A conversation with the White & Case partner and former council of AIG.

Question: How did you get to be the head council at AIG?

Ernest Patrikis:   When I was 55 years old, and I had been at the Fed for 30 years and decided that I was the number two officer of the New York Fed, First Vice President, that they weren’t going to make a lawyer the President of the New York Fed. I decided it was time to move on and I called various people I knew in the neighborhood and amongst those were Hank Greenberg.  I went and met with Hank and he was the fastest.  He said he’d give me a call in two weeks, which he did.  Wages, hours, conditions of employment.  And I had no idea what I was going to do and I don’t think at that time he had any idea what I was going to do. 

I worked for Hank for a year and I called myself – and it was the role that I carried out mostly at AIG-- a “firefighter,” for him, where there was a problem dealing with that problem, going to the next problem, and it also gave me a chance to learn the company.  It was huge, compound, complex, I got to meet people in the United States and abroad and get a feel for the company.  And then I became General Council there.  But working for Hank was a delight.  Notwithstanding his reputation. 

Question: What are some misperceptions about Hank Greenberg’s reputation?

Ernest Patrikis:  Well one, he certainly is tough and resilient; all of those stories are true.  There’s another side of the man about how concerned he is about employees.  How much loyalty and how important loyalty was with him.  Those stories about when a head auditor in Asia had a heart attack in Thailand, Hank stayed up all night on the phone with doctors from New York Hospital and with doctors in Thailand. 

The Star Foundation – and I don’t know if he started this or carried it out, he may have started it.  Every employee for AIG and agents of AIG in the United States and abroad, and these were agents who were – as in Asia, they only sold AIG products, got a scholarship if their child went to an English language college.  The scholarship amount was something like $10,000 or $11,000 and there had to be financial need.  If there was no financial need because the parent was making a large enough salary at AIG. 

So, when one looked at the Star Foundation’s annual IRS report, name of individual after individual after individual and I really learned the scope of it one day when I was in a private dining room waiting for a guest and this gentleman waiter, who was obviously from mainland China.  I asked him what he was going to be doing Labor Day.  And he said he was driving to Cambridge.  And I said, “Why are you driving to Cambridge?”   He said he was taking his daughter, first generation American-born, to MIT, and called it Star Scholar.  So, for people like him, this individual, this was rather significant. 

And that is really something that he really kept up with.  Of course the amounts of money that he gave and the foundations he gave to health and medical, you see that at New York Hospital.  But most of all, he truly cared about employee loyalty.  Loyalty was extremely important to him.  And I think that came out of, perhaps, his Army experience.  You know, when he enlisted under-aged in the Army.  When you’re in a platoon, you develop that amongst people, and he would sometimes say something, I wouldn’t be in a fox hole with that person, which, again, goes to loyalty and trust. 

He decided, I guess, the Head of the Star Foundation was going to be stepping aside.  Florence Davis was the General Council and was going to become the head of the Star Foundation, and I think Florence still is, and he asked me to be General Council.  And that was a unique experience in that I had reorganized the Legal Department at the New York Fed when I was there as General Council.  At AIG, I had to reorganize the Legal Department and put it into some semblance, and it took a while to get a feel for people, and that really for the first I would say, nine months to a year was my major task, was organizing this gigantic Legal Department.  Even when I left eight years later, I’d say it was still a work in progress.

Question: How did we fail to see an $8 trillion housing bubble? (Dean Baker, Beat the Press)

Ernest Patrikis:  Well Shiller at Yale wrote a book, that’s his name, and told us that we had this huge real estate bubble.  I didn’t read the book, but I knew what he was saying.  And awful lot of people knew about it.  The way I look at it, there’s no single cause.  This event, as horrendous as it is, took an awful lot of people working hard to get us there.  It’s bank supervisor’s not doing their job, it’s directors and management of financial organizations not doing their job.  It’s Congress not doing its job with Ginnie Mae and Fannie Mae.  I can go on and on with a large list.  It’s the securitizers who were securitizing and had no skin in the game in terms of the loans they were working at. 

It was the investment banks who would specify the nature of the securitized products and what those loans must call for.  It was the rather slimy brokers for real estate lending and mortgage bankers.  It was S&L’s, Federal S&L’s who had these transactions go through them for usury purposes who really didn’t care what the transactions were.  It just goes on and on.  The Fed, the interest rates too low.  So, it really, I think inappropriate to say it’s any one person when I think it’s a systemic event, and that’s what we have is a systemic event. 

Society is to blame, not any single group of people and we should punish any single group of people.  Our firm gave a presentation last February, and I think we listed two full pages of what I call, “The Villains.” 

Question: How is AIG to blame?

Ernest Patrikis:  Well, at AIG-FP, Financial Products the Swap Sub to me the financial products was unique amongst the AIG Subsidiaries, it was almost as if it was not a part of AIG.  It was extremely independent and set up to be that way.  It also was, I think, unique in that four of the holding company directors were on the board of AIG-FP.  Mr. Greenberg, Howie Smith the CFO, Bernie Adenoff, retired from Sullivan and Cromwell, and Nani Feldstein.  Hank was pushed out because my relationship with these people, they put their arms out and kept me away, as others, and they were successful in doing it because Hank supported them being separate.  I don’t know what kind of oversight was being carried on when we were redoing the Annual Report in 2005 and afterwards.  I’m happy to say, the trades were put on after I left, but I wouldn’t have known about it anyway the way it was run. 

And I also don’t have a full understanding of what happened with risk management.  AIG was perhaps one of the few firms that early on had market risk at both the level of the profit center and in the holding company.  What did happen is that the Senior Market Risk Officer retired.  There was a reorganization and he was going to report to somebody, and I think he decided that he’d rather not report to someone.  He had been reporting directly to Hank and had a good rapport with Hank and he had a feel for financial products and he was tough enough to deal with him.  With him gone, I suspect we lost some edge, and with Hank gone, we lost an edge.  And so the thought about the massive bailout because of the needs of collateral, I don’t know why all those trades were put on. 

But what we’re seeing now is, for many of them, the risk was market value risk.  It was the same thing as long-term capital management.  At AIG, Berkshire Hathaway and Goldman Sachs were going to buy Long-Term Capital Management’s book.  The book would be in the money at maturity.  It was baked-in-the-cake profit, it just didn’t have the capital to get there and we didn’t get a chance to do the transaction because of a meeting at the New York Fed.  In the same way, I’m guessing now, I don’t know, that the financial products book may well be in the money.  Yes, there probably are some bad credit default swaps, but some of that collateral was starting to come back. 

So, it was the need for massive amounts of – the way FP ran is, every transaction was guaranteed by the holding company, by AIG, which was then AAA, which was then AA, and there were triggers in the swaps, so when AIG was downgraded, it affected FP.  Put all of those events together and the massive need for collateral the banks were unwilling to put up, maybe it was just too much for them or they couldn’t see it all, but that was a shock to the system in terms of size, but not a big a shock to the system as Lehman.  I think AIG was sort of gravy.  I think the real massive amount was the Lehman shock to the system of the Lehman failure after the Bear Sterns bailout.

Question: After 2006, what was the thinking among regulators and financial professionals concerning a scenario in which housing prices fell significantly in many areas of the country? (Arnold Kling, Econlog)

Ernest Patrikis:  I think they both had a mistaken view.  And I think – the thought really, if I can recall correctly, really is that the product could withstand it.  That the investors who invested in these products were all mature adults, able to invest buy side investors.  Many of the AAA tranches were acquired by banking organizations who thought they were safe.  And they bought credit default swap insurance on it.  I think there was just too much of an assumption that the product would take care of itself.  That if there were defaults the risk was spread. 

The whole thought of credit default swap and securitization was the spreading of risk and I think that what we’ve learned is that, yes, you can spread it, but the other part of it was, you couldn’t get rid of it because of the lack of liquidity in the market.  And I really see the major issue and the major signal for me was early on when there was no 30, 60, 90-day money in the market and people with positions couldn’t finance themselves.  And I think the Fed was a little slow to pick that up.  But I think too much assuredness in the product. 

It will be interesting to see when the product does come back in a major way, will it just come back again in the same way?  There won’t be any features on it that will yield control in the banking organization so they can get these off balance sheet, not have some of them come back like they are coming back.  But I think there was just too much of an assumption that this product worked.  I guess we’d have to look back to the last recession and say, there really weren’t a lot of issues in housing of a great degree – securitized housing in the last recession, so we lacked experience. 

And the major concern on securitizations was in a market of falling interest rates, people doing refinancing, and we didn’t see that in this market.  Perhaps we’re seeing a little now when people can do it.  But I think the answer is to be a little more skeptical of the product.  I’m disappointed in the buy-side.  We’ve had a lot of criticism of the sell side, which is deserved, but a lot of the people buying these products were institutional investors. 

Question: Would the situation have been better or worse if the bailout had gone to AIG counterparties rather than to AIG itself? (Tyler Cowen, Marginal Revolution)

Ernest Patrikis:  The bailout got to AIG counterparties.  Well, I guess they were bailed out.  I don’t know what that means.  Does that mean if AIG had failed?  I don’t fully understand the question.  Is it assumed that AIG failed and the failure of AIG would cause knock on failures of other firms would have to be bailed out if AIG were in a bankruptcy proceeding?  It would have been messy. 

I really saw the AIG problem in another light.  I think we saw, if I remember correctly, the beginning of some runs in Asia.  Life insurance in Asia is a savings product.  I think Asians will gamble on anything except their lives and there were some runs.  And that would have had a horrendous affect and countries where AIG was a major insurer, Taiwan, Thailand, Philippines, Hong Kong, huge problems there, plus the Narcon affects here of the major banking organizations who were the counterparties who needed the collateral.  So, I think it was a variety of issues. 

And if AIG had gone into bankruptcy, I think the subsidiaries would have had a harder time continuing in business.  At least, as I see it, Chartis, now of AIG Property and Casualty Subsidiary, is percolating along doing fairly well, it’s taken a beating with competitors.  The life insurance company in the states is doing fairly well; the companies outside the United States are doing fairly well, so it’s very interesting,

AIG had a flat organization chart with profit centers and with the exception of financial products and then those who needed financing, I mean the ILFC, the aircraft leasing company, has huge amounts of money to rollover.  Good company, well run, and the issue is certainly not credit worthiness, but financing.  And then AIG’s subprime lending sub.  I learned there are different kinds of subprime lending.  There’s the good subprime loans and the bad subprime loans and that subsidiary was doing fairly well the last time I talked to people.  So, what I see AIG is doing is just exacerbating a problem.  The Lehman shock to the system, the AIG shock enforces it.  And AIG has really become much more of a political issue because of the amount of the bailout. 

Question: How difficult would it have been if a non-bank resolution authority was in place to wind down AIG and transfer its obligations? (Dan Indiviglio, the Atlantic Business Channel)

Ernest Patrikis: Well, if we had something like the proposed legislation which would cover AIG because it has a federal savings bank, then AIG itself could have become part of a bridge bank.  In other words, the holding company in effect would be there and all its assets transferred, it would have adversely affected the shareholders and whatever creditors were not transferred over and continued in business.  This is the resolution that is being considered by Congress, which I think is helpful for institutions who live on liquidity and liquidity is very important to them. 

If that resolution authority hadn’t been in place, it would have been a lot easier to do it. Instead of this thing with the Fed lend some money and the Treasury lend some money and there’s a lot of opaqueness to that and one really has to drill down to understand it all.  But a bankruptcy from AIG would have affected all of the subsidiaries I think and it would have been in much worse shape than today. 

Question: How would you address the problem of regulatory capture? (Ryan Avent, The Economist)

Ernest Patrikis:  I really don’t see it.  I look at my own career of 30 years at the Fed where I did a lot of supervision.  I have a lot of friends in commercial investment banks.  That didn’t affect me when it came to doing remedial work.  I think the answer is, we got things done faster because we knew each other, we’ve dealt with each other over the years.  I really don’t see regulatory capture. 

And this goes go a whole other point that I’d like to get into if anyone hasn’t asked the question.  There is the structure of the Federal Reserve Banks.  Each Federal Reserve Bank has nine directors, three of them are appointed by the Board of Governors including the Chairman and Deputy Chairman of the Reserve Bank, and six are elected by shareholders.  One’s a big bank director, one’s a medium bank director, and one’s a small bank director, and the others are commerce industry, agriculture, labor.  They do not get into bank supervision at the Fed.  Where they help the fed is in terms of what they see in the economy, what people are telling them.  These are usually people who are leaders in their area, be it a union, or banking, or large business organization, global institution.  And provide a lot of insight into what’s going on in the economy.  Every two weeks, they meet and they vote on an interest rate, and then that goes down to the Board of Governors in Washington, along with a message which sums up the director’s feelings of up, down, or stay the same.  And that is not effective until approved by the Board of Governors. 

That system has worked so well over the years about giving intelligence to the Reserve Banks, the Board of Governors.  Again, these people do not get involved in bank supervision.  Some people want to change that.  And in effect want to make the Reserve Banks much closer to the Federal Government than they are today.  And I think that’s not going to happen.  I’ve asked myself why over the years at the Federal Reserve Bank in New York, where people in the community, so willing to tell us about things wrong. And I remember once an SEC Chairman saying, “Why is it they call you, and they don’t call me?”  And the answer is, I don’t think capture.  I think it’s trust, relationships over the years being in the market and that’s an issue that’s being pushed on and I just don’t think it’s right. 

Question: Should the size of large institutions be an area of concern for reasons of political influence and systemic risk? (Ryan Avent, The Economist)

Ernest Patrikis: I don’t think that size alone is an issue.  I mean, every institutions does the right thing, they’re reporting fully the amounts they spend on lobbying.  I know when I was at AIG we were scrupulous about it and we always wondered about whether other firms were as scrupulous as we were in terms of reporting what we did. 

I would go, not monthly, but periodically go and visit, not to lobby, but to let people on “The Hill” know where we were going, directions, issues, things like that.  I don’t know that large institutions – I didn’t hear large labor unions in that statement.  I didn’t hear about other organizations in that statement, and smaller institutions also have organizations, financial and otherwise.  There are the trade associations.  I don’t think it’s any more pervasive – but I’ve always thought in banking, no bank could get a law, they might be able to slow one down, but very, very difficult for a bank to say, here’s what we want, please enact it.  I just don’t see that kind of capture of “The Hill.” 

Question: What would the situation be today if Lehman had been rescued? (Steven Landsburg, The Big Questions)

Ernest Patrikis: I think it would have been different in the degree of severity.  We still would be going through this crisis.  I just think the shock to the system was too strong.  And if we didn’t show the resolve that we needed to, and then when it came to issues like the legislation, how poorly the bill was handled, the TARP Bill was handled, both in the administration and in Congress.  So the Narcon of the Lehman is equally as bad as the decision not to save Lehman. We’d still have all the problems with credit worthiness and those securitizations today, but I think the severity would have been tempered somewhat. 

Question: What could the Fed have done differently in 2007 to mitigate the severity of the crisis? (Steven Landsburg, The Big Questions)

Ernest Patrikis: I don’t know if it was 2007, or earlier when there was good luck in the marketplace.  I remember there was an early intervention by the European Central Bank putting liquidity into the market.  It was massive.  And the Fed followed and put in less liquidity.  And I said to myself, gosh, look at those guys in Frankfurt and all, they’re trying to look like heroes taking this major action.  And the Fed was just following to show that they were there.  And I looked back at that one and I say to myself, I was absolutely wrong in terms of my judgment about it.  That the ECB had it right, and more liquidity should have been provided to the market earlier on.  Again, not a cure all, but perhaps could have tempered the impact on the market somewhat. 

Question: Was less control for CDS’s a general system wide problem, or was it only for AIG counterparties? (Jeffrey Friedman, Causes of the Crisis)

Ernest Patrikis: No, I think the question, I guess, for the counterparties at AIG, and this is a major issue, and not just swaps, but in the wholesale market and that is, to what extent do participants in their market know the current financial position of their counterparties?  I think the answer is, people don’t ask.  They just deal with each other.  This has been a question for 20 years.  Why should I do the trade with you, what’s your financial condition today, and then one answer is, well, if it’s an institution that trades a lot, it can be completely different tomorrow in terms of the financial condition. 

The credit default swap as an instrument has been unfairly attacked.  Now, I have my prejudice.  I was on the board of ISDA, the Swaps Trade Association for a number of years, but I think the product worked well, it continues to be a product that gives us price on securities, and it’s a good indication of price on securities.  Outside of AIG it’s worked well.  In Lehman, there used to be issues on documentation and I credit Tim Geitner in terms of toughing up as should have been done long ago on the need for firms to tighten up and get their documentation complete. 

And someone was telling me of the number of trades, that Lehman has a huge number of trades.  Only one resulted in litigation regarding the validity of the trade because of documentation.  So, I think the swap worked well.  That’s not to say that there’s not a need for standardized swaps to be dealt with on trading platforms and settlement mechanisms, for regulators.  For example, the Basil II perhaps in dealing with the trading book as opposed to the credit book perhaps didn’t have a high enough capital charge.  It’s not to say that everything was perfect, but I think the credit defaults were up was deemed to be the evil instrument because of AIG. 

At AIG it was an issue of risk management.  And I put these two and say the two key words for the next several years in terms of banking supervision are quality of risk management, and quality of liquidity management. 

Question: Was the main counterparty to AIG Goldman Sachs?

Ernest Patrikis:  I don’t know.  I read the papers and say, yes, Goldman Sachs was a major counterparty and there were many stories in the market about debates between Goldman Sachs and AIG on valuations and things like that, that were a bit strange.  So, when someone writes the book maybe they will be able to give us more insight as to really what was going on there. 

Question: Goldman Sachs has claimed the $14 billion they received from AIG’s rescue was immaterial for their bottom line. Do you believe this to be true? (Russ Roberts, Café Hayek)

Ernest Patrikis: Well, I mean, if they were getting collateral from AIG it was good quality collateral.  What were they doing with it?  They were probably re-pledging it.  Hopefully, they were re-pledging it with collateral and were seeking back something that was liquid so that they would have the opportunity if they needed to pay it back as rates changed, market rates change.  So, to me, we’re talking about collateral.  It is an issue of where is my collateral, with the counterparty, that will be focused on by examiners.  The rate I’m charged on my swap will depend in part if I have to put up collateral, whether I let my counterparty re-hypothecate the collateral to another party.  Will people become nervous? 

I had one instance where there was a client who was posting collateral with a bank and the central bank of that country guaranteed all deposits.  So, the client said to the counterpart branch in a foreign bank here in New York, “I want to place that collateral with the bank in the foreign country where it’s 100% guaranteed”  So, in a nervous world we’ll see things like that happen. 

Question: What keeps you up at night?

Ernest Patrikis: Nothing keeps me up at night.  I sleep well every night.  If you ask me what I think about when I’m awake, it is I hope we don’t double dip as an economy.  I think that’s one concern that we perk along, we don’t have a fast up and then a down.  We don’t drop down again.  Over the longer term, I hope that the Fed, when it has to and now is certainly not the time, but when it comes time to really increase rates that the Fed does it, that the will is there.  And I look at the Fed and say, there are seven governors, there are two openings now and there probably will be more.  I would suspect that one or two of the present governors could possibly leave.  And that would give President Obama five out of seven, would be his people.  And that has the potential to cause a problem if Chairman Binacci wants to go one way.  The Fed is not a monolithic beast.  The Chairman is a powerful person, it always has been.  But the decisions of the Federal Local Market Committee require a vote of 12.  So, when I talk about interest rates and I read economists say, look at this, look at this, look at this, I say, “Look to see, when you see the first descent at a Federal Open Market Committee meeting on interest rates, then we’ll know we’re on the way.  Someone will be ahead of the curve, maybe too early, but it takes one brave, probably Reserve Bank President to do it, but we should have the spirit to go to the non-inflationary course that we had before.  We all know it’s an issue, it’s no secret, and I have no reason to believe the Fed won’t do it, but I can feel uneasy. 

Recorded on November 9, 2009