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How We Missed the $8 Trillion Housing Bubble

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.

Recorded on November 9, 2009

AIG’s former head council Ernie Patrikis thinks society should take the blame.

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