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Dig Deeper


Gary Gorton

Wharton School of Business and AIG Financial Products
BA – Oberlin; MA – Michigan; PhD. Economics – Univ. of Rochester

Gorton was a finance professor at the University of Pennsylvania’s Wharton School of Business and a consultant to AIG.  Gorton provided the intellectual justification behind AIG’s trade in mortgage credit default swaps (CDS).  Due in no small part to Gorton’s almost complete misunderstanding of economics as well as his failure to distinguish between correlation and causation; AIG lost at least $60-billion in its CDS trades.  Completely unsurprisingly, Gorton is still considered a rising star in economics and is a professor at Yale.      

AIG’s CDS strategy - which stripped of its Ivy League pedigree – was little more than picking up pennies in front of a runaway freight train.  In its CDS trade, AIG issued “insurance” on mortgage bonds.  This insurance – which was issued not as a conventional insurance policy but provided though complicated trades in financial derivatives – protected the purchasers of the insurance against a specific mortgage bond losing value.  However, and evidence of the otherworldly aspect of the “insurance” provided by AIG via credit default swaps, the people who purchased the insurance rarely owned the mortgage bond that was being insured!  Basically, the CDS issued by AIG was a bet or wager on whether the mortgage bond would lose money or not.  By issuing the insurance AIG was betting that the bond wouldn’t lose money; the purchasers of the insurance were betting that the bond would lose money.  

However, the “bet” that was being made with credit default swaps was not an even-money bet.  The bonds that were being insured were considered of very high quality and the risk of the bonds ever suffering losses was considered very low.  A useful analogy for the market for mortgage credit default swaps in the early 2000s is the heavyweight championship boxing match between “Iron” Mike Tyson and James “Buster” Douglas in February 1990.  In the same way that mortgage bonds were judged very unlikely to ever lose value, Mike Tyson was considered very unlikely to lose to Buster Douglas.  Tyson was an overwhelming favorite in the fight and the final betting line had Tyson as a 42:1 favorite to beat Douglas.  To put these odds in perspective, a winning $50 bet on Tyson would only pay about $1.20!  In much the same way, and because the bonds it was insuring were believed to be of such high quality, AIG had to provide enormous amounts of loss coverage for relatively small premium payments.  It was not unusual that for as little as $35-million in annual premium payments, AIG was willing to expose itself to as much as $1-billion in potential losses on each CDS trade it entered.  

To manage this enormous amount of risk, AIG heavily relied on computer models developed by Gary Gorton.  The models likely used reams of historical data to model the mortgage market.  Like nearly all statistical models of this type, the models – at their absolute best – could only be descriptive of things that had happened in the past.  However, models of this type have no predictive value for what might happen in the financial future whatsoever.  The failure of Long Term Capital Management in the late 1990s should have proven this simple concept conclusively.  However, like some feeble-minded cow continually trying to chew grass on the other side of an electrified fence only to suffer an electric shock in the process, the economic establishment – particularly that part of the establishment with a connection to the Ivy League – continues with their futile and pain inducing attempts to program computers to infallibly peer into the economic future.

In December 2007 – after mortgage bond bombs had started to detonate all over Wall Street – both Gorton and senior AIG management expressed complete confidence in Gorton’s models and the company’s mortgage bond insurance trades.  Of his models, Gorton claimed they “… are guided by a few, very basic principles, which are designed to make them very robust and to introduce as little model risk as possible.  We always build our own models.  Nothing in our business is based on buying a model or using a publicly available model.”  AIG’s CEO, Martin Sullivan (#44), claimed Gorton’s models gave the company a “high level of comfort,” while the head of AIG’s financial products division, Joseph Cassano (#9), believed Gorton’s models were “simple, they’re specific and they’re highly conservative.

As it turned out, Gorton’s models had holes in them large enough to drive a panzer division through sideways.  On February 28, 2008 - just two months after expressing complete confidence in its strategy and Gary Gorton’s models – AIG disclosed in its end of the year regulatory filing that it was carrying a total of $11.5-billion in CDS losses on its books.  In the same filing, AIG stated it had posted $5-billion in collateral against these losses.  On February 29, 2008 Joseph Cassano was forced out of AIG.  The investment community was shocked but these losses were a mere harbinger of all the losses to come.  In a little over six-months, AIG would require an $85-billion bailout, and by the time the bailouts ended, AIG had received well over $100-billion.  

As proof that nothing succeeds like abject failure among Ivy League universities, Gorton was poached – with great fanfare – from Wharton by Yale in May 2008, just before AIG collapsed in September.  Despite his enormous role in AIG’s September collapse, Gorton’s reputation reached its zenith just one month earlier.  In August, during the Federal Reserve’s annual boondoggle to Jackson Hole, Wyoming, Gorton made a presentation on the crisis.  In this presentation – which eventually became a book, Slapped by the Invisible Hand – Gorton reached the completely self-serving conclusion that the financial crisis was nothing more than a “financial panic similar in structure to, though differing in many details from, the panics of the nineteenth and twentieth centuries.” Ben Bernanke’s reaction to Gorton’s presentation speaks volumes about Bernanke’s own ignorance of the financial crisis.  Rather than recognizing Gorton’s presentation for what it clearly was – namely, the Ivy League equivalent of some high school stoner mumbling to his algebra teacher that “the dog ate my homework” - Bernanke was impressed with the presentation and agreed with it.  

As some evidence of the incestuous, Ivy League coven that was at the center of the financial crisis and the myriad ways this coven looks out for itself, it is beneficial to reconcile Bernanke’s praise of Gorton’s presentation to the Fed in August 2008 with Bernanke’s criticism of AIG’s management later.  In his post-crisis memoir Bernanke “seethed” in anger at AIG’s management;

"At the time of our initial rescue of AIG, I kept my emotions in check and tried to view the situation analytically, as a problem to be solved.  But once I understood how irresponsible (or clueless) AIG’s executives had been, I seethed.”  

As shown here, it impossible to criticize AIGs management without also criticizing Gary Gorton.  Ben Bernanke’s crisis memoir is completely silent regarding any criticism of Gary Gorton, or the notion that computers can be programed by Ivy League professors to manage highly leveraged investments and to inerrantly predict the future.

Additional Information:

See Ben Bernanke (#3) for his critical role in the financial crisis which goes way beyond holding Gary Gorton and AIG’s management to different standards.  See Joseph Cassano (#9) and Martin Sullivan (#44) for more information on AIG.  See William Donaldson (#17) for another financial services insider with too much faith in computers.  See Steve Friedman (#22) for how Goldman Sachs benefitted from the bailout of AIG.  See Alan Greenspan (#29) for more information on the computer models used by LTCM and their similarity to Gorton’s models at AIG.  See Mark Rubinstein (#42) for the person at the forefront of the fallacious belief that computers could be programmed to manage highly leveraged investments and predict the future.   See Lawrence Summers (#45) for more information on the intellectual fallacies that formed the foundation of the nonsensical computer models developed by Gary Gorton and others.