When the downgrade came, it was decision time for one man. In his offices on Manhattan's West 54th Street, a professional Doubting Thomas named Jim Chanos had spent the previous two years doing what he described as "brutal" work into the reality of AIG's financial state of affairs. After hundreds of man-hours doing what could fairly be described as a forensic reconstruction of one of the world's largest companies, he was even more confused than when he started.
For many men, the prospect of working that much on something for that long and having little certainty of an answer would be demoralizing. For Jim Chanos, this was good news: he was a short-seller who made money borrowing stock and selling it on the open market on the view that it would decline in value. Thus, his profit was the difference between where he sold the shares and where he eventually bought them back and delivered them back to the lender.
Looking for what couldn't be readily explained had made Jim Chanos a very rich man, but the more he and his staff looked at AIG, the more he couldn't figure how they did it, quarter after quarter, year after year.
Chanos had sprung into the popular imagination when Bethany McLean, a Fortune magazine reporter with a Wall Street background and a love of writing about corporate wrongdoing, wrote an article in March 2001 about a company whose earnings were difficult to trace. Everybody and their grandmother seemingly owned shares, and the media lionized its executives, but she couldn't get a handle on where this magic came from.
The company was Enron. There wasn't much of an effect when her article came out in the spring of 2001.2 Around Labor Day, though, after CEO Jeff Skilling left and the Wall Street Journal started writing a series of articles looking at a group of off-balance-sheet transactions involving hundreds of millions of dollars of debt it had not disclosed, the article looked mighty prescient indeed. Chanos, it would be revealed, played a central role as McLean's source in the Fortune story. He was aided by a pair of Journal reporters, John Emshwiller and Rebecca Smith, whose reporting actually led to the ratings downgrades that forced Enron into bankruptcy.
Enron was Chanos's most public triumph, but not his first. He had found a measure of fame (or notoriety, as his legion of detractors would have it) as a 24-year-old junior analyst in 1982 covering the insurance sector for Gilford Securities, a small brokerage. Well-regarded insurer Baldwin United had evolved from a sleepy piano company to a financial conglomerate after merging with a mutual fund and using massive amounts of borrowing to get into, among other things, mortgage insurance. Chanos, based on state insurance filings that said it was dipping into reserves to get cash, issued a "Sell" rating. No one listened, and the stock doubled. So Chanos doubled down, fleshing out his accounting and cash-flow arguments in more detail and advising clients to sell the stock short. His trading desk lost clients, others scoffed, Baldwin United threatened to sue, and a rival analyst publicly sneered.
Then, on Christmas Eve in 1982, insurance regulators seized the company because it was, per Chanos's arguments, dipping into policy holder reserves for desperately needed cash.
The life of a Wall Street skeptic was not unbridled blessing. A few years later, given a chance to manage money at Deutsche Bank Asset Management, Chanos was unceremoniously dumped from his job when a Wall Street Journal article portrayed him and other short-sellers as spreading rumors and using sneaky tactics to get information on companies.3 So the Wisconsin native launched his own fund, named Kynikos, Greek for cynic.
Unlike other short-sellers, he didn't get too wrapped up in executives, their ability to operate, industries, product success or failure, or even a company's competitive position. He reasoned that good companies can have bad executives and vice versa, and betting on a drop in a stock's price because you think you know more about a product or market cycle in industry wasn't how he wanted to spend his days. Instead, he and his analysts tracked cash flows and return on capital. Chanos wanted to bet against companies whose finances were dependent on manias or fads. Betting against Drexel's clients, for example, in the late 1980s—especially the ones involved in real estate—was obvious. The companies had no cash flow other than what Drexel's junk-bond desk could raise for them. When Drexel went, most of these companies couldn't get additional financing and withered away.
Chanos's reasoning behind it was simple. If a company could not consistently earn a rate of return above its cost to borrow money—if it earned 4 percent on the capital it borrowed but paid out 6 percent to its lenders—that company would eventually have an existential crisis. Executives and their plans came and went, but companies that couldn't generate cash without borrowing it all faded away sooner or later. Companies that were dependent on demonstrably short-term trends like certain kinds of federal contracts or fads for their cash flow were also welcome opportunities.
Using return on capital as a benchmark also allowed Kynikos analysts to reduce complex and opaque companies down to a few simple questions: Is this company able to stand alone without aid from the markets? Or is it in a cash flow spiral and cannot exist apart from capital raising or loans?
If the answer to the former was "yes," then there was an excellent place to begin researching Kynikos's next short.
Chanos had had his eye on AIG for some time. When the insurer was downgraded in March, he ordered a full review of its financials from his staff. If Chanos had some differences in operating style from other short- sellers, temperamentally he was no different from them: an avowed skeptic and financial freethinker, he believed very little in the way of official explanation. At bottom, he did not believe for a second that rating agency concern over the Brightpoint and PNC transactions were the sole reasons for AIG's downgrade.
He began to push his staff harder. He sent spreadsheets back for more work and asked that they pull more files from state insurance commission offices on its operating subsidiaries. On a balance sheet that pushed $1 trillion, a mere $136 million in fines for two bad deals should not shake a ratings agency's faith; he became convinced they were seeing something. That Kynikos's analysts could not move back up the numbers line and reconstruct the earnings with any precision was frustrating, but telling.
AIG was all of Jim Chanos's concerns in the world circa 2005 wrapped up in one. A company earning 15 percent return on equity when its competitors were happy for 5 percent or 6 percent in a market that was both mature and competitive. Huge exposure to real estate. Large and growing private equity and hedge fund units. A black box unit of their very own at FP. Lots and lots of room for accounting judgment calls between U.S. and foreign units and, crucially, a make- your-numbers culture.
Two threads of Chanos's bear fleshing out here. The first is that Chanos had long been skeptical of the explosive growth of hedge and private-equity funds, both in absolute terms and the size of the assets they control. This is to say that he was skeptical of the fact that by 2003 institutional sources of capital—union pension funds, wealthy family trusts, endowments, and the corporate working capital of places like AIG—were happily funneling billions of dollars to anything calling itself a hedge fund. Though he could hardly decry the concept of hedge funds, Chanos was very worried about the fact that he was seeing an exponentially growing amount of capital allocated to highly levered strategies in the bond market. Borrowing 6, 8, and 10 times their equity capital, these new funds would buy various asset- and mortgage-backed- type securities. As long as the market went up, they made outsized returns. The minute it went down, they would be wiped out. A hardened cynic, Chanos cared less about the inevitable and violent deaths of these funds than about the whiplash effect, as the institutions that staked them sought to recoup their losses by redeeming investments in other, better-managed hedge funds, setting off a circular series of redemptions—and selling—as the hedge funds that didn't do stupid things with their money (like his, he supposed) were forced to raise cash to return capital.
Chanos also had developed some defined views of the boom in private-equity (PE) transactions that grew larger and splashier every day. On good days he was amused at their declarations that they added value to corporations. He would often wonder aloud if investment bankers, which was what all PE managers started out as, had ever added managerial or operational value to anything. It was a very good question: many (if not all) companies taken private were saddled with massive debt loads and had their remaining cash flows often redirected to the PE fund coffers as "dividends." On bad days he saw it as a combination of a mania and a plain scam.
AIG was certainly heavily levered to the explosion in hedge and PE funds and the operating income was becoming material to the corporate bottom line. In 2003 it was $227 million; by 2004 it was $515 million. There was virtually no disclosure as to where these funds were invested but a few quick phone calls revealed that they had exposure to all the name-brand, "star" alternative asset managers. At its 25 percent to 50 percent growth rate, it was difficult to imagine it leaving anything other than an ugly crater when it burst. This unit wasn't the only one due for a pasting when the cycle shifted: quarterly Securities and Exchange Commission (SEC) and state insurance filings showed that with north of $400 billion in stocks and bonds, AIG's balance sheet and income statements were going to look very different after a correction.
Where Chanos and his team began to feel like they were making some headway was when they discovered page 54 of the first quarter's 10-Q filing detailing the almost $1.2 billion in collateral postings required with the ratings downgrade to AA+. None of the dozens of analysts who had written about this ever mentioned the collateral calls, nor had management; the filing just mentioned the number. It was a big question mark, and no one knew anything about it.
Chanos and a few analysts pounded on the fund's sources in the big investment banks, analyzed rival insurance companies, and looked for other examples of collateral calls in AIG filings—yet kept coming up empty. Their market sources told them that as far as they could see, none of AIG's trading desks were making some epic one-way trade that had gone against them. In the absence of information, common sense would have to do.
Collateral calls, as every short-seller knew all too well, only came into play when a trade went against you. But they knew AIG's trading desks weren't making a big bet. If it wasn't a trade, then it had to be some sort of insurance or private counterparty credit agreement that wasn't easily observed. AIG, in other words, was renting out its balance sheet. This changed everything. The market was whiter than white hot, every fool with a few million dollars in Manhattan was making money in the market and AIG was still having to post more than a billion dollars in collateral for a one-notch downgrade? As well as they knew collateral calls, Kynikos knew ratings downgrades. They rarely stopped at just one.
For men who did nothing but look for failure and fraud to earn a living, the collateral call issue also opened up a philosophical door they hadn't even pondered. They expected that AIG's recent regulatory track record might bring to light more ugly deals, or alternately, when AIG was forced to play by the letter of the law, margins would get squeezed. They also thought that with enough work, they would find some crummy insurance scam at a small subsidiary that could pose a looming threat. They had not remotely conceived of AIG's being happy to become a way station for all comers to express some sort of off-balance- sheet bet on God only knew what.
If that was considered a good use of capital to AIG management, and if that was what was passing through their risk-management controls—and Kynikos's analysts could imagine no other reason for the collateral calls after the March downgrade—then AIG had better be pricing the cost of renting out its balance sheet to cover risks from additional downgrades when this bull market finally ended. Chanos doubted they were.
Regardless, Chanos had seen enough. In the spring of 2005, his fund's trading desk began selling short what would amount to about 750,000 shares of AIG. He had no idea what AIG was really up to, but he knew there was a secret in there and that it couldn't be good.
He hadn't meant to do it, but in becoming one of the few short- sellers to bet against AIG in this time frame, Chanos had filled in an important missing link in his housing thesis short. AIG was clearly using its balance sheet and credit rating to support some sort of volatile capital markets boondoggle. He knew other companies like mortgage originators were doing stupid things, but he hadn't seen proof of the "smart money" set doing something so fundamentally dangerous. It fit in nicely with the short-seller's holy grail of dangerous and unsustainable behavior that Kynikos's analysts had uncovered in the credit and housing markets. Over the previous two years, they had found:
- A subsidiary of the venerable Lehman Brothers happily providing loans to all comers that required no documents so the firm could make them into bonds.
- Countrywide Financial Corporation had telephone scripts for its army of loan personnel that permitted them to loan up to $500,000 that day to people whose credit worthiness was rated C– by their own system (its second-worst score) and extending loans to applicants who were delinquent on other home loans within the past year.
- The investment banks provided the data that the ratings agencies used to rate the pools of mortgage-backed securities and other securitized products triple-A. There was no credit work involved— at any level—and ratings could be delivered within the hour. They were also the ratings agency's biggest customers, paying them hundreds of millions of dollars annually.
- Businesses like Ambac and MBIA had "evolved" past their longtime businesses of insuring municipal bonds and thrown themselves headlong into the "wrapping" of a fair amount of the collateralized debt obligation (CDO) product, then exploding into the marketplace with a triple-A rating. They were using their balance sheet—at that time, both sported triple-A ratings—to guarantee that this river of new paper would remain triple-A, no matter what happened to its underlying collateral and in the face of any downgrades. They were doing this for about 10 basis points per $1 million of CDOs insured, or $100,000.
The American financial firmament, Chanos would tell colleagues and investors, appeared to have lost its collective mind.
Had they been aware of Chanos's furious efforts to understand their business, it is doubtful that AIG's new management would have much cared. Greenberg had made quick work of short-sellers in the past; with his earnings growth and with their legal headaches receding, their own numbers were looking none too shabby. But the earnings, however fantastic the numbers were, miss the point of the AIG management mind-set.
Looking at the 2005 10-K, filed nearly a year to the day after Sullivan assumed control of AIG, AIG's management and lawyers structured their world much the same as if it were 1970 all over again, and AIG was emerging from the combination of Mr. Starr's hodge-podge of businesses. The $24.9 billion in real estate loans were "heavily collateralized," and the $20.4 billion in real estate–related receivables were "well diversified." Above all, "AA+-rated" meant competence and prudence. They were the risk management keywords for a world based on trust and faith—in the ratings agencies, in securitization and the liquidity of a global marketplace with thoroughly diversified risks, in Fannie Mae and Freddie Mac as trusted stewards of an orderly mortgage market, and the Federal Reserve in maintaining a low-interest-rate policy for so long (and then again when it began the protracted series of rate increases.) This wasn't the childlike trust based on simplistic notion of a shared vision of right and wrong, but the trust in a market of rational actors with interconnected self-interests. No one would do the things that might force them to veer off course because there was simply too much money to be made.
The world Jim Chanos had uncovered didn't exist, because no one at AIG had ever conceived of its even applying to them. Greenberg's ruthless management of risk and his quest for diversification and his acquisitions hadn't made them lazy; people still worked insane hours and earned more in a career in AIG than anywhere else in the insurance industry. It did, however, make them feel impervious.
* * *
As 2005 progressed, Hank Greenberg plotted his next moves from the office of Boies Schiller on Lexington Avenue. It had been the most miserable months of his life; fighting in the frozen Korean waste or against the Germans wasn't half as bad. It was open season on him in the press where he had become both a corporate villain and laughingstock. After 45-plus years of building AIG his career was being reduced every day into some scandal narrative. The most galling was that every time he read his name in print, it was prefaced by some variation of the phrase "disgraced former CEO of AIG."
For David Boies, Lee Wolosky, and the growing "Team Green- berg," reporter hyperbole was the least of their troubles. Generations of legal precedent were going out the door on a daily basis, but no one cared enough to write about that; in contrast, it seemed to make the media happy. On April 10, Eliot Spitzer, in an interview with ABC's George Stephanopoulos, felt secure enough to engage in a freeform riff with the TV newsman: "The evidence is overwhelming that these were transactions created for the purpose of deceiving the market. We call that fraud. It is deceptive. It is wrong. It is illegal. . . . We have powerful evidence . . . it could be criminal."
There is, of course, a long-standing and notable tradition of lawyer bluffing, posturing, and gamesmanship—in a courtroom, after a suit has been filed or an indictment handed down. In Boies's Armonk home, in Wolosky's house in Scarsdale, and Greenberg's apartment in Manhattan, there was utter disbelief. The most powerful attorney general in America was simply cutting out the annoying and tedious business of mustering evidence and filing suit, and pronounced Greenberg guilty of something that was in all likelihood criminal.
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