIONER HENNESSEY: In both cases, though, those are poor--those are incorrect assumptions about inputs into a model. 11 WITNESS KYLE: Correct. 12 COMMISSIONER HENNESSEY: Right? It's not--Mr. 13 Kohlhagen said this in his testimony--it's not the model 14 itself, or the fact that you're using math or a spreadsheet 15 to turn a whole loan into a mathematically complex set of 16 financial products. 17 And I guess what I'm trying to understand here 18 is--Mr. Greenberger, Mr. Kohlhagen, Mr. Kyle--do any of you 19 believe that the process of turning a whole loan into a CDO 20 by itself changes the amount of risk that's involved? 21 somehow was a cause of the crisis? 22 questions of what was done with that CDO, or the lack of 23 transparency with that CDO, is the creation of a CDO by 24 itself a bad thing, or was it a cause in this case? 25 WITNESS KOHLHAGEN: Or Setting aside the other I'll go first. The kids who 72 1 priced those CDOs--and I managed a whole bunch of them then, 2 so I can call them kids--basically did not have a clue about 3 what was going on in the credit markets in the United 4 States. 5 So they were making forecasts--not necessarily 6 assumptions, but forecasts of probabilities of default, 7 probabilities of foreclosure and volatility of the markets in an 8 arena in which they simply did not know what was going on, I 9 used in my testimony, Peoria. 10 11 They did not understand what was going on in the real world. COMMISSIONER HENNESSEY: Right. And you talked 12 about basically the management issue of the two different 13 silos, the credit guys not talking to the math guys. 14 WITNESS KOHLHAGEN: I don't think it--I think it 15 determined the magnitude of the crisis. 16 caused the crisis. 17 forecasts in the ether they were living in, and they'd only 18 been a little bit wrong, then the losses would have been 19 considerably smaller. 20 I don't think it In other words, if they had made those But they were staggeringly wrong because they 21 didn't know what was going on, and no one was telling them. 22 And so what it caused was a huge magnitude of crisis. 23 didn't cause the crisis. It There's still an amount of crisis. 24 COMMISSIONER HENNESSEY: 25 WITNESS GREENBERGER: Do you have a view? I basically agree. All I 73 1 would say is your point about being angry about math-- 2 3 CHAIRMAN ANGELIDES: microphone? 4 5 WITNESS GREENBERGER: COMMISSIONER HENNESSEY: Oh, I wasn't suggesting you were. 8 9 Your point about being angry about math, I'm not angry about math. 6 7 Would you turn on your WITNESS GREENBERGER: But I just don't want to have a GM stock determined by an algorithm. I think it is 10 much preferable that the market determines that price. 11 the market--these kids were determining the price. 12 wasn't a vehicle, an exchange-trading vehicle, for the 13 market to determine the price. 14 15 And There The algorithms will never do as well as the market. 16 COMMISSIONER HENNESSEY: Okay. I want to try and 17 turn to credit default swaps now. 18 to try to understand, were there problems with credit 19 default swaps themselves, the existence of credit default 20 swaps? 21 a capital requirement, which meant that AIG could just keep 22 cranking these things out infinitely? 23 that the risk itself that was created by those products was 24 concentrated? 25 Were they a cause? And in particular I want Or was it basically the lack of And then the fact It seems to me that if those credit default swaps 74 1 had not been sold by a single firm, but instead had been 2 spread out among 50 firms, if you hadn't had the 3 concentration of risk in a particular place, and we've 4 talked about the counterparty risk and the poor 5 understanding of it, it seems to me that those two factors 6 can explain everything that's going on. 7 basically a mechanism through which the underlying problems 8 of concentration of risk and poor understanding of 9 counterparty risk were the actual underlying causes. Comment? 10 WITNESS KOHLHAGEN: And the CDS is I agree with Commissioner 11 Born, and apparently everybody here, that increased capital 12 requirements are going to help. 13 help. Increased regulation may Better information and transparency may help. 14 But in the end, if people behave irresponsibly in 15 a very, very, very large way, they will have very, very 16 large consequences. 17 COMMISSIONER HENNESSEY: In the case of say 18 AIGFP, that irresponsible behavior was essentially taking 19 one side of very, very large bets-- 20 WITNESS KOHLHAGEN: In an unhedged way. It's 21 stunning. 22 over 20 years on the economic and business philosophy of 23 selling and buying things on a hedged basis. 24 $80 billion unhedged. 25 It was a subsidiary that made billions of dollars COMMISSIONER HENNESSEY: And they sold And so my core question 75 1 is: Understanding that the lack of capital requirements 2 made it easy--facilitated AIGFP's ability to do that, was 3 the problem itself the mechanism that they used to do it? 4 Or was it basically here were a bunch of guys who were 5 taking really bad, unhedged risks? 6 WITNESS KOHLHAGEN: The latter. 7 COMMISSIONER HENNESSEY: 8 WITNESS GREENBERGER: Okay. Other views? Well I think you also have 9 to add naked credit default swaps into this. That is, 10 people who had no risk who were able to bet. That 11 exponentially increased--when a mortgage failed, you had the 12 CDOs fail, and the insurance on the CDOs, but you also had 13 the bettors, who Mr. Dinallo says were three to four times 14 the size of the actual mortgage. 15 Convert that. It may very well have been, if 16 there had been no naked CDS, like you can't have naked 17 insurance--I can't insure your life or your car--this would 18 have been a much smaller problem. 19 size of the problem. 20 Maybe one-quarter the So for that reason, I would say--and by the way, 21 Germany has just banned German citizens being able to buy 22 naked CDS on sovereign defaults in Europe. 23 are going to head. 24 Congress, but when we get into these crises further, the 25 anger about the betting will be-- That is where we I'm not advocating that, nor is 76 1 COMMISSIONER HENNESSEY: I'm going to interrupt 2 you. Just because the Germans did it doesn't mean that we 3 should do it. 4 something that a lot of them don't understand is not 5 sufficient justification for doing it. 6 And just because people are angry about But again I want to focus on the causes here of 7 the crisis. 8 why side bets--which is what a naked credit default swap is- 9 -why a side bet in and of itself is a bad thing. 10 Because I am having a tough time understanding WITNESS GREENBERGER: It's a fine thing if you do 11 it in Las Vegas, or Atlantic City, where it is fully 12 regulated for cheating, capital requirements, and everything 13 else. Having side bets-- 14 COMMISSIONER HENNESSEY: Good. Good. Okay, 15 wait, but let me interrupt you here because my time is 16 limited. 17 collusion side bet in a financial market a bad thing? 18 Is a properly capitalized, transparent, no- WITNESS GREENBERGER: I would want to think about 19 that, but my short answer is no. It's just that it's a 20 Utopian consideration from where we were that it's hard to 21 go into the hypothesis. 22 COMMISSIONER HENNESSEY: 23 WITNESS GREENBERGER: 24 25 Right. But we would have been a lot better off if Las Vegas had handled these side bets. COMMISSIONER HENNESSEY: I have no doubt that-- 77 1 (Laughter.) 2 COMMISSIONER HENNESSEY: I have no doubt that the 3 existence of naked credit default swaps allowed these firms 4 that wanted to leverage up these bets to do so easily. 5 What I am trying to understand is: Was it the 6 lack of capitalization? 7 leverage and concentration of risk that was the actual 8 problem? 9 security? 10 The lack of transparency? And the Or was it the fact that there wasn't an underlying I mean, you can buy and sell puts, right? And 11 they're in effect a similar sort of risk-bearing mechanism 12 we don't have problems with. 13 WITNESS GREENBERGER: Mr. Hennessey, you are 14 positing a fully regulated system. 15 fully regulated system there wouldn't have been the problem. 16 COMMISSIONER HENNESSEY: 17 WITNESS KOHLHAGEN: 18 your question is: No. COMMISSIONER HENNESSEY: 20 CHAIRMAN ANGELIDES: 21 WITNESS KOHLHAGEN: Okay. Which question? Whether or not side bets would be a problem. 23 CHAIRMAN ANGELIDES: 24 WITNESS KOHLHAGEN: 25 Okay. My short and long answer to 19 22 I agree, if there was a bad. Whether what? Whether or not side bets are 78 1 VICE CHAIRMAN THOMAS: 2 WITNESS KOHLHAGEN: 3 No, the way he stated the question. Right. 4 WITNESS KYLE: 5 COMMISSIONER HENNESSEY: 6 WITNESS KYLE: 7 Either way? I want to make-Please. I want to make two points related to this. 8 The first is, the financial crisis was caused by 9 the concentration of risks in levered financial institutions 10 which, when they started suffering losses like Citigroup, or 11 AIG, or Bear Stearns, or Lehman, had to de-lever their 12 positions. 13 book. 14 They had to kind of shrink the size of their So when big banks lose a lot of money, it is bad 15 for the macro economy and it takes a long time to recover. 16 That's where "depressions" as opposed to "recessions" come 17 from. 18 have now, which is the type I just described, with the dot 19 com bubble. 20 more risk being moved around. 21 stocks, which exposed trillions-- It is interesting to compare the financial crisis we In the dot com bubble there was a whole lot Trillions of dollars worth of 22 COMMISSIONER HENNESSEY: 23 WITNESS KYLE: But it was dispersed. --of dollars of risk on various 24 people, but these dot com stocks were owned by dispersed 25 investors, and largely not owned by banks. So when the dot 79 1 com bubble collapsed, the losses from the collapse were 2 enormous. 3 portfolios, the spillovers through the banking--and 4 particularly not held by banks--the spillovers into the 5 economy resulted in a recession that we recovered from very 6 quickly. 7 But because the stocks were not held in levered COMMISSIONER HENNESSEY: Okay, so sort of the 8 tentative conclusions that I come to, setting aside Mr. 9 Masters' concern about energy and food prices, is that, to 10 say derivatives is too broad. To say over-the-counter 11 derivatives as a cause is in fact too broad. 12 be looking at the subset of over-the-counter derivatives 13 which are over-the-counter credit derivatives; and that 14 specifically the actual underlying problems were not the 15 over-the-counter credit default swaps themselves, it was the 16 lack of capital requirements, and then the concentration of 17 risk and the levering up that was done with those. 18 Comments from the two of you? 19 WITNESS KYLE: 20 COMMISSIONER HENNESSEY: 25 In the banking system, right. 23 24 Yes, levering up in the banking system. 21 22 That we should WITNESS KYLE: And that would include the shadow banking. COMMISSIONER HENNESSEY: Right. It was the fact 80 1 basically--I simplify this as a bunch of people made the 2 same bad bets on housing prices. 3 through this complex mathematical instrument that a lot of 4 people are scared of. 5 then they also took those bad bets. 6 them in large institutions, and then their counterparties 7 weren't figuring out that they were exposed to counterparty 8 risk. 9 They happened to do this But then what really happened was, WITNESS KOHLHAGEN: They all concentrated And add "too big to fail" as 10 a problem. I mean, basically if these were little tiny 11 community banks, then we wouldn't be here today. 12 COMMISSIONER HENNESSEY: Okay. Good. 13 One other thing is, just again trying to add some 14 clarity here, the $58 trillion number that gets thrown 15 around--and I know that you all are careful when you say $58 16 trillion in nominal exposure, but then the reality is that 17 the net exposure is smaller. 18 I want to see if I can do an example here. Doug, 19 I will sell you a trillion dollars of credit default swaps 20 on General Electric. 21 dollars of credit default swaps from you on General 22 Electric. And then I want to buy a trillion Do we have a deal? 23 COMMISSIONER HOLTZ-EAKIN: 24 COMMISSIONER HENNESSEY: 25 Yes. Okay. We have, as I understand it we have just increased the notional amount of- 81 1 - 2 3 VICE CHAIRMAN THOMAS: Could I get the commission for this? 4 (Laughter.) 5 COMMISSIONER HENNESSEY: 6 Excuse me? Absolutely. Just a couple basis points. 7 As I understand it, Doug and I have just 8 increased the notional value of the over-the-counter 9 derivatives market by $2 trillion, even though there is not 10 in fact any real increase in risk that exists. 11 that basically right, Mr. Kyle? 12 WITNESS KYLE: Absolutely right. Do I have And when the 13 credit events occur that result in the credit default swaps 14 paying off, they hold these auctions. 15 allow the net exposures, which would be zero in the case of 16 your transaction because you're both long and short a 17 trillion dollars, it kind of allows the net exposure to come to the 18 market. 19 And the auctions My understanding is that the experience is that a 20 huge fraction of the notional exposure has been netted out 21 by the time the contracts wind down, and maybe you are 22 looking at one percent, or some fraction of one percent of 23 the notional amounts that people throw around as 24 representing true exposure. 25 COMMISSIONER HENNESSEY: Good. My time is 82 1 expiring, but-- 2 VICE CHAIRMAN THOMAS: 3 COMMISSIONER HENNESSEY: 4 VICE CHAIRMAN THOMAS: 5 COMMISSIONER HENNESSEY: 6 VICE CHAIRMAN THOMAS: 7 Twenty seconds. Two minutes. Twenty seconds. And we'll pay it in notional dollars. 8 9 Do you want more time? CHAIRMAN ANGELIDES: Why don't you guys talk for a minute and forty about the twenty seconds. 10 (Laughter.) 11 COMMISSIONER HENNESSEY: One of the problems that 12 I heard described in the OTC derivatives markets back in '05 13 and '06--Tim Geithner was worried about this when he was up 14 at the New York Fed--was the question of resolving the CDS 15 when a firm in fact failed. 16 All right, and he and the New York Fed were 17 pushing hard saying, look, you guys have got to figure out 18 how you are going to deal with all these overlapping 19 commitments and counterparty risk. 20 I don't know if his push worked. I understand 21 that it's in fact still not even complete, but he's 22 generally getting good reviews of it, but as best I can tell 23 that problem that they were concerned with did not actually 24 rear its head in sort of disorderly resolution of the CDS. 25 Right? 83 1 When Lehman failed, there were concerns about 2 counterparty risk, and counterparty exposure to Lehman, but 3 everybody who owed everybody else money actually basically 4 ended up paying? 5 No? WITNESS GREENBERGER: No. I mean, what's 6 confused is the CDS that guaranteed a Lehman default got 7 netted out to $6 billion, and everybody went hurrah!. 8 at the Lehman bankruptcy. 9 bringing against one of its 6000 creditors, Nomura. 10 Look Look at the lawsuit Lehman is Nomura is debating not the credit default swap on 11 Lehman's viability but Lehman entered into interest rate 12 swaps, currency swaps, foreign exchange swaps, natural gas 13 swaps, energy swaps, with Nomura. 14 there's no market price they owe us a billion. 15 saying we owe $500 million; it's outrageous. 16 17 18 Nomura says because COMMISSIONER HENNESSEY: Okay. Good. Lehman is Then let me try and be a little more precise. I'm not suggesting that the resolution mechanisms 19 are fixed or in fact working well. I guess what I'm 20 suggesting is that I was hearing arguments several years ago 21 that the difficulties in resolving these contracts was a 22 systemic risk. 23 legal disputes about the appropriate valuation. 24 Lawyers and economists go figure this out. 25 have Lehman's default. And what I'm hearing is, there are still Great. But you didn't Because I remember when, the day 84 1 before Lehman was going under we were all saying, okay, are 2 we worried about this as a triggering event? 3 same was true with Bear. 4 pleasantly surprised that the default and the resolution of 5 it didn't cause other institutions to suddenly fail. 6 I think the And everyone was sort of WITNESS GREENBERGER: It didn't cause other 7 institutions to suddenly fail because the American Taxpayer 8 was the lender of last resort to the holes that those 9 institutions had. 10 COMMISSIONER HENNESSEY: 11 WITNESS GREENBERGER: 12 VICE CHAIRMAN THOMAS: 13 No, not for Lehman. Does the gentleman feel he needs an additional 20 seconds? 14 COMMISSIONER HENNESSEY: 15 (Laughter.) 16 COMMISSIONER HENNESSEY: 17 But not for Lehman. Yes, please. To round out that two minutes. 18 WITNESS GREENBERGER: Not for Lehman, because 19 Lehman is now going through a bankruptcy process that is 20 disorderly. 21 York Fed President Geithner said, is: 22 this kind of bankruptcy institution by institution. 23 just not going to let it happen. 24 25 What Secretary Paulson, Chair Bernanke, New Why did it not happen? institutions out. Hey, we can't have We're Because we bailed those They are thriving today because of that. 85 1 That's why there's no disruption. And by the way, the 2 interconnectedness is not just CDS; the interconnectedness 3 is interest rate swaps, currency swaps, foreign exchange 4 swaps, energy swaps, agriculture swaps. 5 So when you say, oh, CDS caused the crisis, that 6 may be true; but the interconnectedness crisis that led the 7 American Taxpayer to have to bail everybody out, because as 8 Michael Masters said, if these institutions failed there 9 would have been cascading effect. 10 And while the derivatives market locked up 11 immediately, Mr. Kohlhagen is right, it didn't lock up 12 completely, why? 13 trillions of dollars at it. Because the American Taxpayer threw 14 COMMISSIONER HENNESSEY: 15 VICE CHAIRMAN THOMAS: All right. Mr. Chairman, on my 20 16 seconds, do we all agree on the expert panel with that last 17 statement by Dr. Greenberger? 18 WITNESS KOHLHAGEN: 19 CHAIRMAN ANGELIDES: 20 WITNESS KOHLHAGEN: I don't agree with that, either. 23 (Laughter.) 24 CHAIRMAN ANGELIDES: 25 What about the part where he agreed with you? 21 22 No, I don't. comments? All right, any other 86 1 VICE CHAIRMAN THOMAS: My concern is the 2 cascading aspect. 3 didn't have that cascading effect, then you've got to come 4 up with another explanation. 5 And if there's disagreement that it WITNESS KOHLHAGEN: I agree that there was the 6 fear of it, and I agree that, had we performed the 7 experiment of let's see what happens if we let AIG go under, 8 that we would have had systematic failure. 9 that. 10 I do not agree with Lehman. I agree with I agree with 11 Commissioner Hennessey that that's arguing among lawyers 12 about a contract value. 13 VICE CHAIRMAN THOMAS: 14 WITNESS KYLE: 15 VICE CHAIRMAN THOMAS: 16 WITNESS KYLE: Okay. May I? Yes. I think that in addition to the 17 OTC derivatives market we need to look at the repo market. 18 And the repo market did not function very well after Lehman 19 failed, especially in the UK as opposed to the U.S. 20 21 22 COMMISSIONER HENNESSEY: As a source of interconnectedness, you mean? WITNESS KYLE: Yes, yes. The repo market is a 23 huge source of interconnectedness because the various banks 24 are borrowing and lending money from one another, and 25 they're borrowing and lending securities from one another, 87 1 and the same arguments about the value of derivatives 2 contracts occur in arguing about the collateral value 3 underlying the repo contracts. 4 5 WITNESS KOHLHAGEN: Kyle on that. 6 7 CHAIRMAN ANGELIDES: you. 8 9 I absolutely agree with Mr. All right. Good. Thank Now just on--Mr. Vice Chair? VICE CHAIRMAN THOMAS: I'm out of time, but that gets back to my function of Wall Street and all the banks. 10 Was it bees in a beehive, or a praying mantis with their 11 mate? 12 13 And that I have not been able to figure out yet. WITNESS KOHLHAGEN: It was praying mantis playing Texas Hold 'Em. 14 (Laughter.) 15 VICE CHAIRMAN THOMAS: 16 CHAIRMAN ANGELIDES: There you go. All right. On my time, some 17 of my remaining time, I do want to ask one question before 18 we go to senator Graham. 19 very good line of questioning that Mr. Hennessey pursued 20 about side bets. 21 And this is on the, I think the I think he put down some markers with respect to 22 those side bets in terms of collateral, and honest, open 23 market, but I do have a fundamental question. 24 25 Doesn't it also matter who is participating in the side bet market, and to what extent? I mean, at the end 88 1 of the day, taking away theory, there were winners and 2 losers. 3 But having actually done pretty well in math, the math is 4 pretty simple here. 5 Some people say, look, it's a big zero sum game. The losers, at least temporarily, and I think for 6 decades to come, will have been the American Taxpayers who 7 did step in to cover the side 8 shouldn't we also be concerned about who participates in 9 side bets, and to what extent? 10 institutions? 11 market? 12 bets gone bad. And so Systemically important Should they be participating in the side bet WITNESS KOHLHAGEN: I say yes. A well-run 13 organization, a bank, a securities firm--and you can pursue 14 this this afternoon with Goldman Sachs--basically at least 15 used to look very, very carefully at their counterparty 16 risk. 17 All of the organizations that they had--you call 18 them side bets; I call them derivatives contracts--with, 19 they looked very carefully and they managed that 20 counterparty risk. 21 Now just a personal comment to Commissioner Born. 22 Back in the '90s when you were advocating greater regulation 23 of the derivatives market, and I was an executive in the 24 derivatives market, I completely disagreed with you. 25 could not imagine the banks mismanaging this function. I It 89 1 was not imaginable to me. 2 speeches, and I've said it since I retired in 2002 in public 3 speeches, and I was wrong. 4 5 And I said that in public CHAIRMAN ANGELIDES: So you are dependent on their ability to manage-- 6 WITNESS KOHLHAGEN: 7 CHAIRMAN ANGELIDES: You're dependent---and to the extent that 8 we're backstopping, that is relevant to participation in the 9 side bet market? 10 WITNESS KOHLHAGEN: --as a Nation we are 11 dependent on private sector firms to manage themselves well. 12 And if they don't manage themselves well, they go out of 13 business-- 14 CHAIRMAN ANGELIDES: 15 WITNESS KOHLHAGEN: 16 fail, then we have a problem. 17 CHAIRMAN ANGELIDES: Or--or---or if they're too big to And I want to just pick up, 18 because I think at the end of the line of questions you 19 added, "don't forget too big to fail," and I didn't want 20 that lost in the side bet discussion about what's proper, 21 what's not, what's perhaps contributory to the crisis and 22 what wasn't. 23 WITNESS KOHLHAGEN: As long as there are firms 24 and trading exchanges in the future that are too big to 25 fail, the Taxpayer is going to be on the hook for them. 90 1 CHAIRMAN ANGELIDES: Mr. Hennessey, why don't you 2 go ahead and take a couple of minutes of time, which will 3 come off our ledger, and then we're going to actually--I 4 made a mistake. 5 going to go to Mr. Wallison, who was the other member of the 6 Working Group. 7 We're not going to Senator Graham, we're COMMISSIONER HENNESSEY: Just to follow up on 8 this. If I mismanage my hardware store and it goes 9 bankrupt, that's not a concern of policymakers. And I 10 think, again the concern of policymakers with a large 11 financial institution mismanaging their risk is, if that 12 large financial institution is too big to fail. 13 And so I think it keeps coming back to 14 policymakers' need, or perceived need for a bailout that 15 then injects the policymakers into overseeing whether or not 16 they were making stupid decisions with their risk 17 management. 18 VICE CHAIRMAN THOMAS: But what I don't 19 understand is, if in fact they were in that position and you 20 have that large a responsibility, as a government you should 21 be on top of it looking at it carefully, making sure that 22 the management was appropriate because the downside bet is 23 too great a risk. 24 25 COMMISSIONER HENNESSEY: Right. If you run a commercial bank, you're not allowed to bet your depositors' 91 1 money on the world cup. 2 WITNESS KOHLHAGEN: If I could just add-- 3 COMMISSIONER HENNESSEY: Like if the supervisors 4 step in and say there are certain things you are not allowed 5 to do. 6 WITNESS KOHLHAGEN: 7 COMMISSIONER HENNESSEY: 8 That's because there's a public guarantee. 9 10 To Mr. Kyle's point-- VICE CHAIRMAN THOMAS: Well especially with the referees at the World Cup. 11 (Laughter.) 12 WITNESS KOHLHAGEN: To Mr. Kyle's point, if the 13 U.S. Government allows private-sector firms to make the 14 money when they win and bails them out when they lose, the 15 American people are going to pay a high price for that 16 system. 17 18 19 20 21 22 23 VICE CHAIRMAN THOMAS: And all of them want to be in the same business. CHAIRMAN ANGELIDES: good discussion. All right. This is a very Mr. Wallison, you're up. COMMISSIONER WALLISON: Thank you very much, Mr. Chairman. As I say in every one of these meetings, we are 24 in the business of trying to find out what caused the 25 financial crisis. So a lot of this stuff, talking about 92 1 various ways that a particular institution like AIG may have 2 missed the boat and made mistakes is not exactly the issue. 3 What we have to find out really is, systemically 4 what was it about credit default swaps that caused problems 5 here. And I don't think I've heard a lot. 6 If we talk about AIG just for a moment, AIG 7 obviously made some bad bets. 8 many of the other institutions who were before us on exactly 9 the same ground. 10 But on the other hand, so did And that is, Citibank kept a lot of super senior securities thinking that they were completely safe. 11 Now of course they lost. AIG lost for making the 12 bet on the other side--that is, they protected these super 13 senior securities. 14 we denounce AIG for making a mistake that was exactly the 15 same as Citibank's. 16 whether there's really any difference between making bad 17 loans and being involved in the CDS world. 18 And the puzzling thing to me is that now And so what we have to find out is I would like to start with you, Mr. Masters, and 19 see if we can bring some clarity here. 20 subprime mortgages, would there have been a financial 21 crisis? 22 WITNESS MASTERS: If there had been no I don't know. I think that's 23 the honest answer. I think that the subprime crisis was a 24 different crisis than the derivatives crisis that I 25 addressed. 93 1 COMMISSIONER WALLISON: Are you saying that even 2 if all the mortgages were 20 percent down payment and made 3 to people who could afford them, they were prime mortgages, 4 the mere fact that credit default swaps existed as a way of 5 people taking on exposure, or eliminating exposure, would 6 have caused the financial crisis? 7 WITNESS MASTERS: The answer is, I think that the 8 derivatives market was a necessary precondition to 9 furthering a subprime credit crisis, if you will. 10 So I think without some crisis involved-- 11 COMMISSIONER WALLISON: I think I can follow your 12 thought, and you're saying that there must be some 13 underlying problem for the CDS to have transmitted the risks 14 or the losses? 15 16 17 Is that what you're saying? WITNESS MASTERS: Yes. I think that there had to be some other-COMMISSIONER WALLISON: Okay. Now you said that 18 the credit default swap market ground to a halt. I think 19 there was some question about that by some of my colleagues, 20 but I actually have some numbers here from Market Serve, 21 which now publishes these numbers, and I want to read you 22 the numbers for the credit default swap market from June of 23 2008 until December of 2008, so that it covers the period 24 where Lehman failed and we believe the financial crisis 25 began, and I think this was the period you were referring 94 1 to. 2 In June--I'll leave out anything other than just 3 the dimensions--251,000. 4 188,000. 5 Lehman, 315,000. 6 December, 255,000. In July, 284,000. In August, In September, the month that we had the failure of October, 379,000. November, 305,000. 7 So that doesn't sound to me-- 8 VICE CHAIRMAN THOMAS: 9 COMMISSIONER WALLISON: 10 was 2008. 11 ground to a halt. 12 to function. And that's the year 2008? Sure. Yes. All of this That doesn't sound to me as though a market has It sounds to me as though it's continuing 13 Now how do you explain that? 14 WITNESS MASTERS: Well I would say what I was 15 really referring to in my testimony was the period from 16 Lehman's failure to AIG's bailout, which was only a couple 17 of days. 18 more clear-- And there were trades that happened. 19 COMMISSIONER WALLISON: 20 WITNESS MASTERS: But to be Okay-- --there was a fear that 21 everything would have stopped. 22 that wouldn't have been taken otherwise to unwind swaps from 23 institutions-- 24 25 And there were actions taken COMMISSIONER WALLISON: So we're talking--I might just interrupt because my time is limited--so we're talking 95 1 about a two-day period when it ground to a halt. 2 the two-day period that caused the systemic crisis? 3 what you're saying? 4 WITNESS MASTERS: longer than two days had AIG collapsed. 6 on to this day. 8 9 Well we actually don't What we do know is that Lehman collapsed. WITNESS MASTERS: 10 It could have gone I mean, it's a situation that-- COMMISSIONER WALLISON: know that. Is that Well it could have been much 5 7 And it was Right. COMMISSIONER WALLISON: And what we wanted to 11 find out from that is what the interconnections that you 12 were talking about actually caused. 13 Can you identify any institution that was caused 14 to go into bankruptcy or otherwise to have a serious 15 financial problem because it was interconnected with Lehman, 16 other than thorough a loan but through a CDS? 17 the name of such an institution? 18 19 WITNESS MASTERS: COMMISSIONER WALLISON: 24 25 Actually, AIG's relation with Lehman turned out to be, in the end, $600 million. 22 23 Well I would say AIG had, had significant counterparty risk with Lehman Brothers. 20 21 Do you have WITNESS MASTERS: using. It depends on the round you're It depends on how you classify exposures. COMMISSIONER WALLISON: seriously connected with Lehman. Okay, but AIG was not 96 1 WITNESS MASTERS: But AIG was connected with 2 other folks, and if anybody had exposures on AIG with Lehman 3 Brothers, suddenly--for instance, let's just say that you've 4 made a bet with AIG, and you've got Lehman as your 5 counterparty, and suddenly--or you made a bet on an AIG 6 issue, on a credit instrument, and you've got Lehman as the 7 counterparty--suddenly now you don't have that hedge anymore 8 that you thought you had. 9 COMMISSIONER WALLISON: Right. But on the other 10 hand, you know what a reference entity is of course. We 11 haven't used the term "reference entity." 12 bets are on a reference entity of some kind. 13 that's the party that has to default in order for anyone to 14 be paid. But any of these That is, Right? 15 So if the reference doesn't fail, the fact that 16 AIG couldn't pay off, or the fact that Lehman couldn't pay 17 off, isn't relevant, is it? 18 WITNESS MASTERS: I think that the issue, I mean 19 you're sort of dancing around the issue. 20 the discussion is different. 21 hypothetically what would happen, and whatnot. 22 Had AIG failed, So you're saying, COMMISSIONER WALLISON: Excuse me, but someone 23 else is talking hypothetically. You're suggesting that if 24 AIG had failed that there would have been some kind of 25 serious crisis. That's hypothetical, because we don't know. 97 1 2 WITNESS MASTERS: Well I think the Treasury Secretary felt like that at the time. 3 COMMISSIONER WALLISON: Right, the Treasury 4 Secretary and others did. 5 except the fear that the Treasury Secretary felt at the 6 time, or the Chairman of the Federal Reserve. 7 WITNESS MASTERS: That is not evidence of anything Well it was a heck of a price 8 to pay for the American public to spend the billions of 9 dollars to bail out AIG, then. 10 COMMISSIONER WALLISON: 11 WITNESS MASTERS: 12 Right. I agree, the-- If what you're asserting is correct. 13 COMMISSIONER WALLISON: --the Taxpayers should be 14 complaining about what the Treasury Secretary did, and the 15 Chairman of the Federal Reserve, but let me go back to your 16 point. 17 That is, that there was some loss as a result of 18 the failure of Lehman Brothers. 19 what that loss was. 20 WITNESS MASTERS: And I want you to identify Hedge funds around the world-- 21 and I've talked to them about this view--suddenly didn't 22 know if their counterparty was good, if they were going to 23 get paid. 24 COMMISSIONER WALLISON: 25 WITNESS MASTERS: Right. And that forced them to unwind 98 1 exposures in many other instruments, to force a rapid de- 2 leveraging, which caused a--certainly affected markets and 3 prices around the world, which wouldn't have happened 4 otherwise had Lehman not failed. 5 6 COMMISSIONER WALLISON: these transactions with? 7 8 WITNESS MASTERS: They unwound them with many different brokers as they could. 9 10 COMMISSIONER WALLISON: Those are dealers, wouldn't you say? 11 WITNESS MASTERS: 12 COMMISSIONER WALLISON: 13 And who did they unwind Right. Swaps dealers. These are swaps dealers. And who are they? 14 WITNESS MASTERS: There are 20 different ones. 15 COMMISSIONER WALLISON: There are 26 or so, and 16 probably many more, but the major ones are about 26. 17 were all the institutions that were thought to be in danger, 18 right? 19 These I mean, if you wanted to go in and buy or sell a 20 swap, you had to deal with one of these institutions that you 21 told us a little while ago were in trouble, and people 22 didn't know whether they were safe or sound. 23 you said? 24 25 WITNESS MASTERS: Isn't that what What I said was, that you had a situation where dealers, well counterparties were fearful. 99 1 COMMISSIONER WALLISON: 2 WITNESS MASTERS: 3 And the fear of other dealers going out of business-- 4 COMMISSIONER WALLISON: 5 WITNESS MASTERS: 6 Right Even though they didn't actually go out of business-- 7 COMMISSIONER WALLISON: 8 WITNESS MASTERS: 9 Yes. Right. --and we don't know what would have happened, as I said, hypothetically. All right, let's 10 just say we don't know what happened. 11 fear that customers needed to unwind their bets with these 12 various dealers, which they did. 13 That wasn't driven by a fundamental belief in the 14 bet they were making. 15 counterparties eventually failing-- It was driven by a fear of 16 COMMISSIONER WALLISON: 17 WITNESS MASTERS: 18 19 There was a palpable Okay-- --and that's what I was really trying to say. COMMISSIONER WALLISON: --but they did deal with 20 the very people who you were suggesting were in some kind of 21 trouble, right? 22 yet when they went to--when they had to unwind their 23 transactions, their swaps, they had to deal with the people 24 who were actually the ones who you said were now in 25 questionable financial condition. I mean, you said people didn't know, and 100 1 WITNESS MASTERS: Well I mean it's, it's sort of 2 like, you know, you've got one going down, and you believe 3 that others are going down. 4 short period of time, before AIG was saved, there are still 5 people still standing. 6 have changed as a counterparty because now you're unwinding 7 bets that you wanted to have on, that you had on as a hedge 8 and you thought were a part of your fiduciary 9 responsibility. And in the interim, which is a But that being said, your actions Now as a fiduciary you have to make the 10 decision to unwind bets that had nothing to do with the bet 11 you wanted to have on. 12 COMMISSIONER WALLISON: Let me read you something 13 from Fitch Ratings, published in early 2009, about 2008. 14 And it says, among other things: 15 generally remained open throughout the crisis, particularly 16 for indices and single-name CDS contracts, and this has 17 enabled market participants to hedge or take on credit 18 exposures. 19 The CDS market has This is in direct contrast to the near complete 20 drying up of liquidity in the CDO market. 21 happened, isn't this true, that although run by the large 22 banks throughout the World, not just U.S. banks but many all 23 over the World, the CDS market continued to function 24 perfectly well through this period? 25 So in fact what I read you the numbers of transactions, and they 101 1 remained just about the same, within the same general range, 2 between June and December of 2008. 3 collapse of that market, as you suggested, was there? 4 People were trying to unwind. 5 that for the two-day period between the time that Lehman 6 failed and the time that AIG was rescued, for whatever 7 reason it was rescued, there was some panic in the market? 8 Is that what you're saying? 9 WITNESS MASTERS: So there wasn't any And what you were saying is I'm saying that there was panic 10 in the market, and it caused institutional investors and 11 other fiduciaries to do things that they would not have done 12 otherwise because they were fearful of credit issues with 13 regard to Lehman, AIG, and other swap counterparties. 14 15 16 COMMISSIONER WALLISON: Was there a domino effect after Lehman, as you suggested? WITNESS MASTERS: There would have been had we 17 not rescued AIG. 18 it changed people's investment strategies to have to account 19 for worrying about one's credit counterparties, when maybe 20 one hadn't worried about that in the past. 21 There was a domino effect in the sense of COMMISSIONER WALLISON: Let me understand what 22 AIG's rescue did. 23 that every other institution after AIG would be rescued? 24 25 Did that mean that--do you think it meant WITNESS MASTERS: I think that the belief of the market was that, once AIG was rescued that that was it; that 102 1 others would be rescued after that. 2 3 COMMISSIONER WALLISON: after that? 4 5 And were others rescued WITNESS MASTERS: It didn't seem like others needed to be. 6 COMMISSIONER WALLISON: Needed to be rescued, 7 right. Okay, so what I'd just like to establish with you is 8 the question of whether Lehman's failure resulted in any 9 substantial loss to anyone else. 10 Do we have any data on that? 11 WITNESS MASTERS: We have the hundreds of 12 billions of dollars that the Taxpayers spent. 13 would say that's quite a significant amount of data, in 14 terms of the amount of dollars that they had to put up, when 15 Lehman went down to bail out AIG. 16 as you will recall there was some question on whether or not 17 AIG should have been bailed out by the Treasury. 18 reason it ultimately--I believe they did it, was because of 19 the interconnectedness of AIG and the derivatives contracts 20 they had on with other folks. 21 22 23 I mean, I And the reason that--and But the And so the Taxpayer ended up with that direct loss. COMMISSIONER WALLISON: 24 interconnected, was it not? 25 WITNESS MASTERS: Lehman was also They were. And I think that 103 1 started the change in behavior, if you will, from one to the 2 other. 3 4 COMMISSIONER WALLISON: time. 5 6 VICE CHAIRMAN THOMAS: COMMISSIONER WALLISON: I could use more than that, but I'll take two. 9 10 Mr. Chairman, yield the Commissioner an addition two minutes. 7 8 I think I've run out of VICE CHAIRMAN THOMAS: Yield the gentleman an additional four minutes? 11 COMMISSIONER WALLISON: 12 negotiate about that later, but that's fine. 13 14 VICE CHAIRMAN THOMAS: (Laughter.) 16 CHAIRMAN ANGELIDES: VICE CHAIRMAN THOMAS: 19 (Laughter.) 20 VICE CHAIRMAN THOMAS: him. Five minutes? 22 23 Are you playing the AIG to No-- --I'm trying to satisfy Is that okay? COMMISSIONER WALLISON: Yes, that's fine. Thank you very much. 24 25 Yield the gentleman an his Goldman? 18 21 Thank you. additional five minutes? 15 17 All right, we'll So we're talking about what happened after Lehman. And you referred to it as a "domino effect." That 104 1 others were going to fail after Lehman. 2 Lehman was cleaned up, was it not, within five weeks with an 3 exchange of funds among the various counterparties? 4 you can identify anyone other than AIG, I don't know that 5 we're talking about any large effect of Lehman's failure. 6 7 I don't see the interconnections yet. Unless And could you make that clear? 8 9 But actually, WITNESS MASTERS: You know, with AIG I mean it's sort of like saying, you know, other than the bullet, Mrs. 10 Lincoln, how was your might at the theater? 11 the issue. 12 COMMISSIONER WALLISON: I mean, it is Well there are outliers, 13 of course, and AIG was an outlier. 14 hear today from this panel, and also from your panel, is 15 about AIG. 16 whether there were other institutions. 17 All of the references we But what we ought to really be thinking about is AIG was actually a tremendous outlier because AIG 18 took only one side of these transactions. 19 policy on the basis of the failure by one kind of 20 institution, one institution, which made a large, a huge 21 mistake, would be a mistake, I think. 22 considering how others in this market behaved. 23 WITNESS MASTERS: So to establish We ought to be But, please. Well I mean, again, there was 24 significant fear from a wide diversity of market 25 participants that the credit component of their counterparty 105 1 swap agreement they would have a problem because of what had 2 happened with Lehman. 3 what happened with other firms. 4 something happening that really seized up the market and 5 made people change their behavior. 6 And especially they were worried So it was the fear of Had AIG gone down, then in my view it is very 7 likely that we would have lost Goldman Sachs, we would have 8 lost Morgan Stanley, and we would have probably lost other 9 institutions as well. 10 COMMISSIONER WALLISON: 11 WITNESS KYLE: Yes. Yes, Mr. Kyle? So keep in mind that after 12 Lehman failed we had the Reserve Fund, the money market 13 fund, which suffered big losses because it held Lehman 14 bonds. 15 the entire money market fund industry. 16 And when it broke the buck, it triggered a run on So I would say that is a spillover from the 17 failure of Lehman into the entire economy. 18 in the government essentially insuring the money market 19 industry, bailing out the whole industry, and it resulted in 20 the Fed kind of bailing out the commercial paper-- 21 COMMISSIONER WALLISON: And it resulted Well if we're going to 22 talk about all those things, you can understand why the 23 Reserve Fund kept those bad securities, and that is because 24 Bear Stearns was bailed out. 25 was going to be bailed out after Bear Stearns, so they were And they figured that everyone 106 1 not going to have to suffer losses on those securities they 2 were holding. 3 So it is not--we can't look at these things in 4 isolation, which is the problem that we are all suffering 5 here, is that we are looking at these instances in isolation 6 as though they are not related. 7 The Reserve Fund lost money because it had 8 assumed that its bad investments were going to be taken care 9 of by the bailing out of Lehman the way Bear Stearns was 10 bailed out. So once we bailed out Bear Stearns, we were in 11 a different world. 12 have to understand. And that is one of the issues I think we 13 WITNESS KYLE: 14 WITNESS GREENBERGER: 15 I agree with that. Commissioner Wallison, may I comment on your-- 16 COMMISSIONER WALLISON: 17 WITNESS GREENBERGER: Sure. First of all, in terms of 18 your numbers, please look at the number of the overall value 19 of credit default swaps. 20 were running around--that's why I used the figure $35 21 trillion to $65 trillion--the swaps dealers were running 22 around, and you can look at DTCC statistics, Bank of 23 International Settlement Statistics, the overall notional 24 value dropped from $65 trillion to $35 trillion. 25 The swaps dealers after Lehman Now can I tell you that for a fact? No. Because 107 1 it's a--if I could finish-- 2 COMMISSIONER WALLISON: One of the reasons--one 3 of the reasons--excuse me, but these numbers are not worth 4 discussing right now because there was compression taking 5 place right around this time. 6 WITNESS GREENBERGER: 7 COMMISSIONER WALLISON: 8 point that you were trying to tell me about? 9 10 WITNESS GREENBERGER: this market was freezing up. 11 12 That's my exact point. Okay. So what is the That Mr. Masters was right, It dropped by half. COMMISSIONER WALLISON: No, I was talking about the number of transactions. 13 WITNESS GREENBERGER: 14 the total value. 15 for $1. 16 market is going down. 17 Yes, and I'm talking about You can have--I can buy a thousand peanuts That doesn't tell me the value of whether this COMMISSIONER WALLISON: Commissioner Hennessey 18 made the valid point. And that was, if he and Commissioner 19 Holtz-Eakin had bet, or had speculated between the two of 20 them, that would have doubled the total amount of credit 21 default swap notional amounts in the market. 22 WITNESS GREENBERGER: 23 COMMISSIONER WALLISON: 24 number. 25 transactions. And it went down by half. That is not a significant The significant number is the number of 108 1 CHAIRMAN ANGELIDES: 2 you, very much. 3 time. Thank you. Thank I just knew this could go on for quite some Thank you very much. 4 Now, Senator Graham. 5 COMMISSIONER GRAHAM: 6 CHAIRMAN ANGELIDES: 7 COMMISSIONER GRAHAM: 8 Time. instructive panel. Thank you-Microphone, Senator. This has been a very I wanted to clear up one thing. 9 A few moments ago Mr. Greenberger had stated I 10 think that the ripple effect of AIG was contained because 11 the Taxpayers stepped up to those other affected parties and 12 essentially made them at least partially whole so they could 13 manage the consequences of AIG. 14 Then you were asked if you, Mr. Kohlhagen, if you 15 agreed or disagreed, and you said you disagreed with Mr. 16 Greenberger's analysis. 17 happened if the Taxpayers had not stepped in to assist those 18 institutions that were affected by AIG? 19 What do you think would have WITNESS KOHLHAGEN: If that was Mr. Greenberger's 20 position, I agree with it. 21 us misunderstood Mr. Greenberger's position in the question. 22 I either misunderstood--one of COMMISSIONER GRAHAM: Did I correctly state your 24 WITNESS GREENBERGER: Yes. 25 COMMISSIONER GRAHAM: And you agree with that? 23 position? 109 1 WITNESS KOHLHAGEN: I personally believe had the 2 government not stepped in to save AIGFP, we would have had a 3 total disaster on our hands; yes. 4 COMMISSIONER GRAHAM: I am interested in this 5 thing which has been defined as either "side bets," "naked 6 credit default swaps," "synthetic CDOs," et cetera. 7 are the social values? 8 economy of these, what I call peripheral derivatives? 9 is, the ones that are a long way away from the farmer 10 What are the values to the American That selling his field of corn? 11 12 What WITNESS GREENBERGER: It has the same value to the economy that Las Vegas and Atlantic City provide. 13 COMMISSIONER GRAHAM: Well then maybe--I'm not 14 going to ask you to speculate on the social value of New 15 Jersey or Nevada in terms of their contributions, but is 16 that to say that you don't think they have a social value? 17 WITNESS GREENBERGER: It's not only that they 18 don't have a social value. 19 sends signals to the market, and I will deal with that in a 20 question. 21 22 23 I know there's this idea that it But, no, I don't think they have social value. If people had not been able to bet--leave aside insuring your risk--nothing would have happened. Now Mr. Kohlhagen or Mr. Kyle said, oh, this 24 sends signals to the market. 25 things were dangerous. People now knew that these Well, there were real credit default 110 1 swaps that sent signals to the market. 2 Buffett once said: 3 default swaps is insurance on the bond. 4 And you know Warren The social value of the real credit Warren Buffett once said, if you feel you need 5 insurance on a bond, don't buy the bond. We went through-- 6 the naked credit default swaps were developed in the 1990s. 7 We went through the founding of this Republic to the 8 beginning of the 1990s without credit default swaps or naked 9 credit default swaps. Senator Graham, you were in public 10 office probably a lot during that period. 11 wasn't one Florida citizen who came to you and said: 12 the heck are all those credit default swaps I need? 13 I'm sure there Where They are now arguably insurance, but if it is 14 insurance, Senator Graham, it should be treated like 15 insurance. 16 insurance policies provide. 17 You should have all the protections that On the naked, it's the mere taking of a bet. And 18 if Mr. Dinallo is right that 3 to 4 times the bets were made 19 as the real risk, the American Taxpayer was the lender of 20 last resort to a casino, worse than a casino because Las 21 Vegas would have made sure the casino had capital. 22 there was no capital backing the bets. 23 COMMISSIONER GRAHAM: Here Does anyone want to defend 24 the synthetic CDOs, et cetera, in terms of their social 25 value? Yes, Mr. Kohlhagen? 111 1 2 WITNESS KOHLHAGEN: with Mr. Greenberger. 3 (Laughter.) 4 WITNESS KOHLHAGEN: 5 I now do officially disagree And he misquoted me. I never said anything about a signal to the markets. 6 The derivatives--by the way, the Republic lasted 7 without the Internet for that same period of time, and I 8 don't think we're arguing whether or not it provides any 9 value. 10 11 WITNESS GREENBERGER: The Taxpayer didn't have to bail out the Internet. 12 WITNESS KOHLHAGEN: 13 COMMISSIONER GRAHAM: Not yet. Wait. Every-Could you just state 14 what do you think is the social value that warrants these 15 transactions being treated as securities, as opposed to I 16 think what Mr. Greenberger would recommend, that they be 17 treated like craps, or the roulette wheel in Las Vegas? 18 19 20 21 22 WITNESS KOHLHAGEN: I interpreted your question more broadly to mean all derivatives. COMMISSIONER GRAHAM: synthetic CDOs. Are you only-- No, I'm speaking of the What I call the "peripheral derivatives." WITNESS KOHLHAGEN: If somebody has an exposure 23 to General Motors, or has an exposure to IBM, or has an 24 exposure to a supplier, has an exposure to assets, it 25 provides a method for them to hedge those risks. And that 112 1 is an extraordinarily valuable economic and financial 2 service. 3 COMMISSIONER GRAHAM: Can't they do that by 4 buying instruments that actually are on the actual 5 indicators of ownership of General Motors, as opposed to 6 buying a synthetic? 7 WITNESS KOHLHAGEN: Not as efficiently, and not 8 as quickly and easily. By the way, Warren Buffett--I'm a 9 big fan of Warren Buffet, as we all are--he has sold 10 billions and billions of equity derivatives. 11 record. 12 WITNESS GREENBERGER: Just for the He also sold Inray 13 Insurance because he couldn't figure out what the 14 derivatives meant, which is why he said they were weapons of 15 mass destruction. 16 17 18 COMMISSIONER GRAHAM: Mr. Kyle, did you have a social value for-VICE CHAIRMAN THOMAS: Would the gentleman yield 19 for just a moment? It is going to get very difficult to 20 carry out a continued discussion if you guys decide to take 21 over the time and talk to each other, versus allowing us to 22 play our role and acknowledge folks. 23 COMMISSIONER GRAHAM: 24 WITNESS KYLE: 25 play a valuable role. Yes. Okay? Mr. Kyle? I think naked CDS bets do And the valuable role they play is to 113 1 provide signals to people who would buy bonds, or who would 2 sell protection, that they may be paying too much. 3 I heard several of the other people here say that 4 if we had had CDS trading on organized exchanges and the 5 market had been generating price signals, then AIG's senior 6 management would have seen what AIG's Financial Products 7 Group was doing, because the price signals they would have 8 gotten from the organized exchanges would have indicated 9 that there was some danger here, and maybe these assets were 10 11 very risky. And I agree with what the other people said. But 12 the mechanism by which the senior management at AIG would 13 have learned that would have been people going in and taking 14 short positions on the products that AIG was betting the 15 other direction on. 16 depressed the price of those products and made people think, 17 well, maybe they're not AAA. 18 of people out there think they're going to default. 19 of people out there are willing to bet that they're going to 20 default, including Mr. Paulson. 21 And those short positions would have Maybe they're not safe. A lot A lot So this notion that moving trading to central 22 exchanges, and having transparent prices sends valuable 23 signals to the market to protect relatively unsophisticated 24 investors relies upon the ability of speculators to take 25 short position, and in particular people like Mr. Paulson to 114 1 take naked positions in the CDS market. 2 COMMISSIONER GRAHAM: Mr. Masters, do you think-- 3 4 CHAIRMAN ANGELIDES: 5 like a couple of extra minutes? 6 COMMISSIONER GRAHAM: 7 CHAIRMAN ANGELIDES: Senator Graham, would you Yes, please. Okay. And then meanwhile, 8 press, I am going to ask you in the back--Press! 9 Sir! Cameras! Folks, I am going to ask you to kind of just wait. 10 You will have your opportunity to take photos of other 11 witnesses. 12 proceeding, if you would please refrain right now. 13 you. 14 So I don't want to distract this important COMMISSIONER GRAHAM: Thank Mr. Masters, what do you 15 think about the question of is there social utility in these 16 peripheral derivatives such as synthetic CDOs? 17 WITNESS MASTERS: I think it depends on what the 18 derivatives are. 19 personally see a lot of use for them. 20 overall, it sort of begs the question. 21 there's--not all financial innovation, which a synthetic CDO 22 is a form of financial innovation, is good. 23 about this in past testimonies. 24 25 With regard to synthetic CDOs, I don't Just in terms of an I mean, you know, And I've talked But, you know, Ford had the Edsel, and in this case I think that synthetic CDOs really with regard to the 115 1 ultimate destruction, that they were part and parcel of with 2 regard to our economic system, in hindsight they certainly 3 don't seem to have a lot of benefit. 4 COMMISSIONER GRAHAM: I'm going to ask a 5 question, and I would like a one word 'yes' or 'no' answer 6 from each member of the panel. 7 We were told that in the year 2000 as part of the 8 Commodities Reform Act there was a prohibition on placing 9 these types of instruments through a gaming commission, such 10 as the Nevada Gaming Commission. 11 a recent conversation that actually the current law in 12 Nevada would authorize these type of items to be a subject 13 of gaming, but for the federal prohibition. 14 15 Should the federal prohibition on placing these matters on a regulated gaming system be repealed? 16 WITNESS GREENBERGER: 17 WITNESS KOHLHAGEN: 18 19 It's my understanding from Yes. I'm sorry, they should not be allowed to be on those exchanges. WITNESS KYLE: I think that derivatives should be 20 traded, CDS should be traded on organized derivatives 21 exchanges, and trading them in Las Vegas for entertainment 22 value is somewhat unnecessary. 23 COMMISSIONER GRAHAM: 24 WITNESS MASTERS: 25 directly to the question: Mr. Masters? I'm just going to respond Yes. 116 1 COMMISSIONER GRAHAM: 2 CHAIRMAN ANGELIDES: Thank you, Mr. Chairman. Thank you, Senator Graham. 3 Mr. Holtz-Eakin--oh, I'm sorry, I always try to alternate. 4 While we're a bipartisan Commission, I try to alternate 5 folks. 6 time. So I will make sure Mr. Holtz-Eakin goes last next 7 COMMISSIONER HOLTZ-EAKIN: 8 Mr. Chairman. 9 economy in years. 10 Thank you, It's my first positive contribution to this Thank you, gentlemen. This has been a very 11 useful discussion. I think we have all benefitted greatly 12 from it. 13 enormous issues left to resolve, so let me just go back and 14 pick up a couple of things. At this point I don't think there are some 15 First, Professor Kyle, it was striking to me that 16 in your opening remarks you immediately went to the notion 17 of shifting risk, and in particular shifting risk to 18 Taxpayers. 19 In light of the discussion since, can you just be 20 real clear about how you view the time line of that? 21 believe that there was an expectation of shifting losses to 22 taxpayers before Bear Stearns? 23 was this a pre--this is a big issue for this Commission, 24 sort of the notion of too-big-to-fail, expectations, moral 25 hazard. Before Lehman? Do you I mean--or So would you walk through that carefully for me? 117 1 2 WITNESS KYLE: I think there was. And here is one of the reasons I think so. 3 Go inside Bear Stearns. They are taking bets 4 basically that housing prices are going to keep going up 5 because they have loaded up on mortgage securities. 6 sense they've got a lot of exposure to the credit risk on 7 mortgages. 8 9 In some So how carefully do you think they modeled the credit risk associated with their exposure to mortgage- 10 backed securities? 11 market melted down, Bear Stearns did know full well that it 12 would be out of business. 13 Keeping in mind that if the housing And the answer to that question is that when they 14 applied to be a CSE firm, regulated by the SEC, they had 15 these scenarios that were essentially melt-down in the Alt A 16 market, or subprime market, and a melt-down in the prime 17 market, but they didn't have these scenarios implemented as 18 part of their risk management. 19 at the bad events that they were insuring against and simply 20 ignored them. 21 In other words, they looked I think if they were not risk-shifting, they 22 would have engaged in a very careful analysis of what those 23 risks were, even if it's just a one percent, or one-tenth of 24 a percent probability, and done a really good job of 25 evaluating the credit risks on the bets that they were 118 1 taking. 2 But the fact that they kind of didn't do it and 3 didn't do it in front of the open eyes of the SEC suggests 4 to me that what was going on was risk-shifting. 5 COMMISSIONER HOLTZ-EAKIN: And just to be real 6 clear. There is one view that says that systematically 7 markets failed to price risk effectively during this period, 8 both internal markets, risk-management systems inside firms, 9 formal markets. That's different than assessing those risks 10 and expecting the government to step in and absorb the 11 losses. 12 You believe it is the latter and not the former? 13 WITNESS KYLE: I believe that they expected the 14 government to step in and absorb the risks in the event that 15 they failed, but the evidence for that is not that they went 16 out and said we might fail, because they're not going to do 17 that. 18 carry on the rigorous intellectual debate about what's going 19 to happen if these bad events occur because internally they 20 effectively realized that it didn't matter what happened 21 when those bad events occurred; it's not their money they're 22 playing with, it's Taxpayer money that's at stake there. The evidence for that is that internally they didn't 23 COMMISSIONER HOLTZ-EAKIN: 24 Mr. Masters, you made the point that CDS in 25 Thank you. particular created systemic risk, and when you described 119 1 that what I heard you say was that it produced in the moment 2 of panic a desire to unwind positions, particularly those of 3 the counterparties. 4 Is there anything special about CDS versus the 5 repo market, corporate lending, asset-backed commercial 6 paper, and other places where we saw a financial market 7 interconnectedness, versus the CDS. 8 special in that regard? 9 WITNESS MASTERS: Is there anything And just to be clear, I think I 10 was talking about unregulated derivatives en mass, not just 11 CDS. 12 about overall derivatives. 13 I mean, CDS is a form of derivative, but I was talking COMMISSIONER HOLTZ-EAKIN: But the language you 14 used was not about contractual relations that produced an 15 interconnectedness. 16 markets are interlinked and you can always have 17 externalities from fire sales. 18 these unregulated derivatives in that regard? 19 It was about the fact that financial WITNESS MASTERS: Is there anything special in Well I think in the case of 20 unregulated derivatives, the problem was that without a 21 central clearing regime there was an unknown element that 22 was difficult to price. 23 price was the positions that another firm, that happened to 24 be your counterparty, had on with other counterparties. 25 whether or not those counterparties would pay off with other And that was what one was trying to And 120 1 counterparties. 2 And so it was a question of if this counterparty 3 doesn't pay off that counterparty, then maybe my 4 counterparty may not pay off with me. 5 this fear of are counterparties good or not, which suddenly 6 appeared, in my view really after Lehman Brothers, was, you 7 know, part and parcel for the change in behavior from 8 institutional investors and counterparties subsequently to 9 Lehman. 10 COMMISSIONER HOLTZ-EAKIN: And so this unknown, And how was that 11 different from just fear of the credit quality of your 12 counterparties during fire sale of assets in general? 13 WITNESS MASTERS: I think it's different because 14 if you have a specific--you know, let's say you're worried 15 about MBS and you have a credit counterparty, and you're 16 worried about their position. 17 go out and buy CDS with someone else on that counterparty 18 and say, okay, even if they go down and I don't get paid off 19 my bets from them, I've got CDS on with someone else and 20 they'll take care of that because I'm making the bet that I 21 get paid if they go down. 22 Then you could theoretically And so I've hedged myself. But in the sense of if everyone suddenly could go 23 down because we're all interconnected and you lose someone 24 that has enough concentration and enough diversity in terms 25 of interconnectedness between various firms, then suddenly 121 1 the CDS that I bought on that firm that I was worried about, 2 it may not be good and I lose my hedge. 3 sort of creates the fear. 4 5 COMMISSIONER HOLTZ-EAKIN: And that's what Okay. Let me try to clean up one more thing with Mr. Greenberger. 6 I wrote this down as you said it. You said if 7 there was no naked CDS, then nothing would have happened. 8 So can you clarify what you mean by that? 9 WITNESS GREENBERGER: Well I would like to 10 clarify it. 11 default three or four times as serious as it was. 12 to say, naked CDS is essentially somebody was betting, made 13 the perfectly rational bet by the way, that people who 14 didn't have good credit wouldn't pay their mortgages. 15 What I mean is this: The naked CDS made every That is So people wanted to--they didn't want to be 16 exposed to the mortgage, because that's a risk. 17 want to get involved in the market. 18 was play the very best kind of Fantasy Baseball. 19 They didn't All they wanted to do After all, in Fantasy Baseball you have to take 20 your turn to pick your player. Mr. Paulson didn't take 21 turns. 22 wouldn't make the Major Leagues. 23 fail, when those underlying mortgages don't get paid, Mr. 24 Paulson makes his $1 billion. 25 market at all. He picked the very poorest players and bet they And so when those things He never invested it in the He's just at a casino, like betting on the 122 1 Yankees beating the Red Sox. 2 VICE CHAIRMAN THOMAS: Mr. Chairman, yield the 3 gentleman an additional two minutes. 4 COMMISSIONER HOLTZ-EAKIN: Two minutes. Mr. 5 Hennessey and I engaged in a naked CDS of exactly this kind of type, 6 and what is the downside risk to the economy for us having 7 done that? 8 9 WITNESS GREENBERGER: betting on. 10 11 12 It depends what you're If you were betting on people would-COMMISSIONER HOLTZ-EAKIN: I'm betting on Peter's mortgage. WITNESS GREENBERGER: Well that's a risky bet-- 13 only kidding, Commissioner Wallison. 14 hard to say if you and Mr. Hennessey--what we have here is a 15 six hundred--well, for credit default swaps a minimum $35 16 trillion market. 17 18 19 20 I mean, look, it's A lot of that was devoted-- COMMISSIONER HOLTZ-EAKIN: And again we've established that those numbers have no particular meaning. WITNESS GREENBERGER: those numbers. But, look, the fear of We went to War in Iraq-- 21 COMMISSIONER HOLTZ-EAKIN: 22 WITNESS GREENBERGER: Fear-- Yeah, we went to War in 23 Iraq because we feared weapons of mass destruction. There 24 were no weapons of mass destruction. 25 in Iraq has nothing to do with weapons of mass destruction. You cannot say the War 123 1 2 COMMISSIONER HOLTZ-EAKIN: This is a Commission about the financial crisis, not the War in Iraq, sir. 3 WITNESS GREENBERGER: And what I'm telling you 4 is, if you don't believe in figures--and I think there's a 5 basis for your skepticism, because it's a private, 6 bilateral, opaque market, people were afraid that this 7 market was so huge--we know from the Paulson bet that a 8 billion dollars was bet on people not paying their 9 mortgages. 10 That means when those mortgages weren't paid, not 11 only did the lenders, or the MBS, or the CDO have a 12 commitment to make, but ACA Royal Bank of Scotland had a 13 commitment to make. 14 billion to the Royal Bank of Scotland so it could pay Mr. 15 Paulson. 16 the hole of three times the number of bets as mortgages that 17 I believe caused this to be a systemic crisis. 18 So the British, for example, gave $16 That had real impact on the economy. COMMISSIONER HOLTZ-EAKIN: It is filling There are centuries of 19 episodes of fear in financial markets that have nothing to 20 do with naked credit default swaps, and fear in highly 21 levered institutions of the financial type will always have 22 some downsides. 23 fear and this particular contractual arrangement. 24 25 So I think we need to distinguish between And the point I was trying to get some clarity about is, in what circumstances these contractual 124 1 arrangements actually generated the downside. 2 me that an earlier discussion focused on concentrations in 3 large institutions that are or are perceived to be too big 4 to fail, 5 institutions, not in the contracts themselves. 6 7 COMMISSIONER HOLTZ-EAKIN: It's the Mr. Chairman, 36 seconds? VICE CHAIRMAN THOMAS: Do you want anyone else to respond? 12 13 Absolutely. inadequate-- 10 11 inadequacy of capital behind them in those WITNESS GREENBERGER: 8 9 It seemed to CHAIRMAN ANGELIDES: Why don't you just add two minutes, Mr. Vice Chairman. 14 VICE CHAIRMAN THOMAS: Unless you want to 15 continue the dialogue, it's your time to control as you 16 wish. 17 18 19 20 COMMISSIONER HOLTZ-EAKIN: finish briefly, and then we'll hear from Mr. Kohlhagen. WITNESS GREENBERGER: Absolutely it is the inadequacy of the capital that caused the problem here. 21 COMMISSIONER HOLTZ-EAKIN: 22 WITNESS GREENBERGER: 23 contract had been capitalized-- 24 25 I would like you to Not the contract. COMMISSIONER HOLTZ-EAKIN: Mr. Kohlhagen on my time. Not the contracts? If the If I could hear from 125 1 WITNESS GREENBERGER: 2 had to bail these people out. 3 WITNESS KOHLHAGEN: --the Taxpayer wouldn't of Just quickly, on your 4 question for Mr. Masters of how it was different from normal 5 counterparty measure, I absolutely disagree with Mr. 6 Masters. 7 risk management. It's exactly the same as the daily counterparty 8 COMMISSIONER HOLTZ-EAKIN: 9 VICE CHAIRMAN THOMAS: 10 I yield back. Mr. Chairman, he yields back. 11 CHAIRMAN ANGELIDES: All right, thank you very 12 much. 13 feels he is being discriminated against. 14 15 Mr. Georgiou, my fellow Greek-American Democrat who COMMISSIONER GEORGIOU: Yes, thank you very much, Mr. Chairman. 16 I think fear is not necessarily a bad thing. I 17 guess to follow on Commissioner Hennessey's point, as a 18 former math major whose high school math skills qualified me 19 for an academic scholarship that enabled me to afford to go 20 to college, not only do I not think math is evil, I am one 21 of the few people in 2010 who actually loves math. 22 And I guess my feeling about it is that 23 derivatives--what we're talking about here, and in 24 particular the credit default swaps, the synthetic CDOs, and 25 a variety of other instruments, are simply another 126 1 manifestation of the current structural problem in the 2 financial services industry that has resulted in the 3 victimization of the real economy and caused such enormous 4 consequences, and devastating consequences, to the Taxpayers 5 and so forth. 6 The problem is not mathematical models, per se, 7 or the creation of financial instruments per se. 8 problem is that the economists building the models, and the 9 kids pricing these instruments, to use Mr. Kohlhagen's term, 10 The bear no consequences for their failure. 11 Their actions are completely divorced from their 12 responsibilities and consequences. 13 earned by the creation of all these instruments by all of 14 these players at every stage of the process, and none of 15 them bore consequence for their failure. 16 Now why was that? There was no capital in the 17 game. 18 entities that created them, and metrics were reached in 19 terms of bonuses and so forth on the basis of these 20 revenues--without consequence to the ultimate failure of the 21 instruments, and the consequences that occurred to the 22 investors who bought them. 23 Fees were earned. These enormous fees were Revenues were booked by the So the problem it seems to me is the connection 24 of some degree of responsibility. And I have been harping 25 on this, hearing after hearing of having more skin in the 127 1 game, of being required to eat your own cooking. 2 kids, the reason why they created all of this stuff was 3 because they made money at it at the end of the day, and 4 they never lost any money regardless of what happened. 5 These You know, one of the examples I guess I would 6 point out to you is there is a chart here that is going to 7 come into the record here. 8 number two. 9 Goldman Sach's synthetic CDOs. We are going to mark it chart It is the multiplication that occurs just in 10 You know, synthetic CDOs, first of all you take 11 the mortgage-backed securities and you slice and dice them 12 up, and then you take the BBB tranches, which are the 13 lowest rated tranches above equity. 14 and you slice them up into CDOs. 15 CDOs. 16 synthetic and partially synthetic CDOs created by Goldman. 17 And the underlying asset-backed securities were replicated 18 2,537 times--one deal replication; 610 times the same 19 security was used in 2 deals; 170 times in 3 deals; and so 20 forth. In one instance the same underlying mortgage was in 9 21 different deals. 22 Then you take those, Then you create synthetic And in this chart you can see that there were 3,408 Now why would you create all those deals unless 23 you could make money from creating them and not have any 24 consequences to their losses? 25 So I guess I would like to ask each of you 128 1 whether, you know, whether you believe that the lack of 2 capitalization in particular--I know some of you have said 3 it already--and the lack of consequences; we've discovered 4 that there were never any clawbacks of any bonuses earned by 5 anybody as a result of the failure of these instruments, and 6 having the government bail out the institution rather than 7 people bear the bankruptcy consequences of normal capitalism 8 contributed to the crisis? 9 Mr. Kohlhagen? 10 WITNESS KOHLHAGEN: I was hoping I could go 11 fourth. I think it is an enabler. 12 let me put it in sort of a praying mantis kind of analogy. 13 I think that basically-- I think what happened is, as I stated in my 14 testimony, the cause of all of this was the U.S. Government 15 trying to bring housing, in a commendable way, to the next 16 group of American citizens, and noncitizens, for that 17 matter. 18 But in order for it to happen, in order for it to 19 happen in a way that it did, the private sector had to 20 enable it. 21 government subsidies. 22 It wasn't just government guarantees and It had to be enabled somehow. So ultimately it came to Wall Street. And Wall 23 Street ultimately said, in the early part of the last 24 decade, wait a minute. 25 way for the market to lend money to people who shouldn't be What you want us to do is to find a 129 1 borrowing money? 2 And the government in effect said, yes, that's 3 what we want you to do. 4 this. And Wall Street said, okay, watch 5 COMMISSIONER GEORGIOU: 6 WITNESS KOHLHAGEN: 7 COMMISSIONER GEORGIOU: Right. Wait, okay, I-- So basically-I could dispute your 8 characterization whether the government encouraged it, or 9 whether the necessity of government encouragement--whether 10 there was any such necessity, whether the market just did it 11 on its own because, after all, at the end of the day, you 12 know, the financial services industry is there to make a 13 profit. 14 There's nothing necessarily wrong with that. The problem it seems to me is divorcing the 15 ultimate consequences and shifting to the Taxpayers and 16 others the burdens of the losses. 17 WITNESS KOHLHAGEN: Left out of all of this, and 18 I think it's implicit in what you're saying, is that what 19 got divorced was the lenders being able to lend money but 20 not take the risk, to find a way to pass the risk on to 21 others who didn't want-- 22 COMMISSIONER GEORGIOU: Lenders, securitizers, 23 credit rating agencies, auditors, I mean the list goes on 24 and on of people who were enriched, who received revenues 25 from creating the system. 130 1 WITNESS KOHLHAGEN: Originally you can go back to 2 the 1970s, the operating model was firms lent money to 3 corporations and people. 4 had skin in the game. And they took the risk. 5 COMMISSIONER GEORGIOU: 6 WITNESS KOHLHAGEN: So they Right. What happened, what changed 7 from the '70s to the early part of the last decade was they 8 found a way to have no skin in the game. 9 COMMISSIONER GEORGIOU: Right. And so--and to 10 me, it seems to me that is an overriding theme that we've 11 seen in our securitization analysis, and the credit rating 12 analysis, the housing mortgage--you know, the mortgage 13 finance area, in all these elements. 14 15 Now I guess, Professor Kyle, you wanted to respond? It looked to me like you had a thought. 16 WITNESS KYLE: Well I don't like the idea of 17 Taxpayer money being used to subsidize the losses of other 18 people's bad decisions. 19 executive compensation and the salary structure of firms on 20 Wall Street, you have to look at who was really bailed out. 21 And for the most part it was the debt-holders that were 22 bailed out. 23 But in addition to looking at So I think what we need is a mechanism to have 24 some discipline imposed on investors in debt securities, and 25 in particular debt securities issued by leveraged financial 131 1 institutions like banks. 2 contingent capital, or a quick resolution mechanism which we 3 might be getting that would essentially convert these debt 4 securities into equity when the underlying institutions get 5 into trouble and therefore force the underlying 6 institution's security owners to pay for the bad decisions 7 of the firms that they invest in. 8 9 10 11 12 And one such possibility would be CHAIRMAN ANGELIDES: Three more minutes for Mr. Georgiou? COMMISSIONER GEORGIOU: If I could. Thank you very much, Mr. Chairman. I want to go back to the discussion that occurred 13 here between Commissioner Wallison and Mr. Masters about 14 what would of happened if one of these firms failed. 15 We know that Bear was saved through a shotgun 16 merger, and Lehman was not. 17 our previous witnesses, Mr. Buffett, seemed to suggest that 18 that was key that Merrill was saved, as well as AIG, because 19 there were so many--the enormity of their counterparty 20 exposure dwarfed a number of the other entities, and so that 21 was required. 22 But Merrill was. And one of Do you have a view, Mr. Masters, of what would 23 have occurred had they not--had AIG and Merrill not been 24 effectively saved? 25 WITNESS MASTERS: Yes. I mean I was thinking 132 1 about the term "saved" in a different manner. 2 words, I think it was more of sort of a behind-the-scenes 3 shotgun marriage. 4 COMMISSIONER GEORGIOU: In other Well, but it was a 5 guarantee. 6 marriage and in the Merrill Lynch marriage, in that a number 7 of those risky securities that were on the books of those 8 entities were guaranteed by the Fed as part of the 9 transaction. 10 There was huge Taxpayer involvement in the Bear Otherwise, the purchasers wouldn't have gone through them. 11 WITNESS MASTERS: Yes, I think it speaks to the 12 scope of the problem. 13 they had to pull out all the stops, if you will, to sort of 14 save the system at that point in time. 15 I think that regulators felt like COMMISSIONER GEORGIOU: And I guess, you know, my 16 fellow Commissioner Wallison, I take it, would assume that 17 had we not saved Bear it would have triggered more 18 responsibility in the system. 19 that at that point it was too late for everybody to unwind 20 their positions in a relatively short period of time because 21 they had amassed these enormous positions, uncapitalized and 22 unhedged. 23 24 25 But I guess one might argue I mean that seems to me to be my fear. WITNESS MASTERS: I think that's absolutely right. COMMISSIONER GEORGIOU: Professor Grasp-- 133 1 WITNESS GREENBERGER: 2 COMMISSIONER GEORGIOU: 3 WITNESS GREENBERGER: 4 you asked the question: 5 It was a very big problem. 6 capitalizing this. 7 Greenberger. Greenberger, I'm sorry. I just wanted to say that Is capitalization a problem here? The American Taxpayer ended up I thought it was interesting, your point that one 8 tranche in a CDO was used nine times in synthetic CDOs. 9 That means every time a default occurred in the real CDO, 10 there was nine times the betting on that. 11 COMMISSIONER GEORGIOU: 12 WITNESS GREENBERGER: 13 betting aggravated the problem. 14 COMMISSIONER GEORGIOU: 15 WITNESS GREENBERGER: Right. That's my point. The Well, and-And the final point I would 16 make is, you, as I think the entire American public wants to 17 know where is the accountability here? 18 with you on that. 19 wouldn't need government. 20 should have been more risk management. 21 been more this. 22 market regulation, is about. 23 Madison said: And I sympathize If men were angels, we We can't keep saying, oh, there There should have That's what regulation in this context, In the securities market you can't do these 24 things. It's not a matter of risk management. 25 governs the market. The SEC In the regulated futures market, the 134 1 CFTC governs the market. 2 there would be no clearing and no exchange trading-- 3 4 In 2000, a decision was made that COMMISSIONER GEORGIOU: Right. Understood. But- - 5 CHAIRMAN ANGELIDES: Byron, we are over time and 6 we are running behind, so I am going to--we need to wrap up 7 right now, except two final minutes to Ms. Born as one of 8 the Working Group members, and then the Vice Chair has a 9 question, and then we will adjourn for lunch. 10 COMMISSIONER BORN: Thank you. I just wanted to 11 follow up a little bit also on Commissioner Wallison's 12 discussions with Mr. Masters. 13 First, just confirm, Mr. Masters, that when you 14 are talking about the interconnectivity through the market, 15 through over-the-counter derivatives that leads to potential 16 systemic risk, you are talking about all over-the-counter 17 derivatives, not just credit default swaps? 18 correct? 19 WITNESS MASTERS: 20 COMMISSIONER BORN: Is that That's right. And in your discussion you 21 were discussing Lehman Brothers failure, a freeze-up for a 22 couple of days in the over-the-counter derivatives market, 23 and the rescue of AIG with a government commitment of $180 24 billion of rescue money. 25 that one big money market fund went down, and so the And also it has been pointed out 135 1 government had to step in to insure money market accounts. 2 But also, didn't the government immediately at 3 this time seek $700 billion in TARP funds? 4 the Discount Window to the investment banks who were the big 5 over-the-counter derivatives dealers? 6 over-the-counter derivatives dealers, Merrill Lynch, Morgan 7 Stanley, JPMorgan, Bank of America, Citigroup, Goldman 8 Sachs, all get tens or hundreds of billions of dollars of 9 direct and indirect support from the government in order to 10 Didn't it open Didn't our largest contain the contagion that would have occurred? 11 CHAIRMAN ANGELIDES: And by the way, I'm going to 12 ask you to go ahead and answer. 13 don't you go ahead and give the answer. 14 WITNESS MASTERS: The time is up, but why I think all those were 15 obviously part and parcel of the bailout. 16 one final point I would say, just in terms of transactions 17 in derivatives, even though you could have had more 18 transactions between the period of Lehman and AIG, at that 19 moment in time, the reality is because of the shrinkage of 20 notional we know that those were all closing transactions. 21 So it was people getting out that did add consequences on 22 other folks. So I just wanted to make that final point. 23 COMMISSIONER BORN: 24 CHAIRMAN ANGELIDES: 25 Thomas. And, you know, Thank you. All right. Vice Chairman 136 1 VICE CHAIRMAN THOMAS: Thank you. I am trying to 2 structure a take-away. 3 I want to see if I can say that after I go through this 4 routine as well. 5 You've been an excellent panel, and I want to try to run down a list of--we're here 6 to try to find the causes of the financial crisis. So I am 7 going to run down a list of items that I heard discussed 8 here, or that we have talked about. 9 like to do is to turn to each of you and, if there is And then what I would 10 something I did not mention that you would, give me like the 11 top three, or the top five from your position. 12 13 14 One, I want to see the degree of diversity or commonality in terms of what you would choose. We talked about U.S. Government support of the 15 housing market. The lack of proper regulation of the 16 financial markets. 17 concerned about. 18 policy, the loose credit standards. 19 management failures. 20 exposed to the mortgage market. 21 Dependence on short-term funding. 22 interconnections. 23 agencies, and all that entails. 24 models in terms of their inducement of certain behaviors. 25 What happened where the rubber meets the road in terms of International capital flows we've been Also, the Federal Reserve interest rate Firm level risk Lack of transparency about who was System-wide leverage. Financial market The too-big-to-fail argument. Rating Corporate compensation 137 1 opportunities on creating these mortgages by real estate and 2 other folk, leading to a degree of fraud. 3 Let's start from the left and go to the right. 4 Three to five, and kind of rank them, if you would, if it's 5 possible. 6 CHAIRMAN ANGELIDES: 7 WITNESS GREENBERGER: And go fast. My view is, if the over- 8 the-counter derivative market had required capital and had 9 been transparent, the rest of the list would have been 10 irrelevant. 11 WITNESS KOHLHAGEN: Number one, the U.S. 12 Government policy to expand the homeowner market. 13 the cause, to my mind. 14 were the Fed's monetary policy, federal regulation 15 liberalization, forbearance, and the absolute 16 irresponsibility of the rating agencies. 17 WITNESS KYLE: That's The enablers, the major enablers I think risk shifting is number 18 one. Irrational exuberance is number two. 19 mandates for home ownership probably number three, but 20 derivatives, OTC derivatives pretty far down the list. 21 WITNESS MASTERS: And government I would say that over-the- 22 counter derivatives had a very significant and key role in 23 transferring credit crisis into a broad scope financial 24 crisis. 25 VICE CHAIRMAN THOMAS: So you have a mono-cause? 138 1 WITNESS MASTERS: A what? 2 VICE CHAIRMAN THOMAS: 3 That was the cause of the financial crisis? 4 WITNESS MASTERS: 5 VICE CHAIRMAN THOMAS: 6 CHAIRMAN ANGELIDES: You have a single cause? Right. Well, a dispersant. Okay. Thank you. All right, gentlemen. 7 you very much for your time and your testimony. 8 appreciate it very much. 9 10 We We are now going to take a break and recommence at 12:25 in this room. 11 (Whereupon, at 12:02 p.m., the meeting was 12 recessed, to reconvene at 12:31 p.m., this same day.) 13 14 15 16 17 18 19 20 21 22 23 24 25 Thank 139 1 AFTERNOON SESSION 2 (12:31 p.m.) 3 CHAIRMAN ANGELIDES: The meeting of the Financial 4 Crisis Inquiry Commission will come back to order. 5 now start our second session of the day on AIG and 6 Derivatives. 7 I want to welcome our witnesses. We will We will begin 8 by doing what we customarily do, which is we will ask all 9 three of you gentlemen to please stand and be sworn. 10 Please raise your right hand. Do you solemnly 11 swear or affirm under penalty of perjury that the testimony 12 you are about to provide the Commission will be the truth, 13 the whole truth, and nothing but the truth, to the best of 14 your knowledge? 15 MR. SULLIVAN: 16 MR. LEWIS: 17 MR. CASSANO: I do. I do. I do. 18 (Witnesses sworn.) 19 CHAIRMAN ANGELIDES: Thank you very much. 20 Gentlemen, we thank you for submitting your 21 written testimony which the Commissioners have had a chance 22 to review. 23 that each of you provide an oral statement of no more than 24 five minutes. 25 We would like to begin today's session by asking There is a device at the table which will signal 140 1 yellow when there's one minute to go, and red when your time 2 is up. 3 minutes, and that will allow us then significant time to ask 4 you questions on the matters before this panel. And so we would ask you to adhere to that five 5 So with no further ado, I am going to go--I think 6 this time, I always vary the order--I am going to start with 7 you, Mr. Sullivan, then go to Mr. Lewis, and then Mr. 8 Cassano. 9 your statement, that would be terrific. 10 11 WITNESS SULLIVAN: So if you would begin Thank you, sir. Good afternoon. 12 13 We will go in that order. Chairman Angelides, Vice Chairman Thomas, and Members of the Commission: 14 My name is Martin Sullivan. I was President and 15 Chief Executive Officer of AIG from March of 2005 through 16 June of 2008. 17 My career at AIG spanned almost four decades. I started work at age 17 in the accounts 18 department of AIU London Ltd., which was the UK-based non- 19 life subsidiary of AIG. 20 responsibility for the property underwriting side of the 21 business. 22 Thereafter I took on increasing In 1996 I moved to New York, and I have lived 23 there ever since. I became Chief Operating Officer and later 24 President of AIU. In 2002, I became Co-Chief Operating 25 Officer of AIG. 141 1 As Co-CLO, my primary oversight responsibilities 2 continued to be in the non-life area of AIG's insurance 3 business. 4 President and Chief Executive Officer of AIG. 5 assumed this position, the company was in crisis. 6 outside auditors had informed the Board that they could not 7 rely on prime management certification. 8 9 In March 2005, I was asked by the Board to become At the time I AIG's We thus had to advise all interested parties that we would be delaying the filing of the 2004 10K. We then 10 undertook an internal review of AIG's books and records. 11 This review spanned AIG's major business units globally and 12 involved more than 30 multi-discipline teams reviewing the 13 company's global operations. 14 I was meeting regularly with our key state and 15 federal regulators, and working with senior management to 16 strengthen and enhance AIG's overall financial reporting and 17 internal control environment. 18 AIG was segmented into four lines of business: 19 life, non-life, financial services, and investments. 20 Financial Services subsidiaries engaged in diversified 21 financial products and services, including aircraft and 22 equipment leasing, consumer finance and insurance premium 23 financing, and capital market transactions. 24 25 AIG's AIGFP, within the capital markets area, conducted interest rate, currency, equity, commodity, energy, and 142 1 credit transactions. 2 was CEO of AIGFP. 3 Services, Mr. Dooley. 4 During most of my tenure, Mr. Cassano He reported to the head of Financial Mr. Dooley in turn reported to me. You have also asked me to address risk management 5 practices at AIG. 6 Management were credit, market, operational, and later 7 liquidity. 8 units reported to the Chief Risk Officer, Mr. Lewis, who 9 reported to the CFO until early 2008, and then to me. 10 The four components of Enterprise Risk The senior managers who headed each of these Mr. Lewis provided regular reports to both the 11 finance committee and the audit committee. 12 business units also had their own risk control units. 13 risk was managed both at the parent and line-of-business 14 level. 15 Many of the Thus The risk controls in place at AIG were designed 16 to ensure that all information was shared across business 17 lines, and that senior risk managers approved all strategic 18 decisions. 19 on its overall strategy, and in light of all relevant 20 business factors. 21 in March of 2005, risk management was a priority for the 22 Board and for me. 23 But each business unit then made decisions based And because of the events that occurred Finally, you have asked me to discuss the events 24 of 2007 and 2008. We devoted significant time and effort to 25 analyzing and disclosing in detail the company's potential 143 1 exposure across the board in all of its businesses to the 2 deteriorating U.S. residential housing market. 3 AIG repeatedly revised and corrected estimates as 4 it developed better information. 5 was advised by its independent auditors that they believed a 6 material weakness existed in its internal controls over 7 financial reporting and oversight relating to the fair value 8 valuation, sometimes referred to as the mark-to-market 9 valuation of AIGFP's super senior credit default swap 10 In February of 2008, AIG portfolio. 11 Shortly thereafter, AIG issued a Form 8K 12 describing this issue and revising its valuation of the 13 portfolio. 14 assessment of its valuation controls and procedures, and 15 instituted managerial changes within AIGFP. 16 After issuing its Form 8K, AIG also undertook an Throughout my tenure as CEO, my goal was to 17 communicate as openly and directly as possible within the 18 organization with investors and with regulators. 19 appreciate this opportunity to share my views, and I look 20 forward to your questions. 21 Thank you very much, indeed. 22 CHAIRMAN ANGELIDES: 23 24 25 I Thank you, Mr. Sullivan. Mr. Lewis? WITNESS LEWIS: Chairman Angelides, Vice Chairman Thomas, and Members of the Commission: 144 1 I am pleased to help in any way I can in the 2 Commission's efforts to learn about AIG and the complex 3 derivative financial instruments that I understand to be the 4 subject of today's hearing. 5 I am the Chief Risk Officer of AIG. I joined AIG 6 in 1993 as the company's Chief Credit Officer, and in 2004 7 was appointed the company's first Chief Risk Officer by 8 then-CEO M.R. Greenberg. 9 As Chief Risk Officer, I established and 10 continued to be responsible for the AIG corporate-level risk 11 management function known as Enterprise Risk Management, or 12 ERM. 13 As an insurance company, AIG is in the business 14 of taking on risk. 15 responsibility and accountability for the risks assumed by 16 the various AIG business units actually reside within the 17 business units themselves. 18 AIG's basic approach is that My role as Chief Risk Officer, supported by 19 Enterprise Risk Management is to assist the businesses in 20 identifying, evaluating, and managing aspects of their 21 risks. 22 I understand that the focus of today's hearing is 23 on complex financial derivatives, and in particular on the 24 credit default swaps sold by AIG's Financial Products 25 Division known as FP. So let me then get right to that 145 1 subject. 2 An important aspect of the management of the risk 3 from FP's sale of credit default swaps involved the CDO 4 structure of the assets underlying the swaps themselves. 5 Basically, as I believe the Commission now very 6 much understands, a CDO consists of a tower of loans with 7 the uppermost level known as the super senior level having 8 the first right to the entire tower's cash flow in the event 9 of defaults and consequent losses above an agreed-upon 10 11 level. FP's approach to the management of its risk was 12 to structure the credit default swaps so that they would 13 only be triggered if the underlying losses were severe 14 enough to rise to the highest levels in the tower, a risk 15 that FP determined to be exceedingly unlikely even under 16 severe economic scenarios. 17 FP's analysis of the risk was supported by 18 significant risk management resources residing within FP 19 itself, and reporting to its CEO. 20 nor its risk personnel reported to me, I understood FP's 21 analysis of the risk to include quantitative modeling 22 developed by a leading finance professor at Wharton which 23 assumed features of the worst economic conditions that have 24 existed at any time since World War II. 25 While neither FP's CEO This statistical analysis demonstrated to a 99.85 146 1 percent confidence level that the upper level portion of a 2 CDO tower insured by an FP credit default swap would not 3 suffer credit losses. 4 FP sold its first default swap in 1998, and for 5 years things worked as FP's models had predicted. 6 in the latter part of 2005 ERM at the corporate level began 7 to get concerned based on increasingly aggressive bank 8 lending practices, and a housing market that was unduly 9 heating up. 10 However, In early 2006, my chief credit officer discussed 11 these concerns with FP's CEO in London who responded that 12 FP's own risk analysis was identifying the same concerns, 13 and that he had decided it was time to shut down. 14 At that point, commitments were already in place 15 so it was not realistic to terminate the business 16 instantaneously. 17 end its business of new credit default swap sales involving 18 subprime exposure. 19 However, with one exception FP decided to As to those swaps already on the books, the 20 judgment was that they would continue to perform 21 satisfactorily given the safety of the tower structure, and 22 the fact that those swaps covered earlier mortgages provided 23 at a time of more conservative lending practices. 24 25 As it turned out, we were wrong about how bad things could get. What ended up happening was so extreme 147 1 that it was beyond anything we had planned for. 2 tower structure, nonetheless, did provide significant 3 protection to AIG because those investors at the top of the 4 tower were legally protected by their superior rights to the 5 tower's cash flow. 6 The CDO But the market's apparent anticipation of further 7 cash flow declines, combined with an extraordinary erosion 8 in market liquidity generally, resulted in a collapse of 9 fair values, thereby triggering collateral calls. 10 AIG's liquidity was thus depleted, not 11 withstanding that credit losses to AIG were not actually 12 occurring and, given more time, the values would have been 13 expected to come back. 14 As the credit crisis reached its peak, AIG's 15 ability to maintain its liquidity declined precipitously as 16 credit markets froze, other liquidity issues developed, and 17 FP could not make good on all collateral call demands. 18 19 It was at that point that the Federal Government stepped in with Taxpayer assistance. 20 I would be pleased to answer any questions. 21 CHAIRMAN ANGELIDES: 22 WITNESS CASSANO: 23 24 25 Mr. Cassano. Chairman Angelides, Vice Chairman Thomas, Commissioners: My name is Joseph Cassano. I worked at the Financial Products Division of AIG for over two decades, and 148 1 was the head of the group since January of 2002. 2 I was proud of FP's employees and remain proud of 3 them today. 4 critical of our work, please direct that criticism at me, 5 not them. 6 If, as a result of this process, you are Thank you for having me. I fully appreciate the 7 importance of your mission generally, and the importance of 8 the events surrounding the AIG bailout specifically. 9 I want to thank your staff especially for their 10 professional approach and many courtesies during my 11 cooperation with the Commission. 12 written submission. 13 I know you have read my I will not repeat it here. Although my perspective diverges in important 14 ways from the popular wisdom, I am very willing to answer 15 all your questions about our portfolio of credit swaps; our 16 risk assessment and monitoring of that portfolio; our 17 decision to exit the subprime business in early 2006--well 18 ahead of many others in the market; our continuing 19 surveillance of that portfolio; the fundamental analysis and 20 contractual rights that formed the basis of our response to 21 collateral calls during my tenure; the analytic method we 22 used to value the portfolio for accounting losses; and 23 issues surrounding our compensation structure generally, my 24 compensation in particular, and the circumstances leading to 25 my retirement. And of course any other questions the 149 1 2 Commissioners may have. Chairman Angelides, you said that this 3 Commission's work would be tethered to the hard facts. 4 grateful for that. 5 recollection and candid perspectives. 6 your questions. 7 I am I intend to give you my best CHAIRMAN ANGELIDES: I look forward to Thank you very much. We 8 will begin the questioning now. I will begin the 9 questioning, and then we will go to Vice Chairman Thomas, 10 and then to the Members of the Commission who led this 11 portion of our inquiry. 12 I want to start with some questions first of all 13 on the management of derivatives by the organization. So 14 this is really about both the derivatives business as well 15 as risk management in the company. 16 start with the perspective that things did not go well. And I obviously want to 17 Earlier today one of our witnesses indicated that 18 his view--which I think is shared by many--is that the story 19 of AIG's management was one of irresponsibility only matched 20 by a lack of accountability. 21 about the risk management measures and how you viewed this 22 marketplace. 23 So I want to talk a little bit Mr. Sullivan and Mr. Cassano, on December 5th of 24 2007 there was an investor conference. And at that time, 25 Mr. Sullivan, you said that the risks that AIG took in the 150 1 housing sector was, quote, "risk supported by sound analysis 2 and a risk management structure that allows AIG to put our 3 capital to work in an efficient manner." 4 And you went on to say that AIG, quote, "had a 5 centralized risk management function that oversees the 6 market, credit, and operational management of each of our 7 businesses as well as the parent company." 8 During that same investor call, Mr. Cassano, you 9 said that AIGFP performed, quote/unquote, "thorough due 10 diligence on each CDS trade" and it was, quote, "a very 11 selective process" with, quote, "rigorous modeling 12 assumptions." 13 I want to ask you a number of questions about 14 risk management. 15 record a number of documents. 16 Management." 17 received and reviewed both from AIG and from Price 18 Waterhouse Coopers. 19 In that regard, I want to enter into the It is a document called "Risk There are a number of documents which we've So the first is that in 2005 the amount of 20 derivatives that you've written triples from about $17 21 billion to $54 billion during that year. 22 Mr. Sullivan, you told our staff that you did not 23 know in 2005 that the decision had been made, and that in 24 fact you had tripled your exposure to credit derivative 25 swaps for asset-backed securities. Tell me why you were out 151 1 of that loop. 2 WITNESS SULLIVAN: Thank you, sir. As I 3 mentioned earlier in my opening remarks, obviously during 4 2005 I was focused on resolving the issues that were facing 5 the corporation at that time, and I won't repeat those for 6 the record. 7 8 My first knowledge of the CDS, super senior CDS portfolio was sometime during 2007. 9 CHAIRMAN ANGELIDES: So you had a book of $78 10 billion of exposure by 2007 and you didn't become aware of 11 it until then? 12 WITNESS SULLIVAN: What I was receiving was 13 regular reports from not only Mr. Cassano on his business, 14 but also from Mr. Lewis and Mr. McGinn on AIGFP's business 15 in its totality, including the credit default swap 16 portfolio. 17 recognized that portfolio, and there were no issues raised 18 in the correspondence that would have given me cause for 19 concern. 20 But to the best of my knowledge, I never CHAIRMAN ANGELIDES: Okay, Mr. Cassano, in the 21 management reports sent up to the parent company, would the 22 information have been there that in fact the exposure had 23 gone from $17 billion in 2005 at the beginning of the year 24 all the way up to $78 billion in 2007? 25 in the management reports floating up, correct? That would have been 152 1 WITNESS CASSANO: Yes, sir. 2 CHAIRMAN ANGELIDES: Okay. Secondly, I want to 3 talk about this. These were representative multi-sector 4 CDOs. 5 and in 2004-2005-2006 they were almost overwhelmingly 6 residential-backed and very substantially subprime. 7 example, in a survey we did of some of these CDOs that you 8 issued protection on, 84 percent were backed by RMBS, 9 residential mortgages in '05, 89 percent in '06. But if you look at--we did a sample of some of these, For And just 10 as an example, while you indicated you decided to stop 11 writing on subprime instruments, in January of '06 for 12 example you backed an instrument called RFC3 where that CDO 13 was 93 percent subprime and 7 percent HELOC. 14 My question for you, Mr. Cassano, is: You said 15 you did thorough due diligence. Were you aware of the quality of the 16 mortgages? 17 Were you confident that you had a full understanding of the 18 nature of what you were backing? 19 fast. Do you do direct analysis of the loan data? Oh, I'm sorry. I went 20 93 percent subprime, 7 percent home equity loans. 21 WITNESS CASSANO: Chairman Angelides, the numbers 22 that you're referencing in these portfolios I don't know 23 specifically, and I'm happy to look at them again and go 24 through that with you. 25 But I think to answer your question more 153 1 directly, we never diluted our underwriting standards at any 2 point in time. 3 the AIG Credit Risk Management, that we then employed in 4 underwriting these transactions. 5 We had rigorous standards, standards set by It's important to recognize I think that we did 6 take the difficult decision to exit the business in 2005. 7 But the other thing that I think substantiates our 8 underwriting criteria in these transactions is that many of 9 these multi-sector CDOs that we did now reside in Maiden 10 Lane III, which is the special-purpose vehicle that the 11 government set up after the bailout of AIG. 12 And to date that vehicle is performing. I think, 13 you know, I'm sure the Commission knows the statistics. 14 Federal Government lent that vehicle $24 billion. 15 that vehicle has repaid $8 billion through the performance 16 of these transactions. 17 sit, when I look at the portfolio residing in Maiden Lane 18 III, I don't think any of the transactions have pierced the 19 attachment levels that we had set in our underwriting 20 standards. 21 The To date And as far as I can see from where I CHAIRMAN ANGELIDES: But my understanding, Mr. 22 Cassano, on that point that, while the real economic losses 23 today may be relatively small, that the projections for the 24 economic losses may be upwards of 25 percent, perhaps up to 25 50 percent on those portfolio. Do you think that's just not 154 1 2 accurate? WITNESS CASSANO: What I look to is the 3 performance, and to see if anything has been pierced. 4 we've gone through obviously one of the worst financial 5 crises since, you know, in anybody's lifetime. 6 move through this and we come through the financial crisis, 7 the only thing I can do is look at the existing portfolio 8 and say that it is performing through this crisis, and it is 9 meeting the standards that we set. 10 And as we And I think our reviews were rigorous. 11 the portfolios are withstanding the test of time in 12 extremely difficult circumstances. 13 CHAIRMAN ANGELIDES: Now I think All right, let me move on 14 because it really does bring me to the next issue, which is 15 that here is something that I want to particularly query Mr. 16 Sullivan about, and that's the following: 17 The contracts that were written with 18 counterparties like Goldman provided for collateral calls if 19 there were declines in market value, mark-to-market. 20 will stipulate at the beginning that of course Mr. Cassano 21 was aware of this, Mr. Forster was aware of this, Mr. Frost 22 was aware of this, Mr. Sun at AIG Financial Products were 23 aware of it. 24 calls on AIG if there were economic losses, real losses, on 25 the loan; if there were downgrades to AIG; and thirdly, if Now I My understanding is there would be collateral 155 1 there were declines in market value of these securities, 2 which in fact did happen. 3 And I am going to talk to you a little more at 4 length about how this happened, particularly with respect to 5 Goldman Sachs, in a few minutes. 6 have to ask you, because here is a major commitment by your 7 company--and I'm going to ask you, too, Mr. Lewis--in which 8 you're backing ultimately $78 billion of protection. 9 what was imparted to us in our interviews is that you said But, Mr. Sullivan, I just And 10 to the best of your knowledge you were not aware of these 11 mark-to-market terms in these contracts until the summer of 12 2007, which makes sense since you weren't aware of the 13 contracts apparently until 2007. 14 Your CFO said that he wasn't aware that the 15 contracts required posting of collateral if the fair value 16 declined. 17 '07. He first became aware in the third quarter of 18 Mr. Lewis, you are the Chief Risk Officer and you 19 told our staff that you didn't know about this until Goldman 20 made its first margin call on July 27th, '07. 21 asked if the provisions caused consternation within the 22 company, in our interview you say, quote, "I would say 23 that's an understatement." 24 25 And when The Financial Services Division CFO, Mr. Habayeb, will be here tomorrow and he said he didn't know. AIG Chief 156 1 Credit Officer Kevin McGinn said he didn't know. How could 2 it come to be, Mr. Sullivan and Mr. Lewis, that you have $78 3 billion of contract and you do not know that the contracts 4 have a provision in them where you're going to have to post 5 billions of dollars if market values decline, which in fact 6 happened? How does that happen? 7 And I might add--and I don't want to be--you 8 know, particularly in the context of compensation, $100 9 million plus awarded to you as CEO, how does that happen? 10 I mean, how would you now characterize that? 11 WITNESS SULLIVAN: Thank you, sir. I mean, the 12 only way I can respond is by giving you the facts. 13 is that I only became aware of the CDS portfolio during 14 2007, although I was receiving reports that did not indicate 15 that there were any issues pertaining to that portfolio and 16 recognizing that no new business had been written since the 17 end of 2005. 18 CHAIRMAN ANGELIDES: Well actually that's not 19 true. 20 It did climb to $78 billion. 21 pipeline, and there were--we have a log. 22 made. 23 full wind-down did not happen immediately. 24 another $24 billion of exposure, unhedged. 25 The fact I mean, the book was $54 billion at the end of 2005. There were deals in the There were deals Now apparently a decision was made to do it, but a WITNESS SULLIVAN: You added Well my understanding was that 157 1 obviously there was a meeting of the minds, as both my 2 colleagues have articulated, between ERM and AIGFP to cease 3 writing that business, or writing new business at the end of 4 2005. 5 As I said, the first time I became aware of the 6 portfolio and collateral calls, to the best of my 7 recollection, sir, is-- 8 CHAIRMAN ANGELIDES: 9 WITNESS SULLIVAN: 2007. --2007. 10 CHAIRMAN ANGELIDES: 11 Mr. Lewis, you are the Chief Risk Officer. 12 That's stunning. Anything you want to add to this? 13 WITNESS LEWIS: I would state that the risk 14 issues that were the focus of the attention at AIG were 15 around the actual credit risks and the underlying 16 portfolios. 17 with FP was to determine what the likelihood was of 18 suffering credit losses through defaults and losses in the 19 underlying mortgages. 20 And the rigorous work that we did, together The liquidity aspects were something that we, 21 quite frankly, just didn't focus on to the extent that we 22 now know we should have. 23 time of the crisis, had traded in very narrow bands, highly 24 liquid, AAA securities, until the crisis occurred when they 25 traded off quickly. These instruments, up until the And then there was no market. 158 1 2 CHAIRMAN ANGELIDES: there was a liquidity provision? 3 4 But were you aware that WITNESS LEWIS: You weren't, were you? No, I was not, until the day I testified. 5 CHAIRMAN ANGELIDES: All right, let me now ask 6 one more question, and then I want to turn to Mr. Cassano 7 and ask a little bit about how this market worked, this 8 over-the-counter market worked, and I'm going to really talk 9 about the relationship with Goldman. 10 But I want to ask one more question of the two of you, which is: 11 So the decision is made ostensibly to stop 12 writing protection on subprime-backed CDOs, even though the 13 exposure continues to climb. 14 division of your company, AIG Investments, which invests on 15 behalf of the insurance subsidiaries, is upping its bet very 16 substantially. 17 investment. 18 But meanwhile, another Decisions are made to change the policy for At the very time that one unit is saying let's 19 pull back, AIG Investments starts to load in and invested a 20 substantial amount of money, about $49.5 billion, or 65 21 percent of your $75 billion security lending portfolio in 22 securities backed by subprime mortgages. 23 of 2007. 24 25 That's by the end In the end of the day, you didn't hedge your credit default swap portfolio. You dramatically increased 159 1 your securities lending portfolio. And in the end of the 2 day you lose about $40 billion on these credit default 3 swaps. 4 lending portfolio. You lose about $55 billion on your securities 5 Again, how does this happen? How do you begin to 6 up your exposure in one part of the company--I think Price 7 Waterhouse Cooper said that this was a conclusion that this 8 was a risk management failure, but you told our staff that 9 you didn't think it was. 10 So you're recognizing a risk in one place, but 11 you're substantially upping your bets in another. 12 that happen? 13 How does The two of you? WITNESS LEWIS: The, the circumstances at the 14 time were discussed. The concerns that we had about the 15 overheating of the market and the relaxation of lending 16 standards was discussed throughout the corporation with both 17 Financial Products and the Investment Department. 18 The Investment Department was--is also 19 responsible, obviously, for investing the cash of the 20 corporation to receive and to earn a profit. 21 tradeoff between risk and return which our investment 22 professionals are responsible for. 23 So there's a We in Risk are only obviously concerned about the 24 downside. So what occurred--and I think you referred to 25 investment guidelines that established an overall limit, not 160 1 a directive or an-- 2 CHAIRMAN ANGELIDES: 3 WITNESS LEWIS: You lifted the limit, yes. The limit was determined, and it 4 was a quid pro quo, if you will. 5 The compromise that we reached was that they would--their 6 investments would only be in the highest grade of the 7 securities, triple B, RMBS. 8 structure. 9 We agreed to up the limit. There were no CDOs in that CHAIRMAN ANGELIDES: All right. But at the end 10 of the day, you did decline the exposure supposedly in one 11 area, but you upped it in the other, and apparently--I just 12 want to make the point--do you still disagree with Price 13 Waterhouse Coopers that this was a failure in risk 14 management? 15 WITNESS SULLIVAN: I think, with respect, sir, 16 that Mr. Lewis has articulated what occurred, there was a 17 dialogue between the credit offices and the ERM staff, and 18 that the decision was made to make those investments in high 19 grade securities. 20 CHAIRMAN ANGELIDES: All right. I guess the 21 answer is, you still don't believe it was a failure. 22 right, let me move on. 23 All Mr. Cassano, in the time I have right now before 24 we can circle back, I want to probe an issue. I have been 25 fascinated by how this over-the-counter derivatives market 161 1 worked as between parties, particularly the fact that it 2 wasn't traded on exchanges, and clearly I want to get a bead 3 on precipitating factors in the crisis. 4 And at kind of the heart of the questions I am 5 going to ask is: 6 the subprime lending? 7 decline in market values? 8 along the way? 9 Was it really the diminishing quality of Which you dispute. Was it a rapid Or were there dominos pushed here Now it's no secret that Goldman Sachs was a very 10 significant counterparty of yours. 11 about, of the $78 billion of exposure, they had about $21 12 billion of that exposure. 13 I believe they had I am going to enter an item into the record, 14 which is a chronology of all the capital calls that Goldman 15 Sachs made, the amount of collateral you posted, the amount 16 of credit protection that Goldman Sachs went and bought on 17 your company as well as a lot of the correspondence back and 18 forth. 19 But when you look at that record, some things are 20 clear. Goldman Sachs was first in the door demanding 21 collateral. 22 timing and amount. 23 '07, of all the counterparties, while they were 27 percent 24 of your book, you had posted 89 percent of the posted 25 collateral was for them. They were the most aggressive in terms of the For example, by the end of the year of 162 1 By June 30th, while they were 27 percent of the 2 overall book, 48 percent of the collateral calls being made 3 were by them. 4 of the amount they were asking for, when they were asking 5 for it, and they were much more aggressive in marking these 6 securities down. 7 They were way ahead of everyone else in terms And so, you know, when I look at this I'm trying 8 to figure out what happened. Are they just reflecting what 9 was happening in the market? Is it like one of those 10 Discovery Channel episodes where the cheetah is chasing down 11 the weak member of the herd? 12 begins pushing market values down? 13 Is it the first domino that Now, Mr. Cassano, in our staff's interview with 14 you, you said that you thought something was up with Goldman 15 because their first collateral call, which comes in July 27, 16 '07, they revised it quickly downward from $1.8 billion to 17 $1.2 billion, because they based it on bids, not the mid- 18 point between bid and ask. 19 reserved the rights to dispute, for $450 million. 20 They settled, even though they You said that Mr. Sherwood had told you that 21 Goldman, quote, "didn't cover ourselves in glory during this 22 period." 23 market is starting to come our way, which you took from our 24 interview as an implicit admission that Goldman's initial 25 collateral calls were too low. Later on you said that Mr. Sherwood said that the 163 1 You noted that Mr. Blankfein had announced that 2 Goldman was short on the subprime market, and you wondered 3 whether Goldman was pushing or driving the market. 4 The records here--I want to ask you: How do you 5 perceive what happened here? And I'm trying to also get to 6 how the heck do you set market prices during this time 7 period when Goldman in its own disclosures as it begins to 8 continue to sell synthetic CDOs, they sold $63 billion worth 9 of these from I think '04 all the way through April of 2007, 10 I want you to give me your perception of what was happening 11 here. 12 WITNESS CASSANO: I will. 13 CHAIRMAN ANGELIDES: 14 WITNESS CASSANO: Is that a lot? Yes. And I will, as I go 15 through this, if I miss anything that you're still 16 interested in, just probe me again and we'll just keep going 17 through it until I cover it. 18 19 CHAIRMAN ANGELIDES: And I may have to go to other members because of my time. 20 WITNESS CASSANO: Yes, sir. 21 If we take the period of July--the initial 22 collateral calls that came to us, if we put ourselves back 23 into that period, it was a period where it was one of the 24 first periods of increased market disruption due to what was 25 to become the financial crisis of '08. 164 1 Goldman Sachs made the call on us of 2 $1.8 billion. 3 of the call, surprised at the lack of incrementality to the 4 call, right? 5 They then--we were surprised at the magnitude It went from nothing to $1.8 billion. Obviously my job is not to trust Goldman Sachs 6 numbers but to verify. 7 out and asked other major participants in the market for 8 pricing on the same instruments, or similar instruments, and 9 we received wide variances from the Goldman numbers. 10 11 12 13 14 We received their numbers. We went And Goldman's numbers were always lower than the others. CHAIRMAN ANGELIDES: And I should remark in this chronology they're lower all the way through. WITNESS CASSANO: Yes, sir. And so my team, I 15 instruct my team to assert basically the contractual rights 16 that we had, which is to review the marks and the calls that 17 they're making, along with others. 18 Chairman Angelides, the call rapidly declined, right? 19 went, as you pointed out, $1.8 billion at the end of July, 20 $1.6 billion it became very rapidly. 21 billion within maybe another 10 days. 22 my dates are right, by the very early part of August, the 23 number was down to $600 million. 24 market not a lot is going on. 25 And, as you pointed out, It It then moved to $1.2 But by the time, if And this time in the The market is beginning to seize up at this point 165 1 in time, so not a lot of changes. 2 regular dialogue with the folks at Goldman. 3 CHAIRMAN ANGELIDES: 4 WITNESS CASSANO: And my team was in a Go ahead. As we went through this 5 process, we did settle at the $450 million mark. I 6 called my counterpart at Goldman, Mike Sherwood, and I 7 said, Look, Mike, I don't understand what happened over at 8 your shop where you come in at one point eight and end at 9 four fifty, but I did know that it was difficult to source 10 clear views of pricing in a market on transactions that 11 really don't trade actively even in the best of times. 12 And what Mike said in the call was, look, I don't 13 think we covered ourselves in glory in this whole process. 14 And the reason for me calling him was to say, look, we need 15 to meet again. 16 figure out an objective way of getting values here. 17 are we going to manage this going forward? 18 You and I need to sit down and we need to And how And we met to do that again, to sit down and iron 19 that out, in September, in the early part of September. 20 -but I think your question is: 21 was going on? 22 So- What's my perception of what I think my perception at the time, and still now, 23 is that we were working in an opaque market. Because of the 24 market disruptions, it was difficult to find price 25 discovery. I think even a firm as esteemed as Goldman Sachs 166 1 was having trouble getting price discovery. 2 And what made--convinced me that this was a 3 difficult process was the rapidity at which they lowered 4 their prices, or in which they raised their prices and 5 lowered the collateral call. 6 7 CHAIRMAN ANGELIDES: They kept at it for a number of months. 8 9 But then they kept at it. WITNESS CASSANO: these periods, right. They kept coming. I'm sort of segmenting it into And because what happens then in 10 September is we meet to try and figure out a way in which we 11 can use the contractual rights that we have in the contract. 12 Right? 13 If you have a strong disagreement in our 14 collateral calls and you don't agree with the counterpart, 15 the contractual rights that exist is for you to ask for a 16 dealer poll, all right? 17 We're not agreeing. 18 people to put prices on these things. 19 out and we'll use those as the arbiter. 20 And say, look, I don't like this. Let's go to the market. Let's get four Let's average those We went and discussed that in September. And 21 then the process went dormant for awhile. But also at the 22 same time that it went dormant, if you remember in late 23 September I think the Fed may have made one of the initial 24 rate cuts, which sort of added a relief rally to the market. 25 And so this issue went on a back burner. 167 1 It wasn't until I think the very end of October, 2 the beginning of November, when I received another call from 3 Mr. Sherwood. 4 at their month-end numbers. 5 up, and they were going to make another call, and 6 another significant amount, and this time their call was at 7 $3 billion. 8 9 And he explained to me that they were looking He wanted to give me a heads- I said to Mike, look, we've got to look at these numbers because of what happened the last time. And at that 10 point, that was when the response was: 11 think the market is coming our way at this time. 12 CHAIRMAN ANGELIDES: Well, you know, we All right. Well, I am going 13 to move on. 14 chronology, which I believe is the first time it's been done 15 because it's a very interesting look at how this market 16 worked. 17 We have entered into the record this full I do want to return to this issue. I know that 18 we have the Goldman folks later today. We have a full panel 19 tomorrow morning. 20 like to follow up with some additional questions on this 21 matter, but I do want to move to other members at this time. If there is some time at the end I would 22 With that, Mr. Vice Chairman? 23 VICE CHAIRMAN THOMAS: Thank you, Mr. Chairman. 24 My understanding from staff is--and first of all I want to 25 thank you for coming. We have to be able to at least 168 1 understand the mindset and the activities at the time from 2 many different sources to understand the way you looked at 3 the world at that time. 4 And it is always easy in hindsight in anything to 5 talk about what would’ve, could’ve, should’ve, but our goal 6 in part is to try to understand where you were at the time 7 that it happened. 8 9 I know, Mr. Cassano, you are looking at where you are today in terms of the value, and you make those 10 arguments. And I used to hear an old story which was 11 supposed to be funny, about a guy who pulls up to a gas 12 station in Vermont and asks directions of the old Yankee 13 there, and he finally said: 14 your life? Well, have you lived here all 15 And the old guy says: Not yet. 16 So are you able to project risk ahead? I assume 17 that would have been part of your fundamental business. 18 the answer that I thought I heard from you to the Chairman's 19 question was that they haven't fallen apart yet. 20 Do you believe you're going to make money on 21 these? 22 project that out? 23 And Is there going to be a loss eventually? WITNESS CASSANO: Can you Vice Chairman, nobody can see 24 into the future. What I was responding to the Chairman's 25 question was that we employed a very--one of the questions I 169 1 think is: 2 the problem in this portfolio? 3 Was it credit risk that destroyed, that caused I think the credit risk analysis that we did, and 4 the underwriting standards that we met, and the structural 5 supports that were built into the transaction are so far 6 standing the test of time. 7 8 VICE CHAIRMAN THOMAS: who said "not yet." 9 Yes, just like the fellow So, so far. In terms of this assessment, in terms of risk, 10 you mentioned in your testimony something that others have 11 repeated. 12 after all, AAA. 13 diligence in terms of risk, how the rating companies were 14 coming up with what were AAA ratings? 15 few years ago was or was not the same standard? 16 simply took the AAA label for what it was? 17 18 Did you ever look into, as part of your due And what was AAA a Or you And I guess, Mr. Lewis, you're part of that question as well. 19 20 That is, that the underlying structure were, WITNESS CASSANO: But you're asking me first, right, Vice Chairman? 21 VICE CHAIRMAN THOMAS: 22 WITNESS CASSANO: Sure. Go ahead. We did a fundamental analysis 23 of the transactions. My team reviewed the underlying 24 portfolios and the underlying assets within the portfolios 25 directly. 170 1 2 So we were not reliant on the rating agencies to tell us what was good or bad in these portfolios. 3 VICE CHAIRMAN THOMAS: So you were actually 4 observing the degradation of the types of collateral--in 5 fact, no collateral, no-doc loans--that was occurring in the 6 mortgage activities backing these? 7 WITNESS CASSANO: That is--the issue that you 8 identify about the underwriting standards slipping is 9 exactly what made us come to the conclusion that we needed 10 to exit the subprime underwriting within the multi-sector 11 CDO business as we saw the beginnings, or the potential for 12 those underwriting standards not hitting the targets that we 13 had set because of the issues that you just identified. 14 VICE CHAIRMAN THOMAS: 15 WITNESS CASSANO: And that was in '05? The analysis was done in the 16 last quarter of '05, and the decision was made in December 17 of '05, and then we ran through the portfolio. 18 VICE CHAIRMAN THOMAS: One other date check, Mr. 19 Sullivan. You indicated that you got the margin call, or at 20 least the initial communication, with Goldman in July of 21 '07? 22 WITNESS CASSANO: Yes, sir. 23 VICE CHAIRMAN THOMAS: And you were not 24 surprised, because you knew in the contracts that there was 25 a margin call. You were surprised at the size of the 171 1 margin? 2 WITNESS CASSANO: 3 VICE CHAIRMAN THOMAS: 4 5 Yes. Was that when you found out there were margin calls, Mr. Sullivan? WITNESS SULLIVAN: Thank you, Vice Chairman. 6 think to the best of my recollection it was some weeks or 7 months later. 8 9 VICE CHAIRMAN THOMAS: After he appropriate amounts for the margin call? 11 of that at the time that it occurred? 12 it months, weeks or months later? WITNESS SULLIVAN: 14 nowhere around the July time. 15 in the year. 16 began the negotiations in terms of whether or not those were 10 13 I You weren't aware You found out about Certainly I think, certainly I think it was much later on VICE CHAIRMAN THOMAS: Okay. I'm just trying to 17 take this stuff in. 18 will admit I have never been involved in an enormous multi- 19 national operation in which apparently there's not as much 20 communication about what I would consider a major problem in 21 a significant sector of the business. 22 I appreciate your cooperation, and I So I want to ask some questions, Mr. Sullivan, 23 about how we got into this. If you weren't aware there were 24 margin calls--I guess I should address it to Mr. Cassano, 25 but anybody who could answer me--you were in this business 172 1 fairly fast and furious prior to your recognition that you 2 had dug a hole that you could not climb out of in essence, 3 so you stopped digging. 4 Was it motivation on the basis of a compensation 5 structure that you were doing all this in the volume that 6 you were doing it? 7 was going to make a lot of money? 8 doing it were making a lot of money? 9 the same thing. 10 Because it was a line of business that WITNESS CASSANO: Or that people who were And they're not always I think one way of looking at 11 this is to say that we, early on in 2005, we took the 12 decision to run down our portfolio-- 13 VICE CHAIRMAN THOMAS: I'm more interested in 14 '02, '03, '04 when you were running it up. 15 of the bet from almost all comers. 16 WITNESS CASSANO: Taking one side I think what you need to look 17 at within these transactions is the underwriting standards 18 that we committed to to do these transactions. 19 I've heard this phrase that it's a one-sided bet, 20 but when you think about the protections that we built into 21 the contracts through the subordination levels, through the 22 structural supports that we built into the contracts, and 23 then through the very, very strict underwriting standards we 24 performed, this was extremely remote risk business. 25 And it's not the credit risk here that eventually 173 1 became the issue at hand. 2 underwriting standards, and the credit risk within these 3 transactions, have to date been supported and still perform. 4 My point has been that the VICE CHAIRMAN THOMAS: 5 you the question: 6 Federal Government? 7 Then I guess I have to ask How much money did you get from the WITNESS CASSANO: For the credit default 8 portfolio? The Federal Government paid $40 billion. But 9 one of the things I wonder about when I look at that is I've 10 never understood why the $40 billion was accelerated to the 11 counterparts. 12 Now I haven't been involved in that, and I'm only 13 looking at it from afar, but when I think about the 14 contractual defenses and the contractual rights we had in 15 the contracts, it has caused me to scratch my head and ask 16 why was it that $40 billion was accelerated to the 17 counterparts. 18 19 VICE CHAIRMAN THOMAS: the room when that kind of a decision was made. 20 21 Mr. Sullivan, were you in the room when that decision was made? 22 WITNESS SULLIVAN: 23 company some months earlier. 24 25 Okay, so you weren't in No, sir. VICE CHAIRMAN THOMAS: else. I had left the Okay, it's always someone So partly convenient leaving helps a lot in our not 174 1 fully understanding. 2 This is one of the problems that I have when I 3 try to explain what occurred, and so maybe I need a little 4 help. 5 homes through what they believe is really no fault of their 6 own, although we could nitpick in terms of why did they go 7 ahead and get money out of their homes in terms of 8 diminishing their equity and all of those other arguments. 9 But what I have a hard time doing is explaining There are people out there who are no longer in their 10 why some people in the business, that their Taxpayer dollars 11 kept in business, even receiving as much as a million 12 dollars a month when some of the folk who lost their homes 13 won't make that much in their lifetimes. 14 a newspaper story that their tax dollars going to AIG. 15 does "A" stand for? 16 WITNESS LEWIS: 17 VICE CHAIRMAN THOMAS: And then they read What "American." American. The Taxpayer 18 dollars going to AIG wind up in a bank in Great Britain, in 19 a bank in Germany, a couple of banks in Germany, banks in 20 France, banks in Scotland, in Maiden Lane III in banks in 21 Canada. 22 to them, that what occurred between you and the Federal 23 Government was something that should have been done, needed 24 to be done, and that in fact was the right thing to do in 25 terms of resolving this issue? How do I explain to them, based upon what happened 175 1 2 Is there anything you can give me that I can tell them? 3 WITNESS LEWIS: Mr. Vice Chairman, what I would 4 say is that AIG was under tremendous liquidity pressure at 5 that point in time, and the Taxpayer came in through the 6 Federal Reserve Bank of New York and assisted AIG. 7 board made the determination to accept that assistance and 8 move on. 9 And our At that point in time, however, when the 10 government came in, the markets were still in decline, and 11 there were further liquidity needs being put upon AIG. 12 that period of time, the Federal Reserve Bank took over 13 negotiations and determined--and went and had discussions 14 with the counterparts. 15 decision was made that the best way to arrest the further 16 requirements of liquidity on AIG would be to set up the ML 17 III structure. 18 default swaps were extinguished and cancelled, and for that 19 the decision was made that the cash collateral that we had 20 posted, which the Federal Reserve had funded, would be part 21 of the consideration given to the counterparties, as well as 22 the sale of their CDOs to the ML III structure. 23 We were not a party to that. At And a And through that structure, the credit VICE CHAIRMAN THOMAS: And what probably begins 24 to concern me even more is that, even to date, witness--did 25 you see the article in this morning's New York Times? 176 1 WITNESS CASSANO: Yes, sir. 2 VICE CHAIRMAN THOMAS: Discussing the 3 possibility, when you decided, as you indicated, Mr. Lewis, 4 to accept and move on, that apparently, and my timing may 5 not be exactly right, the move on part was an agreement that 6 was reached with the Federal Government in terms of a 7 condition of aid that there would not be certain activities 8 pursued by AIG, either of a legal or other nature, toward 9 Goldman Sachs, I think the story said. Were any of you 10 aware of that prior to the story breaking this morning in 11 The New York Times? 12 WITNESS SULLIVAN: I was just going to answer, I 13 didn't read the article and unfortunately I had left the 14 company months earlier. 15 question. 16 17 So I can't respond to your VICE CHAIRMAN THOMAS: So you haven't read the article? 18 WITNESS SULLIVAN: No, sir. 19 VICE CHAIRMAN THOMAS: That apparently there was 20 an arrangement in which they would not pursue legal--Mr. 21 Lewis, I guess you're the one left there. 22 going to talk about retirement if I ask. 23 WITNESS LEWIS: Everybody else is No, I was not aware of that. But 24 our Legal Department would have been responsible for those 25 negotiations. I was not a party to it. 177 1 VICE CHAIRMAN THOMAS: 2 just ask your opinion. 3 read the story? Well I guess then I would Can you give me your opinion of--you 4 WITNESS LEWIS: Yes. 5 VICE CHAIRMAN THOMAS: How is someone supposed to 6 take the information in the story about that kind of a deal 7 being arranged? 8 9 How do you take it? WITNESS LEWIS: involved. Well I--as I say, I was not I'm not responsible for the legal negotiations of 10 AIG, and certainly not for the Federal Reserve Bank. 11 time-- 12 VICE CHAIRMAN THOMAS: Are you shocked or 13 surprised that there would be a deal like that? 14 think it was a fair thing? 15 been in their position? 16 response. 17 18 At the Do you Would you have done it had you All I'm looking for is a personal WITNESS LEWIS: Without knowing the other circumstances, I would be surprised, yes. 19 VICE CHAIRMAN THOMAS: You would be surprised 20 that they did agree to that? 21 was so bad they would agree to anything, and that was what 22 they wound up agreeing to? 23 WITNESS LEWIS: Or that maybe the situation Surprised, but I certainly can't 24 take into consideration other aspects that I am not aware 25 of. 178 1 VICE CHAIRMAN THOMAS: Mr. Chairman, hopefully 2 others can do a better job of trying to unravel this. 3 will hold my time. 4 CHAIRMAN ANGELIDES: 5 COMMISSIONER BORN: 6 I Ms. Born. Thank you very much, Mr. Chair. 7 I would like to start out with talking with Mr. 8 Cassano. AIG Financial Products was a large over-the- 9 counter derivatives dealer. And partly because of the 10 Commodity Futures Modernization Act, partly because of your 11 location of many of your operations in London, you weren't 12 really effectively regulated or overseen by a U.S. 13 regulator. 14 in weren't really overseen by the U.S. regulators. 15 And the products in the markets you were dealing AIG's derivatives portfolio I understand in 2007 16 was $2.7 trillion, of which I understand about a little over 17 $2.1 trillion were actually in financial products. 18 right? 19 20 21 WITNESS CASSANO: Is that Those numbers make sense to me, but I haven't looked at them lately. COMMISSIONER BORN: And you were a dealer in many 22 kinds of derivatives, not just the credit derivatives? 23 that correct? 24 WITNESS CASSANO: 25 COMMISSIONER BORN: That's right. With respect to your Is 179 1 portfolio as a whole, did you hedge any parts of that 2 portfolio? 3 WITNESS CASSANO: 4 COMMISSIONER BORN: 5 WITNESS CASSANO: Yes. Which parts? Much of--we just--we ran books, 6 derivatives portfolios in interest rates and currencies, in 7 equity derivatives, commodities, and in credit. 8 of those portfolios, we operated with risk mitigants, 9 including the super senior credit derivative portfolio, as I 10 was talking about earlier, with the first loss pieces on the 11 underwriting we did. 12 And in all But we ran--you know, nothing is a hundred 13 percent hedged, but the books were generally considered 14 fully hedged. 15 COMMISSIONER BORN: 16 credit derivatives portfolio. 17 like more than $560 billion in notional amount of credit 18 derivatives in your portfolio in 2007. 19 hedging in the conventional sense? 20 tranching and the level at which you were insuring? 21 Well let's look at your I think there was something Were you actually Or were you relying on I want you to answer as to whether you were 22 hedging the way you were hedging your interest rates by 23 taking offsetting positions. 24 25 WITNESS CASSANO: Perhaps the best way to delineate this is that the super senior credit derivative 180 1 book, which is the book you're--the super senior credit 2 derivative book globally, which is the book you're 3 referencing at $560 billion, we were using basically an 4 actuarial basis in order to secure that business. 5 So it wasn't--it's not hedged in the conventional 6 sense that you're talking about buying and selling interest 7 rate risk. 8 9 COMMISSIONER BORN: You were just relying on the structure of the instrument and what you were assessing as 10 the safety factor, the extremely low risk of default that 11 you were assessing for that instrument. 12 otherwise hedging by going out and getting offsetting? 13 weren't purchasing any credit default swaps to offset the 14 ones you were selling? 15 You were not You Is that correct? WITNESS CASSANO: Yes. But, you know, and I've 16 made this point before, but if you look at if there had been 17 any realized losses in these portfolios, and as I've said we 18 can see the Maiden Lane III portfolio, but we also can see 19 the other portfolios as they still exist in AIG, and as best 20 as I can tell there had been limited--and perhaps Mr. Lewis 21 knows this answer better than I do because I'm not inside 22 the company anymore--but there have been limited losses 23 associated with the piercing of the attachment point where 24 risk would come to AIG. 25 I think, from what I saw in the AIG reports, 181 1 there was a realization event when they unwound a portfolio 2 that they had. 3 COMMISSIONER BORN: But in your assessment of the 4 risk in the underlying of the super senior credit default 5 swaps that you had been issuing, you were only looking at 6 one kind of risk on those instruments, weren't you? 7 default risk on the underlying? 8 WITNESS CASSANO: 9 COMMISSIONER BORN: 10 The Yes. You were not looking at the risk that AIG would have to post collateral, for example? 11 WITNESS CASSANO: We managed the liquidity risk 12 during the process. 13 transactions that had the collateral calls associated with 14 them were the transactions in the United States. 15 multi-sector book. 16 provisions. 17 We knew, as I think we need to--the We had those collateral calls' We knew we had the resources to manage those 18 collateral call provisions. 19 company, we adequately managed-- 20 21 22 It's the COMMISSIONER BORN: reserves? Through my tenure with the Were those from capital Where were your liquidity provisions being held? WITNESS CASSANO: Well it was liquidity that we 23 needed, right? You needed to be able to pledge collateral, 24 or to give people collateral at that time. 25 and liability committee within our group, that Asset We had an asset 182 1 Liability Committee, who did a continuous review of our 2 liquidity needs and our potential liquidity needs. 3 And if we needed to, we could liquidate an asset 4 that we had. 5 liquid securities. 6 then use those to pledge the collateral--pledge as 7 collateral. 8 9 We managed some approximately $50 billion in We could liquidate those securities and As I understand it at least, and again, you know, your knowledge is probably more perfect than mine, is that 10 there were no--there were strains, but there were not issues 11 meeting the collateral calls all the way up to the September 12 events when the capital markets had seized up completely. 13 But I think all through that period, the FP team 14 was able to adequately meet the collateral calls through the 15 liquidity provisions that we had. 16 COMMISSIONER BORN: Mr. Lewis, as the Chief Risk 17 Officer, were you aware of the collateral obligations of 18 AIGFP on these contracts? 19 WITNESS LEWIS: As I testified earlier, I only 20 became aware of the collateral call provisions in this book, 21 the book regarding residential mortgages, in the latter part 22 of '07. 23 COMMISSIONER BORN: And had you--therefore you 24 had not made any kind of liquidity provisions up until that 25 time for that obligation? 183 1 WITNESS LEWIS: The responsibility for liquidity 2 risk management did not--was not directly under my 3 jurisdiction. 4 liquidity risk management process that Financial Products 5 did undertake where they reviewed their contingent liquidity 6 requirements. 7 However, I was generally aware of the And the requirements presented by this book of 8 business did not rise to a level of concern until the market 9 really crashed in the '08 period of time. 10 COMMISSIONER BORN: So you think there were 11 adequate liquidity provisions even though AIG ended up 12 losing $40 billion on that portfolio? 13 WITNESS LEWIS: Well clearly-- 14 COMMISSIONER BORN: And needing a government bailout 15 and commitment of $180 billion-plus? 16 WITNESS LEWIS: Clearly, clearly as it turned out 17 we did not have adequate liquidity management processes that 18 took into account such a severe stress to the market and the 19 requirement for liquidity under those stressful conditions. 20 And clearly we did not. 21 During that period of time, '07 into '08, I was 22 asked to take on responsibility together with our treasury 23 of addressing liquidity risk management processes and 24 framework in the corporation. 25 responsible for liquidity. Until that time, I was not But clearly, as it turns out, we 184 1 did not have adequate liquidity risk management. 2 we would have had sufficient liquidity to weather that 3 storm. 4 COMMISSIONER BORN: Otherwise, Let me ask Mr. Cassano 5 whether he was aware of the practices of other large over- 6 the-counter derivatives dealers with respect to their CDS 7 transactions. 8 as an over-the-counter derivatives dealer? 9 dealers actually hedging those risks? 10 Was it unusual to hedge credit default swaps WITNESS CASSANO: Or were other It's a broad category, CDS. If 11 we're talking about super senior CDS and looking at them on 12 an actuarial basis, I think--and the super senior, it's my 13 understanding that there were many dealers who--or many 14 participants in the market who had the same types of 15 positions that we did, where they were relying on the 16 underwriting standards of these trades. 17 COMMISSIONER BORN: 18 WITNESS CASSANO: 19 20 Well for example-But, Commissioner, if I could go back-COMMISSIONER BORN: --Goldman Sachs in the 21 transactions that we've seen where you wrote credit default 22 swaps for Goldman Sachs, Goldman Sachs was apparently using 23 you to hedge its own commitments to other customers with 24 credit default swaps. 25 WITNESS CASSANO: In that instance, that's 185 1 possible. I don't know what Goldman was doing. 2 that there were others who were treating the business the 3 same way we did. 4 COMMISSIONER BORN: 5 institutions were doing that? 6 WITNESS CASSANO: I do know Do you know which The monoline insurance 7 companies were looking at it the same way. 8 were--those are the ones who come to mind right now. 9 COMMISSIONER BORN: There Did you ever consider putting 10 up side-capital reserves the way, for example, a monoline 11 insurance company would be required to do in order to back 12 up your obligations on these contracts? 13 WITNESS CASSANO: We had reserves in AIGFP 14 against our entire book. There was a program that we needed 15 to--that we had developed between us and the credit risk 16 management and market risk management functions in which we 17 set aside reserves for the risk that this business took. 18 So we had a pool of reserves that was available. 19 I think, you know, one of the--when I look at this business 20 and I try and segment what happened and what went--what 21 caused the bailout, it doesn't appear to me to have been a 22 credit risk issue. I think it was a liquidity issue. 23 And it was a liquidity issue that was brought 24 about by the seizing up of the capital markets, but also 25 added to that issue was that there was a market disruption 186 1 event going on in terms of trying to find the fair value for 2 these contracts. 3 instruments. 4 I've said before, even in the best of times would trade 5 freely. 6 Because these aren't tradable These aren't the kinds of things that even, as And so, putting on--trying to come up with a fair 7 value estimate for these contracts in a market disrupted 8 period is difficult. 9 estimation, as the crisis moved on was--and it's the thing I 10 raised earlier where I said I don't understand why the funds 11 were accelerated to the counterparties the way they are--we 12 should have gone to the dealer poll. And what should have happened, in my 13 The reason we should have gone to the dealer poll 14 at some point in time--and, you know, either sometime in the 15 summer or in the early autumn--was I believe the dealer poll 16 would have failed, because of the market disruption that was 17 going on. 18 COMMISSIONER BORN: 19 WITNESS CASSANO: 20 COMMISSIONER BORN: Well, let's-Can I-Before we get into, you know, 21 whether the markets were accurate, or how we--I would rather 22 ask you-- 23 WITNESS CASSANO: 24 COMMISSIONER BORN: 25 --if the dealer poll failed-- something else, if you please. I would rather ask you about 187 1 WITNESS CASSANO: Sorry, Commissioner. 2 COMMISSIONER BORN: Aren't these exactly the 3 kinds of concerns, drying up of liquidity, need to post 4 collateral, downgrading of the company, downgrading of the 5 underlying reference collateral, loss of price--loss of 6 value in the underlying reference collateral, that you 7 should have been thinking about in hedging or keeping 8 capital reserves? 9 WITNESS CASSANO: So, Commissioner-- 10 CHAIRMAN ANGELIDES: 11 COMMISSIONER BORN: 12 WITNESS CASSANO: I yield five minutes. Thank you. Commissioner, as I said, with 13 the contractual supports that we had, and the contractual 14 rights that we had in the contracts, in a severe event that 15 would have caused prices to go as low as they were, as they 16 did, we should--and you assert those contractual rights, 17 what you then do if this dealer poll fails, which it would 18 have because nothing was trading, right. 19 distressed periods, money market instruments aren't trading. 20 In these Liquidity is at a super premium. It's difficult 21 to find anything other than a Treasury that might trade. 22 The dealer poll would have failed. 23 to a negotiated situation. 24 where the company was during the period that I was in the 25 company. You would have been back And where you would have been is You would be negotiating deep discounts on these 188 1 collateral calls. 2 So from my point of view, a failsafe mechanism 3 built into this process that said that we did have adequate 4 liquidity reserves, because we were able to meet the 5 collateral calls, that in the severe scenario that you're 6 outlining, the contracts allowed you to assert rights that 7 would then compel the counterparty to come back to the 8 table-- 9 10 COMMISSIONER BORN: rights. 11 WITNESS CASSANO: 12 COMMISSIONER BORN: 13 But you never asserted those point. Commissioner, this is-And you never got to that That's pretty hypothetical. 14 WITNESS CASSANO: But, Commissioner-- 15 COMMISSIONER BORN: 16 these, your exposure on this? 17 market and try to get offsetting contracts? Did you ever try to hedge Did you ever go into the 18 WITNESS CASSANO: As I've said before, we were 19 relying on our underwriting standards. 20 COMMISSIONER BORN: 21 WITNESS CASSANO: 22 COMMISSIONER BORN: So you're saying, 'no'? Yes, ma'am. I know that you say that you 23 reduced--you made a decision no longer to write CDS on super 24 senior CDOs in early 2006. 25 numbers. I don't quite see that in the 189 1 At the end of 2005 you had $54 billion in that 2 portfolio. Two years later, in 2007, you had $80 billion. 3 That's a 50 percent increase almost. 4 stopped writing and yet you almost doubled--you increased by 5 50 percent your portfolio after you supposedly stopped 6 writing these? 7 WITNESS CASSANO: How was it that you The answer to this is in the 8 details. Because what we announced was that we were 9 stopping our underwriting of subprime securities in 2005. 10 We still underwrote multi-sector CDOs that had 11 prime or had CMBS in them. 12 clear on this-- 13 14 And I think we've been fairly COMMISSIONER BORN: And that's what's in that $80 billion? 15 WITNESS CASSANO: And that's the--there are two 16 things that are in that number, just to be clear, right? 17 took the decision at the end of '05. 18 a pipeline. 19 about the end of May. 20 exemption at the end of May that we did in coordination with 21 an agreement with ERM. 22 We We had commitments in We ran those commitments through until just I think there was one special And by I believe it's June of '07, we were no 23 longer underwriting any subprime collateral on our multi- 24 sector CDO book. 25 exposure in our book, or had such limited exposure in our And that is why we have such limited 190 1 book to the problematic vintages of '06 and '07. 2 you know, you need-- 3 4 COMMISSIONER BORN: Because, Well you still lost $40 billion. 5 If you had been being treated as a regulated 6 insurance company, you would have had to keep adequate 7 reserves. 8 exchange, there would have been no question about price 9 discovery because there would have been trading that would If you had been trading on a regulated futures 10 have a transparent and available price. 11 been no question about AIG building up a big exposure 12 because your contracts would have been mark-to-market twice 13 a day, and you would have had to pay margin at the end of 14 the day, if the value of your contracts eroded. 15 There would have Were you exploiting a regulatory gap by avoiding 16 insurance regulation with these credit default swaps which 17 acted virtually like insurance? 18 regulation in instruments that were virtually like futures 19 in order to be able to build up this enormous exposure and 20 make profits on an almost infinite leverage? 21 CHAIRMAN ANGELIDES: 22 then we will circle back. 23 the question. 24 25 WITNESS CASSANO: Were you avoiding futures' And, by the way, time. Go ahead. And I want you to answer Commissioner, I would have been happy to do this business in a regulated insurance company. 191 1 And I think in some of the public statements I've made in 2 the past, I have advocated that these transactions are 3 almost similar to, or in many ways are-- 4 COMMISSIONER BORN: 5 WITNESS CASSANO: Identical. --insurance contracts. And, 6 that I would have thought that was a good thing. Because 7 what it would have done, since insurance contracts are not 8 mark-to-market, it would have saved us the issue of having 9 to come find a fair value for these contracts when no market 10 existed, and discovery of prices and creating a fair value 11 was near-impossible. 12 So when you ask me if I was avoiding: No. I 13 would have encouraged that kind of regulation, and I would 14 like to have had this business done in an insurance company. 15 16 COMMISSIONER BORN: insurance company? 17 Why didn't you just become an You were a subsidiary of one. WITNESS CASSANO: We were a dealer in 18 derivatives, and this business in itself trades in the 19 derivatives markets. 20 were doing. 21 22 COMMISSIONER BORN: 25 Because that was a nonregulated market. 23 24 And, you know, that's the business we CHAIRMAN ANGELIDES: much. Mr. Hennessey? All right. Thank you very 192 1 COMMISSIONER HENNESSEY: 2 I want to see if I can do this in reverse 3 chronological order. 4 in September. 5 of the three who was still there. 6 Thank you, Mr. Chairman. I want to start with that third week And I guess, Mr. Lewis, you were the only one So, September 17th, 18th, 19th of 2008 is when 7 the Federal Reserve Bank of New York provides $85 billion of 8 revolving credit to AIG, to the parent company, right, not 9 to AIGFP? 10 WITNESS LEWIS: To the parent company, yes. 11 COMMISSIONER HENNESSEY: Okay. And that was 12 because AIG was facing a liquidity crisis. 13 to pay somebody. 14 the money at that point in time? 15 you talking about adverse market conditions. 16 there was a sudden increase in the demand for cash from AIG, 17 for instance from counterparties? 18 risk of a ratings downgrade. 19 raise the cash that you needed in overnight markets? 20 21 22 You needed cash What was the proximate need? Who needed And I've heard a couple of Was it because Or I've heard talk of the Or was it that you couldn't What was the reason for the significant change in a need for liquidity? WITNESS LEWIS: In that period of time, the 23 liquidity was completely dried up in the markets. And there 24 was little access to AIG's usual sources of liquidity to 25 issue commercial paper, issue debt, et cetera. It was a 193 1 general freeze of liquidity in the markets. 2 The demand for liquidity at the AIG level at that 3 point in time was in order to continue to meet the margin 4 call requirements at FP, as I recall. 5 securities lending business we were trying to increase 6 liquidity because the customers that we dealt with in the 7 securities lending business, who were themselves financial 8 institutions, were themselves trying to husband liquidity at 9 the time. 10 And also in our So the Federal Reserve came in with a revolving 11 credit of $85 billion. 12 that was borrowed under that facility at the first day, but 13 I-- 14 COMMISSIONER HENNESSEY: 15 that. 16 backward. 17 I don't recall the specific number I'm not interested in I'm trying to rebuild the chain of events by working So the Fed provided the $85 billion of cash. AIG 18 needed the cash both because there was a supply--there was a 19 decline in the supply of available cash, and there was an 20 increase in the demand for cash from their counterparties on 21 both the collateral calls on AIGFP and also on the 22 securities lending? I've got it right so far? 23 WITNESS LEWIS: 24 COMMISSIONER HENNESSEY: 25 Yes. Okay. Now those collateral calls had been going on for some time, right? I 194 1 mean, they didn't just start in September. 2 has been happening is week bumping up against Mr. Cassano 3 saying, look, I was right in how I estimated the value of 4 these CDOs and CDS, and by the way the process by which that 5 dispute was resolved was nontraditional. 6 And what I think But I guess what I'm trying to get at was: Whose 7 job was it to anticipate the possibility and manage the risk 8 of an increase in collateral calls? 9 WITNESS LEWIS: At the AIG, Inc., level, 10 ultimately the responsibility for ensuring sufficient 11 liquidity of the corporation rested with the CFO and the 12 treasurer of the corporation. 13 COMMISSIONER HENNESSEY: Okay, and to whom do 14 they look to manage the risk that our counterparties might 15 show up and demand more money, and we might argue with them 16 but we might lose that, whether we're right or wrong? 17 that the treasurer and the CFO? 18 business units within AIG? 19 WITNESS LEWIS: Yes. Are those individual The respective chief 20 financial officers and treasurers in the business unit 21 subsidiaries would be responsible for the liquidity 22 management in those businesses. 23 Is COMMISSIONER HENNESSEY: Okay. Because I'm going 24 to, Mr. Cassano, your point about this being a liquidity 25 issue because, whoever was right in evaluation of these 195 1 underlying securities, someone got it wrong in terms of 2 their estimation that they would win or lose that dispute, 3 or that the process would not work out their way. 4 5 Was that you who mis-estimated the risk that you might have to put up more cash to your counterparties? 6 WITNESS CASSANO: Commissioner Hennessey, I don't 7 think I mis-estimated the risk. 8 time with the company, which I was always able to negotiate 9 extremely steep discounts with all the large requests for 10 I think if you look at my collateral. 11 So when someone would come and ask for 12 collateral, doing fundamental analysis of the collateral 13 call, and combined with asserting the contractual rights 14 within the contracts, we were able to substantially discount 15 the collateral calls that were being made, and continue to 16 adequately manage them. 17 COMMISSIONER HENNESSEY: Right. And you were 18 able to work that out, say, for instance with Goldman every 19 single time, and then something changed. 20 when? 21 WITNESS CASSANO: What changed, and I left the company in March, 22 right? 23 I wish I was able to have stayed on and helped through this 24 process, because I don't know the answer to this. 25 I was asked to retire in March, at the end of March. This is--of the things that I look at as 196 1 surprising to me is, even in the period in September, I 2 don't understand why people didn't look at the contracts and 3 assert the rights under the contracts to preserve the 4 liquidity. 5 not have to have accelerated the $40 billion that it did. 6 And I think if they did that, the Taxpayer would COMMISSIONER HENNESSEY: Okay, after you left did 7 the payouts then of those collateral calls change 8 qualitatively from when you had been doing it? 9 able to negotiate deep discounts. You had been Then you leave. Then 10 things change and AIG is paying out more cash to Goldman and 11 other counterparties? 12 Is that how it works? WITNESS CASSANO: What I'm thinking about is the 13 September number. 14 September and I can see that the counterparties were paid 15 off at 100 cents on the dollar. 16 involved in the collateral call process from the time, from 17 March 30th. 18 big dates of the bailout right now. 19 20 23 I'm not sure. I wasn't So all I can see is what the events were on the But I don't know how the negotiations went during the interim period. 21 22 I mean, I can see what happened in COMMISSIONER HENNESSEY: Anything you can add, Mr. Lewis? WITNESS LEWIS: I was not directly involved in 24 the negotiations with the counterparts regarding the 25 collateral call postings. My only involvement was I 197 1 attended a couple of meetings, two meetings specifically, 2 with Goldman Sachs where we were trying to understand their 3 marks, their prices, and to what extent they were really 4 real prices in the marketplace. 5 6 And so I did attend two meetings there where they discussed their prices. 7 COMMISSIONER HENNESSEY: Okay, and I'm not 8 interested in the particulars of specific transactions. 9 trying to get a sense of the general gestalt here. 10 what we have is a disagreement over how much these 11 securities are worth. 12 certain amount because you've got certain assumptions about 13 the housing market. 14 thought. Right? I'm Because You think they're worth a Your counterparties have a different 15 Your auditor comes in and says: 16 over-valuating--you're over-valuing those securities. 17 right. 18 induced in part by the signal from your accounting firm, 19 that then tips AIG's behavior. 20 Cassano leaves, but that the firm starts making more 21 payouts, more cash is going out the door, and you're running 22 down your liquidity more. 23 specifics, but presumably something changed after he left. 24 25 You then leave. WITNESS LEWIS: We think you're All And then presumably, I assume That it's not just that Mr. Is that--and I don't need I am not aware--I am not aware of our external auditors' view that we were overstating the 198 1 value of the derivatives that we filed in our financial 2 statements. 3 We worked very closely with our external auditors 4 to determine what we ultimately filed as our best estimate 5 of the fair value of those securities. 6 7 8 9 COMMISSIONER HENNESSEY: Mr. Chairman, did you have something? CHAIRMAN ANGELIDES: Yes. I had two comments. was getting clarification on the second. I But, Mr. 10 Hennessey, I did want to point out, in the chronology which 11 the staff has prepared, I think you've alighted on a very at 12 least important issue here of at least pre-Mr. Cassano's 13 departure there seems to be a pretty fulsome record here of 14 disputing, challenging collateral calls. 15 Whether it's that the paper trail becomes thinner 16 after that date or not, after that time period you see a 17 dramatic acceleration in the calls and the payments by AIG. 18 And I think you've lighted on something from a risk 19 management standpoint that was very interesting. 20 COMMISSIONER HENNESSEY: Right. Thank you. 21 Because as I'm looking at this, I'm seeing, you know, March 22 3rd, Goldman increases their margin call from $2.5 to $4.2. 23 Two weeks later they increase their margin call from $4.2 to 24 $4.8 billion. 25 come up with different values and can have different views And I understand that different people can 199 1 as to how much collateral is necessary, but given that that 2 dispute is now highly visible, and I presume that all the 3 way up to you that you're aware that there are disputes with 4 Goldman in the hundreds of millions if not billions of 5 dollars as to how much collateral should be posted, did 6 anyone at that point in time--I guess I'll ask you, Mr. 7 Sullivan, did anyone at that point in time say what happens 8 if these disputes keep going? 9 up? 10 What happens if they ratchet Do we have enough cash on hand? Because it wasn't until nine months later that, 11 you know, that you had to knock on the door and get money 12 from the New York Fed. 13 CHAIRMAN ANGELIDES: And one more point, 14 Mr. Hennessey. I got clarification on this second point, 15 because you asked two very good questions. 16 just for clarification, yes, Price Waterhouse Coopers did I 17 believe in the preparation of the 8K, which was filed in 18 February of 2008, indicated that they should have been 19 taking into account the marks and the market in valuing 20 their portfolio. 21 COMMISSIONER HENNESSEY: 22 WITNESS SULLIVAN: And secondly, Mr. Sullivan? Commissioner, what I can tell 23 you is that I was aware of two collateral calls, by name, 24 Goldman Sachs and Calyon. 25 do early on in 2008, given the illiquidity in the What the company had decided to 200 1 marketplace, and bearing in mind we could have had a 2 hurricane, we could have had an earthquake, or whatever, we 3 made the decision to build up our cash reserves. 4 AIG had significant cash flow, and we made the 5 determination to build up our cash. In the event that any 6 event occurred that required AIG to pay out cash, we didn't 7 have to sell into what was becoming a fairly illiquid 8 market, and became a very illiquid market. 9 announced--we advised the market of that because, obviously, And we actually 10 if you're harboring cash, you're not generating any 11 investment income of any consequence. 12 Up until the time I left in the middle of June of 13 2008, whatever collateral call that emerged, we were able to 14 handle those, and there was certainly no need, or no 15 indication whatsoever when I left that in three months time, 16 or four months time the company was going to need government 17 intervention. 18 What occurred during the period around the dates 19 you articulated in September, unfortunately the only person 20 on this panel that was there was Mr. Lewis, and I think he's 21 articulated very well what occurred. 22 COMMISSIONER HENNESSEY: Okay, because here's 23 what I'm finding difficult. In March we know that there are 24 disputes between AIG and Goldman in the hundreds of millions 25 of dollars--or, sorry, billions of dollars of margin calls 201 1 based on a difference of opinion about the values of certain 2 securities. 3 You're there up until June. You know that there 4 is a risk from this because--and we know this because you 5 tell us that you are building up cash reserves--but then 6 things change so dramatically. 7 estimated the liquidity risk, and I'm trying to understand. 8 Because separating out the question of how much were these 9 securities worth, somebody didn't figure out how much cash 10 Somebody seriously under- you might need if these margin calls got out of hand. 11 Is that a fair characterization? 12 WITNESS SULLIVAN: All I can say in response, 13 sir, is we were building up cash, given the significant cash 14 flow of the organization, in order to respond to any set of 15 circumstances, whether it was a collateral call, a 16 hurricane, an earthquake, whatever. 17 the time I left there was, to the best of my knowledge, we 18 were able to respond to whatever collateral calls were 19 required. 20 And up until that time, we were still building up 21 cash. 22 able to help you but I simply can't. 23 24 25 And as I said, up until What happened after I left, sir, I would like to be COMMISSIONER HENNESSEY: I'm running out of time. I understand. Okay. I want to come now to-- VICE CHAIRMAN THOMAS: Yield to the gentleman. 202 1 COMMISSIONER HENNESSEY: 2 you had two disputes with Goldman. 3 of the securities, and one was over the process by which 4 differences of opinion would be resolved. 5 WITNESS CASSANO: Okay. It sounds like One was over the value Is that fair? I don't--I think of it as all 6 just one negotiation that we're having with them in the 7 process. 8 9 COMMISSIONER HENNESSEY: Okay. Because where I'm coming to is I was frustrated by the back and forth with you 10 and the Vice Chairman in the "not yet," which is you made 11 certain assumptions about what would happen to housing 12 prices. 13 point hasn't been punctured? 14 right here. And what you said is that so far the attachment I think I've got the language 15 WITNESS CASSANO: Pierced. 16 COMMISSIONER HENNESSEY: Pierced. Which sounds 17 to me like you're saying the cash flows on these things that 18 were rated AAA are still flowing? 19 WITNESS CASSANO: 20 VICE CHAIRMAN THOMAS: 21 22 Yes. Mr. Chairman, yield the gentleman five minutes. COMMISSIONER HENNESSEY: Thank you. And what I 23 think I heard the Vice Chairman saying is, well just because 24 the cash flows have flowed so far, that doesn't mean that 25 they're going to continue to flow. 203 1 And so what I'm trying to get at is, now, later, 2 now that we know more about the housing market, does your 3 estimate of the value of those, has it changed? 4 declined in time? 5 WITNESS CASSANO: Has it When I was answering the Vice 6 Chairman's question it was a question about the fundamental 7 analysis, and whether or not there had been or would be 8 enough defaults to pierce the attachment level at which we 9 had structured these deals. 10 COMMISSIONER HENNESSEY: And now we're in a 11 different environment. Now we all have more information 12 about what's actually happened in the housing market. 13 WITNESS CASSANO: Right. 14 COMMISSIONER HENNESSEY: Given that new 15 information about the housing market, what do you think 16 about the value of those securities? 17 WITNESS CASSANO: I still think that the 18 underwriting standards that we had set will support those 19 transactions-- 20 COMMISSIONER HENNESSEY: My question is not about 21 the underwriting standards. My question is: If you think 22 of yourself in a profit-making environment back in time, if 23 you could scribble a note and send yourself a message back 24 in time and say here's what's going to happen to housing 25 prices, would that information have changed your valuation 204 1 then? Were you overly optimistic in what would happen to 2 housing prices? 3 WITNESS CASSANO: I think what we--I'm sorry, I'm 4 struggling with the confluence of the underwriting standards 5 and the performance of default in the mortgage market, and 6 then the question of value that you're ascribing to the 7 portfolios. 8 trade anymore. 9 Because it's clear that these things don't It's clear that the market is not trading, unless 10 it's a government-guaranteed mortgage product. 11 market itself is ascribing--you know, it's in a disrupted 12 state, and it still is. 13 And so the So putting a value on these is a difficult 14 proposition without the market--without market 15 participation. 16 COMMISSIONER HENNESSEY: Right. And I'm not 17 asking what you think the market would--how the market would 18 value these. 19 assumptions at that point in time about the cash flows that 20 would occur. 21 What I'm asking is, you were making Have your estimates, now that you have more 22 information about those cash flows, changed? 23 cash flows? 24 25 WITNESS CASSANO: Those future I still think the cash flows from the underlying portfolios will meet the commitments, 205 1 and these will--we will not pierce the attachment levels. 2 COMMISSIONER HENNESSEY: Okay. And in that 3 judgment does PWC in effect have a different judgment about 4 that? 5 6 WITNESS CASSANO: PWC. 7 8 COMMISSIONER HENNESSEY: WITNESS CASSANO: Commissioner Hennessey, I think we're conflating two issues. 11 12 But is that what they were saying in their statement? 9 10 I don't have any contact with COMMISSIONER HENNESSEY: Help me separate them because I'm struggling. 13 WITNESS CASSANO: And the issue that developed 14 with PWC is we were creating a valuation model that we 15 initially started to create in order to have a way of 16 fundamentally reviewing collateral calls that came in. 17 It was then determined that that model that we 18 were working on should be used for the accounting, or fair 19 value of this overall portfolio. 20 made by the CFO of Financial Services. 21 And that determination was We then, working with that model, kept trying to 22 improve it and modify it as we moved along. So we had 23 iterations. 24 iterations of that model. 25 And I think we can say we had two main We had a basis that we used at the-- 206 1 COMMISSIONER HENNESSEY: I'm sorry, I'm running 2 out of time and I've got to interrupt. 3 which is they were criticizing your model rather than the 4 results that are coming from the model, I believe. 5 WITNESS CASSANO: Right. I get the point, The main criticism that 6 PWC had was to an adjustment that was needed to be made to 7 the model that I, sitting here today, still believe that 8 model, that adjustment needs to be made. 9 decision that PWC made, and because they were our auditors And because of the 10 we had to abide by that decision, I believe that the 11 portfolio has been understated on the books of the company, 12 and severely understated on the books of the company, 13 because the adjustment that they rejected was an adjustment 14 between what a cash instrument would trade at and what a 15 credit derivative would trade at, which has no cash 16 involved. 17 And there's a basis in those two. COMMISSIONER HENNESSEY: So what I think I'm 18 picking up from you is that you believe today that the 19 original valuation of these securities was in fact and is 20 still valid. 21 collateral calls that they have made are in some way, shape, 22 or form just wrong? 23 And, that both what Goldman has said and the WITNESS CASSANO: Yes. I believe that the 24 models--other people's prices have overstated the losses 25 associated with these portfolios. 207 1 COMMISSIONER HENNESSEY: 2 CHAIRMAN ANGELIDES: 3 questioning. Okay. Thank you. Very good line of Mr. Wallison? 4 COMMISSIONER WALLISON: Thank you, Mr. Chairman. 5 One of the really interesting things about this 6 whole area is how very few people seemed to see the risks of 7 losses before they occurred. 8 ask you to start--and this is addressed to you, Mr. Cassano. 9 And I guess I would like to What did you think, what do you think now was 10 your major error here? 11 of responses to my colleague, did you make an error? 12 Or, do you think, based on your line WITNESS CASSANO: If I was to think about--when I 13 think about this, and I think about the single error that 14 may have been made by me, I reflect on when I retired that I 15 didn't volunteer--and volunteer more forcefully--to give up 16 my position as the president of the company, but to become 17 the chief clerk and negotiator for the collateral calls. 18 Because I believe that you need to have--these 19 are negotiations among market participants, and you need to 20 use, in periods of severe market disruption, you need to use 21 all available rights that are there and allowed by you. 22 I believe I would have, as I did previously while I was the 23 head of the division, negotiated for substantial discounts 24 on the collateral calls. 25 preserve that segment of cash. And Therefore allowing the company to And then, even when the 208 1 calamitous events of the capital markets seizing up in 2 September, the three issues that faced AIG--the FP 3 collateral calls, the securities lending portfolio, combined 4 with the diminution in value of the insurance company's 5 mortgage portfolios, that I would have gone to the 6 counterparts and I think even then I would have been able to 7 negotiate substantial discounts by using the rights 8 available to us such that the Taxpayer would not have had to 9 accelerate the $40 billion to the counterparts. 10 11 12 So--and I see that as the linchpin in the issues that we're talking about. COMMISSIONER WALLISON: If I understand you 13 correctly, you're saying that if you had been allowed to 14 stay and work on this problem, the Taxpayers would not have 15 been required to put up any money, at least for the question 16 of the credit default swaps that you all had purchased? 17 that correct? 18 WITNESS CASSANO: I--I don't want to say "any 19 money," but I think I would have negotiated a much better 20 deal for the Taxpayers than what the Taxpayers got. 21 think I would have negotiated an appreciably better deal. 22 COMMISSIONER WALLISON: 23 enter this market? 24 order to do this? 25 And I When did you decide to And what analysis did you receive in WITNESS CASSANO: Is In the--I believe we entered 209 1 into the market in the beginning of--in 2003. 2 things in the business, it was sort of an incremental 3 strategy. 4 built on incrementalism and picking up on the last things 5 that were done. 6 Like most You know, the whole capital markets' business is What my team did at the time was a thorough 7 review of the structures of the multi-sector CDO market, the 8 CDO market, and then the underlying collateral. 9 was the review that was done. 10 And that And then from there, the business began to grow 11 through 2003. 12 talked about the growth in 2005, although that growth, as a 13 rate of growth in the portfolio, was lower than the previous 14 years. 15 the beginning of '05 and running down the portfolio in '06. 16 I think it grew appreciably in 2004. We've And we've spoken about exiting of the business at COMMISSIONER WALLISON: We know that you were 17 dealing with Goldman Sachs. 18 your total portfolio that Goldman Sachs was consuming? 19 were they your initial customers? 20 come along later? 21 WITNESS CASSANO: Can you give us a percentage of Or were they--did they I--well, as the Chairman stated 22 in his remarks, I think Goldman was approximately $20 23 billion of our portfolio. 24 - 25 And And this specific portfolio was - COMMISSIONER WALLISON: That would be about a 210 1 quarter? 2 WITNESS CASSANO: 3 COMMISSIONER WALLISON: 4 Right. But were they at the beginning, or did they come along afterwards? 5 WITNESS CASSANO: I actually think the--to the 6 best of my recollection on this point, I think there were 7 other banks that were initial participants. 8 9 COMMISSIONER WALLISON: Goldman. You were protecting Did you wonder why Goldman needed this protection 10 if you were under the impression that this was almost a 11 risk-free investment on your part? 12 WITNESS CASSANO: My understanding of what 13 Goldman was doing was that they were continuing to warehouse 14 and replicate the risk. 15 deals themselves, that they were laying off the risk with 16 others as they kept accumulating new deals into their shop. 17 18 19 20 21 And, while they had a pipeline to COMMISSIONER WALLISON: to you. And they kept coming back Was your pricing particularly good, do you think? WITNESS CASSANO: I think our pricing was competitive with the market. I don't think that was... COMMISSIONER WALLISON: What alerted you to the 22 danger of these transactions in 2005? What kind of analysis 23 did you do at that time which suggested to you and your 24 staff that things were much different than they had been 25 when you entered in 2003? It's only a two-year period. 211 1 What happened? 2 WITNESS CASSANO: Yes, sir. I think in the--just 3 before, if you don't mind, just a little bit of context, is 4 that there is a rapid growth curve in the CDO market and in 5 the subprime market from 2003, 2004, 2005, 2006, and even 6 '07, and this market is moving up very quickly, growing 7 exponentially. 8 9 My head trader came to me in 2005--this is Andrew Forster, and he said to me that he was beginning to become 10 concerned that there was a potential that underwriting 11 standards would begin to slip; that we would not be able to 12 meet our underwriting standards in this project. 13 We discussed it. Obviously I asked Andy if there 14 was anything we needed to do at this moment, and he said 15 that what he really would like to do is go and do more 16 research on this issue. 17 And we talked about who would be the right people 18 to do this. 19 of this business in North American, Professor Gorton, who 20 worked with us intimately on this product type, and Andrew 21 went--Andrew was based in London, went to the States, and 22 they met with a variety of people in the market. 23 We chose Al Frost, who is one of the marketers They met with loan originators, portfolio 24 managers, investment banks, and banks, discussing the 25 subprime market and this potential for increasing-- 212 1 decreasing standards and underwriting issues. 2 When Andrew returned is when he gave me his 3 analysis of the market. 4 decision. 5 way in any of these kinds of things. 6 still thought that the business was good to do. 7 those who thought, gee, the business is good to do, but I 8 sort of understand some of the arguments. 9 who--Andrew Forster who said, look, I think we need to get 10 COMMISSIONER WALLISON: get out. To Andrew, But you didn't actually You continued to enter these contracts. WITNESS CASSANO: 16 COMMISSIONER WALLISON: 18 There were when we took the decision to exit the business. 15 17 There were those who And I sided with Andrew on this, and that was 13 14 I think the groups were pretty split along the out. 11 12 And that's what led to our December Right. Was that because you were obligated in some way to do it? WITNESS CASSANO: We had a commitment of a 19 pipeline of these transactions that we had been working on. 20 They have a fairly long gestation period. 21 through that pipeline. 22 We were working When we took the decision to exit the business, 23 we discussed the pipeline and discussed whether or not we 24 needed to adjust standards. 25 What do we need to do? The team believed that they were ahead of the 213 1 curve in sort of identifying, and I think they were probably 2 ahead of most in identifying this potential for underwriting 3 standards slipping. 4 And then we also took a review of the portfolio 5 that we had. 6 you see this are you sure you don't have any issues in what 7 you own now? 8 9 Because obviously the question is: Well, if And we did that review. And we were comfortable with the underwriting standards that we had committed to. And those portfolios, 10 as they are now in Maiden Lane, would see us through the 11 test of time. 12 I think I want to make one thing clear, if I can. 13 During this process in the review, and even in the period 14 where we were beginning to ramp down the pipeline, we never 15 let our underwriting standards slip. 16 rigorous underwriting standards in which we made sure, not 17 only the FP teams review and analysis of these transactions, 18 the ongoing review of the book of business that we had, but 19 also we always made sure that we had the approval on all of 20 these transactions from a second set of eyes and a second 21 credit team at the AIG parent. 22 COMMISSIONER WALLISON: We also maintained the The puzzling thing about 23 this is that you didn't say just now that you are obligated 24 to continue to buy--to take on this risk. 25 were contractually obligated to take on the risk? Did you feel you 214 1 You decided--let me repeat what I thought I heard 2 you say. 3 that you would terminate going into this market any further 4 probably because you thought underwriting standards were 5 beginning to decline in the market and you didn't want to 6 take any further risk. 7 You said in 2005 you decided, after some debate, But were you contractually obligated to add what 8 I think is something like $30 billion more in risk during 9 the next couple of years? 10 11 WITNESS CASSANO: Remember, Mr. Commissioner, the decision that we took was the decision to exit the-- 12 COMMISSIONER WALLISON: 13 WITNESS CASSANO: 14 COMMISSIONER WALLISON: 15 WITNESS CASSANO: Go ahead. Everybody okay? Yes. The decision that we took was 16 the decision to exit the subprime underwriting market. 17 have--we did continue to underwrite prime mortgages, and we 18 made sure that those mortgages--you know, that the 19 underwriting standards for that business continued. 20 We So the $30 billion number that you're referencing 21 I think is a combination of two different products. I think 22 it includes some products that had subprime in them, and 23 that was the portfolio that we ran down. 24 includes transactions that had prime securities, and it 25 included transactions that had commercial real estate in But it also 215 1 them also, I believe. 2 So coming back to the decision that we made, and 3 whether or not we were contractually obligated, no, we were 4 not contractually obligated. 5 that we made in 2005 because we thought we could still run 6 through a pipeline of deals that we were building up, and we 7 would be able to still maintain our credit standards. 8 believe we never let our credit standards slip on this 9 issue. 10 This was a business decision And I Because what we say was the potential for 11 leakage, or slippage in these contracts; not that the 12 underwriting standards had slipped. 13 and I believe as we move forward in the more problematic 14 vintages of '06 and '07 is where most of the problems in the 15 housing market took place. 16 COMMISSIONER WALLISON: Remember, this is 2005, Yes, but that's when you 17 were buying 50 percent more than you had taken before. 18 Wasn't that true? 19 In 2006 and 2007? WITNESS CASSANO: Again we should look at the 20 portfolio. 21 portfolios. 22 at the asset classes that are composed of these portfolios. 23 And then we can see how we maintained our underwriting 24 standards through this process. 25 One of the issues is to look at the underlying Look at each portfolio individually. And look And I think the point I'm making is, 2006 and 216 1 subprime, when running through the pipeline to 2006 it was 2 accessing mostly 2005 vintage mortgages at that time. 3 those mortgages still had reasonable house price 4 appreciation, good covenants in them, and where the 5 underwriting standards had not yet deteriorated. 6 COMMISSIONER WALLISON: And I think one of the things 7 that sets AIG apart from others is that you took only one 8 side of a very substantial book. 9 other than the monolines, that did something like this? Are you aware of others, And 10 did you, if you were not aware of it, or if you were aware 11 of it would you tell us about others who might have been 12 doing this in the market? 13 WITNESS CASSANO: Nobody comes to mind right now. 14 COMMISSIONER WALLISON: And if not, then were 15 you--why did you suppose that you had done a better analysis 16 of this than, say, Goldman Sachs which was relying on you to 17 provide it with some protection? 18 WITNESS CASSANO: What we relied upon was the 19 underwriting standards that we had. I think we had a 20 rigorous set of standards. 21 standards were set by the people at AIG. 22 did a very good job on our fundamental analysis. 23 believe these portfolios are standing the test of time today 24 when it comes to credit risk analysis, as they are paying 25 back the Taxpayer in Maiden Lane III. As I've said before, the I think my team And I 217 1 And these portfolios have survived, and are 2 paying, and are performing in one of the most difficult 3 times in the capital markets in most of our lifetimes. 4 COMMISSIONER WALLISON: So would you--I'm 5 wondering whether what you are saying is that if you had 6 been allowed to remain in charge of these portfolios, and if 7 they hadn't in fact--if they were not going to depreciate 8 very substantially as you think, as you're saying now they 9 would not have, and have not, do you think that AIG could 10 11 12 13 have survived without any support from the government? WITNESS CASSANO: It's a big question, because there were other issues besides this portfolio that-COMMISSIONER WALLISON: But let's leave the other 14 part alone and just talk about the question of credit 15 default swaps. 16 WITNESS CASSANO: 17 COMMISSIONER WALLISON: 18 VICE CHAIRMAN THOMAS: 19 Okay. Just one minute? Yield the gentleman an additional two minutes? 20 COMMISSIONER WALLISON: 21 VICE CHAIRMAN THOMAS: 22 WITNESS CASSANO: 23 So-- Two minutes. Okay. I think your question is, if I remained in the company? 24 COMMISSIONER WALLISON: 25 WITNESS CASSANO: Yes, of course. Right, would I have been-- 218 1 2 3 COMMISSIONER WALLISON: If you had continued to be in charge of this subject. WITNESS CASSANO: If the company had left me--I 4 believe, or one of the things I question, is if I was able 5 to stay in the company as the chief negotiator of the 6 collateral calls in these transactions, I think I would have 7 used all the rights and remedies that were available to us 8 in the negotiations. 9 have not had to forward, or accelerate the $40 billion that And in that process, I think we would 10 the government did at the time, and I think I would have 11 been able to negotiate substantial discounts from the 12 collateral calls that had been made to date. 13 And I reflect on that only because I was able to 14 do it in the six months from July to March of '08 that this 15 business was being--when we were negotiating the collateral 16 calls while I was there. 17 COMMISSIONER WALLISON: I'm trying to--this is a 18 totally hypothetical question, and so I want you to leave 19 out the other decisions that were made by others about the 20 purchase of other assets that turned out to be rather poor. 21 I'm trying to focus in on the credit default swaps and your 22 views of what would have happened if that was the only bad 23 investment that AIG had made, can you say that there is a 24 chance--if you put a percentage on it, you're a business 25 person, you can probably put percentages on it--can you say 219 1 that the credit default swap portfolio that AIG had 2 purchased under your administration would have caused the 3 company to suffer losses or not? 4 would you put on that? 5 WITNESS CASSANO: What kind of percentage I think our portfolio would 6 have set--would--I think if we're working on a hypothetical- 7 - 8 COMMISSIONER WALLISON: 9 WITNESS CASSANO: Yes. --we have to remove the fair 10 value concept and we just look at the performance of the 11 portfolios themselves, if we're looking at the portfolios 12 performances of themselves, I believe these portfolios will 13 perform over the test of time. 14 will be incurred at the attachment point that we underwrote. And I believe that no losses 15 COMMISSIONER WALLISON: 16 CHAIRMAN ANGELIDES: Thank you. Good. I was going to defer 17 to the very end, but since this issue has been raised by Mr. 18 Hennessey and Mr. Wallison, I am just going to pursue it 19 just for a minute or two more and try to go very quickly 20 here in respect to my other members. 21 essentially make the point, a couple of points here, which 22 is that obviously the crisis, with respect to AIG, was 23 driven by these mark-to-market values. 24 failure of AIG to negotiate reasonable settlements of those. 25 And I will say that the chronology that I entered But this goes--you And secondly, by the 220 1 into the record--and this is in the way of absolution-- 2 appears to indicate that there's some pretty hard fighting 3 with Goldman Sachs in particular through March of 2008, and 4 then after. 5 I used the analogy when I started here: Was 6 there a cheetah hunting down the weak member of the herd? 7 It appears somewhere in March of 2008 the Cheetah may have 8 caught the member of the herd. 9 I am trying to get to this very issue of was a 10 first domino pushed over? 11 And I just want to call out a couple of things. 12 Or did someone light a fuse here? I mean, Goldman appears to have been--and this 13 is, as you said, they were hard negotiators, but they were 14 below everyone else's marks. 15 aggressive. 16 similar. 17 was much higher. 18 think a call because it appears that Goldman's given them 19 their marks. 20 They go back away. 21 They were much more Other entities didn't make calls that were The price scene, as you look at the chronology, And in fact at one point SocGen makes I They bring them to you. You dispute them. Right after that first collateral call on July 22 30th, Mr. Forster, who will be with us tomorrow, tells 23 another member of AIG Financial Products that the Goldman 24 margin call, quote, "hit out of the blue, and a f[ing] 25 number that's well bigger than we ever planned for." 221 1 Goldman's prices were, quote/unquote, "ridiculous." 2 On August 1st, Mr. Athan writes to Mr. Forster 3 that Goldman was, quote, "not budging or acting irrational." 4 On August 2nd, this is when you get Goldman to back down. 5 Quote--this is an e-mail from Mr. Forster to I think you, 6 "They" Goldman, "realized they needed to use mids not bids" 7 meaning they needed to use the mid-point not just the bid 8 price. 9 Mr. Forster on August 16th, 2007, says: I've 10 heard several rumors now that GS--"GS" meaning Goldman--is 11 aggressively marking down asset types that they don't own so 12 as to cause maximum pain to their competitors. 13 rozbush, but it's the sort of thing GS would do. 14 It may be You said I think on September 11th there's 15 another communication between Mr. Athan and Mr. Forster 16 saying that SocGen NY said they, quote, "received marks from 17 GS on positions that would result in big collateral calls 18 but SG disputed them with GS." 19 But what I get in a flavor here--and there's 20 another e-mail from you saying that SocGen was, quote, 21 "spurred by GS calling them." 22 where there's no open trading, is it possible that the mere 23 act of driving down prices drives down prices? So in this opaque market 24 WITNESS CASSANO: Yes. 25 CHAIRMAN ANGELIDES: Okay. And your contention 222 1 is that, had you not had this driving down of mark-to-market 2 prices for which there was no real market, you might not 3 have faced the liquidity challenge at the end, if in fact 4 AIG had continued to contest those using all their remedies? 5 WITNESS CASSANO: Can I say, basically, yes. 6 CHAIRMAN ANGELIDES: Okay. Okay, thank you very 7 much, members, for allowing me to do that. 8 get some clarification on that matter. 9 VICE CHAIRMAN THOMAS: 10 CHAIRMAN ANGELIDES: 11 VICE CHAIRMAN THOMAS: 12 CHAIRMAN ANGELIDES: 13 14 I just wanted to Mr. Chairman? Yes-Just to---and thank you, Mr. Vice Chair, for your courtesies today, too. VICE CHAIRMAN THOMAS: --and wants to understand 15 what's going on, the way I would describe it to someone 16 else, or the way I would ask the question is: 17 Goldman was out to get you? 18 WITNESS CASSANO: 19 VICE CHAIRMAN THOMAS: 20 WITNESS CASSANO: 21 VICE CHAIRMAN THOMAS: 22 WITNESS CASSANO: 23 24 25 Do you think No. No? I don't know what was-Were they out to get AIG? I don't know what was going on in Goldman's side, and what they were-VICE CHAIRMAN THOMAS: Had they done some of the same things, and they needed money, and they were going to 223 1 get it out of you? 2 WITNESS CASSANO: Vice Chairman Thomas, I don't 3 know what was on the other side of the Goldman trades. 4 know that Goldman kept coming to the table with us, and I do 5 know that as they came to the table--and this happened over 6 a long period of time-- 7 VICE CHAIRMAN THOMAS: 8 WITNESS CASSANO: 9 I do Right. --they kept reducing their collateral calls. 10 VICE CHAIRMAN THOMAS: I understand that. And 11 then you left AIG, I guess asking why you left, or why they 12 wouldn't keep someone who was fairly aggressive in their 13 corner--and clearly the negotiation structure changed after 14 you left--is a question I will ponder. 15 WITNESS CASSANO: 16 VICE CHAIRMAN THOMAS: 17 Are you asking me why I left? to, but I'm pondering it. 18 WITNESS CASSANO: 19 (Laughter.) 20 VICE CHAIRMAN THOMAS: 21 (Laughter.) 22 WITNESS CASSANO: 23 I don't think I'm supposed Okay. Sorry, sir. So what would you ponder? Well if we can ponder this together-- 24 (Laughter.) 25 VICE CHAIRMAN THOMAS: Just you and me-- 224 1 WITNESS CASSANO: And a couple of cameras. 2 VICE CHAIRMAN THOMAS: 3 WITNESS CASSANO: Well-- I was at the--after the 4 Material Weakness finding, and the disallowance of the 5 Negative Basis Adjustment in our modeling effort, at the end 6 of that week Mr. Sullivan asked me to come and see him. 7 as I think he said in his testimony, he told me that changes 8 needed to be made. 9 the changes that needed to be made. 10 11 12 13 retire. And He didn't think I would be happy with And he suggested that I And I did. VICE CHAIRMAN THOMAS: have been at a higher level. Okay. Maybe you should I'm through. CHAIRMAN ANGELIDES: We will now go to the next-- 14 I will say one thing. One thing we will want to follow up 15 on you, because members have asked, is this issue of you 16 continuing to write CDS. 17 be on notice that we will--the staff has indicated that CDS 18 continued to be written on what was called "prime RMBS," and 19 at least in our review it looked like that included Alt A, 20 interest-only, no-doc, low-doc. 21 want to visit that issue to get clarity. 22 and Home Equity Loans that included subprime. 23 get clarity about whether there really was a stop. We won't take time now, but just 24 All right. 25 COMMISSIONER GRAHAM: So I think we're going to Pay option ARMs, So we want to Senator Graham? Thank you, Mr. Chairman. 225 1 I want to use my time to talk about risk 2 management in four buckets. 3 "situational awareness." 4 "personnel." 5 One is what I would call Another is "history." Another is And then "organizational structure." On the situational awareness, it would seem to 6 me, and I will state as a lay person in this area, that 7 there were certain advantages to doing business with AIG in 8 this area that weren't available from other competitors in 9 the marketplace. 10 One was that you had in your contracts this 11 provision that required you to put up collateral if there 12 was a reduction in the market value of the underlying 13 assets. 14 And, two, the fact that you could put up 15 collateral. 16 particularly the monolines, were not allowed to put up 17 collateral until there was a default. 18 I understand that some of your competitors, In light of that, it would seem to me that you 19 would be in a very competitive position in terms of the 20 premiums to coverage that you would offer, since you had 21 contractual benefits from the side of your purchasers that 22 others did not have. 23 24 25 Is that a correct hypothesis? WITNESS CASSANO: pledge collateral. I know that we were able to I'm not sure what others could do. COMMISSIONER GRAHAM: Apparently, I've been told, 226 1 because of certain conditions from the rating agencies the 2 monolines were not allowed to post collateral until after 3 default. 4 WITNESS CASSANO: Okay. 5 COMMISSIONER GRAHAM: I'll accept that, yes. Well if that's the case, 6 then what I don't understand is, it seems as if you were 7 actually significantly underpriced, according to this chart 8 that we have about one particular security, which was the 9 Abacus-- 10 11 VICE CHAIRMAN THOMAS: Senator, just one moment while we get this chart-- 12 COMMISSIONER GRAHAM: 13 VICE CHAIRMAN THOMAS: 14 COMMISSIONER GRAHAM: 15 Goldman Sachs Synthetic CDO Abacus 2004-1. 16 this chart, AIG would sell you $1.76 billion of coverage for 17 an annual premium of $2.1 million. 18 19 20 WITNESS CASSANO: premise here. It's number four. --so that others can see. Yes, okay. This is the According to Is that correct? I'm going to accept your I just haven't--I don't know these numbers. COMMISSIONER GRAHAM: Well, then you'll just see 21 the others selling the same product, that TCW, you could buy 22 $22.5 million for $384,000; and with GSC you could buy $7.5 23 million for $510,000. 24 different ratios of premium cost to amount of coverage. 25 I mean, these are dramatically You indicated that you thought that your premium 227 1 charges were competitive with the marketplace, selling what 2 looks like to be a superior instrument for the reasons that 3 I cited earlier, yet you're getting dramatically less per- 4 dollar of coverage than others. 5 Is this an accurate reflection of what the 6 marketplace was? 7 were competitive with the market. 8 9 10 And if so, it does not appear as if you WITNESS CASSANO: I would need to spend some time and understand what this chart is exactly. COMMISSIONER GRAHAM: Then, unless Mr. Lewis or 11 Mr. Sullivan wishes to comment, I will defer and if you 12 could give us a written response to-- 13 14 15 WITNESS CASSANO: I'm more than happy to work with your staff on this, yes. COMMISSIONER GRAHAM: All right. The second 16 thing is history. 17 Coopers made a number of recommendations to the AIG Board 18 Chairman Robert Willumstad. 19 call "history." 20 In February of '08, Price Waterhouse One of those was what I would They said that a factor in the current situation 21 regarding the super senior credit default swaps was a lack 22 of leadership, unwillingness to make difficult decisions 23 regarding FP in the past, and inexperience in dealing with 24 these complex matters. 25 Mr. Sullivan I assume as the CEO. Mr. Robert 228 1 Willumstad communicated PWC's concerns to you? 2 WITNESS SULLIVAN: Sitting here today, sir, I 3 don't recall Mr. Willumstad discussing that with me. 4 Mr. Cassano articulated earlier, shortly after the filing of 5 that 8K we recognized that changes needed to be made within 6 AIGFP. 7 and I, we concluded that Mr. Cassano would retire. 8 9 But as And during a very short meeting between Mr. Cassano COMMISSIONER GRAHAM: According to this, in terms of history, it said there had been an unwillingness to make 10 difficult decisions regarding FP in the past. 11 this--were there issues that had been surfaced previously 12 that had not been dealt with? 13 14 15 WITNESS SULLIVAN: Do you--had As I said, sir, sitting here today I can't recall Mr. Willumstad discussing that with me. COMMISSIONER GRAHAM: Were you aware, 16 independently of what Price Waterhouse told the Chairman of 17 the Board about these problems at FP in the past? 18 19 20 WITNESS SULLIVAN: Without knowing the specifics of what motivated their comments, sir, I can't. COMMISSIONER GRAHAM: Okay, number three is the 21 area of personnel, where the PWC comments said: Ensuring 22 that people have the skills, including leadership, 23 execution, and change management skills and ability to hold 24 people accountable, and experience in dealing with large- 25 scale improvement and change efforts. 229 1 You've informed us about the decisions relative 2 to Mr. Cassano. 3 you made between February of '08 and September of '08? 4 Were there any other personnel changes that WITNESS SULLIVAN: Just for the record, sir, I 5 left in June, so I won't respond to that period in time. 6 Following Mr. Cassano's agreement to retire, Mr. Dooley, who 7 was the head of the Financial Services Sector, and Mr. 8 Cassano reported directly to him, took over as interim CEO 9 during that period of time as we went out to look for a new 10 head of AIGFP. 11 Sitting here today, I can't recall any other 12 changes during that period of time. 13 others who came or left, but I simply can't recall. 14 COMMISSIONER GRAHAM: But there may have been But from February to June 15 of '08, in light of this comment about your personnel, you 16 made one change? 17 18 19 Is that right? WITNESS SULLIVAN: As far as AIGFP is concerned, that's-COMMISSIONER GRAHAM: I mean what about the rest? 20 I don't think these comments were particularly intended to 21 be limited to FP. 22 elsewhere in the company? 23 Were there any major changes made WITNESS SULLIVAN: Sitting here today, one that I 24 recall is we changed the reporting line of Mr. Lewis from 25 the CFO to myself. 230 1 2 CHAIRMAN ANGELIDES: Would you like a couple of extra minutes, Senator? 3 COMMISSIONER GRAHAM: 4 CHAIRMAN ANGELIDES: 5 COMMISSIONER GRAHAM: Yes. Two minutes to the Senator. Okay, that gets to the 6 fourth issue, which is the organizational structure. 7 said there was a need to address the reporting lines for 8 ERM, the lack of access that ERM had into units like AIG 9 Investments and others, and that Lewis had not aggressively 10 11 PWC addressed these issues in the past. One of the matters that came up earlier was the 12 fact that, while one unit of the company had adopted at 13 least a stated policy that they were no longer going to be 14 purchasing these types of securities, that another unit, AIG 15 Investment, increased its holdings by some $50 billion. 16 Was the fact that there was no access by the ERM 17 to the AIG Investment Unit a factor in the failure to 18 communicate what one unit of the company had decided was an 19 excessively risky investment to another side of AIG? 20 WITNESS SULLIVAN: I can't answer the question as 21 to why they decided to continue investing there, but I do 22 believe to the best of my knowledge that the information 23 flow between ERM and AIG Investments was there. 24 25 I think the Credit Risk Committee had oversight, and I think the data flow and Mr. Lewis would be much more 231 1 able to respond there, was there. 2 COMMISSIONER GRAHAM: 3 WITNESS SULLIVAN: In light of-- But following this period of 4 time, sir, it's also probably that I put Mr. Lewis on the 5 Executive Committee of the company, and also I've, just 6 sitting here, recalled that I did ask the CFO to take over 7 senior management responsibility for the Financial Services 8 Division at the time, shortly before I left. 9 COMMISSIONER GRAHAM: In December of 2007 at the 10 Investors Conference Day, you made a statement which 11 included this quotation, AIG took in the U.S. residential 12 housing sector was, quote, "risk supported by sound analysis 13 and a risk management structure that allows AIG to put our 14 capital at work in an efficient manner." 15 Two months later, on February 6th of '08, this 16 report by PWC was given to your Chairman of the Board with 17 multiple critical comments about your risk management. 18 that cause the company to reassess whether it had in fact a 19 risk management structure that allowed it to put its capital 20 to work in an efficient manner? 21 CHAIRMAN ANGELIDES: Right. 22 answer the question and move on? 23 please. 24 25 WITNESS SULLIVAN: Did And then can we Answer the question, No, sir. I truly believe everything I said at the December Investor Call, based on 232 1 all the information I was receiving. 2 3 COMMISSIONER GRAHAM: And that report by Price Waterhouse 60 days later didn't cause you to reassess that? 4 WITNESS SULLIVAN: With the utmost respect, sir, 5 I'm not sure what report because I don't think I ever saw 6 that report. 7 sir? 8 9 10 11 I don't think it was addressed to me, was it, COMMISSIONER GRAHAM: Chairman of the Board. WITNESS SULLIVAN: Thank you. COMMISSIONER GRAHAM: 13 CHAIRMAN ANGELIDES: 15 Thank you. Mr. Georgiou--and actually, I think on this very point, perhaps. COMMISSIONER GEORGIOU: 16 Mr. Chairman. 17 come right back to it, if I can. 18 So I'm not sure I ever saw that report. 12 14 No, it was addressed to the Yes. Thank you, I actually want to make one point, and I'll Mr. Sullivan, you were paid $107 million from 19 2003 to 2008, including $47 million during 2008? 20 correct, roughly? 21 22 23 24 25 WITNESS SULLIVAN: Is that I have no knowledge or recollection of those numbers whatsoever, sir. COMMISSIONER GEORGIOU: You don't remember how much you made? WITNESS SULLIVAN: I certainly don't recall 233 1 earning that amount of money, sir. 2 3 COMMISSIONER GEORGIOU: established. 4 5 CHAIRMAN ANGELIDES: COMMISSIONER GEORGIOU: And, Mr. Cassano, you were paid $280 million from 2000 to 2007, correct? 10 11 These are from public filings of the company. 8 9 These are from public filings. 6 7 That's what our staff WITNESS CASSANO: I don't know the periods, but I made over $300 million during my career at AIG. 12 COMMISSIONER GEORGIOU: Okay, including a million 13 dollars a month during the six months after you retired as a 14 consultant? 15 WITNESS CASSANO: 16 COMMISSIONER GEORGIOU: 17 Yes. Mr. Lewis, you're still the Chief Risk Officer, correct? 18 WITNESS LEWIS: Yes. 19 COMMISSIONER GEORGIOU: And you received about 20 $15 million in total compensation from 2004 to 2008? 21 what our records reflect. 22 WITNESS LEWIS: That's I believe the compensation I 23 received--I don't know the total of that number, but it 24 would have included cash and stock compensation valued at 25 the time. 234 1 2 COMMISSIONER GEORGIOU: And Mr. McGinn, I take it, is still the Chief Risk Officer, is he? 3 WITNESS LEWIS: 4 COMMISSIONER GEORGIOU: 5 Right. Yes, he is. And he was during this period? 6 WITNESS LEWIS: Yes. Mr. McGinn was appointed 7 Chief Credit Officer in the summer of 2004 when I was 8 appointed to the Chief Risk Officer position. 9 COMMISSIONER GEORGIOU: And he's the one, is he 10 not, who suggested that the period of time--that the 11 increase, the 50 percent increase, in exposure to these 12 derivatives after the time that you decided--the exposure 13 that was created by AIG Investments after the time that 14 AIGFP decided to stop funding them, was akin to Nero playing 15 the fiddle while Rome burned. 16 not? 17 That was his comment, was it Do you recall that? WITNESS LEWIS: I have seen an e-mail from Mr. 18 McGinn where that statement was made. 19 not refer to FP, but to other parts of AIG. 20 COMMISSIONER GEORGIOU: I recall that it did To the AIG Investments, 21 which was continuing to expose the company to these types of 22 risks after the decision was made by FP no longer to go 23 forward in that regard. 24 25 Now I guess my question is really to Mr. Sullivan. You were there until June of '08. Did you 235 1 ever consider replacing the Chief Risk Officer, Mr. Lewis, 2 or the Chief Credit Officer, Mr. McGinn, in light of what 3 occurred? 4 government assistance to AIG, a commitment of up to $52 5 billion more, and the loss by shareholders of $147 billion 6 of market capitalization, which is what AIG was worth at the 7 end of '07, and it's worth nothing now, effectively. Which included, of course, $130 billion of 8 Now did you ever think that maybe the Chief 9 Credit Officers or the Chief Risk Officers ought to be 10 replaced? 11 12 WITNESS SULLIVAN: Not up until the time I left the organization, to the best of my knowledge, sir. 13 COMMISSIONER GEORGIOU: Okay. And did anybody 14 try to claw back any of this compensation from any of these 15 people, in light of the failures that occurred? 16 of your knowledge, did any executive ever give back any of 17 the money that they made on the basis of the products that 18 were created that caused the company ultimately to fail? 19 20 21 WITNESS SULLIVAN: To the best To the best of my knowledge, no, sir. COMMISSIONER GEORGIOU: Okay. And did the Board 22 of Directors ask you, as CEO, to give back any of your 23 compensation in light of your leadership of the company 24 during this period? 25 WITNESS SULLIVAN: To the best of my knowledge, 236 1 2 no, sir. COMMISSIONER GEORGIOU: Okay. All right, I'd 3 like to turn, if I could, then to a discussion of the 4 December 5th of '07 representation that there was a $1.5 5 billion estimated unrealized valuation loss on the super 6 senior credit default swap portfolio. 7 I would like to introduce into the record, if I 8 could, there's a three-page document, which I've written all 9 over but I'm sure we'll introduce into the record a clean 10 copy, which is our staff analysis and summary of this 11 particular report to the public. 12 CHAIRMAN ANGELIDES: 13 COMMISSIONER GEORGIOU: 14 CHAIRMAN ANGELIDES: 15 With attachments? With attachments, please. So be it, entered into the record, or whatever they say here in Congress. 16 COMMISSIONER GEORGIOU: Yes. 17 Now during this December 5th of '07 investor day 18 conference, Mr. Cassano reported that there was an estimated 19 $1.5 billion unrealized valuation loss on the super senior 20 credit default swap portfolio, and didn't disclose at that 21 time, and nobody disclosed from the company to the investing 22 public, that that included two accounting adjustments, one 23 of which was something called a negative basis adjustment of 24 $3.6 billion, and something else called a "structural 25 mitigant adjustment" of $732 million. 237 1 Do you recall that discussion, Mr. Sullivan? 2 WITNESS SULLIVAN: Sitting here today I recall 3 Mr. Cassano during that presentation giving an update of the 4 unrealized loss valuation number following the third quarter 5 number we'd issued some weeks earlier. 6 COMMISSIONER GEORGIOU: Right. Which was $1.5 7 billion, which was disclosed to the public and the investing 8 public, at that time. 9 10 WITNESS SULLIVAN: If that was the cumulative number. 11 COMMISSIONER GEORGIOU: And the fact that there 12 were adjustments associated with that was not disclosed. 13 And at that time, had those adjustments not been made the 14 unrealized loss would have been $5.9 billion as of December 15 of '07, if you would add those numbers back in. 16 Now it turns out that two months later, on 17 February 11th of '08, AIG issues a new Form 8K in which it 18 reports the adjustments that were not disclosed on 12/5/07, 19 and that it expected to include the structural mitigant in 20 the unrealized valuation loss but not the other matter, that 21 negative basis adjustment, which is another accounting 22 adjustment, because it could not reliably quantify the 23 judgment. 24 25 Now at that time, the unrealized loss was estimated to be, if I'm correct here, $11.9 billion--$11.1 238 1 billion. 2 your estimate of it at December 5th of '07 from, at one 3 point, $5 billion to $11.1 billion, which you reported in 4 February that you had actually had an unrealized loss in 5 December of $11.1 billion. 6 So it jumped up, between December 5th, between In response to that, of course, the market for 7 the stock cratered. It dropped $6 a share, from $50 to $44, 8 an 11.7 percent decline. 9 public was a subject of the Securities and Exchange And this representation to the 10 Commission and Department of Justice investigations, and in 11 the course of which it appears that Mr. Cassano--that, Mr. 12 Sullivan, you testified to our staff during our 13 investigation that you never learned of the adjustment until 14 February of '08. 15 Mr. Habayeb said he learned of the adjustment in 16 late January of '08. 17 the adjustment in late '08, and he learned it from Mr. 18 Habayeb. 19 Mr. Bensinger said that he learned of Mr. Cassano, however, said that the negative 20 basis adjustment was disclosed to all of these executives 21 and to Price Waterhouse Coopers before the December 5th, 22 '07, Investor Day Conference, and several documents 23 corroborate that contention. 24 CHAIRMAN ANGELIDES: Two minutes. 25 COMMISSIONER GEORGIOU: Okay. Thank you. 239 1 Now we're clear that these negative basis 2 adjustments wasn't disclosed on 12/5, and that the increase 3 of your estimate as of 12/5 changed between 12/5 to February 4 8th from $1.5 billion to $11.1 billion in loss. 5 And I just want to ask you, Mr. Sullivan, about 6 some documents. Because there's a document that's attached 7 to this summary which are typed notes prepared by Price 8 Waterhouse Cooper of a November 29th, '07, meeting, which is 9 a week before you told the public that this number was $1.5 10 billion, which says that: 11 of the credit default swap book included a potential need to 12 quantify the CDS spread. 13 technicals, but the typed notes also reveal that if AIG used 14 Goldman's values there could be an impact of $5 billion for 15 the quarter. 16 Cassano said that the valuation I won't get into all the And you're quoted as saying, Mr. Sullivan, that 17 this would, quote, "eliminate the quarter's profits 18 entirely." 19 Mr. Forster, who was at this meeting, told the 20 FCIC staff that CEO Sullivan responded to the $5 billion 21 comment by saying he was going to have, quote, "a heart 22 attack." 23 remember this part of the meeting, and he told FCIC staff 24 that he does remember a later part of the meeting that does 25 not include AIGFP executives. But Mr. Sullivan told FCIC staff that he does not 240 1 Can you tell us what you remember about the 2 "heart attack" comment, and why it is that the public was 3 told that this loss was $1.5 billion when really it was 4 closer to $5.9 billion in December? 5 WITNESS SULLIVAN: Well thank you, Commissioner. 6 First of all, I can't help you with the "heart attack" 7 comment because I have berated myself over many months to 8 try and recall the first part of the discussion of that 9 November meeting. I've been asked many times, and 10 unfortunately I simply can't recall. But you may rest 11 assured I have berated myself over that. 12 On the second part of your question, the first 13 that I recall hearing about negative basis points and the 14 lack of being auditable was, to the very best of my 15 knowledge, in early February. 16 COMMISSIONER GEORGIOU: Okay, all right. I'm 17 just going to leave it there. 18 Daubeney's, handwritten notes from the November 29th meeting 19 includes a notation that Mr. Cassano said we need to 20 quantify the CDS spread to the cash. 21 but subject to change. 22 The PWC partner's, Henry Could be 10 percent, And that was the modification that you utilized 23 as the negative mitigation to effectively reduce the $1.5 24 billion loss, unrealized loss, to significantly--to report 25 that loss to the public, when in fact just two months later 241 1 you've decided that the loss is $10 billion more, as of 2 December of '07. 3 And also on 12/1 of '07 Mr. Cassano sent an e- 4 mail to Messrs. Habayeb, Dooley, Bensinger, Lewis, Herzog, 5 and McGinn in which he wrote that: 6 for cash versus CDS we derive from the market, and that this 7 adjustment was discussed with PWC, with Price Waterhouse 8 Coopers, and CEO Sullivan. 9 We make an adjustment So all of these documents, which our staff 10 discovered, suggest very strongly that the representation 11 that was made on December 5th was shaved, effectively, as to 12 the unrealized loss on these CDS. 13 ought to have disclosed to the public a more accurate 14 number. 15 And, that ultimately you And I guess I would suggest to you that this 16 appears that AIG was as forthcoming to the investment public 17 about its losses at that time as British Petroleum has about 18 the amount of oil that's been spilling into the Gulf. 19 I mean, it's astonishing to me, and I suppose I 20 really ought to ask Mr. Cassano: 21 recollection? 22 Coopers and to your senior management in December? 23 Does this reflect your Did you disclose this to Price Waterhouse CHAIRMAN ANGELIDES: 24 going to move on. 25 go to Mr. Holtz-Eakin. All right, and then we're Mr. Cassano, quickly, because we want to 242 1 WITNESS CASSANO: My recollection of the meeting, 2 I don't remember the comment of Mr. Sullivan saying I'm 3 having a heart attack. 4 projecting what I thought the potential loss could be as of 5 December 31st. 6 I do remember that I was asked about So I was asked to look forward. And we were in 7 that meeting initially discussing the Goldman collateral 8 call with senior management and PWC. 9 project the numbers that we had in front of us with a When I was asked to 10 Goldman call, and I did a very back-of-the-envelope 11 calculation and said, look, let's look at this. 12 calculate this out. 13 amount of the book, four times what the number is, and it 14 could be as high as $5 billion. 15 Multiply it by the notational--the I do remember that Mr. Sullivan said that may 16 wipe out the quarter. 17 said, yes, I understand. 18 19 I said, it is what it is. CHAIRMAN ANGELIDES: But then you Let's move on. We're out of time. COMMISSIONER GEORGIOU: 23 CHAIRMAN ANGELIDES: 25 Right. reported it as $1.5. 22 24 And he And we went on. COMMISSIONER GEORGIOU: 20 21 Just made, and effectively. Mr. Holtz-Eakin. The point's been made. Yes, the point has been 243 1 COMMISSIONER HOLTZ-EAKIN: 2 Mr. Chairman. 3 do this with us today. 4 Thank you, Thank you, gentlemen, for taking the time to One of the disadvantages of going last is that, 5 when you don't understand things you prove that you're 6 really very slow, because it's been asked and I still don't 7 quite understand the story that I've heard today, which is 8 that that Taxpayers are out hundreds--over $100 billion, but 9 if I get the collective testimony right, you, Mr. Cassano, 10 ran a Financial Products Division that had such impeccable 11 underwriting standards that the CDSs would never have shown 12 cash flow outflows, and indeed the economic value of the 13 underlying securities is 100 cents on the dollar to this 14 day, which means that for the remainder of the company the 15 crash of AIG was being an unfortunate bystander of the 16 freezing up of commercial paper markets so you couldn't meet 17 your short-term liquidity needs? 18 accident? 19 And this is all just a big Or, maybe it's because of large losses in the 20 securities' lending area, which seemed to go on, Mr. Lewis, 21 despite the fact that the Financial Products Division had 22 clearly signaled that it was unwise to continue to be in 23 that market. 24 25 And I still have not heard a clear answer of how the judgment was made to continue to stay in that? So for 244 1 the record, one more time, why is it that, after Financial 2 Products and the company as a whole had reached a decision 3 that it was after 2005 not going to be in subprimes to the 4 degree that you allowed Securities Lending to go forward? 5 WITNESS LEWIS: I believe your question refers to 6 the investments by AIG Investments in residential mortgage- 7 backed securities? 8 COMMISSIONER HOLTZ-EAKIN: 9 WITNESS LEWIS: Yes. The concerns that we had and 10 discussed in the corporation about the deterioration of 11 underwriting standards and lending practices in the banking 12 industry were discussed with the Investment area. 13 And as I said I think in my testimony, or 14 earlier, the Investment Department, who was tasked with 15 investing AIG's cash, and also specifically the securities' 16 lending business, they discussed those concerns with us. 17 And there was a compromise reached. 18 The Credit Committee of AIG agreed to allow up to 19 a certain amount of investments in residential mortgage- 20 backed, or asset-backed securities, which included 21 residential mortgage-backed securities. 22 And the tradeoff that the Investment Department 23 determined was to purchase only the highest quality 24 investments available in the marketplace. 25 their investment research people were concentrating on And furthermore, 245 1 trying to select those securities by loan originators, by 2 sponsors, by managers that they thought had a lower 3 percentage of concern in the area of underwriting practices 4 in the originating banks. 5 6 But it was a tradeoff, a balancing of risk and return opportunity, and there was a tradeoff made. 7 8 In the FP situation, it was a different business. The super senior credit default swap business was one of-- 9 COMMISSIONER HOLTZ-EAKIN: But to be clear, it's 10 a different business but it is still conditional on the 11 underwriting, the origination standards in the mortgage 12 business. 13 weakness and said let's get out, and you decided to go 14 ahead. 15 And in the end, that was what FP identified as a WITNESS LEWIS: The underlying assets were 16 clearly very similar, and therefore correlated. 17 the risk profile that was taken in both of these areas was 18 quite different. 19 COMMISSIONER HOLTZ-EAKIN: The other part of 20 this, to just listen, is quite puzzling. 21 you, Mr. Sullivan. 22 However, And this is for Why the siloed and disconnected risk management? 23 The liquidity management over with the CFO. Mr. Lewis not, 24 or his predecessors as chief risk officers not engaged in 25 that. When in the end it was the combination of liquidity 246 1 risks and these losses in lending, leaving aside Financial 2 Products which is still evidently 100 cents on the dollar, 3 that did your company in. 4 5 6 In retrospect, did you have adequate risk management and coordination across the units? WITNESS SULLIVAN: Well I think as Mr. Lewis 7 responded to your earlier question, the dialogue took place 8 with the Credit Risk Committee. 9 attention that the Investment Company was doing something 10 11 Nobody brought to my that it should not have been doing. And I think as he articulated, there was dialogue 12 between the Credit Risk Committee, ERM, and the AIG 13 Investments. 14 COMMISSIONER HOLTZ-EAKIN: Well I'll just take 15 the liberty of making an observation, because Commissioner 16 Thomas is not here, but that in the end you are the head. 17 And the fact that they're having a dialogue doesn't excuse 18 you from the responsibility to make sure the enterprise is 19 not at risk as a whole. 20 And that's just an observation. One of the things I find amazing about this is 21 that there are evidently no limits placed on the amount of 22 CDSs that can be--the total amount of insurance that can be 23 outstanding. 24 25 Mr. Lewis, how did you get comfortable with the idea that FP could have an unlimited amount of CDS exposure? 247 1 WITNESS LEWIS: AIG Financial Products did not 2 have an unlimited amount of capacity to write this business. 3 The-- 4 5 COMMISSIONER HOLTZ-EAKIN: limit? 6 7 Did it have a dollar WITNESS LEWIS: It did have a dollar limit, but not in the--not in the dimension of total notional size. 8 As Mr. Cassano mentioned earlier, the 9 underwriting criteria and analysis that was done by FP was 10 to determine, based upon the underlying risk of the assets 11 in a CDO pool, what the--what a loss could rise to under a 12 very stressed situation. 13 And so we agreed on a set of criteria that said 14 that if Financial Products wished to incur risk in the 15 structure that exceeded a certain confidence level, given 16 the stresses that we put on those portfolios, that we would 17 limit the total amount of exposure that FP could incur for 18 that amount that exceeded that worst-case scenario that we 19 utilized. 20 dimension of total notional amount. 21 So there was a limit. It just was not in the COMMISSIONER HOLTZ-EAKIN: Thank you. The other 22 thing I've found puzzling is, Mr. Cassano, you evidently 23 were a one-man army against an invasion of Huns wanting 24 collateral posted. 25 off what afterwards turned into a real rush on the cash. And your performance evidently staved 248 1 That would appear to make Mr. Cassano a very, 2 very substantial and important part of this process. 3 institutions at risk, when he is unable to perform his 4 duties--it makes me wonder, Mr. Sullivan, why did you not 5 retain him? 6 So the Why was he replaced? WITNESS SULLIVAN: Well as I testified earlier, 7 following the issuance of the 8K we determined that changes 8 needed to be made in AIGFP, changes with regard to 9 compensation, changes with regard to matrix reporting. And 10 in that very short meeting that Mr. Cassano and I had, we 11 determined that at that time he should retire and a new 12 leader should be recruited to push through those changes in 13 the organization. 14 15 COMMISSIONER HOLTZ-EAKIN: So it was his capacity to manage organizational change, not the FP product line? 16 WITNESS SULLIVAN: Could you repeat that, sir? 17 COMMISSIONER HOLTZ-EAKIN: So the decision was 18 made on his capacity to management the organizational 19 change, not actually his capacity to manage the FP product 20 line? 21 WITNESS SULLIVAN: The decision was made that it 22 was an appropriate time for Mr. Cassano to retire on the 23 basis that we needed to push through changes, various 24 changes, through AIGFP. 25 COMMISSIONER HOLTZ-EAKIN: Mr. Cassano-- 249 1 2 VICE CHAIRMAN THOMAS: Would the gentleman like an additional two minutes? 3 COMMISSIONER HOLTZ-EAKIN: Please. 4 I just want to make sure I understand. 5 Mr. Hennessey I think went through this pretty clearly, and 6 I think I understand your position, which is that, given the 7 credit analysis, the CDSs never in fact would have had any 8 cash outflow; there was no real reason to expect that, and 9 to this day you maintain that's true; and that, moreover, 10 anyone who was doing fundamental analysis, or in liquid 11 markets these things would be trading at 100 percent on the 12 dollar to this day. 13 sound? 14 15 16 The underlying securities were that WITNESS CASSANO: It's probably my background, but the conflation of the hundred cents on the dollar-COMMISSIONER HOLTZ-EAKIN: There's a CDS out 17 here, and there's an underlying security. 18 would have cost you a dime-- 19 WITNESS CASSANO: This one never Because these would have 20 continued to meet the cash flow up to the level where we 21 were attaching-- 22 COMMISSIONER HOLTZ-EAKIN: Agreed. And, 23 moreover, because these were correctly assessed by you, they 24 would not diminish in value unless they trigger the demands 25 for collateral that you actually achieved. That, you don't 250 1 believe, is a true market-based phenomenon, that was your 2 counterparties trying to pick your pocket. 3 WITNESS CASSANO: The estimated diminution in 4 value was created--the, the very, very large estimated 5 diminution of value was created by other people. 6 no trading going on, so there was no price discovery in 7 these instruments. 8 9 There was That meant that it was hard to determine what the--there was a market disruption. You couldn't determine 10 it. So I think you needed to rely on the actuarial analysis 11 to tell you whether or not these would be money-good assets. 12 COMMISSIONER HOLTZ-EAKIN: And your actuarial 13 analysis said these were money-good, 100 cents on the 14 dollar? 15 are other marks out there that put these things at 50 cents 16 on the dollar, or even less, if I'm right. Obviously there's disagreement about that. 17 There How did you manage that risk as an organization 18 and as a unit that you might in fact face different 19 estimates and have to post collateral? You said you had $50 20 billion in collateral inside FP alone. Why was that 21 insufficient? 22 such a poor job of managing this valuation risk and thus the 23 collateral calls? 24 25 And how did you end up, ex poste, having done WITNESS CASSANO: was there. I can only talk about when I 251 1 2 COMMISSIONER HOLTZ-EAKIN: were there. 3 4 WITNESS CASSANO: VICE CHAIRMAN THOMAS: Yield the gentleman an additional minute. 7 8 And I can talk about what I think needed to be done in-- 5 6 Talk about when you WITNESS CASSANO: --what needed to be done in the analysis when people were asking for collateral calls. 9 COMMISSIONER HOLTZ-EAKIN: 10 minute, I'll cut it. 11 full contractual rights -- Since I only have a I've heard what you say. 12 WITNESS CASSANO: 13 COMMISSIONER HOLTZ-EAKIN: You used the Yes, sir. --I understand that. 14 And that's good bargaining, agreed. 15 this game must have realized they might not always get 16 everything they wanted, even the full execution of their 17 contract rights. 18 But AIG somewhere in Where were you provisioning for losses? WITNESS CASSANO: 19 into the FP business. 20 the valuation losses. We had credit reserves built They wouldn't have been enough for 21 COMMISSIONER HOLTZ-EAKIN: 22 WITNESS CASSANO: Why not? The reserves that we had, the 23 valuation losses, right, the fair value, what I think of as 24 the-- 25 COMMISSIONER HOLTZ-EAKIN: This is the market 252 1 risk that evidently was so uninteresting that no one 2 bothered to account for it anywhere. 3 WITNESS CASSANO: 4 COMMISSIONER HOLTZ-EAKIN: 5 I-We did have a market event, so it was historically very important. 6 WITNESS CASSANO: But there was a market 7 disruption that occurred that would have said that you 8 should assert your contractual rights that would have 9 reduced or increased the value of the portfolio in a 10 negotiated settlement. 11 have been done. 12 And that is what I am saying should I think greater adherence to the underlying 13 rights in the contract would have served the Taxpayer better 14 than what happened. 15 16 21 22 23 COMMISSIONER HOLTZ-EAKIN: How would the Taxpayer be better served? 19 20 One more second, one point five-- 17 18 COMMISSIONER HOLTZ-EAKIN: VICE CHAIRMAN THOMAS: Yield the gentleman three seconds. COMMISSIONER HOLTZ-EAKIN: How would the Taxpayer have been better served? WITNESS CASSANO: Because I think if you brought 24 people to the table--it's my opinion that there was a market 25 disruption, that you would not get any market quotes for 253 1 these underlying instruments. 2 Basically that process would have failed. 3 counterpart would’ve had to come back to the table to 4 negotiate with you, because then you had to come to a 5 negotiating settlement. 6 position because they would no longer be arguing that 7 there's a fair-value estimate out there. 8 9 The But now you were in a stronger COMMISSIONER HOLTZ-EAKIN: I just want to make sure I understand the argument, whether it's right or wrong. 10 So rather than doing a hundred cents on the dollar to the 11 counterparts, a better deal would be struck, fifty cents on 12 the dollar, so less money goes into AIG in order to satisfy 13 the counterparts, and in that logic the counterparts are 14 also then just fine? 15 Whereas, the logic for intervention at the time 16 was AIG must be bailed out so that markets as a whole don't 17 fail. 18 dollar, aren't they just going to come around AIG and need 19 another fifty cents from the Taxpayer anyway? 20 really think you were not that important to markets and 21 could have been allowed? So if we would give them only fifty cents on the 22 23 24 25 WITNESS CASSANO: Or do you I didn't quite follow your analysis. COMMISSIONER HOLTZ-EAKIN: You're saying that we could have plowed half the money into AIG that we did, 254 1 because we didn't have to send all this money out to the 2 counterparts. 3 WITNESS CASSANO: 4 COMMISSIONER HOLTZ-EAKIN: 5 Right. And everyone would have been fine after that? 6 WITNESS CASSANO: I don't believe the 7 counterparts--in the negotiation, the counterparts would 8 have terminated the contracts. 9 said, yes, we still want this protection. They would have looked and Because, 10 remember, they were getting the protection now from the 11 United States. 12 United States Government. 13 the Government, and the negotiation that said there is no 14 ability to determine future value here, the counterparts 15 would have said, fine--I believe they would have said, fine, 16 we can live with the provisions as we have them right now. Basically the owner of the company was the Therefore, with the support of 17 Does that make sense? 18 COMMISSIONER HOLTZ-EAKIN: Oh, I understand that 19 part. 20 financially whole and been able to continue. 21 question we will not know the answer to. 22 23 The question was whether they would have also been CHAIRMAN ANGELIDES: That's the Well we may never know the answer, but we do have two more panels to probe the answer. 24 (Laughter.) 25 CHAIRMAN ANGELIDES: Ms. Born, you had a very 255 1 quick question, and then we will wrap up. 2 a break and get on to our next panel, and we will shorten 3 our break substantially. 4 COMMISSIONER BORN: We've got to take I just wanted to continue on, 5 Mr. Lewis, a little bit with you about the losses that 6 relate to the securities lending operation of AIG 7 Investments. 8 9 There have been some suggestions that the real problem for AIG was that securities lending program and not 10 the credit default swap portfolio of AIG Financial Products. 11 I wondered if you would comment on that. 12 WITNESS LEWIS: In the securities lending 13 portfolio, there were some losses that were realized in the 14 nature of the Investment Department selling securities in 15 order to meet the liquidity needs to return the cash 16 collateral to the securities borrowers. 17 Those losses were covered, because those losses 18 were actually the responsibility of the Insurance Company, 19 the AIG Insurance Company subsidiaries that were lending the 20 securities. 21 Those losses were covered by AIG, Inc. The issue that I think you raise is the fact that 22 in this market where there was a huge change in fair value, 23 or market value of the residential mortgage-backed 24 securities, investments could not rely on liquidating those 25 securities to honor the obligation to return the cash 256 1 2 collateral. So AIG had to come up with liquidity elsewhere in 3 order to meet those obligations. 4 was in part funded by the Federal Reserve Bank. 5 COMMISSIONER BORN: And that liquidity need If we are looking to what the 6 primary cause of AIG's failure and the need for the 7 government bailout is, which cause was it? 8 equally both, the credit default swap portfolio, or the 9 securities lending diminution of the RMBS? 10 WITNESS LEWIS: Or was it just From my point of view, I think 11 that looking back on it now, from my point of view the 12 disparity, or the gapping out, if you will, of what we risk 13 professionals and insurance professionals thought was the 14 underlying value of the credit quality, or the intrinsic 15 value of the portfolios, whether it was in securities 16 lending or in FP, that value diverged just tremendously in 17 this marketplace where liquidity dried up. 18 And if you will the failure in my view is that, 19 clearly knowing what we know now, we did not stress the 20 disparity between our underlying views of credit quality, 21 which was shared by others, including rating agencies, et 22 cetera, that we did not stress enough how much the market 23 value and liquidity could diverge from people's view of 24 intrinsic value. 25 And as we went through this decline, there were 257 1 many changes by all of the experts and economists around the 2 globe as to how bad this could get, and how much 3 deterioration in housing there could be. 4 we went along. 5 The issue was the divergence of intrinsic value or credit 6 quality and liquidity available in the market for those 7 instruments. But the intrinsic value was not the issue. 8 CHAIRMAN ANGELIDES: 9 COMMISSIONER BORN: 10 And we adjusted as CHAIRMAN ANGELIDES: All right? Thank you. Thank you, and we will now 11 adjourn this session. I will just say this, in concluding. 12 I want to thank the panels for being here, or the witnesses 13 for being here, but I do want to say something. 14 There are many questions yet to be answered, but, 15 Mr. Sullivan, I must say this to someone who was a CEO, that 16 I have found the kind of lack of knowledge and lack of 17 recollection disturbing. 18 it, not to be conclusionary, but we will probably debate on 19 this panel many, many issues, but I do not think that the 20 failure of leadership and effective management at AIG will 21 be a matter of much debate in this Commission. 22 23 It just seems to me I need to say Thank you very much, gentlemen, for being here today. Thank you. We will recess until 3:25. 24 (Whereupon, a recess was taken.) 25 CHAIRMAN ANGELIDES: The meeting of the Financial 258 1 Crisis Inquiry Commission will come back into order. 2 now in our third session of the day, Goldman Sachs and 3 Derivatives. 4 We are I want to thank Mr. Cohn and Mr. Broderick for 5 joining us today. 6 we usually do. 7 please rise and be sworn, which is customary for all 8 witnesses. 9 Thank you. We will start our session, as I am going to ask both of you gentlemen to If you would please raise your right hand, do you 10 solemnly swear or affirm under penalty of perjury that the 11 testimony you are about to provide the Commission will be 12 the truth, the whole truth, and nothing but the truth, to 13 the best of your knowledge. 14 MR. COHN: I do. 15 MR. BRODERICK: I do. 16 (Witnesses duly sworn.) 17 18 19 CHAIRMAN ANGELIDES: Thank you very much, gentlemen. Now we are in receipt of your written testimony, 20 and we thank you for that. 21 like each of you to make a five-minute opening statement, no 22 more than five minutes, and then we will move to questions 23 and answers by the Commission. 24 25 As we have indicated, we would As you know, we are examining today the role of derivatives in the financial crisis, and that will be the 259 1 context for the questioning today. 2 In front of you there are monitors. And when 3 that monitor goes to yellow, it means there is one minute to 4 go. 5 I would obviously appreciate it if you can keep it within 6 the designated time. When it goes to red, it means your time is up. 7 So what we will do is, we will start with Mr. 8 Broderick. 9 we will go to Mr. Cohn. 10 Why don't you commence your testimony, and then Microphone on, please. WITNESS BRODERICK: I'll get it yet. Chairman 11 Angelides, Vice Chairman Thomas, and Members of the 12 Commission: 13 And so Good afternoon. My name is Craig Broderick. I 14 have been the Chief Risk Officer of Goldman since 2007, and 15 prior to that I was the firm's Chief Credit Officer. 16 I would like to start by addressing the role of 17 risk management within Goldman Sachs. Our firm assumes risk 18 as an integral part of its business of market making, 19 underwriting, and otherwise providing a wide range of 20 financial services to our clients. 21 The nature of our role of financial intermediary 22 means that we take this risk only--very willingly, but only 23 subject to basic principles which define our overall 24 approach to prudent risk management. 25 First, we must understand the risk that we're 260 1 taking--how we measure it; how much we're taking; in what 2 form; with whom; for how long; and by how much that risk 3 might change as market conditions change. 4 Secondly, we must determine how we can control 5 the risk. 6 and other means; how we can ensure that it does not become 7 too concentrated, and so forth. 8 9 10 That is, how we can mitigate it through hedging Third, we have to feel comfortable that we can achieve a return for our shareholders, that it's appropriately aligned with the level of risk that we're taking. 11 To ensure disciplined risk management across our 12 businesses, we've built a substantial risk organization 13 within Goldman Sachs. 14 components: 15 In concept, it is built around four The first is effective governance, of which 16 independence is the cornerstone. 17 the firm comprising roughly 50 percent of Goldman Sachs does 18 not report to, and has complete independence from, the 19 revenue-generating divisions. 20 The entire control side of This independence is critical. For example, our 21 controller's group, not our business units, has the final 22 say on the marks of all of our positions. 23 governance also comes from extensive participation by all 24 levels of the firm, including our most senior management, 25 and through the use of formal committees, informal postings, Effective 261 1 and the rapid escalation of risk-related matters. 2 The second component is information. We firmly 3 believe you cannot manage what you cannot measure. 4 central tenant is our daily discipline of marking all the 5 firm's positions to current market levels, not where we wish 6 the prices were, or should be, or where we think they will 7 be tomorrow; but, rather, where we can trade them today. 8 9 We do so because we believe it is one of the most effective tools for assessing and managing risk, providing 10 the most transparent and realistic insight into our 11 exposures. 12 A We have invested heavily in our risk technology 13 over the years and today have systems that, while certainly 14 not perfect, are able to comprehensively capture our 15 positions and track and analyze these positions in a 16 multiple of ways that provide valuable insights into our 17 overall portfolio. 18 The third component is people. Even with the 19 best technology, ultimately effective risk management 20 involves individuals making continual portfolio judgments. 21 The daily monitoring of our credit market risk limit is 22 informed by constant dialogue between our traders and our 23 risk managers. Especially during abnormal market conditions, 24 it's the experience of our business and risk management 25 professionals and their appreciation for the nuances and 262 1 limitations of each risk measure that help guide the firm in 2 assessing its risk exposures, and maintaining these 3 exposures within prudent levels. 4 The fourth and final component is the active 5 management of our positions. 6 that proactive hedging of our market and credit risk is 7 beneficial both to our clients and also our firm, most 8 notably by minimizing the potential need for us to take 9 outsize actions during periods of stress. 10 As part of this, we believe More broadly, effective risk management, 11 including hedging, serves to reduce systemwide risk, 12 minimizing the likelihood that a counterparty failure of any 13 size could adversely affect the system. 14 In hedging our market and credit risks we make 15 active use of a variety of derivatives which I know is of 16 particular interest to the committee. 17 they're the only means of hedging, but because they're often 18 the most efficient. 19 We do so not because Credit derivatives, for example, are often useful 20 in helping us to facilitate the extension of credit to 21 clients and may make the difference as to whether a 22 transaction can be executed or not. 23 Given the focus on the role of derivatives in the 24 financial crisis, I want to note my view that this crisis 25 occurred primarily as a result of inadequate risk management 263 1 2 and, at its heart, a deterioration in lending standards. The effects of poor lending decisions were 3 multiplied through the use of securitization and other off- 4 balance sheet structures which reduced not only the 5 transparency into these risks, but also the capital 6 available to cover any losses. 7 Certainly derivatives facilitated further 8 leverage in the system, but from the data I've seen they 9 were relatively small competitors given that losses in this 10 11 area were a fraction of cash-lending related figures. Even so, derivatives exposures need to be managed 12 carefully, and that is why we approached the use of these 13 instruments in the same way that we manage other types of 14 risks, by applying disciplined fair-value accounting, 15 employing multiple types of risk metrics, and managing 16 individual counterparty exposure so that, in the aggregate, 17 the firm's overall level of risk is kept at prudent levels. 18 Notably, we approached our interactions with AIG 19 exercising these very same principles and conservative risk 20 management practices. 21 22 CHAIRMAN ANGELIDES: How are you doing in terms of time to wrap up, Mr. Broderick? 23 WITNESS BRODERICK: 24 CHAIRMAN ANGELIDES: 25 WITNESS BRODERICK: One-half a page. Great. Okay. To be sure, we have all 264 1 learned valuable lessons from the market events in recent 2 times, and it is clear that no approach to risk management 3 was without its limitations. 4 However, we believe the four basic principles 5 that I noted were largely effective in the face of 6 unprecedented market turmoil. 7 8 Thank you. questions. 9 10 CHAIRMAN ANGELIDES: Broderick. 11 12 I look forward to answering your Thank you very much, Mr. And now we will move to Mr. Cohn. WITNESS COHN: Chairman Angelides, Vice Chairman Thomas, and Members of the Commission: 13 Thank you for the opportunity to contribute to 14 the Commission's work to understand the causes of the 15 financial crisis. 16 I would like to begin my testimony with an 17 apology. 18 responsive to the FCIC's request for information. 19 apologize for any failure on our part. 20 our efforts to provide the documents and information you 21 want, road maps to those documents, and extensive engagement 22 with your staff. 23 You have stated that we have not been sufficiently We We have redoubled We recognize the significance of your mission, to 24 examine the underlying causes of the financial crisis, and 25 we will work hard to help you fulfill it. 265 1 In examining the crisis, one area that has 2 attracted considerable attention has been derivatives. 3 Although derivatives can be complex, in essence they are no 4 different from any other financial instrument or product. 5 Derivatives are used to lock in prices and to 6 hedge, or protect against events like inflation or credit 7 risk associated with a company. 8 implies these types of instruments derive their value from 9 prices of underlying assets like stocks, bonds, commodities, 10 11 The name "derivative" and interest rates. For financial intermediaries like Goldman Sachs, 12 activity and derivatives is interrelated with our activities 13 in the underlying instruments. 14 value of our position, marking our books, or managing our 15 risk, we look at our operations in aggregate, which means we 16 include cash and derivatives. 17 Whether calculating the This is important because it goes to the heart of 18 how we view risk. 19 institutions can be very dangerous. 20 brought about through the most basic of products, like bank 21 loans or mortgages, as was the case with many institutions 22 that failed in 2008. 23 Concentration of risk within financial But they can also be For Goldman Sachs, the cornerstone of risk 24 management is fair value or mark-to-market accounting. This 25 commitment to fair value accounting in all types of markets 266 1 is important with respect to two main issues--the first 2 being AIG. 3 We bought credit protection from AIG against the 4 value of financial instruments on which we, acting as an 5 intermediary, had provided protection to other clients. 6 As the housing market deteriorated, Goldman Sachs 7 began to mark down the value of some of these positions. 8 believe our marks reflected the realistic value that the 9 market was placing on these securities and the price at 10 We which we and others were willing to trade. 11 The markdowns resulted in collateral calls to AIG 12 consistent with our mutual agreement. 13 some of these collateral calls, we spent a considerable sum 14 to insure against the risk that AIG would not pay us. 15 Because AIG disputed The second area where marking to market proved 16 vital was in the residential mortgage related market. 17 Although this business accounted for less than one percent 18 of our net revenue in 2007, a lot of attention has focused 19 on our decision to reduce risk beginning in 2006. 20 There is a view that we anticipated the crisis to 21 come. We did not. In fact, there were many different views 22 within our firm, let alone in the wider market as to the 23 future direction of housing prices. 24 series of losses in our mortgage business through the daily 25 marking to market of our position, it seemed prudent to But having observed a 267 1 reduce our net exposure to the subprime residential housing 2 market. 3 attempt to reduce our risk. When a pattern of losses occurs in the business, we 4 Given the focus and seriousness of the charge 5 that bets were made against clients, certain clients, we 6 have reviewed every RMBS and CDO that we underwrote from 7 December 2006 till today. 8 9 During the period, we underwrote approximately $14.5 billion of CDOs. At the end of June 2007, we held 10 approximately $2.4 billion of bonds issued by these CDOs. 11 Against this, we bought protection representing about one 12 percent of the total amount underwritten. 13 In the same period, the firm underwrote nearly 14 $47 billion of RMBS. 15 $2.4 billion of bonds issued by the RMBS Securitization 16 Trust. 17 18 19 At the end of June 2007, we held about Again, the total amount of credit protection we bought was one percent of the amount underwritten. During the two years of the financial crisis, 20 Goldman Sachs lost $1.2 billion in its residential mortgage 21 related business. 22 these numbers underscore that fact. 23 We did not bet against our clients, and It is always useful with hindsight to examine 24 actions taken. Of course we regret that we didn't do many 25 things better, like having less exposure to leveraged loans 268 1 which caused us approximately $5 billion in losses; having 2 less exposure to mortgages; and of course we wish we had 3 seen more proactively the effects of the housing bubble. 4 We believe that the most important conclusion 5 from a review of the crisis are that the system, and 6 individual institutions, needed more capital, more 7 liquidity, and more transparency, and better risk 8 management. 9 Mr. Chairman, thank you once again for the 10 opportunity to appear before you today. 11 answering the Commission's questions. 12 13 CHAIRMAN ANGELIDES: I look forward to Thank you very much, Mr. Cohn. 14 We will now begin our question period. As is 15 customary, I will begin the questioning, followed by the 16 Vice Chairman, and then the Commissioners who led this part 17 of our inquiry. 18 But before I start, I do want to pick up on some 19 information requests and just put these on the public 20 record. 21 First of all I will acknowledge, as our staff 22 would, that since the issuance of the subpoenas we have been 23 provided--before, but particularly after the issuance of the 24 subpoenas--significant information. 25 There are a couple of additional items I would 269 1 like, though, to note for the record here and ask if we can 2 please get this information as soon as possible. 3 We asked for some information, as complete as 4 possible, on the basis for the marks you made, particularly 5 with respect to mortgage-backed securities or synthetic 6 CDOs, all the mortgage-related securities for which there 7 was not essentially an active trading market. 8 9 10 So we would like to get the basis for the marks you made during 2007-2008, particularly with respect to those marks provided to AIG. 11 And also, I know that you've provided us some 12 information about the marks that were given with respect to 13 the Bear Stearns Asset Management Funds, and you have 14 provided that. 15 point, but we would like to follow up with you on that 16 matter. 17 We do not believe it is complete at this So can we have your commitment that we can get 18 that information so that we can understand the basis of your 19 marks, how you marked to market, very specifically? 20 WITNESS COHN: Absolutely. 21 CHAIRMAN ANGELIDES: 22 Secondly, we have requested information because Okay. Thank you. 23 you've stated many times that you were fully hedged against 24 events at AIG. 25 swap protection with respect to AIG. Clearly, Goldman did purchase credit default And you have provided 270 1 us in a sense in aggregate the counterparties from whom you 2 purchased that protection. 3 the specific amounts from those counterparties. 4 for example there may be a purchase of $100 million of CDS 5 that lists the counterparties, but it doesn't break it into 6 the specific amounts. 7 since the company stated it was fully hedged, in the level 8 of CDS protection that existed pre-essentially Federal 9 Reserve loan to AIG, so that we can understand the nature of But you have not yet provided us You know, And we are particularly interested, 10 your hedging, whether it was full hedging or phantom 11 hedging, or who the counterparties were and what their 12 position was. 13 14 So can we have your commitment to get that information? 15 WITNESS COHN: 16 CHAIRMAN ANGELIDES: 17 WITNESS COHN: 18 19 Absolutely. Thank you. And it would have all been pre. So that's fine. CHAIRMAN ANGELIDES: Good. Next, and this may 20 take a few minutes to go through. 21 information so we understand the extent--and Ms. Born may 22 follow up on this also but this is on my time right now to 23 alleviate some of your burden--is that for revenues and 24 profits from derivatives trading as a business. 25 We have asked for Now I know Mr. Viniar in his statement has said, 271 1 well, we don't really have a derivatives business, so to 2 speak. 3 providing revenues and profits from derivatives' trading and 4 dealing business isn't possible. 5 information. 6 And to date I think Goldman Sachs has told us that But we would like that And let me just say, it seems to me that from a 7 management perspective you've got to be able to cut your 8 revenues and your operations in many different ways-- 9 horizontally, vertically, diagonally. 10 11 So maybe there's been a miscommunication. Is it possible to get from you the management 12 reports that would indicate the size and nature of the 13 revenues and profits from derivatives' dealing? 14 WITNESS COHN: We would not have management 15 reports that would break it down that way. 16 opening statement, we look at our risk aggregate. 17 whether you're looking at a cash security or a derivative of 18 that cash security, it's the same underlying risk. 19 therefore we manage it in one bucket. 20 So when-- 21 CHAIRMAN ANGELIDES: As I said in my And And So you have no breakdowns 22 for any of your managers in which you can segregate out your 23 derivatives activities and the cash flows that come from 24 that activity from your other activities? 25 words, you might have an underlying security, and you might So in other 272 1 have derivatives, and you don't separate that in any way, 2 shape, or form in any of your operational reports for 3 managers? 4 WITNESS COHN: We don't. 5 delta, is what I would call it. 6 situation. 7 We look at our net So I'll use a simple If you're long 100 shares of stock, you're long 8 100 shares. If you're long one at-the-money option, it's 9 got a 50 delta. So it's 50 shares. 10 positions, you'd be long 150 shares. 11 a 150-share risk. 12 So if you had those two And we look at that as And now we run some other risk parameters, saying 13 if the market moved 5 percent up, or 5 percent down, what 14 would the risk parameter look like, but it's virtually 15 impossible for us to separate those two because the same 16 exact underlier will determine the profit and loss and 17 actually you'll use that to show the risk. 18 CHAIRMAN ANGELIDES: 19 from profit and loss? 20 dealing? 21 22 23 What about revenues apart Fee income generated by derivatives WITNESS COHN: We could break out underwriting fees, because they are actually distinct fees. CHAIRMAN ANGELIDES: All right, because I'm doing 24 this for the benefit of the Commission, I don't want to eat 25 up all my time. Not I--I believe we want to pursue this 273 1 matter, and so I think probably the best way is we need to 2 have a more fulsome discussion to see how you do break it 3 down. 4 got to have a lot of ability in your management reports to 5 see how you're doing in different divisions, who's 6 performing, who's not; what spreads are. 7 to pursue this discussion. 8 9 It just seems to me you're pretty smart guys. WITNESS COHN: You've So we would like We are happy to work with your staff and give them as much transparency as we have. But 10 I'll be honest with you, we can dig and dig, we won't find 11 that report. 12 CHAIRMAN ANGELIDES: All right. So the last 13 thing I said, there are other items, and our inquiry is 14 ongoing, and I will leave it at that. 15 So let me jump right into what I would like to 16 address today. I don't know if you had a chance to hear the 17 previous session with the AIG folks? 18 WITNESS COHN: We heard some of it. 19 CHAIRMAN ANGELIDES: Okay. Well I do want to-- 20 you know, I do want to pursue what people did in the 21 marketplace and why they did it. 22 this matter of the relationship between AIG and Goldman 23 Sachs, and the valuation of the CDS book, and the collateral 24 calls, and the posting of collateral with respect to that 25 book. And to particularly pursue 274 1 And at a certain level I am looking not for a 2 "who done it," but trying to understand who built this bomb, 3 who might have built bomb shelters, and who and when the 4 fuse was lit for all this. 5 So we have established already--and I don't think 6 we need to go over it--but just for the record, that you 7 were clearly very active in the creation of mortgage-backed 8 securities, synthetic CDOs, by our account I think from July 9 '04 to May '07 you did about 48 synthetic CDOs; about 3500 10 tranches that were referenced. 11 going to talk about this in more detail. 12 I think Mr. Georgiou is In 2007, by your own account you were very active 13 in CDO issuance and RMBS issuance. 14 market with which you were very familiar. 15 understanding is that, Mr. Cohn, in your interview, and Mr. 16 Broderick, in your interview, you did stipulate that the 17 creation of synthetic products did allow for more leverage, 18 possibly inflating the bubble some. 19 So clearly this was a And my What I wanted to really focus on, though, is I 20 wanted to focus on the other side of this equation, the 21 protection you were buying from AIG, and to understand how 22 this worked. 23 Particularly, given that it was an over-the- 24 counter market, it was opaque, there appeared to be 25 disruption in the market, very hard to get price discovery; 275 1 you may have known that in our earlier session I entered 2 into the record a chronology of essentially your decisions 3 in December 2006 to, quote/unquote "get closer to home," to 4 reduce your exposure to subprime, to begin to reposition 5 yourself, a chronology that starts there and then really 6 marches through the collateral calls you made to AIG, the 7 responses to those, the postings that were made. 8 chronology includes the protection you bought against AIG. 9 Also that If you look at the chronology--and I think you 10 are aware of this--Goldman was first going in the door 11 asking for collateral. 12 aggressive in terms of the time frame and the amount asked 13 for. 14 Goldman was by far the most As of 12/31/07 you were about 27 percent of the 15 CDS book, and you had had posted on your behalf 89.4 percent 16 of the total collateral posted. 17 48 percent of the total collateral calls were yours versus 18 27 percent of the total book. 19 20 21 By June 30th of '08 you had I mean, you were way ahead of everyone else in terms of amount being demanded and the time frame for that. Your marks were consistently lower than other 22 participants in the marketplace. 23 I am trying to understand. 24 of discussion here about how this worked. 25 And so as I said earlier, I think it became quite a matter Does the setting of marks move the market? Did 276 1 you have reasons, because at least according to some 2 accounts you were net short in 2007 to move the market down. 3 And as I said earlier, you know, I wondered whether this was 4 just pure straight-up business negotiation, or whether there 5 was in fact like a Discovery Channel the Cheetah hunting 6 down the member of the herd. 7 knowing or unknowing, motivation aside, that the Goldman 8 calls against AIG were the first dominos in a chain that 9 began to drag down at least market valuations versus 10 11 Or whether, in some respects, economic losses of these portfolios. So let me start with this: You go in the door-- 12 first of all, I know you made very aggressive marks. You 13 made your decision in December of '06 to reposition yourself 14 to get closer to home, to reduce subprime risk, to start 15 marking the inventory. 16 In March of 2007, in one of the offerings out in 17 the marketplace--and this was a standard offering--you said 18 there's no established trading market for the securities. 19 That was in a synthetic CDO, one of the Timberwolf CDOs. 20 May 11th, Mr. Broderick, this is where you send 21 your memo saying we're in the process of considering making 22 significant downward adjustments to the marks on their 23 mortgage portfolio and that, quote, "this will have 24 potentially big P&L impact on us, but also our clients due 25 to the marks and associated margin calls." 277 1 In May you send to the Bear Stearns Asset 2 Management Group, according to reports--and that's what I 3 want to verify--marks that are at 50 to 60, where other 4 marks are in the 90s. 5 When you make your collateral call to AIG, the 6 shear amount of it stuns them. 7 marks are dramatically, as they say, Goldman's prices were, 8 quote/unquote, "ridiculous," that's Mr. Forster. 9 It's $1.8 billion. The On August 1st there's an e-mail from Mr. Athan to 10 Mr. Forster at AIGFP saying that Goldman was, quote, "not 11 budging and are acting irrational." 12 collateral call was pulled down significantly, because it 13 was based on bids not the midpoints, apparently. 14 And of course that But--and I go through more of this, and I will, 15 but all through the next several months you're asking for 16 more. 17 market. 18 You're marking it significantly below the rest of the Why is this? What do you know? What do you know about the 19 market that everyone else doesn't know that puts you in a 20 position of marking these securities at significantly lower 21 levels and making these kinds of calls? 22 WITNESS COHN: Chairman Angelides, let me start. 23 First of all, on your point that we had called for more 24 collateral from AIG and had collected more collateral than 25 anyone else, I think you should go back and reference the 278 1 different trading documents. 2 I'm not sure all the counterparties had the 3 ability to call for collateral. 4 counterparty and was not easily--did not like to sign two- 5 way margin agreements. 6 to see if anyone else had the ability to collect margin. 7 AIG was a highly rated So you should check with that first CHAIRMAN ANGELIDES: And I will say, we will do 8 that. But the charts that are in the documents that we put 9 out do reflect others marking margin calls. 10 WITNESS COHN: I understand. 11 CHAIRMAN ANGELIDES: Like SocGen who accelerate 12 theirs, about a year after you are. 13 WITNESS COHN: Okay. There were different 14 provisions in different trading agreements. 15 lot of time on that. 16 CHAIRMAN ANGELIDES: 17 WITNESS COHN: Okay. Let's not spend a But we'll do that. Let's go to the second part 18 of your questions, which was why were our marks where our 19 marks were. 20 And if you look at our trading agreement with 21 AIG, it very clearly states our marks are to be determined 22 by fair value, not fundamental value. 23 fair value is where things are transacting, or one would 24 interpret a transaction to take place, based on other 25 relevant transactions going on in the market. Our determination of 279 1 So until there is a transaction, or until there 2 is some transaction that equates to a security you have, it 3 is difficult to mark the book. 4 during this period of time, you went through a period of 5 time where you had increased volatility. 6 But what was happening In increased volatility what normally happens in 7 markets is bid offers widen, because people are unsure of 8 the real underlying value. 9 eventually some trades start taking place. Bid offers widen, and then As more and more 10 trades start taking place, the market tends to converge 11 around an area of value. 12 So what we did is, as trades took place we used 13 those actual real live trades as reference points to create 14 fair value in marking our book. 15 CHAIRMAN ANGELIDES: So you're telling me in the 16 spring and summer of '07, leading up to those collateral 17 calls, you have actual trades at those values substantiating 18 not just an episodic but substantiating the market? 19 WITNESS COHN: Yes. 20 CHAIRMAN ANGELIDES: Okay, we'd like to have that 21 provided to us. Because what we're seeing from other 22 documents is we're seeing the fact that it was a disrupted 23 market, and that there weren't real trading values. 24 fact, if you heard the testimony earlier today, when Goldman 25 first makes its collateral call, as I said, it was revised And in 280 1 from 1.8 down to 1.2 on the basis that it was--yes, sir? 2 3 WITNESS COHN: It was revised from 1.8 to 1.2, and then they paid us the money-- 4 CHAIRMAN ANGELIDES: 5 WITNESS COHN: 6 CHAIRMAN ANGELIDES: They paid 450-- Exactly. Exactly, exactly. But it 7 was revised downward, and you did settle temporarily but 8 with a stand-still agreement for 450, but according to Mr. 9 Cassano, Mike Sherwood at Goldman admitted that when he and 10 Cassano spoke in September, Cassano recalled that Mr. 11 Sherwood said that Goldman, quote, "didn't cover ourselves 12 in glory." 13 Then he goes on to say that, quote, "The market 14 is starting to come our way," which implies that you had a 15 position in the market, indications at least from Mr. 16 Blankfein and others that you were net short. 17 Mr. Cassano took it that he interpreted Mr. Sherwood's 18 comments as an implicit admission that Goldman's initial 19 collateral calls were too low. 20 And I guess my question is: And at least In this kind of 21 marketplace, if someone is net short, if you were, someone's 22 net long, at some point you criticized AIG's mark saying, 23 well, it's in their interest to keep them high because 24 they're in their position. 25 fact that you were net short to begin pushing prices down? Were you at all motivated by the 281 1 WITNESS COHN: No. We had transactions on the 2 other side. 3 margin to our clients on the other side. 4 We were paying out the equal and opposite So as I said in my opening statement, in AIG we 5 sat in the middle of buyers and sellers. 6 books, one set of marks. 7 paid on those marks. 8 9 10 We had one set of We collected on those marks. We So to the extent we were moving marks up or down, it was money in the door going right back out the door to the other side. 11 CHAIRMAN ANGELIDES: Just--I know I've been 12 talking fast, but collateral calls too high marks, too low. 13 That's what I meant. 14 WITNESS COHN: Yes, I knew what you were saying. 15 CHAIRMAN ANGELIDES: Yes, I knew you knew what I 16 meant. 17 actually three additional documents I'd like to enter into 18 the record, which were provided by your counsel and cleared 19 by your counsel today, I might add, in our discussions with 20 our counsel. 21 But let me explore this a little more. There are There's a memo that ultimately floats up to Mr. 22 Lehman. It's from a Ram Sundaram (phonetic) in your shop. 23 And it's on actually the very day you're making the 24 collateral call to AIG. 25 collateral calls being generated overnight is embarrassing And he says: The extent of 282 1 for the firm, $1.9 billion from AIGFP alone. 2 focus on developing a process for ensuring accuracy for all 3 marks, especially those which are being sent to clients and 4 those that are the basis for margining open transactions. 5 We need to And it looks as though there's a lot of dispute. 6 SocGen, apparently, according to AIG, was contacted by 7 Goldman Sachs, as AIG would have it, to encourage them to 8 make a collateral call, but they end up not making it and 9 disputing your marks. 10 I have two other documents here I'd like to enter 11 into the record. 12 starts with an e-mail from Mr. Lester Brafman to David 13 Lehman dated July 27th. 14 Lehman to Daniel Sparks, and it's about some feedback. 15 an e-mail string from J. Lee to David Lehman about AIOI 16 Insurance. 17 July 31st, saying: 18 more than twice as bad as the second-worst dealers, and all 19 their positions are super senior. 20 margin call out of them will be an issue. 21 The first one, by the way for the record, The second document is from David They are objecting to your marks. It's This is on Our marks--meaning Goldman's marks--are It sounds like getting a It goes on to say: Earlier, also about the same 22 organization, he said, our margin call based on our MTM was- 23 -mark-to-market--was totally unaccepted; warned he will 24 strongly protest against this. 25 And there's another e-mail from an Alana Ash to, 283 1 it comes to you, Mr. Broderick, in which it indicates that 2 both CIBC and AIG are contesting marks. 3 I guess I really do want to get to the root. 4 this non-traded market, I'm trying to get the extent to 5 which you are making a market in marks by what you're doing. 6 By your pushing these marks down, are you pushing prices 7 down? 8 9 10 11 WITNESS COHN: through marks. In We are not pushing prices down The market itself is setting pricing levels. And most importantly, we were prepared, openly prepared, to trade at those marks. 12 CHAIRMAN ANGELIDES: 13 WITNESS COHN: 14 CHAIRMAN ANGELIDES: But did you? We have traded at those marks. Okay, this is why we wanted 15 the information, and have asked for the information. 16 I'm not saying you withheld it, but to see the actual basis, 17 on actual marks for that time period I think is crucial to 18 this discussion. 19 All right. And I am going to stop at this moment. 20 will return to this subject, but I want to leave time for 21 the other Commissioners. 22 Mr. Vice Chairman? 23 VICE CHAIRMAN THOMAS: Thank you, Mr. Chairman. 24 I will apologize to my fellow Commissioners because I did 25 not ask the last panel if they would answer questions in I 284 1 writing. I am sure they will. 2 So I won't be negligent with you fellows. 3 Obviously we're going to have additional questions. 4 very much like for you to respond in the positive to my 5 question of: 6 you get them back to us? 7 WITNESS COHN: 8 WITNESS BRODERICK: 9 VICE CHAIRMAN THOMAS: If we get questions to you in writing, would Yes. (Nods in the affirmative. 10 WITNESS BRODERICK: 11 VICE CHAIRMAN THOMAS: 12 I would She can't record a nod. Yes. Thank you. My assumption is there won't be a subpoena necessary to follow up on that. 13 WITNESS COHN: No. 14 VICE CHAIRMAN THOMAS: Your apology I guess was, 15 you know, nice. 16 engaged in business the way your reputation indicates you 17 engage in business, and you were going to do what you were 18 going to do until we could trump you in a way that you 19 couldn't keep doing what you were doing. 20 I actually just thought that we were So it was a business relationship. 21 getting answers, so we issued a subpoena. 22 responsive. 23 the ground rules. 24 25 We weren't You're now being And if that's the ground rules, we operate by This morning--I don't think you were here earlier enough to hear the first panel of economists--we were just 285 1 talking about fundamental derivatives, what were they, how 2 did they come about, how do we wind up with what we were 3 doing in the housing market. 4 And I want to kind of shift it to a much broader 5 questions, only because you guys are big in almost every 6 field you go into, and you're good at what you do, and I 7 would like to ask you some questions: 8 9 If you think there's any validity to the statement of one of our panel members, Dr. Kohlhagen. I 10 asked him at the end: 11 fundamental cause, or one of the principal causes of the 12 financial crisis? 13 What did you think was the And he focused very tellingly and directly on the 14 government's desire to get people into their own homes. 15 can look at the Community Reinvestment Act, with both 16 Republican and Democratic Administrations, in attempting to 17 get people into their own homes through Fannie Mae and 18 Freddie Mac. 19 government went to Wall Street and asked them to lend to 20 more people. And his statement was, he said that the 21 Wall Street responded: 22 people with lower credit quality? 23 having an opportunity to move vigorously in a particular 24 area. 25 You So you want us to lend to Watch us, in terms of So I assume you would answer yes to the question: 286 1 Did Goldman help facilitate the new mortgage market? 2 mean, once we started moving away significantly from 3 originating-to-hold to originating-to-distribute, you've got 4 to wind up with some structures. 5 I I'm trying to figure out where you guys were, 6 looking at opportunities. 7 our original panel and said your job was to make markets. 8 And so I assumed you looked at this opportunity, and you 9 looked at what was going on your general field, and you came 10 Your chairman came before us on up with some ideas to make markets like CDSs and CDOs. 11 What was your mindset in terms--were those 12 necessary devices? Were they the best ones available? 13 don't know anything about you guys' business or how things 14 operate. 15 based on your valuation, the best way to get into the 16 business of what we wound up getting in over our heads on? So were there other ways to do it? 17 WITNESS COHN: 18 Our business is pretty fundamental. 19 facilitator. I Or were those, Mr. Vice Chairman, let me explain. We are a client 20 VICE CHAIRMAN THOMAS: 21 WITNESS COHN: 22 with all over the world. 23 basis all over the world trying to buy or sell certain risk, 24 certain assets, certain securities. 25 Um-hmm. We have clients that we interact They come to us on a real-time We respond to what they want-- 287 1 VICE CHAIRMAN THOMAS: Could I pause on that 2 basis? Because one of the things about advertising, plus or 3 minus, is that they help create markets by getting people to 4 want something they didn't know they wanted. 5 Are you engaged in creating markets on that basis 6 at all, where you come up with an idea and see if people 7 like it? 8 come to you with? 9 10 WITNESS COHN: We're not that smart to anticipate what people are going to want. 11 12 Or are you simply a sponge, soaking up what people VICE CHAIRMAN THOMAS: I'm going to put that statement in the category with the apology, but that's okay. 13 WITNESS COHN: Okay. What we are smart enough to 14 do is listen to our clients and react to what they tell us 15 they want. 16 So when a client calls me and says, hey, I have a 17 long mortgage exposure. 18 Please work with me. 19 how our business evolves over time. 20 facilitating our client franchise. 21 I need to find a way to go short. We work with the client. VICE CHAIRMAN THOMAS: And that's It is really Okay, and so you start 22 with something that's kind of more fundamental, the CDO, 23 CDSs. 24 Or did you come up with that as a way to better facilitate 25 what they had originally asked for? Did they come to you with the idea of synthetic CDOs? How did you get into 288 1 synthetic CDOs? 2 WITNESS COHN: I don't know precisely the moment 3 that a synthetic was created. 4 first. 5 industry is about 30 seconds. 6 transaction or do something, because there are underwritings 7 and you have to publish prospectus, the entire world gets to 8 see what you did. 9 10 I'm not sure we did the very The half life of creativity in the financial service The minute you publish a new VICE CHAIRMAN THOMAS: giving someone an award for being first. 11 WITNESS COHN: 12 VICE CHAIRMAN THOMAS: 13 14 15 I wasn't interested in You were into it. We respond-You got into it for reasons that allowed you to do more of, better than? WITNESS COHN: We did it for reasons that our client franchise demanded us to be there. 16 VICE CHAIRMAN THOMAS: 17 being very clever, you make a lot of money. 18 Boy, for you guys not In looking at two groups who were here before us 19 today, the AIG group, and you guys, and activities that 20 other folks are going to talk about in that more narrow 21 relationship, you have a lot of clients. 22 of your concerns would be to make sure that you spread risk 23 over as broad a basis as possible because you don't want to 24 concentrate it? 25 And obviously one Would you describe the relationship between 289 1 Goldman and AIG as probably concentrating more risk than you 2 would otherwise have liked, but they were there and, you 3 know, you play tennis with who shows up at the court 4 sometimes, not who you wanted to play tennis with? 5 WITNESS COHN: It's impossible for me to say what 6 AIG had on the other side. 7 an important relationship to us. 8 be more and more involved in this market. 9 10 VICE CHAIRMAN THOMAS: WITNESS COHN: And you were facilitating We were facilitating our customers. 13 VICE CHAIRMAN THOMAS: 14 WITNESS BRODERICK: 15 They constantly wanted to your customers. 11 12 AIG was an important client, and So you did more of it. Commissioner, may I comment on that? 16 VICE CHAIRMAN THOMAS: 17 WITNESS BRODERICK: Sure. If you think about AIG at the 18 time that we were dealing with them, which was primarily in 19 this space in the '04 and '05 period, they looked like the 20 perfect customer for this. 21 They were not by any means our only customer, or 22 even our majority customer, but they were-- 23 VICE CHAIRMAN THOMAS: 24 WITNESS BRODERICK: 25 space in particular. Who was bigger than them? They were the largest in this 290 1 VICE CHAIRMAN THOMAS: 2 WITNESS BRODERICK: 3 Yes, so that they were. In this particular space, that's right. 4 VICE CHAIRMAN THOMAS: 5 WITNESS BRODERICK: Right. But from looking at them as a 6 suitable, appropriate counterparty, they really ticked all 7 the boxes. 8 around. 9 expertise. They were among the highest rated corporates They had what appeared to be unquestioned They had tremendous financial strength. They 10 had huge, appropriate interest in this space, backed by, you 11 know, a long history of trading in it. 12 So it was, from an assessment of appropriate 13 counterparties' perspective, they looked like the right type 14 of entity to do a substantial amount of business with. 15 VICE CHAIRMAN THOMAS: I don't think I ever got 16 an answer out of you in terms of Dr. Kohlhagen's initial 17 suggestion that this was basically government, and as I said 18 bipartisan, Republican and Democrat Administrations, trying 19 to move people into homes. 20 that with new inventions, and willingness to move down 21 quality measures to get people into them. And people were accommodating 22 And of course we saw the quality move from some- 23 down to nothing-down, to some indication of income that you 24 could cover it, to no docs in which there's no income 25 necessary. And you kept generating these documents based on 291 1 mortgages that continued to look worse than we've ever seen 2 before, but for some reason the rating companies were giving 3 them high ratings. 4 And I'm getting back to the whole question of, 5 your goal, stated by your chairman, and you again repeating 6 it here, that your job was to make markets, and I assume to 7 make efficient markets, and to be a facilitator to making 8 things happen. 9 relationship that we wound up getting into as, to a certain So would it be fair for me to look at this 10 extent, a market promoted by government, and that you were 11 more than willing to cooperate in that, supporting a 12 government-supported structure helped build a pyramid that eventually 13 collapsed? 14 15 16 WITNESS COHN: There is some truth to that, but it's not the whole truth. VICE CHAIRMAN THOMAS: Oh, just some truth is the 17 best answer I've had in a long time. 18 "some" not the "whole." 19 WITNESS COHN: So let's focus on the S-O-M-E. As there was a social agenda to 20 increase home ownership in the United States, many of the 21 bodies that were out there to promote home ownership, 22 including the agencies, were by statute lowering their rules 23 and regulations to accept different and new types of loans. 24 25 So there was a major decision for the agencies to get into the subprime market; that they would then accept 292 1 subprime loans. 2 VICE CHAIRMAN THOMAS: But your ability to assist 3 them in creating products which absorbed them, securitized 4 them, and getting people to participate, was there ever a 5 discussion at Goldman that this was also a kind of a 6 positive social policy that we ought to work with to make 7 sure those get soaked up and plugged into the system? 8 you could make money off of doing that? 9 WITNESS COHN: And I wouldn't go as far as to say 10 there was a social policy discussion. 11 natural ebb and flow of the market. 12 originators that were looking to sell mortgage product that 13 they had originated with individual homeowners started 14 looking differently than what we were used to. 15 It was just the The mortgage We went to the traditional buyers of mortgage 16 asset-backed and mortgage security paper and said, are you 17 interested in buying this? 18 yield? 19 that space? 20 the loan and the ultimate buyer of the loan. 21 What is the price? What is the What is the discount you need to commit capital to And we intermediated between the originator of VICE CHAIRMAN THOMAS: So sometimes don't you try 22 to sell? You're just not there as a facilitator and you're 23 playing to manipulate--so if you had these products, and you 24 wanted to sell them, did you ever refer to them in terms of 25 the rating companies, in terms of AAA and other associated 293 1 descriptions? 2 WITNESS COHN: There were always rating agency 3 descriptors involved. 4 descriptors was the actual price. 5 would give you a much clearer picture of what the market 6 would think about the real underlying value and the value of 7 the collateral. 8 9 But more important than rating agency VICE CHAIRMAN THOMAS: The prevailing price Okay, and now I'm going to reserve my time, but I just have to go back at you a little 10 bit. 11 who you are and what you do, but if you have brokers making- 12 -traders making calls, and you have flip books showing 13 through your Abacus transactions what people can have, I 14 mean that's basically selling, and advertising, and 15 attempting to get people to accept something that you have 16 created, and offered, and think you can make money on, isn't 17 it? 18 And I understand the shtick you go through in terms of WITNESS COHN: We think we can make money, but 19 the evolution of the flip book was a client response, a 20 reverse-inquiry, as we call it. When a client inquires to 21 us: And they may not want the 22 entire structure, but they want a chunk of it that's large 23 enough that we make a business decision, if they take that 24 piece, are we prepared to take the rest and then 25 redistribute it? Can you create XYZ for me? 294 1 VICE CHAIRMAN THOMAS: I understand, and I 2 actually can do that, too, having been successfully elected 3 16 times. 4 exactly the way I want it. 5 better understand our need to have issued a subpoena to get 6 information out of you. You ask me something, I can give you an answer And I'll end this session by I 7 Mr. Chairman. 8 CHAIRMAN ANGELIDES: 9 Very quickly, I just, since you raised it, I want to kind of just finish up rather than 10 doing it at the end. 11 you were on a trail of. 12 I do want to just pick up on something The only thing I want to say for the record, and 13 I know the other Commissioners will surely deal with this, 14 is the idea that a synthetic CDO helped to meet a housing 15 goal is still unexplained to me. 16 Other Commissioners I think will probe this 17 issue, but I don't see the way in which it created more 18 capital specifically to create more housing opportunity. 19 But the way I've been looking at it, a bomb went 20 off. And it's pretty clear to me, and you weren't the sole 21 participants here, is that Goldman participated in building 22 the bomb. 23 securities that ultimately blew up. 24 disputed, and I don't think you were the sole folks in that 25 arena, but clearly you did that. You were very active issuers of the very I don't think that's 295 1 I don't think it's disputed that you built a bomb 2 shelter, starting in December of '06; that you decided, 3 looking at the market, that it was time to protect yourself. 4 What I'm trying to get to is how did this cascade 5 of events really begin. 6 of the rotten nature of the subprime loans in the market? 7 Or was it in fact activities of market participants that in 8 the same way that they pushed prices up, and the bubble 9 pushed them down as the bust came. 10 11 Was it the underlying poor quality So that's why I'm interested in this interplay between you and AIG. And I just want to ask one more time. If you 12 look at an August 16th e-mail from Andrew Forster at AIGFP 13 to Alan Frost, he said: 14 GS is aggressively marking down asset types that they don't 15 own so as to cause maximum pain to their competitors. 16 may be rubbish, but it's the sort of thing GS would do. I've heard several rumors now that It 17 On September 11th, there's an e-mail from Tom 18 Athan at AIGFP where it says SocGen NY said they, quote, 19 "received marks from GS on positions that result in big 20 collateral calls, but SG disputed them with GS." 21 If you go on, there's an e-mail from Joe Cassano, 22 November 1st, that said that the collateral call from SocGen 23 was, quote, "spurred by GS calling them," and AIGFP had not 24 heard from SocGen since disputing the call, but obviously 25 the allegation is you told SocGen get in there and make a 296 1 call. 2 So I guess, what do you say to people who ask you 3 the question: How would you tell me you didn't drive prices 4 down? 5 can look at to understand this market to see whether there's 6 fair pricing going on, or this is really just a struggle 7 between people, big financial institutions who have a very 8 distinct market position? Let me reverse it. 9 WITNESS COHN: What's the objective evidence I To me, it's simple. Actual trades 10 and the fact that we were willing, and we were aggressively 11 willing, to liquidate our portfolio back to those clients at 12 those marks. 13 CHAIRMAN ANGELIDES: Well then the proof will be 14 in the pudding. And I think the trail of marks, the trail 15 of transactions, whether it was really a liquid market or 16 whether those were episodic trades I think will be very 17 revealing. 18 All right, let's go to Ms. Born. 19 COMMISSIONER BORN: 20 thank you both for appearing. 21 Thank you very much, and I would like to focus on Goldman Sachs' business 22 in over-the-counter derivatives. 23 Sachs conducts an enormous over-the-counter derivatives 24 business? 25 WITNESS COHN: Am I correct that Goldman We have a very active business. I 297 1 don't know if it's "enormous." 2 details on who does what in the over-the-counter market. 3 are a very active player. 4 COMMISSIONER BORN: I mean, there's not a lot of Well I think We your Chief 5 Financial Officer, David Viniar, told Commission staff that 6 Goldman Sachs is one of the top five over-the-counter 7 derivatives dealers in the world. 8 incorrect? 9 WITNESS COHN: 10 Do you think that's I think that's accurate. COMMISSIONER BORN: At the end of 2009, isn't it 11 correct that Goldman held 1.2 trillion over-the-counter 12 derivatives in the notional amount of $45.6 trillion, more 13 than four times the gross national--gross domestic product 14 of the United States? 15 WITNESS COHN: 16 WITNESS BRODERICK: 17 18 number. Do you know that, Craig? I don't know the precise It's certainly very large. COMMISSIONER BORN: I think Goldman Sachs told 19 our staff that the two of you were the most knowledgeable 20 about your derivatives business. 21 22 23 WITNESS COHN: We are quite knowledgeable, but I don't know the exact notionals at any moment in time. WITNESS BRODERICK: And in fact notionals from a 24 pure risk perspective, or any other management perspective, 25 is really not especially meaningful, in fact not meaningful 298 1 at all. 2 3 WITNESS COHN: Which goes back to the panel this morning. 4 COMMISSIONER BORN: Well this is the data that 5 the Office of the Comptroller of the Currency has published 6 for year-end in terms of your position in over-the-counter 7 derivatives. 8 they get that data from you. 9 Do you think they are inaccurate? WITNESS BRODERICK: I assume The data may very well be 10 accurate. 11 wouldn't be the metric that we would choose to reflect 12 relative size, or relative risk inherent in a business. 13 example that was provided earlier today by a couple of your 14 Commissioners where they did, on a pretend basis, obviously, 15 $2 trillion in completely offsetting risk demonstrated that 16 pretty clearly. 17 The point I think we are both making is, that COMMISSIONER BORN: The Well perhaps when you give us 18 your revenues and pre-tax earnings on your over-the-counter 19 derivatives dealing, we'll have another and perhaps better 20 measure of the size of your business, don't you think? 21 WITNESS BRODERICK: Mr. Cohn was very clear that 22 from a firm MIS perspective, breaking out derivatives 23 specifically from the rest of our trading business is not 24 something that we do. 25 meaning to us from a risk perspective. It's not something that has any 299 1 VICE CHAIRMAN THOMAS: 2 WITNESS BRODERICK: Management Information, COMMISSIONER BORN: Well it may not be something 3 4 I'm sorry? What is "MIS"? sorry. 5 you do as a regular basis for your management, but I'm sure 6 you have the financial records to do that. 7 WITNESS BRODERICK: I'm not even sure how you 8 would, though, because the example that Mr. Cohn provided 9 was a equity, of cash equity position, and a delta 10 equivalent option position, which perhaps you could take 11 those two trades and say, okay, of a total trading amount of 12 trading gain of X, we can allocate two-thirds to cash and 13 one-third to options, and maybe you could reconstruct 14 something like that. 15 positions, which is in fact what we have on our books, where 16 you don't have two longs that nicely aggregate. 17 long and an off-setting hedge, of which part of the long 18 will be cash, and part of the short will be, a hedge will be 19 cash and part will be derivatives. 20 But then take much more complicated You have a And so allocating complicated dynamically managed 21 positions on an ongoing basis, and allocating specific 22 revenues to them, I frankly don't know how you would do it 23 even conceptually. 24 25 COMMISSIONER BORN: Well we will certainly go into this in more detail with Mr. Viniar tomorrow, but it 300 1 seems to me it must be a little difficult to manage the risk 2 in your derivatives portfolio if you're not able to measure 3 the portfolio and the profits and revenues related to it. 4 Isn't it, Mr. Broderick? 5 WITNESS BRODERICK: We don't-- 6 COMMISSIONER BORN: I thought you said that to 7 8 manage things you needed to measure them? WITNESS BRODERICK: Absolutely. But what we 9 manage, and what we measure, is the positional risk that we 10 have across products, and across counterparties, and across 11 all sorts of other parameters. 12 cash, and derivatives, and other positions, on the basis 13 that that's what's really meaningful to us. 14 All of those aggregate, Whether we have exposure in market risk terms in 15 the form of derivatives or in cash products is not really 16 what's meaningful. 17 Now there are exceptions to that, right? So when 18 you're thinking about managing derivatives, there are credit 19 risks which occur in derivatives which don't occur 20 equivalently in cash. 21 pull out the current exposure and potential exposure, and 22 other metrics associated with those derivatives. 23 And so for credit risk purposes we But for the question which you're asking, which 24 is how you allocate--how you think about market risk, it 25 really is not relevant to us the precise form in which they 301 1 occur. 2 COMMISSIONER BORN: Well the Office of the 3 Comptroller of the Currency reports on an annual basis what 4 the revenues on derivatives are from commercial banks. 5 have a great deal of derivatives trading through your 6 commercial bank entity that's reported, as well. 7 You Do you suppose that you're telling the Office of 8 the Comptroller of the Currency that you can't give them the 9 revenues from that operation? 10 WITNESS BRODERICK: From the--which operation? 11 COMMISSIONER BORN: From the derivatives 12 operation. 13 commercial banks in 2009 had $22.6 billion in revenues. 14 15 That's what they report. WITNESS BRODERICK: that. They reported that the I'm not aware that we can do We can certainly follow up. 16 COMMISSIONER BORN: Well I would be interested in 17 seeing exactly what you report on a quarterly and annual 18 basis to the Comptroller of the Currency in terms of your 19 derivatives' related revenues. 20 What proportion of the over-the-counter 21 derivatives' contracts that Goldman enters into with 22 counterparties are standardized? 23 customized? 24 standardized so that they would be theoretically capable of 25 clearing on a clearinghouse. And what portion are And by "standardized," I mean sufficiently 302 1 WITNESS COHN: It's something that right now 2 we're looking at to some degree. 3 answer that question. 4 5 COMMISSIONER BORN: I would not be able to You don't even have a ballpark estimate? 6 WITNESS COHN: It would be a bad guess. 7 COMMISSIONER BORN: Would it interest you to know 8 that Jamie Diamond of JPMorgan testified under oath before 9 this Commission that approximately 75 to 80 percent of 10 JPMorgan's derivatives' contracts are standardized? 11 you think that would have any comparability to Goldman's 12 activities? 13 WITNESS COHN: It may. And do I mean, we are in very 14 similar businesses to each other, so I would think there 15 would be a high degree of correlation between what their 16 book of business looked like and what ours did. 17 COMMISSIONER BORN: Well I would ask you to 18 provide to the Commission--and I think we asked you this in 19 January as well--to provide to the Commission the proportion 20 of your derivatives' contracts that are standardized as 21 opposed to customized. 22 WITNESS COHN: (Nods in the affirmative.) 23 COMMISSIONER BORN: Can you tell us what proportion-- 24 VICE CHAIRMAN THOMAS: 25 WITNESS COHN: Was that a 'yes'? Oh, sure. 303 1 VICE CHAIRMAN THOMAS: Oh, okay. Because when 2 you nod, it's really hard to pick up for the record what it 3 was that you respond to. 4 Thank you. COMMISSIONER BORN: Can you tell us what 5 proportion of your over-the-counter derivatives business 6 consists of acting as a dealer with customers, and what 7 portion is proprietary trading on behalf of Goldman Sachs 8 itself? 9 WITNESS COHN: I would say the vast, vast 10 majority of our over-the-counter business is customer- 11 related, ninety-plus percent. 12 COMMISSIONER BORN: Would you also be able to 13 provide us with more exact statistics, please? 14 asked for this in January, as well, and we haven't received 15 it. 16 WITNESS COHN: We will try. 17 best-efforts to come up with the number. 18 COMMISSIONER BORN: Because we Again, it will be a We would also, and I think 19 have requested in January, a breakdown of revenues and pre- 20 tax earnings based on the over-the-counter derivatives 21 dealing business and the proprietary speculative trading. 22 I would like to show you a chart. I don't know 23 that it has a number, but it's the balloon chart entitled 24 "Goldman Sachs' Top Derivatives Counterparties Notional 25 Exposure as of June 2008." Do you have a copy of it? 304 1 WITNESS COHN: 2 COMMISSIONER BORN: 3 Yes. I would like to ask that this be entered into the record of the hearing, please. 4 VICE CHAIRMAN THOMAS: 5 COMMISSIONER BORN: Without objection. This chart shows Goldman 6 Sachs' relationships with 49 of its top derivatives' 7 counterparties. 8 Goldman Sachs as of June 2008 in each of 5 major types of 9 derivatives. It's the top 9 or 10 counterparties of 10 It does show how complex and extensive Goldman's 11 relationships with this small number of counterparties are. 12 I notice that none of the credit derivatives products top 10 13 counterparties as of then included AIG. 14 I thought you said a few minutes ago, Mr. Cohn, 15 that you think AIG "was or biggest customer in this space"? 16 You must have meant something other than the credit 17 derivatives swaps' space. What did you mean by that? 18 WITNESS COHN: I think Mr. Broderick said that. 19 COMMISSIONER BORN: Oh, I'm sorry. 20 WITNESS BRODERICK: And I think this chart here 21 shows top credit derivatives products by notional amount, 22 and the numbers are very large. 23 derivative product that I see, although it's a little hard 24 to read the chart, is in the hundreds of billions of 25 dollars. The smallest credit 305 1 COMMISSIONER BORN: $314 billion. 2 WITNESS BRODERICK: Thank you. And as you may 3 have seen from other information that we provided, the 4 notional exposure of trades that we did with AIG was 5 substantially less than that. 6 probably saw were $23.5 billion or so. 7 to the heart of the difficulty of using notional exposures 8 as reflective of real risk. 9 I think the numbers that you And that really gets These entities with whom we trade here are very 10 active market makers. 11 countless basis--not a countless, but a very large basis, 12 with in most cases offseting trades, and all subject to 13 collateral arrangements and other risk mitigants which bring 14 the risk down very substantially. 15 would not appear in this category at all. 16 17 We trade back and forth on a COMMISSIONER BORN: But based on notional AIG And why was it that you traded with AIG without collateral up front? 18 WITNESS BRODERICK: Without collateral up front, 19 we did not feel it necessary to--and, frankly, they would 20 not have agreed to collateral up front. 21 an entity that was AAA until sometime in 2005, and then AA 22 until a whole lot later, dealing with an equivalently rated 23 entity. 24 25 Remember, this is The arrangements that are customary on that basis are to trade with, on a flat basis, so both sides post 306 1 margin as mark-to-markets move against that entity, and in 2 some cases subject to trigger levels. 3 AIG, the arrangements that we had were substantially that. 4 And in the case of And then in addition, we had our own separate 5 credit protection mechanism, which we can talk about 6 separately. 7 COMMISSIONER BORN: Well back to the chart. As I 8 said, this shows 49 of your counterparties. 9 than that because many of the same large institutions are 10 In fact, fewer among your top 10 counterparties in each of these sectors. 11 But in fact you have 1.2 million contracts 12 outstanding, at least as of the end of 2009. 13 customers? 14 counter derivatives' contracts? 15 How many counterparties do you have on over-the- WITNESS BRODERICK: I don't know the precise 16 number, but it's more than 10,000. 17 number. 18 How many COMMISSIONER BORN: It's a substantial And so there are that many 19 interconnecting counterparty relationships through the 20 contracts? 21 Correct? WITNESS BRODERICK: I don't know if I would say 22 "interconnecting," because I think that would exaggerate the 23 degree of overlap across those counterparts. 24 OTC counterparts are single-product in nature, or a couple 25 of products, and many of them are end users dealing just Many of those 307 1 2 3 4 5 with us and with perhaps a handful of other banks. So that's different I think than the interconnectivity reference in this diagram. COMMISSIONER BORN: mean bilateral. Well by "interconnectivity" I I mean, these are contractual-- 6 WITNESS BRODERICK: Yes. 7 COMMISSIONER BORN: --relationships between you 8 9 10 and 10,000 other entities. WITNESS BRODERICK: By that definition, right. Yes, thank you. 11 CHAIRMAN ANGELIDES: 12 COMMISSIONER BORN: Five minutes? Yes. And in addition to 13 price risk on these contracts which you manage I'm sure by 14 hedging and other devices, unlike what AIG was doing on its 15 credit default swaps, there's some operational risk related 16 to these contracts as well, and there is counterparty credit 17 risk, which I assume, Mr. Broderick, is part of your job to 18 oversee the management of? Is that correct? 19 WITNESS BRODERICK: Yes, it is. 20 COMMISSIONER BORN: And do you find it a daunting 21 task to oversee counterparty credit relationships in more 22 than 10,000 contracts and relationships, many of which have 23 more than 10,000 counterparties, many of whom have more than 24 one contract with you? 25 WITNESS BRODERICK: I think risk management 308 1 across a firm such as ours is challenging and dangerous if 2 not done properly. 3 organization supported by the highest levels in the firms 4 that have resourced us extremely well across a number of 5 areas that gives us a confidence that we are able to 6 undertake credit risk management and market risk management 7 and operational risk and other risk management effectively. 8 That's not to say that we do not make mistakes, and we have, 9 but I think by and large we have done it effectively. 10 I think we have a very substantial COMMISSIONER BORN: Warren Buffett appeared 11 before us at our last hearing and testified that he 12 considers it virtually impossible to oversee the size of 13 portfolio. 14 Sachs' portfolio is almost as big. 15 16 He mentioned JPMorgan, but of course Goldman Do you consider it a daunting task? And what techniques do you use to manage it? 17 WITNESS BRODERICK: Warren Buffett is a very wise 18 person. 19 operations and show him exactly how we do think about the 20 risk management of derivatives and other products, and so 21 forth, and perhaps he would change his mind in this regard. 22 We'd welcome the chance to get him into our But the answer to the question is: We have very 23 extensive groups which are dedicated to risk management as 24 per the components that I mentioned earlier. 25 supported by a vast infrastructure group within the firm They are also 309 1 comprising about half the organization that includes the 2 Controller's Group, which is responsible--which has final 3 responsibility for the marks of our products and so forth 4 across the firm. 5 the operational risk issues, including collateral calls and 6 so forth. 7 units themselves who have a very direct skin in the game 8 when it comes to risk management generally, and take that 9 responsibility seriously. 10 11 The Operations Group, which has many of And then it's also supported by the business So the firm as a whole is focused on risk management in all of its component parks. 12 VICE CHAIRMAN THOMAS: 13 COMMISSIONER BORN: 14 VICE CHAIRMAN THOMAS: Commissioner Born? Yes. This side of the panel 15 awards Mr. Broderick a 9 for his answer on the Warren 16 Buffett question. 17 (Laughter.) 18 CHAIRMAN ANGELIDES: 19 be extraordinarily pleased. 20 WITNESS COHN: 21 COMMISSIONER BORN: 22 Exactly. I hope that wasn't on my time. 23 (Laughter.) 24 CHAIRMAN ANGELIDES: 25 And investor relations will No. By agreement of the Chair and Vice Chair, it was, strangely enough. 310 1 (Laughter.) 2 VICE CHAIRMAN THOMAS: 3 time--notional, I'm sorry, that's it. 4 5 It was a nominal amount of CHAIRMAN ANGELIDES: On Ms. Born's time, would you please add two seconds. 6 (Laughter.) 7 COMMISSIONER BORN: I think you mentioned to our 8 staff, Mr. Broderick, that you think the lack of 9 transparency in the over-the-counter derivatives market 10 posed a certain risk management problem because you can't be 11 aware of the potential exposures that your counterparties 12 may have to other obligations. 13 14 And I wondered whether you were aware of any of AIG's other exposures? 15 WITNESS BRODERICK: The comment is accurate, and 16 the association with AIG is entirely appropriate in this 17 regard. 18 The fact is we were not aware, and really had no 19 way of knowing what AIG's ultimate disposition in terms of 20 risk exposures were, either in respect to the trades that we 21 did direct with them, which is to say they could have laid 22 off all or more than all of the risk of the trades that we 23 did with them specifically-- 24 25 COMMISSIONER BORN: So you weren't aware of whether or not they were hedging-- 311 1 WITNESS BRODERICK: Let alone what-- 2 COMMISSIONER BORN: --or otherwise making 3 provision for those-- 4 CHAIRMAN ANGELIDES: 5 WITNESS BRODERICK: 6 CHAIRMAN ANGELIDES: wrap down. 9 10 --let alone what other counterparties were-- 7 8 Two minutes. Two minutes, and then we'll Go ahead. WITNESS BRODERICK: Let alone with other counterparties were doing with them. 11 COMMISSIONER BORN: So were any other people at 12 Goldman Sachs, to your knowledge, aware of either AIG's 13 exposures or how they were hedging--whether they were 14 hedging or not hedging those exposures? 15 16 17 WITNESS BRODERICK: No one was aware that I'm COMMISSIONER BORN: The U.S. Government has aware of. 18 bailed out AIG to the tune of $130 billion with additional 19 pledges, and it has paid $40 billion on its CDS exposure. 20 Goldman in turn has received something like $14 21 billion for a number of the CDOs on which AIG had written 22 credit default swaps. 23 Don't you consider Goldman's need for funds from 24 the American Taxpayer and on these transactions, and on your 25 counterparty relationship with AIG a risk management 312 1 failure? 2 on this? 3 4 5 Why did the American Taxpayer need to bail you out WITNESS COHN: Let me start, and Craig will finished because you asked two questions. First of all, the total payment was 6 $12.9 billion, of which $4.8 billion was in the secured 7 funding book, which was just repo or reverse repo. 8 nothing whatsoever to do with the CDO market. 9 It had And in the CDO market, the payments that were 10 made there, Goldman Sachs, as we have stated many times, we 11 were acting independently of any other event that may have 12 happened in the market, or may have happened with AIG. 13 We were managing our credit risk, as well as 14 market risk with them, as prudently as we knew how. 15 moment they did not make a collateral payment to us, we took 16 precautions. 17 out and insured ourselves against an unforeseen and 18 something we couldn't even think about event happening, 19 because that's our rigor and our prudent risk management, is 20 to just go out and insure yourself. 21 money, you must go out and take some protection. 22 23 And the We spent our shareholders capital, and we went WITNESS BRODERICK: If someone owes you What else would you like me to address in that regard? 24 COMMISSIONER BORN: 25 CHAIRMAN ANGELIDES: Well, I mean my time is up. I think she wants to know 313 1 why you took the money, and wasn't that an indication of 2 failure? 3 WITNESS BRODERICK: I respectfully disagree with 4 the implication. The fact is, as Mr. Cohn mentioned, we 5 took money in one bucket because we were unwinding fully 6 secured trades that we could have liquidated through 7 alternative means and realize the same value. 8 We took money in a second bucket because AIG 9 specifically wanted to change the form of its risk from 10 derivatives into cash, and we facilitated, at their request, 11 that transaction. 12 bucket, which was CDS related margin payments that they owed 13 us in due course, consistent with the government's objective 14 of making creditors whole through this process. 15 And we took money in the form of the last WITNESS COHN: I think Mr. Broderick's statement 16 at the end is the important statement. 17 for the money. 18 government was involved trying to mitigate the future risk 19 of AIG. 20 simultaneously entered into a transaction where we would 21 work to get AIG back the securities that were causing them 22 the trouble. 23 we had, and then we would re-deliver them to AIG. 24 25 We did not ask AIG We were part of a solution where the We were part of numerous counterparties that We would buy them from the counterparties that COMMISSIONER BORN: So you never asked the Federal--nobody at Goldman Sachs ever talked to the Federal 314 1 Reserve Bank of New York about the terms of this, and how it 2 should be done, and how you wanted your money 100 cents on 3 the dollar? 4 Is that your testimony? WITNESS COHN: My testimony--no, that isn't what 5 I said. My testimony is, in the 11th hour when the Federal 6 Reserve was trying to strike a deal with the counterparties 7 of AIG, yes, we had conversations with the Federal Reserve. 8 But ultimately we were sent documentation on a Sunday 9 afternoon and asked very vocally to sign it. 10 COMMISSIONER BORN: 11 CHAIRMAN ANGELIDES: All right. By the way, I am not going 12 to ask any more questions, but I am going to clarify the 13 request I made of you earlier. 14 In terms of giving us trading information, I just 15 want to make sure--I don't want to be a broken record on 16 this--when we get that trading information, it is for 17 comparable securities, comparable trades. 18 Because just to be clear, what I am trying to 19 establish is, as I said, following up on the Vice Chair, it 20 is pretty clear that you helped build the bomb. 21 clear you built a bomb shelter. 22 to get to is: 23 very important information in trying to determine what set 24 of events happened and why. 25 And now the question I want Did you light the fuse? Mr. Hennessey? It's pretty Thank you. And this will be 315 1 COMMISSIONER HENNESSEY: Thank you, Mr. Chairman. 2 I am looking at this chart. Could we put that 3 chart back up again? 4 because I keep coming back to a few points over and over 5 again. 6 housing market. 7 is about concentration of risk in large financial 8 institutions. One is just about flawed assumptions about the 9 10 And I am very interested in this chart One is about highly correlated risk. One I have already expressed my skepticism about the notional amounts. 11 Mr. Broderick, you mentioned a $23 billion number 12 with respect to credit derivatives. 13 represent? 14 WITNESS BRODERICK: What does that number That number represents the 15 notional value of trades, CDS across all products, across 16 all the CDS products, by which I mean Abacus trades and 17 other--and other CDOs and CDS transactions that we did with 18 AIG against which they posted collateral. 19 the answer. 20 21 COMMISSIONER HENNESSEY: WITNESS BRODERICK: 23 COMMISSIONER HENNESSEY: 25 Okay, so that's an AIG- specific-- 22 24 I think that's Yes, it is. --credit derivatives specific notional number? WITNESS BRODERICK: Yes, that's correct. 316 1 COMMISSIONER HENNESSEY: 2 WITNESS BRODERICK: 3 4 little bit. Okay. And that may be off by a I don't remember the precise numbers. COMMISSIONER HENNESSEY: Just ballpark. And--but 5 you have some sort of economic measure of your actual 6 exposure of counterparty risk to any firm and any product in 7 this chart, right? 8 WITNESS BRODERICK: Yes, we do. 9 that you mean credit risk, specifically? 10 COMMISSIONER HENNESSEY: 11 WITNESS BRODERICK: 12 COMMISSIONER HENNESSEY: And I think by Yes. Yes. And can you give us a 13 sense of order of magnitude? I mean, we're seeing numbers 14 on here which are measured in hundreds of billions and 15 trillions of dollars in terms of notional amounts. 16 WITNESS BRODERICK: Right. 17 COMMISSIONER HENNESSEY: When you're looking at 18 actual counterparty credit risk with a particular firm, and 19 not concentrated in a line, when you're looking at SocGen or 20 Credit Suisse, or something like that, and you're thinking 21 about the economic credit counterparty risk you face-- 22 WITNESS BRODERICK: 23 COMMISSIONER HENNESSEY: 24 25 Yes. --that number is measured in? WITNESS BRODERICK: So in the case of a typical 317 1 financial institution, we would have a series of collateral 2 arrangements of, let's say, basic as other trading 3 arrangements, each supported by a collateral arrangement 4 with a trigger level, where that trigger level would be set 5 at very low levels. 6 And so let's say that we have zero triggers 7 across three products where we have a certain amount of 8 business that we're likely to do. 9 do in calculating exposure is say we have theoretically zero What we would therefore 10 exposure, right, because of the collateral arrangements set 11 at that level. 12 However, we know that there is a delay between 13 the time that a market moves against the client, which would 14 trigger a collateral posting requirement on their part, and 15 our calling for them, to them for that collateral, and their 16 posting it or not, as the case may be. 17 post it, then we close them out. 18 And if they don't And so there is an inherent delay in that whole 19 process. 20 two-week collateral collection/close-out period, and we 21 calculate a potential market move over that period. 22 And so what we do is take, for the most part, a That gives us what we call a collateralized 23 potential exposure figure, which is probably the most 24 appropriate reference for this purpose. 25 The numbers vary depending on the details of the 318 1 trades we do with our clients, but they are, you know, 2 orders of magnitude smaller than what you see in the way of 3 notional exposures here. 4 counterparts, tens or maybe hundreds of millions of dollars. 5 In the case of AIG, it was at the higher end of that range, 6 which is the reason that we supplemented our normal risk 7 mitigants with a separate set of arrangements under which we 8 purchased credit protection externally in the market for 9 essentially this margin shortfall. 10 COMMISSIONER HENNESSEY: 11 WITNESS BRODERICK: 12 numbers that are quite small. 13 They're measured in the, for large Okay-- And then you get down to COMMISSIONER HENNESSEY: --two follow-ups here. 14 One is the way that you think about this, the chart here is 15 very colorful, but I notice that a lot of these large 16 financial firms are showing up in multiple colors. 17 WITNESS BRODERICK: Um-hmm. 18 COMMISSIONER HENNESSEY: I presume that the way 19 you think about it is on a firm level, rather than a firm- 20 and-product basis, right? 21 WITNESS BRODERICK: 22 COMMISSIONER HENNESSEY: What happens if Barclay 23 ceases to exist or doesn't pay us. And then you're looking 24 at your exposure across all of the different transactions? 25 WITNESS BRODERICK: Correct. And our risk measures are 319 1 very comprehensive in that regard. 2 to an apples-to-apples basis as we can across the different 3 derivative transactions and different non-derivative 4 transactions that we do. 5 effectively, yes. 6 WITNESS COHN: We aggregate on as close Our systems aggregate that And to just put some real quick 7 clarity on that. 8 that appear multiple times are what we would consider market 9 professionals trading counterparties. 10 In these big circles, and these circles We have very little exposure to them. 11 margin us, we margin them on a nightly basis. 12 COMMISSIONER HENNESSEY: 13 WITNESS COHN: When they Okay, so-- And in a Barclays with 14 $2 trillion, I would say my overnight exposure would be 15 measured maybe in $100 million depending on how big of a 16 market move. 17 risk." 18 So from tonight's close to when they pay me, I 19 make the call. 20 tomorrow. 21 And it's sort of what we would call "daylight They agree to the call. COMMISSIONER HENNESSEY: Okay. We pay each other Because what I'm 22 getting at here is that I don't think this chart is helpful 23 to me because it's in terms of notional exposure, for one. 24 Two, it's breaking apart the counterparty risk 25 into different types of financial structure, which I find 320 1 confusing. 2 And then three is, I think I'm supposed to 3 conclude something based on the relative sizes of the 4 circles, but what I hear you telling me is that when you're 5 measuring--when you're comparing the relative sizes of the 6 circles from an economic standpoint, what is a small circle 7 here may be bigger, and what's a big circle--Barclays 8 circle--may in fact be quite small because of the nature of 9 the risk that you're bearing with respect to them? 10 Is that a-- 11 WITNESS COHN: Correct. And in fact I'm looking 12 to see here, I was looking to see because there's a small 13 circle that actually has a lot more risk associated with a 14 big circle because we would have a nonstandardized market 15 making trigger with them. 16 So I don't really see anyone on here that's a 17 small circle, because almost everyone on here is what I 18 would consider a market professional. 19 pay each other each day in the market. 20 21 VICE CHAIRMAN THOMAS: Market professionals Would the gentleman yield briefly? 22 COMMISSIONER HENNESSEY: 23 VICE CHAIRMAN THOMAS: Yes, please. I was trying to figure out 24 how we might deal with this, and what I was thinking of was 25 maybe a pie chart for each of them so that there would be 321 1 segments pertaining to, I don't know, maybe there's nine or 2 so, but what I'm hearing you saying is the way that you 3 really keep the balance is more like you do with a buddy 4 where they bought dinner last night, and I'm buying it 5 tonight, and the difference is six bucks. 6 So it's always the difference of what you owe and 7 collect, rather than any kind of total amount? 8 aggregate your risk totally? 9 WITNESS COHN: 10 Correct. VICE CHAIRMAN THOMAS: Since you So-So even putting it into a 11 pie chart to look at the pieces wouldn't necessarily focus 12 this. 13 to really judge what it is that we're looking for. And I'm throwing us on your mercy to give us some way 14 WITNESS COHN: 15 VICE CHAIRMAN THOMAS: 16 And I'll try and do this easily. I thank the gentleman. It's on my time. 17 WITNESS COHN: Take a Barclays. We're picking 18 them because they're in the lower right. 19 probably trade with them in a variety of legal entities 20 across a variety of different products. 21 With Barclays we Each legal entity has to get netted down. So if 22 they have longs and shorts, and we have long and shorts, we, 23 between ourselves, mark to market. 24 same place. 25 COMMISSIONER HENNESSEY: We mark it all at the Within an entity? 322 1 WITNESS COHN: 2 COMMISSIONER HENNESSEY: 3 Within a legal entity. A subset of Barclays, and so forth? 4 WITNESS COHN: I don't want to get too 5 complicated through all the legal entities, but with 6 Barclays we would mark our book, they would mark our book. 7 They would say, hey, based on our longs and shorts, you owe 8 us $10 million. 9 $9.9875. 10 We'd say, yeah, we think we owe you We'll send you ten. And that happens every day. 11 with Barclays every day. 12 that with Morgan Stanley. 13 with Perabot. 14 And so we do that We do that with JPMorgan. We do that with SocGen. We do We do it We don't do that with General Motors. So if we've got a derivative on with General 15 Motors, we would not collect from them until it got to the 16 margin trigger. 17 triggers, daylight risk. 18 will move. 19 interdealer market pays each other. So these are what we would call zero We'll trade with you. We'll settle tomorrow. The market And that's how the 20 So these--if I actually went and took that chart 21 and made it exposure, all those dots up there would be tiny 22 and we'd put up other bigger dots, which would be clients. 23 24 25 COMMISSIONER HENNESSEY: Clients, like General Motors, or whoever. WITNESS COHN: Berkshire Hathaway, General 323 1 Motors, GE. 2 type clients. 3 governments in there. 4 You know, you would go into other corporate Or governments. There would be a lot of COMMISSIONER HENNESSEY: So on any given day, 5 your actual economic risk exposure to various firms is much 6 larger to nonfinancial firms, or to non, what is it, 7 dealers, than it is to these firms? 8 9 WITNESS BRODERICK: That's sometimes the case. The only point I would note is--and Mr. Cohn was mentioning 10 specifically derivatives exposures because that's what's 11 included here--when you think about banks, the only other 12 significant issue to mention is we have other types of 13 exposures, as well. 14 For instance, deposits which we maintain. Now 15 they're overnight. 16 long-term risk, but certainly some of the numbers can get 17 relatively large. 18 And so they don't constitute a lot of WITNESS COHN: If you were to sit in our Risk 19 Committee, which meets every week, and our detailed risk 20 packet, we have the largest exposures listed there. 21 would not be the names on this sheet of paper. 22 COMMISSIONER HENNESSEY: Okay. They And I think 23 you've already answered one of my questions, which is you 24 will sometimes explicitly hedge your counterparty credit 25 risk with a particular firm. And it sounds like you did that 324 1 with AIG once you figured out that they weren't as good of a 2 risk as you initially thought? 3 WITNESS BRODERICK: I think that's right, 4 although I would amend the last part of that. We hedged our 5 risk with AIG by agreement going back quite early in our 6 trading when they were a really good--or we conceptually 7 agreed to hedge our risk going back when they were very good 8 credit. 9 material way when they started missing margin calls. We only needed to start acting on that in a 10 Because that's what gave rise to that requirement that we 11 hedged essentially the uncollateralized portion of our risk. 12 COMMISSIONER HENNESSEY: Okay, so can you 13 qualitatively characterize for me in that third week in 14 September when AIG was failing, presumably you all had 15 already started hedging a lot of your AIG-specific risk. 16 How exposed was Goldman? 17 jeopardy if AIG ceased to exist? 18 WITNESS COHN: Was the survival of your firm in No. We were hedged long, long 19 before that. What Craig was saying, at some point you get 20 enough exposure to a company that, just as a natural risk 21 mitigant, you start buying credit default swaps. 22 COMMISSIONER HENNESSEY: 23 WITNESS COHN: 24 25 Now we heard-- So we were hedged long, long before that period of time. COMMISSIONER HENNESSEY: Now we heard from a 325 1 panel of experts this morning that they believed that if the 2 New York Fed had not dumped $85 billion into AIG that there 3 would have been massive systemic effects. 4 Understanding your answer on Goldman, do you 5 agree with that, either for other large firms, or for the 6 system as a whole? 7 8 WITNESS COHN: Yes. I agree with that. And I am surely happy we didn't have to find out. 9 COMMISSIONER HENNESSEY: And why? Was that 10 because other firms were not managing their counterparty 11 risk like you were? 12 was the reason for that? 13 WITNESS COHN: Or was it some fear factor? Or what I think it was both of those. 14 was other firms had more liberal lines with them. 15 firms had less collateral. 16 literally billions of dollars of cash flows in securities 17 that would of had to have instantly been replaced. 18 It Other They were just at the nature of It's not just the fact that they ceased to exist 19 and they owe you money. 20 So if you had a flat book and AIG was on one side, all of a 21 sudden they disappear, you have to go into the market and 22 replace. 23 You've got a huge replacement risk. The market didn't have the capability to replace 24 everything that AIG was on the other side of simultaneously. 25 As we know how big their books were, this was an event that 326 1 would be too big for the market to deal with in a specific 2 moment of time. 3 4 5 COMMISSIONER HENNESSEY: And that's because AIG was too large a share of the total capacity of the market? WITNESS COHN: They were very concentrated in 6 certain financial instruments. And the breadth and depth of 7 those markets would have ceased to exist, and AIG was most 8 likely, in most of these products, one direction. 9 that everyone would need to replace the exact same thing Meaning 10 simultaneously. Anyone who was willing to replace it would 11 know that the market had a huge dislocation, and there was 12 not a normal supply/demand factor. 13 COMMISSIONER HENNESSEY: So everyone did this one 14 kind of business with AIG. With AIG gone, there would be 15 nobody else. 16 side of that trade would have just charged an arm and a leg? And whoever else wanted to get on the other 17 WITNESS COHN: Correct. 18 COMMISSIONER HENNESSEY: Okay. Following up on 19 Commissioner Born's questions earlier, I think I get your 20 answer, which is you are a client service business and that 21 you are in the business of doing what your clients want in 22 providing them with those products and services. 23 understand that sometimes you can't lay off the risk from 24 one of those transactions and so you've got to hold it. 25 you're earning gains and losses on that risk that you're I And 327 1 bearing. 2 I understand that sometimes you all say, you know 3 what, we are holding too much of risk X that we've 4 accumulated because we've been doing services for clients, 5 so let's try and--you know, let's pay a little more to 6 offload it. 7 Are you saying that sort of at ya'll's level, at 8 the firm level, you're never saying: 9 is a kind of risk where we think we should bear more of it 10 You know what? Here and let's increase our exposure to that risk? 11 I understand that that's a small share of your 12 business, but are you saying, you know, come on, actually 13 this risk is priced pretty cheaply. 14 WITNESS COHN: Let's dial this up? At our level we are always pushing 15 back in the organization. The natural organization will 16 tend to grow and want to do things. 17 level, our responsibility is prudence to be far enough away 18 from the business to take a macro view and make sure that 19 everything is in line relative to everything else we're 20 doing in the firm. 21 COMMISSIONER HENNESSEY: 22 WITNESS COHN: At Craig's and my So you-- So it would never come from the 23 office, from the senior management office, to increase risk. 24 It would come-- 25 COMMISSIONER HENNESSEY: --from a business unit 328 1 saying, hey, we think we can make money X because this is 2 mispriced? 3 WITNESS COHN: Yes. It tends to push--the risk- 4 on would push up through the organization; risk-off pushes 5 down through the organization. 6 WITNESS BRODERICK: And that's not inappropriate 7 from a fundamental market making perspective, either, right? 8 Sales people and traders interested in providing the best 9 service to clients from time to time see the benefits in 10 prepositioning, for example, some inventory when they think 11 that it's going to be especially attractive. 12 And so even with a purely market making function 13 in mind, which is what characterizes most of our business, 14 there are entirely consistent reasons for putting in place 15 inventory, or short inventory for that matter. 16 WITNESS COHN: And then there's numerous trades 17 that need to be approved through the organization. 18 Craig and I, as well as David Viniar, it is our job to not 19 approve those for a lot of different reasons; they just 20 don't meet the hurdles, they don't meet the benchmarks; 21 they're just not prudent for us to have on. 22 COMMISSIONER HENNESSEY: 23 WITNESS COHN: 24 25 And Got it-- So there are certain levels where things naturally have to gravitate to us. VICE CHAIRMAN THOMAS: Mr. Chairman, yield him 329 1 two additional minutes. 2 COMMISSIONER HENNESSEY: Let me ask, a few of us 3 had a line of questioning of the expert panel this morning 4 about naked credit default swaps, or perhaps calling them 5 "side bets." 6 My question was: If a naked credit default swap 7 is properly capitalized and transparent, is there any 8 downside to it from a systemic standpoint? 9 externality that is created by it by having lots of side 10 Is there any bets? 11 And then, is there--Senator Graham's question-- 12 what is the benefit to the market and to the financial 13 system as a whole of having these naked transactions exist? 14 WITNESS COHN: "Properly capitalized" was the key 15 words when you asked the question. 16 have no problem. 17 having a CDS market. 18 Properly capitalized, I And in fact I think there is a benefit to Let me first explain to you--and this is a 19 relatively short history--the biggest advent in the mortgage 20 market in the last 15 years was or is the ability to go 21 short. 22 Prior to that period of time, you could have two 23 positions in the mortgage market. 24 no position; or you could own mortgages. 25 You could be flat, have It was really in the modern trading world that 330 1 you had any ability to take a negative, or contra view in 2 the mortgage market. 3 So what happened? First of all, we attracted more capital in the 4 market. 5 mortgage security because they knew if things went wrong 6 they would have an ability to hedge. 7 ability to get out. 8 9 So more people were willing to buy mortgage and They would have an They could manage their risk. It was also a risk transference. securities you were transferring risk. In all of these Someone ultimately 10 wanted to own the risk, and so you were transferring risk 11 into another area. 12 price transparency. More trading. More capital. Means more And that is important for a market. 13 These were diversified portfolios. 14 thing that you had in the mortgage market prior to these 15 amalgamated securities is if you went out and bought a 16 mortgage you owned that mortgage in that area. 17 very difficult for people to amalgamate mortgages in a 18 variety of different states, a variety of different 19 counties, a variety of different underlying collateral. 20 The other And it was What these securities did is they allowed you to 21 build a highly diversified portfolio of mortgage exposure. 22 So if you wanted Florida, and you wanted California, you 23 didn't want Ohio, you could do that. 24 subprime, you could do that. 25 subprime and credit cards, you could do that. If you wanted If you wanted a combination of 331 1 That evolution helped spur this market on. And 2 the ability that that created was really why this product 3 grew, why it grew so fast, and why it allowed home ownership 4 to grow simultaneous. 5 6 7 But I go back to the beginning. You needed to have the adequate amount of capital involved. COMMISSIONER HENNESSEY: Okay, so your contention 8 is that the increased amount of capital that increased home 9 ownership that occurred from this new product was a good 10 thing, and that the bad aspects of it are in effect entirely 11 a result of the lack of capitalization and lack of 12 transparency? 13 14 15 16 WITNESS COHN: What really happened here is, as the mortgage market got more-VICE CHAIRMAN THOMAS: Yield the gentleman one more minute. 17 COMMISSIONER HENNESSEY: 18 WITNESS COHN: Just for this answer. As the mortgage market got more 19 sophisticated and we went to higher loan-to-values, and we 20 went to less income verification, and we came up with all 21 these new exotic products, what the end result of that was 22 is you made the performance of the underlying asset that 23 much more important. 24 loan-to-value loan, you don't have a lot of wiggle room in 25 the collateral. Especially when you have a 100 percent 332 1 So as we expanded these new products, we really 2 expanded the reliance on home price at least holding steady, 3 but mostly appreciating. 4 increase capital as we increased the sophistication of the 5 underlying mortgage. 6 And what happened is, we didn't COMMISSIONER HENNESSEY: So it became more 7 sensitive to the accuracy of the projections of default and 8 assumptions of home prices, those kinds of things. 9 WITNESS COHN: 10 examples. 11 $100,000 mortgage. 12 Yes. Look at--I'll give you some Mortgage number one, you buy a mortgage, a You put down $20,000, 20 percent down. Mortgage number two, $100,000 mortgage, you put 13 no down. 14 have 10 percent positive equity over here. 15 who bought the security, he's still fine. 16 percent cushion. 17 Housing market retrenches 10 percent. We still The bond holder He's got a 10 Bond holder over here that bought the security, 18 uh-oh, we already have a negative shortfall of 10 percent if 19 that house gets foreclosed. 20 So, yes, the reliability on the performance of 21 the underlying asset really exploded and we forgot to attach 22 the proper amount of risk capital to that risk when the 23 asset went down. 24 COMMISSIONER HENNESSEY: 25 CHAIRMAN ANGELIDES: Thank you, Mr. Chairman. All right. Thank you. Mr. 333 1 Wallison? 2 COMMISSIONER WALLISON: Thank you, Mr. Chairman. 3 Was AIG an outlier in terms of the amount of 4 obligations that they took on in relation to others in the 5 market, and without apparently hedging? 6 WITNESS BRODERICK: In retrospect, they clearly 7 were. 8 weren't the only entity that went long subprimes, and others 9 did as well, but they certainly in hindsight were the 10 They weren't the only--it's worth noting, they longest and the least hedged. 11 COMMISSIONER WALLISON: When did you, when did 12 Goldman decide to get substitute, or additional coverage for 13 its exposure to AIG? 14 15 WITNESS BRODERICK: And by that you mean external hedging in the market? 16 COMMISSIONER WALLISON: 17 WITNESS BRODERICK: Um-hmm. We agreed conceptually to do 18 that at the time we started trading with them in reasonable 19 size. 20 place the facilities to start trading. 21 back to I think it was '04; it might have been actually 22 earlier than that, but it was well before we had any real 23 risk then, however defined. 24 hedge under the GAAP process that I mentioned earlier when 25 they started missing margin calls. And when I say "conceptual," I just mean putting in And that really goes We actually only started to need to 334 1 COMMISSIONER WALLISON: But you did actually seek 2 coverage even before they started missing any of these 3 calls. 4 5 6 WITNESS BRODERICK: We put the structure in place to provide coverage. COMMISSIONER WALLISON: Was this your customary 7 way of dealing? 8 that caused you to be wary of where they might be going? 9 Or was there something about AIG's exposure WITNESS BRODERICK: There's certainly nothing 10 exceptional about their exposure. 11 not an unusual practice. 12 our large financial institutions, but it's by no means--by 13 no means unique. 14 I would say that this is It's not standard across all of What was interesting to AIG--about AIG in this 15 regard was that we had a number of different trading 16 arrangements with them, each of which had trigger margins 17 that were larger than our customary, zero to use the 18 examples which Mr. Cohn did and which are in fact pretty 19 customary among the large financial institutions. 20 triggers were $50 million, or they were a percentage of 21 outstanding trades, or some other variation, which on a one- 22 off basis wouldn't have caused us particular concern. 23 These But across the totality of many lines, with many 24 AIG entities, it just seemed to us to be prudent to put in 25 place this additional hedging arrangement. And so we did, 335 1 long before there was any real requirement for it. 2 COMMISSIONER WALLISON: But did you stop placing 3 these requests, or these obligations, with AIG at that 4 point? 5 When you started hedging in effect your AIG 6 obligations, which were already hedging something else, I 7 assume, did you stop dealing with AIG? 8 9 WITNESS BRODERICK: The significant collateral calls for AIG occurred in the third quarter of '07. We had 10 stopped doing really any material business with AIG long 11 before then. 12 13 14 COMMISSIONER WALLISON: you put a date on that? "Long before then"? Was it 2005? WITNESS BRODERICK: It was late 2005, early 2006. 15 We did a couple of transactions in 2006 that were not 16 subprime-related. 17 Can COMMISSIONER WALLISON: That sounds like it's 18 about the same time that AIG itself started turning off the 19 spigot, so to speak. 20 WITNESS BRODERICK: Yes, that would be-- 21 COMMISSIONER WALLISON: Was there anything that 22 you all were seeing in the market at that time that caused 23 you to think that maybe you were too exposed to AIG? 24 25 WITNESS BRODERICK: By--I'd have to go back and look at our records in detail, but I think the answer is, 336 1 no, at the time in late '05 early '06 the markets had not 2 moved materially at all. 3 minimis, and so it would not have caused us any particular 4 concern. 5 Our current exposure was pretty de They were still a AA credit. They were still 6 extremely well regarded by the market for all sorts of 7 issues, through all sorts of parameters. 8 9 10 11 COMMISSIONER WALLISON: Mr. Cohn, why did Goldman become a bank holding company and go under the wing of the Fed? WITNESS COHN: At the time we became a bank 12 holding company, the market was in severe turmoil and there 13 was a lot of volatility around the market, and a lot of 14 volatility around funding markets, and a lot of volatility 15 around price discovery and everything else going on. 16 At the time, we felt it was prudent to get the 17 imprimatur of the Fed regulation. 18 was something that shareholders, as well as counterparties, 19 as well as clients of Goldman Sachs thought was a very good 20 thing to have. 21 have to be under the umbrella of the Fed regulator was 22 important to us. 23 And having Fed regulation And we also agreed it was a good thing to So at the time we made a decision that we would 24 be Fed regulated. We thought it was something that was 25 going to happen inevitably anyways, and at that point we 337 1 just decided that it was time to do it. 2 COMMISSIONER WALLISON: Were there any 3 difficulties in short-term funding positions for Goldman 4 Sachs at that point? 5 WITNESS COHN: Not particularly. The funding 6 markets were difficult, but we were getting everything 7 funded. 8 availability was there. Spreads were wide. 9 10 You were paying more, but the COMMISSIONER WALLISON: What about your--how much were you funding, if any, overnight? 11 WITNESS COHN: I don't know the specific number. 12 We tend to run our book very small on an overnight funding 13 basis. 14 Mr. Viniar, who is here tomorrow, will know those 15 numbers cold. But I think you will see that it was a very 16 small number. We tend to term out all of our repo. 17 pay up to term out our repo. 18 COMMISSIONER WALLISON: And we So even though you 19 weren't doing much funding overnight, you felt threatened by 20 the conditions in the market? 21 22 23 WITNESS COHN: The market environment was very difficult. COMMISSIONER WALLISON: 24 you explain that to me? 25 understanding that. And how, exactly? Can I'm having a little bit of trouble I can understand if you were like, say, 338 1 a Bear or a Lehman, which were funding overnight. 2 you were not doing that very much? 3 WITNESS COHN: 4 COMMISSIONER WALLISON: 5 kind of pressure. 6 wing of the Fed? 7 I take it We were not. You were not under that So what was the reason to go under the WITNESS COHN: As I said, Mr. Viniar will give 8 you detail on our funding book night by night, if you'd 9 like. The--the issue that was going on was, was really the 10 marketplace in some regards really concerned about the 11 regulatory environment, concerned about how you ran your 12 business, concerned--and our clients, and our 13 counterparties, as well as ourself, thought it was a good 14 idea to be under the Fed regulation. 15 16 COMMISSIONER WALLISON: Did you ever use the Fed's discount window? 17 WITNESS COHN: We used it one night at the 18 request of the Fed to make sure our systems were linked with 19 their systems, and it was for a de minimis amount of money. 20 21 22 COMMISSIONER WALLISON: after that? WITNESS COHN: No. And as I said, we used it on 23 the Fed's request for de minimis. 24 COMMISSIONER WALLISON: 25 You never had to use it credit default swaps from AIG? Why did Goldman Sachs buy Was it to protect anything 339 1 in your portfolio? 2 obligations that you had already assumed to your clients? 3 4 Or was it to lay off, or hedge WITNESS COHN: Most of it was the latter. Most of the transactions we had 5 with AIG were the other side of client transactions, where 6 we were putting the pieces of the puzzle together and they 7 were one of the pieces. 8 9 COMMISSIONER WALLISON: I take it that you did not, as you said at the outset--and I thought this was 10 wonderfully candid and valuable to us--that you did not 11 anticipate what was going to happen in the future, but you 12 did begin to reduce your exposure. 13 What is the difference between "not anticipating 14 what's going to happen in the future" and "reducing your 15 exposure"? 16 Why did you do that? WITNESS COHN: We reduced our exposure on the 17 fact that our position consistently, day by day, was losing 18 small amounts of money. 19 was going on in the market. And we were uncomfortable with what 20 So we made what we figured to be a very prudent 21 decision to minimize or negate as much risk in the book as 22 we possibly can, and get closer to home. 23 were trying to have no position. 24 long, or not to be short. 25 26 COMMISSIONER WALLISON: And literally we We were trying not to be Can you put a little bit more on the term "uncomfortable about what was going on in 340 1 2 the market"? This--gut feelings in an organization as data 3 driven as Goldman Sachs doesn't quite feel right. 4 you mean "uncomfortable"? 5 WITNESS COHN: 6 WITNESS BRODERICK: What do Craig will elaborate. I think the simple matter is, 7 we had positions that we thought from a risk metric 8 perspective were low risk, and by that I mean low 9 volatility, and pretty well balanced across, in certain 10 respects across the firm, and yet they lost money, as Mr. 11 Cohn mentioned, for some relatively short period of time, 12 like 10 days in a row. 13 And one of the most important risk metrics that 14 we have is daily P&L. 15 given what we understand about the positions that we have 16 on, should we in reference to specific market moves in a 17 specific day, or longer period of time, expect to have made 18 money or lost money for that position? 19 And what we do is sit back and say, And our answer--you know, our expectation for 20 those positions that we had on was that we should be 21 relatively flat. 22 intermediation business that we were running. 23 as it was really low risk, then we were happy to run it. 24 25 This was a very low profit-margin And so long Once you start losing money for several days in a row, it causes you to question your basic understanding 341 1 about the business. 2 there's a lot more going on here than we thought and the 3 bottom is going to fall out, or anything nearly as 4 directionally specific as that. 5 something that we do not understand, and we are sitting with 6 a fairly long position because of the client trades that we 7 talked about earlier. 8 we should just reduce the overall risk until we figure out 9 what's going on in the market. 10 11 get back in. Or if we don't like it, we can stay flat. I'll be very succinct. Our risk reports and our P&L decoupled. WITNESS BRODERICK: Yes, that's a good way of putting it. 16 17 Maybe we should just flatten--maybe WITNESS COHN: 14 15 All it means is there's Then if we like the market at that point, we can 12 13 It doesn't suggest that you think, gee, COMMISSIONER WALLISON: little bit more. 18 Please complete that a We love the succinctness, but... WITNESS COHN: Okay. Our risk reports were 19 telling us one thing, and our P&L was doing something 20 different than our risk reports said it should do. 21 22 23 COMMISSIONER WALLISON: What do you mean by "risk reports"? WITNESS COHN: We run a vast majority of risk 24 reports, scenario analysis, what if, all these moves, all 25 these correlations, uncorrelated, jump to default, jump to 342 1 risk free, I can go through hundreds of them. 2 reports would have said--did say at the time, because I 3 remember going through this, that these securities in our 4 portfolio should react like this. 5 It wasn't. But our risk There was a breakdown in what was 6 going on in all of our risk reports, which to some extent 7 are all based on historical data, and exactly what was going 8 on in the market. 9 10 COMMISSIONER WALLISON: on that? 11 WITNESS COHN: 12 COMMISSIONER WALLISON: 13 WITNESS COHN: 14 COMMISSIONER WALLISON: 15 WITNESS COHN: 16 17 What was the time frame That was end of December. December of what year? Of '06. So at the end-- That period where we got closer to home, derisk, started in end of '06. COMMISSIONER WALLISON: So what you're saying is 18 that the numbers that you were expecting to see in the 19 market, which were not otherwise visible to anyone else, 20 were warning you that the market wasn't behaving the way it 21 normally would behave? 22 WITNESS COHN: The numbers I'm talking about were 23 very visible. We had a large position in AAA conforming 24 residential loans. 25 never moved more than a point in a month in decades. AAA conforming residential loans had All of 343 1 a sudden they were moving in two-point increments in a day. 2 Our risk report said that can't happen. We 3 didn't understand what was going on. 4 point, we said: 5 and we've got the position, we have a duty as caretakers of 6 the firm to get rid of that position and assess what's going 7 on with our risk reports and what's going on in the actual 8 market. 9 When we got to that If our risk reports can't say it happens, COMMISSIONER WALLISON: Well if it was visible to 10 everyone else in the market, why were you the only ones who 11 were acting on it? 12 WITNESS COHN: I can't answer that. 13 COMMISSIONER WALLISON: Was your--I assumed the 14 answer would be that your risk management techniques were 15 better, more sophisticated, or were you doing a different 16 kind of business in some way. 17 WITNESS BRODERICK: I think what I would say is, 18 the question implies that we had some great understanding or 19 expectation of how markets would move in the future, and the 20 fact is we really didn't. 21 markets are moving in a way that's unexpected. 22 explain it? 23 more down side on a risk/return basis than we had in mind. 24 25 Not really. We sat there and said, hmmm, the Can we But it looks like there's some And so I think the direct answer to your question is: It's not a view of how the market will move or anything 344 1 else, as merely equating risk to return and determining that 2 at that particular moment there was more risk relative to 3 the return than was expected in the business. 4 prudent thing to do is to reduce the risk. 5 WITNESS COHN: And so the My only inference would be that we 6 are very adamant at marking our books at real prices every 7 night. 8 denial. 9 think they make sense or not. And we were not in denial. Real trades are where we mark the book, whether we 10 11 And we are never in VICE CHAIRMAN THOMAS: Would the gentleman yield briefly? 12 COMMISSIONER WALLISON: 13 VICE CHAIRMAN THOMAS: Sure. I mean, from what we have 14 heard from everyone else, that to me is the fundamental 15 difference. 16 that didn't fit their model, either froze or tended to 17 believe the model far longer than they should have. 18 That those folks who ran up against reality And your technique of looking at profit and 19 losses and forget the model if it isn't showing up in terms 20 of profit or loss, you get out until you can figure out why. 21 WITNESS COHN: Correct. 22 VICE CHAIRMAN THOMAS: No one, no one has said 23 that was the way they operated. So I now understand one 24 basic difference between you and a few other folk that we've 25 had in front of us. Thank you for the time. 345 1 2 CHAIRMAN ANGELIDES: Thank you. going to do is-- 3 COMMISSIONER WALLISON: 4 CHAIRMAN ANGELIDES: 5 Yes. COMMISSIONER GEORGIOU: Mr. Georgiou, and then Thank you. Thank you very much for accommodating me, Mr. Chairman. 8 9 I'm going to come back. we will come back to you, Mr. Wallison. 6 7 And what we're I would like to suggest, Mr. Cohn and Mr. Broderick, that this characterization of Goldman Sachs 10 as exclusively client driven and having been forced into 11 these postures by clients is somewhat too facile in my view. 12 For example, you say you were hedged on your risk 13 that AIG might fail. 14 willingly in connection with the marks that you established, 15 you had to go out and put hedges against their potential 16 failure. 17 Once they failed to put up collateral But we never had to test the proposition of 18 whether those parties who were your counterparties on those 19 hedges were prepared in the circumstances that you called 20 upon them to actually pay up. 21 that. 22 You know, nobody will know I understand that you put those hedges up, but of 23 course people had hedges with AIG and nobody knows the 24 answer. 25 I guess I wanted to try to get to a point. A few hearings ago I asked Hank Paulson, who of 346 1 course was your former CEO and the former U.S. Treasury 2 Secretary under President Bush, and one of the architects of 3 the bailout, I said: 4 conflicts associated with the various roles played by 5 Goldman Sachs and other investment banking firms? 6 Goldman Sachs. 7 How difficult is it to reconcile the Not just You know, one, you have a role as an underwriter 8 of securities where you owe fiduciary duties to the 9 investors who purchased the securities, and to the issuer of 10 11 the securities for which you're raising funds. You act as a neutral market maker creating and 12 placing instruments for clients who come to you seeking to 13 undertake or offload a particular risk. 14 proprietary trader, acting for your own account. 15 perhaps also as an advisor representing buyers or sellers in 16 acquisition transaction or either party in a merger. 17 You act as a And And I asked Hank Paulson how difficult it was to 18 reconcile all those different roles. 19 Exceedingly difficult. 20 for the managers of an investment bank, the shareowners of 21 an investment bank, and ultimately regulators of an 22 investment bank. 23 And he said: And that's the ultimate challenge You know, these are all different roles that you 24 play legitimately within your business structure, and not 25 all of them are consistent. 347 1 For example, when you asked for collateral from 2 AIG and gave them marks which they weren't satisfied with 3 with regard to your exposure to them, some of your other 4 clients like Bear Stearns Asset Management and others 5 probably wouldn't be too happy if those marks were 6 established in the marketplace either because that might 7 require them to down-price, to mark their own book to 8 market, which would have an impact on them. 9 And I guess we have an e-mail somewhere that Mr. 10 Sparks and the mortgage group on the CDOs and CDO-squares 11 wrote that the marks will potentially have a big P&L impact 12 on Goldman's clients, and that Goldman needed to survey our 13 clients and take a shot at determining the most vulnerable 14 clients' knock on implications, et cetera. 15 important to senior management, writing this is getting lots 16 of 30th floor attention right now. This was 17 I am not suggesting that you were differentiated 18 in that regard from a number of other parties, but this was 19 an instance where you had positions. 20 protect your position by getting more collateral. 21 you identified the mark, the more collateral you got. 22 You were trying to The lower But the consequence to some other clients of 23 yours might have been detrimental, or perceived to be 24 detrimental by them in establishing a mark that was lower. 25 And since nobody knew what the marks, the proper marks were 348 1 for some of these 2 securities, you are there. So I guess I am just suggesting to you that if 3 ought not be--we ought not to leave this room thinking that 4 it is so easy to establish that there aren't conflicts that 5 have impacts on your clients when you're acting on your own 6 account, or vice versa when you're acting on behalf of a 7 client you might impact your own account in certain 8 instances. 9 And I guess one of the things that I want to 10 identify with the chart, what we have is charts 2 and 3, is 11 sort of the amplification of risk that was created by a 12 number of essentially collateralized debt obligations and 13 synthetic CDOs, and CDO-squared, and a variety of other 14 instruments that created more risk than you would expect. 15 CHAIRMAN ANGELIDES: 16 COMMISSIONER GEORGIOU: 17 is coming next. 18 whatever. 19 20 Chart 2? That's chart 3. That one So you can leave it up there if you want, CHAIRMAN ANGELIDES: Chart 2 is what he's asked for. 21 COMMISSIONER GEORGIOU: 22 chart which shows a lot of deals, basically. 23 underlying residential mortgage-backed securities which then 24 become referenced in collateralized debt obligations. 25 Chart 2. And this is a And there are You know, you have the mortgage-backed 349 1 securities. 2 equity, the BBB traunch. 3 a CDO. 4 these tranches get used in the creation of a whole series 5 of other securities. 6 You have the lowest rated tranche north of Then you slice and dice those into And then they get used in the creation--some of And it has an amplification effect where some of 7 the tranches get used over and over and over again. 8 example, some securities are replicated. 9 of the securities that you folks created, the 3408 were used 10 again. 11 170 were used a third time. 12 used in 9 deals. 13 For 2537 of the times, And then 610 were used actually a second time. And Even to one that was actually Now what that does is of course if the underlying 14 tranche fails, it has an impact on a whole number of deals, 15 potentially. 16 sense, servicing what you argue are your clients' demands to 17 be in these various instruments. 18 And this amplification effect comes from, in a But it ought not to be forgotten that these 19 various instruments also generated fees for the firm, which 20 of course you are entitled to make. 21 that also has a--sort of shows it in a slightly different 22 way, which just takes a couple of the things that you did 23 and shows that the original value of the C Tranche for 24 example of a particular funding, Glacier Funding, was worth 25 $15 million. Let me look at number 3 But if you amplify it through all the other 350 1 deals that it got used in, it ended up having an $85 million 2 essentially, in a sense, notional value. 3 in any of those--the underlying tranche failed, it impacted 4 all of these securities. 5 But when it failed I can never figure out why it is that they always 6 use Greek names to construct these securities. 7 embarrassing. 8 they do. It's sort of You know, all these toxic securities. But 9 And I guess then I would like to look at four-- 10 you know, so that's just an amplification which I think is 11 really not an answer. 12 13 CHAIRMAN ANGELIDES: Senator Graham is going to reference the other two charts. 14 COMMISSIONER GEORGIOU: 15 CHAIRMAN ANGELIDES: 16 COMMISSIONER GEORGIOU: 17 18 Is that right? Yes. Okay, well that's fine. Let me just leave it. I just wanted to make one last--I guess I didn't 19 really get to ask you a question, for which I'm sorry 20 because I've got to go off to another appointment. 21 I would just ask you all to reflect upon the dilemmas faced 22 by regulators, and really within your own firm, of trying to 23 ensure that the various roles that you play are 24 appropriately recognized and appropriately tempered. 25 I guess I guess, could I just have 30 seconds for them 351 1 each to respond to that? 2 3 VICE CHAIRMAN THOMAS: respond in writing. 4 WITNESS COHN: 5 CHAIRMAN ANGELIDES: 6 VICE CHAIRMAN THOMAS: 7 I can do it in 30 seconds. Go ahead. Oh, come on. It's a very difficult, complex response to all those charts. 8 9 Or you could ask them to WITNESS COHN: I'll be succinct. deals is what you're talking about there. It's 47 total 3400 securities. 10 This is no different than the tens of thousands of swaps 11 that are written every day on the S&P 500. 12 underliers. 13 are affected. 14 There's 500 And if one defaults, all 10,000 of those swaps This is no different than the tens of thousands 15 of swaps written every day on the U.S. dollar versus another 16 currency. 17 one reference point that is involved in tens of thousands of 18 securities. 19 Or, more importantly, on U.S. Treasuries. It is This is the way that the financial markets work. 20 People choose a specific security that they want exposure 21 to, whether it's pooled or unpooled, and they aggregate it. 22 The Dow's go 25 stocks in it. 23 of thousands of swaps, or securities written with Dow 24 components. 25 I guarantee you there's tens COMMISSIONER GEORGIOU: Well whether you push or 352 1 they pull is always subject to some question, I guess that's 2 is all I would say. 3 time you do it, and really that's one of the--that's 4 obviously one of your functions. 5 that's inappropriate. 6 7 So I'm not suggesting Mr. Broderick, just a quick response and then we'll go on to the others. 8 9 And of course you're earning fees each WITNESS BRODERICK: So long as the individual entities entering into these trades are well capitalized, 10 then there is no particular issue. 11 has come up again and again in derivatives generally, and in 12 other types of instruments, including securitization, is 13 whether there is adequate capital ascribed against the 14 risks. 15 COMMISSIONER GEORGIOU: I think the point that Right. But everybody who 16 has testified before us has essentially told us they thought 17 they were not adequately capitalized, from Alan Greenspan 18 on. 19 20 WITNESS BRODERICK: problem, not so much the reliance on a single outlier. 21 22 And therein you have the real COMMISSIONER GEORGIOU: Thank you very much. I appreciate the courtesy. 23 CHAIRMAN ANGELIDES: Senator Graham--oh, I 24 apologize. Mr. Wallison to finish up. 25 the allocation of time, Mr. Vice Chair? I apologize. What's 353 1 VICE CHAIRMAN THOMAS: 2 COMMISSIONER WALLISON: 3 VICE CHAIRMAN THOMAS: 4 COMMISSIONER WALLISON: Three minutes. Three, did you say? Yes. Good. For now. Thank you. I just 5 wanted to finish up, but I wanted to follow up on some of 6 the things that my brother Byron was just talking to you 7 about. 8 9 10 11 Why were synthetic MBS created, mortgage-backed securities, synthetic mortgage-backed securities? Would you like to answer that, Mr. Cohn? WITNESS COHN: Well, I’ll answer it. Again, 12 there were participants in the market that wanted exposure, 13 that clearly leverage is one of the components that drove 14 their decision. 15 synthetic CDOs is no different than leverage that is 16 available in many other markets today, and many other listed 17 markets today. 18 But the leverage available in these So in trying to compete with other listed 19 markets, this market-by-market participation desire to get 20 more leverage, they created a more and more levered product. 21 It also was created for real customization, 22 really being able to slice and dice up different sections of 23 the mortgage market, different regions, different asset 24 classes, different securities. It's very difficult. 25 impossible to do them in cash form. It's If you do them in cash 354 1 form, someone actually has to go out and buy it. 2 way to get long. 3 synthetic security to get short. 4 But a way to get short, you need the COMMISSIONER WALLISON: 5 nonsynthetic securities? 6 WITNESS COHN: Just as the S&P 500 does. imitates real, underlying stocks. 8 underlying mortgages. 10 These were imitating real Is that right? 7 9 That's a COMMISSIONER WALLISON: It These were imitating real So there was demand for this exposure by some group? 11 WITNESS COHN: Correct. 12 COMMISSIONER WALLISON: 13 this particular kind of instrument? 14 than, I'll call them, "real"? 15 WITNESS COHN: Why was there demand for Why synthetic rather Well, again, if you take a real 16 exposure you can only create a real exposure from the long 17 side. 18 COMMISSIONER WALLISON: 19 WITNESS COHN: To have a real exposure, you go 20 out and buy the securities. 21 mortgages. 22 are in pools. 23 Okay? Um-hmm. You go out and buy the If you go out and buy the mortgages, they So you've got to buy the whole pool. Maybe you don't want the whole pool. Maybe you 24 don't want the first 10 percent default, you want the second 25 ten percent, and you want the bottom ten percent default. 355 1 So by creating the securities, you can (a) get 2 short; (b) you can customize the attachment points of the 3 default points. 4 COMMISSIONER WALLISON: So what you were doing, 5 then, one way to look at what you were doing, is you were 6 satisfying a demand for this without creating new weak 7 mortgages. 8 WITNESS COHN: We didn't create any mortgages. 9 COMMISSIONER WALLISON: Right. But my point is 10 that real mortgage-backed securities were created from real 11 mortgages. 12 to create more subprime mortgages in order to give people 13 the same exposure. 14 You imitated them, but it was not necessary then WITNESS COHN: I would use the word "mirror." 15 mirrored them. 16 mirrored it in a synthetic form. 17 We We exactly took the pool that existed and we WITNESS BRODERICK: And I think, Commissioner, it 18 is an interesting question as to whether, if synthetic CDO 19 or equivalent products had not existed whether the demand 20 pool would have been such to in fact increase the supply of 21 subprime mortgages. 22 23 COMMISSIONER WALLISON: is my question. Well that fundamentally May I have another couple of minutes? 24 CHAIRMAN ANGELIDES: Yes. 25 COMMISSIONER WALLISON: So I just want to be sure 356 1 that we are focusing on this, because, although a lot has 2 been made about the fact that these synthetics were created, 3 nevertheless these synthetics were between consenting 4 adults. 5 were sophisticated enough to understand what they were 6 buying. That is to say, they were being sold to people who 7 These were not sold to the public. And, that it 8 amounted to an opportunity to reduce the actual--not that 9 you were assuming that this was an opportunity to do it, but 10 they amounted to an opportunity to create the same kind of 11 risk without actually making subprime or other weak 12 mortgages. 13 WITNESS COHN: Correct. 14 COMMISSIONER WALLISON: All right, let me go back 15 then to the final question that I had before, and that is: 16 You were very candid, Mr. Cohn, in saying that you did not 17 foresee the collapse of the housing market, or the housing 18 bubble. 19 And you now are in company with just about 20 everyone who has testified before this Commission. 21 seemed to see the collapse of the market. 22 judge AIG as against Goldman Sachs? Nobody So how can we 23 AIG didn't foresee the collapse of the market, 24 either, but we are treating them as having made some huge 25 mistakes. Whereas Goldman Sachs came out of it pretty well. 357 1 2 What is the difference between Goldman Sachs and AIG? 3 4 WITNESS COHN: It's a good question, and I'll try and do the question justice. 5 I think the big difference goes back to what 6 Craig was talking about. 7 active risk management business. 8 investing business. 9 We at Goldman Sachs are in the We are not in the AIG had shareholder--I'm sorry, had premium, 10 policyholder premium to invest. And they were trying to 11 create a rate of return by buying assets, buying securities, 12 and making investments to create an adequate rate of return 13 so they would have money to redeem their policies or pay off 14 claims. 15 We at Goldman Sachs are not in that business. 16 are in the active market making business, and we come in 17 every day of our lives and we try and manage our risk, and 18 we try and tailor our risk, and understand it more clearly 19 than we have the day before. 20 COMMISSIONER WALLISON: We I just want to ask one 21 final question. You're right of course, but you and AIG 22 were doing the same thing in effect. 23 purpose than you had, but what was the fundamental 24 difference between you not being able to see what was in the 25 future and they not being able to see what was in the They had a different 358 1 2 future? WITNESS COHN: As a best guess, we were making 3 our portfolio to market every day, every minute, and taking 4 realistic samplings of the environment. 5 6 COMMISSIONER WALLISON: CHAIRMAN ANGELIDES: 8 COMMISSIONER GRAHAM: Thank you. couple of minutes at the end to go back to the consenting adults' discussion, but I would like to-- 11 CHAIRMAN ANGELIDES: 13 Senator Graham. I'm going to reserve a 10 12 Thank you, Mr. Chairman. 7 9 Okay. Senator, why don't you pull your microphone towards you. COMMISSIONER GRAHAM: --but I would like to focus 14 primarily on the Goldman Sachs-AIG relationship. 15 selling credit default swaps at the same time that AIG was. 16 Were your swaps essentially the same character as theirs? 17 For instance, did you have in your swaps this provision that 18 if there was a diminution in market value that collateral 19 would be provided? 20 WITNESS BRODERICK: You were The arrangements that we had 21 for the swaps that we essentially intermediated with AIG 22 were largely-- 23 COMMISSIONER GRAHAM: No, I'm not talking just 24 With AIG--you were selling credit default swaps to lots of 25 people, right? 359 1 WITNESS BRODERICK: Most of the counterparties 2 that we did business with, we had bilateral collateral 3 arrangements with, yes. 4 5 6 7 COMMISSIONER GRAHAM: to those that AIG had, using as one example this issue of-WITNESS COHN: We wouldn't know what AIG's contracts were. 8 COMMISSIONER GRAHAM: 9 WITNESS COHN: 10 11 12 13 Were your contracts similar What? We wouldn't know what AIG's contracts were. CHAIRMAN ANGELIDES: He's asking about your contracts with your counterparties. COMMISSIONER GRAHAM: I'm telling you as a matter 14 of fact that AIG had a provision in its contracts that said 15 that--which you well know because you dealt with it--that 16 they could be required to put up collateral if there was a 17 diminution in the underlying assets' value. 18 was a somewhat unusual provision, I don't know. 19 20 21 Which I gather Did you have that provision in your contract with your customers? WITNESS BRODERICK: If the provision you're 22 talking about is the standard mark-to-market, which I 23 believe is the case, then that was the standard across most 24 of our counterparties. 25 It was not unusual at all. COMMISSIONER GRAHAM: So you were selling 360 1 basically a fungible CD to what AIG was selling. 2 right? 3 WITNESS BRODERICK: 4 COMMISSIONER GRAHAM: 5 Is that Yes. Mr. Cohn, you have a quizzical look on your face. 6 WITNESS COHN: I'm not sure that it's fung--I'm 7 not sure what AIG was selling, so I'm not sure it was 8 fungible. 9 And I don't want to mislead you. COMMISSIONER GRAHAM: Okay. I'm trying to get to 10 the point. 11 selling your CDSs at a considerably higher price than AIG 12 was selling its similar if not totally fungible product. 13 you know if that's correct? 14 There's been a statement made that you were WITNESS COHN: I would doubt that we would ever 15 have the luxury of selling something higher than someone 16 else in the market. 17 Do It's not the way it typically works. WITNESS BRODERICK: There is lots of room for 18 confusion in those sorts of statements because CDS may look 19 fungible but in fact they may be referencing different 20 seniority underliers. 21 of mortgages where one has an attachment point way up on the 22 risk spectrum, and one has way down the risk spectrum may 23 look, at cursory glance relatively similar, but in fact in 24 risk terms they are fundamentally different. 25 low, and one is very high. And a single CDS referencing a pool One is very 361 1 2 COMMISSIONER GRAHAM: Could you put four and five up? 3 CHAIRMAN ANGELIDES: Could I ask a two-second 4 question on my time, quickly? 5 a differential payment between what you were paying AIG for 6 protection and what the arrangement was with our 7 counterparties? 8 difference? 9 Were you receiving, was there Was there a significant economic WITNESS BRODERICK: 10 CHAIRMAN ANGELIDES: 11 WITNESS COHN: In terms of premium? Yes. At the time we were buying 12 protection from AIG, they were the cheapest provider. 13 someone else had been willing to sell it cheaper, we would 14 have bought it from them. 15 16 WITNESS BRODERICK: If But, Mr. Chairman, the point is-- 17 COMMISSIONER GRAHAM: Were they--do you know what 18 the difference--you said they were the cheapest provider. 19 Do you know what-- 20 21 WITNESS BRODERICK: This was not a high margin business. 22 CHAIRMAN ANGELIDES: So your sales to others were 23 higher, but not--in the range of how many basis points, 24 perhaps? 25 WITNESS BRODERICK: I don't know. 362 1 2 CHAIRMAN ANGELIDES: follow up. 3 All right, perhaps we can I'm sorry, Senator. COMMISSIONER GRAHAM: Yes. Maybe you can help 4 explain that chart there. Because it looks as if, for 5 instance, that AIG was willing for $2.1 million a year to 6 sell you coverage on $1.76 billion worth of underlying 7 assets. 8 significantly higher ratio of premium to risk--I mean 9 dramatically higher. Whereas, the other groups were selling at a 10 WITNESS BRODERICK: 11 COMMISSIONER GRAHAM: 12 chart correctly? 13 Yes. Am I interpreting that And if so-- WITNESS COHN: I don't know quite how to 14 interpret that chart, but your question I completely 15 understand. 16 were selling protection on the super super senior tranche, 17 the least likely and last to default. 18 So in the AIG block of the $1.76 billion, they Other people were selling, or buying protection 19 on different tranches with a much higher probability of 20 defaulting. 21 COMMISSIONER GRAHAM: So you're saying that this 22 chart is apples to oranges because maybe whatever TCW was 23 selling, where you had to pay $384,000 a year to get $22.5 24 million coverage may have been a significantly different 25 product than the one that AIG was insuring? 363 1 WITNESS COHN: The AIG was AAA super senior. 2 TCW transaction was an unrated security that we traded a 3 swap on. 4 5 It had no rating on it whatsoever. CHAIRMAN ANGELIDES: Senator, on my time again, can I just quickly ask a question? 6 COMMISSIONER GRAHAM: 7 CHAIRMAN ANGELIDES: Yes. I think the one thing I'd 8 like to ask about this chart, here's the real question. 9 know AIG's not hedged. million a year. 11 would you agree that these synthetic CDOs allowed for 12 enormously leveraged bets? 13 million a year; you stand to gain $1.76 billion. 14 leveraged. I mean, it's the leverage bet. I mean, To wit, you're putting up $2.1 Hugely Would you agree? 15 WITNESS COHN: 16 CHAIRMAN ANGELIDES: 17 WITNESS COHN: Correct. To both positions. To the event you can cling, just 18 like automobile insurance, just like home insurance, you 19 don't pay the whole price of your home in insurance. CHAIRMAN ANGELIDES: Right. But they're each 21 highly leveraged, correct? 22 leveraged, particularly in a synthetic CDO? 23 You But in a sense you are paying $2.1 10 20 The WITNESS COHN: I mean, these are all highly They're levered based on the 24 probability of default, of you--in essence, they're 25 leveraged on the probability your house is going to burn 364 1 down. 2 COMMISSIONER HENNESSEY: 3 CHAIRMAN ANGELIDES: Could I ask a question? And I interrupted the 4 Senator, but I'm going to make up for it some day. 5 Commissioner? 6 COMMISSIONER HENNESSEY: Insurance by itself I 7 don't think the term "levered" is appropriate. 8 pay an insurance premium on my car, which is a fraction of 9 the value of the car, right? 10 If I'm also insuring nine other cars that I don't own, I think of that as leverage. 11 12 I mean, I CHAIRMAN ANGELIDES: These were--you were buying protection on securities you didn't own. 13 WITNESS COHN: Yes. 14 CHAIRMAN ANGELIDES: 15 COMMISSIONER GRAHAM: Senator, I'm sorry. But my--in most states you 16 are required to have insurance in order to get a license tag 17 for your car, at least that is true in Florida. 18 that is true most places. 19 I think You can buy insurance for the same stated 20 coverage with wildly different cost depending on who the 21 company is. 22 company, you can do it, but you understand that maybe when 23 you actually need the insurance they may not be there. 24 25 If you want to buy from super cheap insurance Was AIG in the marketplace? cheap insurance to credit default swaps? Was it the super 365 1 2 3 WITNESS COHN: Dependent on product, dependent on day, dependent on market, we would check away. COMMISSIONER GRAHAM: No, I'm talking about 4 keeping apples to apples in terms of the product. Just like 5 the best automobile insurance company has the same contract 6 as the worst. 7 Allstate you're pretty sure if you have an accident you're 8 going to collect. 9 know whether they're going to be there when you need them. The difference is, if you buy it from If you buy it from a discount, you don't 10 Was AIG considered to be a cut-rate CD? 11 WITNESS COHN: I don't think you can say that. I 12 think AIG was on the market, and certain days there would be 13 other people that would have sold the protection at a 14 cheaper price, and certain days that AIG would have offered 15 the protection at a cheaper price. 16 17 18 I would be wrong to say consistently 100 percent of the time they were the cheap low-cost provider. COMMISSIONER GRAHAM: Well I am now going to use 19 my remaining minute and fifteen seconds to go to the 20 consenting adult thing. 21 If the consenting adults are two people who are 22 about to get in an automobile and one of them is drunk and 23 the other one agrees to ride in the passenger seat with the 24 drunk driver, that's two consenting adults agreeing to ride 25 together under the circumstances. 366 1 The problem is, the only people--they are not the 2 only two people who are going to be affected by the drunk 3 driver. 4 run over by the drunk driver. 5 It could be that it will be a third party that gets So the fact that within this arrangement there 6 are two consenting adults is not the end of the story. 7 question is what happens to the rest of society? 8 what worries me about these, what I call peripheral 9 derivatives. The And that's That is, they may be very good for a person 10 who wants to be able to engage in the most leveraged of 11 transactions, but when that activity that is gratifying to 12 that consenting adult ends up affecting the rest of the 13 population by contributing to a financial meltdown of the 14 scale that we are now experiencing, then I think you have to 15 look at it from a different perspective. 16 Now I asked the first panel, and I will ask you, 17 what is the social value of these extreme derivatives? 18 if there's not a social value, then why aren't they just 19 treated as gambling, and not given the patina of 20 respectability that they have as a security? 21 22 WITNESS COHN: I would love to answer that. Multiple factors of social value. 23 Number one, pricing transparency. 24 Number two, we brought new capital into the 25 market. And 367 1 2 Number three, we were able to build more diversified portfolios. 3 Number four, it provided ability to short. 4 Number five, it provided different ways of risk 5 transference through the system which allowed the underlying 6 mortgage market to grow. 7 COMMISSIONER GRAHAM: How many of those could you 8 accomplish if you were doing this on a Nevada Gaming 9 Commission regulated market? 10 WITNESS COHN: 11 CHAIRMAN ANGELIDES: 12 WITNESS COHN: 13 CHAIRMAN ANGELIDES: 14 pumpkins in this room at 6:00. 15 16 17 18 19 All right. I'm not a gaming expert. By the way, we turn into COMMISSIONER GRAHAM: This consenting adult is surrendering his last 29 seconds. CHAIRMAN ANGELIDES: Thank you very much. Douglas Holtz-Eakin. COMMISSIONER HOLTZ-EAKIN: 20 Mr. Chairman. 21 today and your patience. 22 I don't think any of them. Thank you, And thank you to both of you for your time I just wanted to clean up some details. I found 23 your answers to Commissioner Born's questions about the 24 management information systems, and not keeping separate 25 books for derivatives, it was utterly convincing but it did 368 1 raise the following question: 2 3 If you don't track those separately, how do you pay your derivatives desk? 4 WITNESS COHN: 5 derivatives desk. 6 per underlier. 7 We don't have a specific Everything is commingled. We manage risk So I don't have to make that decision how to pay 8 a derivatives desk, because in certain situations you have 9 to look at 10 the whole thing. COMMISSIONER HOLTZ-EAKIN: Second question. It's 11 been said, and I think you even said this, Mr. Broderick, 12 that the CDOs, the credit default swaps, contributed to 13 difficulties in transparency which may have exacerbated the 14 financial crisis. 15 exactly those same instruments--however complicated they may 16 be--you were able to assess very well your counterparty risk 17 versus AIG. 18 steps to mitigate those exposures. 19 But at the same time, in the presence of And indeed at the right points took conscious That seems to be a little bit of a contradiction. 20 Can you help me out with that? 21 that? 22 WITNESS BRODERICK: Why couldn't everyone do I think we have a risk 23 culture which is focused on effective risk management, and 24 it includes the components that I noted earlier, starting 25 with effective mark to market. And when I say, or I would 369 1 agree that from time to time transparency is less than one 2 might like, it means that marking to market is harder than 3 one might like. 4 And that means that you need the right people, 5 and you need the right processes and procedures, and so 6 forth. 7 you've got to devote those resources. 8 and other successful participants in the market have as 9 well. 10 But to be an effective participant in this market, COMMISSIONER HOLTZ-EAKIN: And I think we have, Just to I understand, 11 that difficulty in marking to market is independent of 12 freeze ups, lack of transactions, things like that. 13 just the difficulty in seeing through these instruments and 14 marking them to market? 15 WITNESS BRODERICK: No. It's It's particularly true 16 during times of market stress. 17 middle to late '07 for instance when the market was--when 18 the underlying subprime market was highly volatile in terms 19 of payment performance, and so forth, and the underlying 20 asset prices were therefore fluctuating quite a bit, and all 21 the associated derivative products, whether it was the RMBS, 22 or whether it was the CDOs, or whether it was the synthetic 23 CDOs were moving accordingly. 24 25 It was particularly true in It was, you know, it was more challenging than usual to track the--to track what the actionable price 370 1 across these portfolio of products was. 2 COMMISSIONER HOLTZ-EAKIN: Leading question: 3 everyone had had Goldman Sachs' risk management regime, 4 would we have had a financial crisis? 5 WITNESS BRODERICK: 6 WITNESS COHN: If You can answer that. Pure guess. I think we still 7 might have. Because at the end of the day, it's not a 8 science; it's an art form. 9 man-years and women-years dedicated to understanding those 10 reports. 11 risk manager. 12 So we've got hundreds of years of Just having the reports doesn't make you a great And having the organization that we have with a 13 operations, compliance, controllers function separate, then 14 the trading and the controllers and compliance ultimately 15 having ultimate authority, and having a senior management 16 team like Craig and myself and David Viniar who will be 17 here, and others, living risk management every day of our 18 lives, the systems clearly would have helped them, but again 19 you've got to interpret the system. 20 COMMISSIONER HOLTZ-EAKIN: Okay. Thank you. 21 mean, that's actually very helpful. 22 question, which is: 23 Goldman Sachs had for a long time a plan on the shelf to 24 become a bank holding company. 25 I It does lead to my next Andrew Sorkin reports in his book that WITNESS COHN: Is that true? Correct. 371 1 2 COMMISSIONER HOLTZ-EAKIN: And why would you have such a plan in place? 3 WITNESS COHN: We--we are in the risk management 4 business, and we manage all of our risks. 5 alternative outcomes available to us. 6 something that we had been contemplating for a long period 7 of time, and based on what was going on in the market, and 8 based on where we felt the regulatory environment was going, 9 we decided to execute. 10 COMMISSIONER HOLTZ-EAKIN: We try and have And that was So before you 11 executed, when you decided to have such a plan on the shelf, 12 what risk were you managing? 13 WITNESS COHN: Just managing the overall 14 positioning of Goldman Sachs in the world, becoming a bigger 15 firm, becoming a more global firm, dealing with different 16 clients. 17 Some of our clients wanted to trade with banks. 18 We had certain clients that had different capital or margin 19 requirements if they traded with a bank versus a nonbank. 20 And so there were certain business that we had to forego by 21 not being a bank. 22 And you're always going through an analysis of 23 should you become a bank to pick up that additional 24 business? 25 always felt like we needed to have an actionable plan on the What are the pros? What are the cons? And we 372 1 shelf. 2 COMMISSIONER HOLTZ-EAKIN: How much did access to 3 Fed Discount Window lending in times of liquidity crises 4 figure into having that on the shelf? 5 6 WITNESS COHN: Not at all. We don't really have assets in our bank that were eligible for the Fed Window. 7 COMMISSIONER HOLTZ-EAKIN: Okay. And then I have 8 just a couple of minutes left and we have to get out of the 9 room, but I want to take this opportunity to just ask you 10 your views on something that we hear very different things 11 about. 12 This morning Professor Kyle from the University 13 of Maryland said very clearly that prior to Bear there was 14 an expectation by large financial institutions that they 15 could shift losses to Taxpayers, that too-big-to-fail was a 16 real thing, that the moral hazard was inaction, and that it 17 affected the behavior of firms such as yours. 18 Others have asserted that, no, that wasn't true 19 until the Federal Government's actions toward Bear Stearns, 20 and then certainly in the aftermath of Lehman there became 21 this cemented notion. 22 What is your view of the Goldman Sachs 23 expectations regarding government intervention prior to 24 Bear, post-Bear, and how do you think the rest of the market 25 perceived this? 373 1 WITNESS COHN: Prior to Bear I had never once, 2 for one millisecond, thought that there was any backstop in 3 our organization, or business, or in the financial services 4 industry. 5 I felt every moment I was at Goldman Sachs that 6 we needed to run our business independently, and if we made 7 mistakes and did things wrong we would have to suffer the 8 consequences, including all of the unforeseen things that 9 could potentially happen if things really got bad. 10 11 12 COMMISSIONER HOLTZ-EAKIN: And after Bear Stearns? WITNESS COHN: After Bear Stearns, there was 13 confusion, to be honest with you. 14 what happened. 15 this the new game plan? 16 How was the world going to react? 17 Brothers weekend even more confusing for people. 18 19 20 21 How it happened. Why did it happen? Was Was this not the new game plan? Which made the Lehman Not only did it make it confusing for financial institutions, it made it confusing for world investors. COMMISSIONER HOLTZ-EAKIN: All right, Mr. Chairman, I yield back. 22 CHAIRMAN ANGELIDES: 23 Mr. Vice Chair? 24 VICE CHAIRMAN THOMAS: 25 There was confusion to Thank you. I have a duty to try to make sure that we have an accurate record. And as I recall, 374 1 Mr. Cohn, you were talking about AIG in terms of their 2 investment concerns, that they had to get a return on 3 investment that dealt with the premiums. 4 And the discussion that we had was with the 5 subsidiary of AIG, which was the Financial Products. 6 understanding is they were completely walled off from any of 7 the insurance activities in AIG. 8 statement that you made about their motivation? 9 10 WITNESS COHN: Would that change the That would change my motivation. 11 12 Yes. And my VICE CHAIRMAN THOMAS: I figured it would, if I'm accurate. 13 WITNESS COHN: Yes. 14 VICE CHAIRMAN THOMAS: So we have it on the 15 record and we work with it whichever way it goes. 16 you. 17 CHAIRMAN ANGELIDES: Thank Ms. Born asked if she could 18 ask a quick clarification before we adjourn out of this 19 room. 20 COMMISSIONER BORN: Mr. Cohn, you said that you 21 thought the systemic harm could have come from AIG if the 22 government hadn't stepped in to backstop it because of its 23 concentration in certain instruments, and you didn't 24 designate the instruments. 25 swaps? Did you mean credit default 375 1 WITNESS COHN: That was one of them. But they 2 were a huge player in other markets as well. 3 big repo counterparty. 4 They were involved in many different asset classes. 5 They were a They were a big secured lender. They had an enormous amount of paper out being 6 owned by the money market funds. So money market funds were- 7 -I could go through. 8 chambers, or silos where they would have had an effect that 9 would have been systemic. 10 11 There were a lot of different COMMISSIONER BORN: They were just such a big player in so many markets. 12 WITNESS COHN: Yes. 13 COMMISSIONER BORN: 14 WITNESS COHN: 15 COMMISSIONER BORN: 16 CHAIRMAN ANGELIDES: They were too big to fail. In essence, yes. Thanks. All right. Thank you very 17 much. Just the one thing is, there are some follow up pieces 18 of information, which we have discussed. 19 bone, on this management information system, we want to 20 press that. 21 Like a dog with a I know you had all these contracts. I've got to 22 believe you actually track revenues from contracts, but 23 we'll pursue that. 24 25 I want to thank you for coming. the public who listened in today. I want to thank And I want to thank 376 1 Senator Dodd and the Senate Banking Committee for once again 2 allowing us to meet in this hearing room. 3 I want to thank all the Commissioners and the 4 staff for their hard work, and we will adjourn for now and 5 reconvene at 9:00 a.m., in this room, tomorrow morning. 6 Thank you all very much. 7 (Whereupon, at 6:01 p.m., Wednesday, June 30, 8 2010, the Commission meeting was recessed, to reconvene at 9 9:00 a.m., Thursday, July 1, 2010.) 10 11
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