Oh boy. This is beautiful:
The misadventures that AIG's silo architecture can create are sharply illustrated by the company's disasters in mortgage securities. These problems certainly were spawned in AIG Financial Products. But the fact is that FP had a moment of enlightenment in late 2005, when it began to believe that the housing boom was nearing an unfortunate end and decided to stop selling credit default swaps on super-senior tranches of CDOs. It had a few deals in the pipeline, however, so total "multisector" CDS – AIG's name for these spiffy items – climbed a bit further in early 2006, to a total of nearly $80 billion. Later, as 2006- and 2007-vintage mortgages turned toxic, AIG talked proudly to analysts about its wise decision to pull out before trouble hit. The company proved to be excruciatingly wrong in thinking it was safe, of course, since earlier vintages have been creamed too. But the point is that by August 2007 – the start of the credit crisis – CEO Martin Sullivan and FP's boss, Joseph Cassano, were saying to everybody who'd listen that FP had ducked the mortgage bullet by avoiding the 2006 and 2007 securities that were by that time viewed as poisonous.
Various other AIG silos, unfortunately, weren't listening. The regulatory statements filed by AIG's operating subsidiaries show that a raft of these companies, and particularly the life insurers among them, were still loading up on late-vintage residential mortgage-backed securities (RMBS) in December 2007 – months after AIG had begun congratulating itself on ducking the mortgage bullet. Why, Liddy is asked, would one arm of AIG be buying mortgage securities while another is pronouncing them dangerous? As if there might be someone in AIG's empire he didn't care to offend, Liddy states his answer carefully: "You know, the company is a highly decentralized, far-flung enterprise. And different pieces of the company took different risks. Let me just leave it at that."
We won't leave it entirely, though, because the RMBS turned out to be connected by tunnel to the netherworld called securities lending. For many years, the AIG operating companies, like many other large holders of fixed-income securities, have lent these to banks and brokers that have reasons for needing them – maybe clients wanting to sell short. For this service, the lenders had received cash collateral that slightly exceeded the value of the bonds. Over the years, AIG's companies had invested this short-term money in conservative, liquid investments and thus been always ready to repatriate the collateral if their customers wanted it back.
But this strategy didn't make much money. So in the middle of this decade, the AIG companies began both to greatly increase the amount of securities lending they were doing – the total hit about $90 billion in the third quarter of 2007 – and to invest the collateral in longer-term, seemingly safe AAA securities that offered good yields. The main choice for investment was, you guessed it, RMBS. That bit of elegant selection left AIG's operating companies not only using short-term money to invest long, which is known folly, but also putting this money into impenetrable securities poised to both tumble in value and establish new records for illiquidity. When news of AIG's problems spread in 2008, the banks and brokers came tearing back to redeem their cash collateral, and the AIG companies couldn't hand it over, because it was tied up in unsalable RMBS. This was a second vise that tightened around AIG. One company insider calls this whole investment plot "just one of the dumbest things I've ever seen."
And guess who bought those RMBS? The US government. And guess with whose's money?
Lovely, ain't it?