The Great American Financial Sandwich: AIG, PwC, and Goldman Sachs

It may have been the first time you had ever heard of AIG.  As big as it is, it wasn’t really a household name outside of the financial services world.  And certainly, big as it is, the average businessperson probably could not describe everything they did and why.

The Wall Street Journal, September 16, 2008

The U.S. government seized control of American International Group Inc. — one of the world’s biggest insurers — in an $85 billion deal that signaled the intensity of its concerns about the danger a collapse could pose to the financial system.

The step marks a dramatic turnabout for the federal government, which had been strongly resisting overtures from AIG for an emergency loan or some intervention that would prevent the insurer from falling into bankruptcy. Just last weekend, the government essentially pulled the plug on Lehman Brothers Holdings Inc., allowing the big investment bank to go under instead of giving it financial support. This time, the government decided AIG truly was too big to fail.

The U.S. negotiators drove a hard bargain…

 

Can you fault the journalists for not having any idea how incomplete and relatively inaccurate so much of what was written in haste back then would turn out to be?

The Washington Post, January 26, 2010:

 

The federal bailout of AIG, which grew to a more than $180 billion commitment, has attracted controversy and hounded Paulson, Geithner and other officials who helped orchestrate the troubled insurer’s rescue in September 2008.

In hearings last week before Congress, Treasury Secretary Tim Geithner came under fire for the bailout, given his prior role as Chairman of the New York Federal Reserve Bank, the chief architect of the deal:

From The Guardian, January 27, 2010

The US treasury secretary Timothy Geithner was accused of incompetence, obfuscation and of making “lame excuses” during a furious hearing on Capitol Hill over the government’s contentious bailout of the sprawling insurer AIG.

In an unusually ill-tempered confrontation, members of Congress from both parties rounded on Geithner over a decision to use taxpayers’ money to pay out the full $62bn (£38bn) owed by AIG to banks such as Goldman Sachs, Merrill Lynch, Barclays and RBS… The biggest counterparty receiving money from AIG was Goldman Sachs. Visibly rattled, Geithner was obliged to confirm to the committee that his chief of staff, Mark Patterson, is a former ­Goldman Sachs banker, as is Geithner’s predecessor at the treasury, Henry Paulson. But he angrily defended those involved…”

 

But if you’ve been reading my stories about AIG and their auditor PwC, you would have first heard about AIG in 2007. I start with their earlier accounting issues, restatements, investigations and lawsuits as a result of, let’s call it, Crisis One, to differentiate it from Crisis Two – the $180 billion bailout that became necessary, suddenly, unexpectedly, as a result of a confluence of unprecedented economic events and that could not have been anticipated by anyone, anywhere, in any way shape of form…

Yeah, right.  If you believe that, Joe Cassano’s got a great deal for you on a piece of Maiden Lane III.  Sounds quite green and leafy, no?

In June of 2007, I told you about former AIG Chairman and founder Maurice Greenberg suing AIG and PwC as a result of a shareholders derivative suit against him. I said, “Isn’t it time for PwC to resign as AIG auditor?”

In August of 2007, Greenberg’s firm C.V. Starr…

“…which remains an AIG shareholder—alleges in its petition [to the SEC] that AIG’s longtime independent auditor should be forced to resign because an AIG special litigation committee earlier this year authorized shareholders to pursue a derivative action against PwC in Delaware Chancery Court. “AIG’s decision to have the derivative plaintiffs prosecute the claims against PwC on behalf of AIG instead of having AIG’s own counsel prosecute the claims cannot eliminate the conflict that exists,” the Starr petition says.”

 

In October of 2007, I told you how PwC was sued by AIG shareholders who filed an amended complaint because when AIG management took over the shareholders derivative suit, stepping into their shoes, they did not comply with their wishes and decided to not sue PwC.

“…filed in Delaware Chancery Court on Friday. AIG shareholders previously sued in 2004, naming former Chief Executive Maurice “Hank” Greenberg, former Chief Financial Officer Howard Smith, PwC and others as defendants. In the amended complaint, filed on Friday, the shareholders seek damages from PwC and others…

In June, AIG took over the shareholders’ lawsuit against Greenberg and Smith, becoming sole plaintiff in the case and leaving shareholders to decide whether to pursue claims against some or all of the remaining defendants, including PwC.

AIG, the largest U.S. insurer, on Friday restated its claims against Greenberg and Smith for allegedly breaching the fiduciary duties they owed the company, while shareholders refiled their claims against some of the original defendants. AIG “decided not to sue (PwC) based on the recommendation of a special litigation committee of AIG’s board of directors” and the company “continues to have full confidence in the independence of PwC,” a company spokesman said…

 

Also in October 2007, in spite of their role as a defendant in lawsuits by AIG shareholders, in spite of their longstanding relationship with the firm that was now in so much trouble, PwC was reappointed as AIG’s auditor, with the endorsement of Arthur Levitt. Levitt had been hired by AIG to restore good corporate governance to AIG.

 

Bloomberg, October 11, 2007:

The company interviewed at least three others over the course of a year for the job, which starts 2008, said AIG spokesman Chris Winans.

PricewaterhouseCoopers, AIG’s auditor for more than two decades, had approved financial results from 2000 to 2005 that were restated amid Spitzer’s probe, lowering earnings by $3.4 billion. AIG investors sued the auditor in a Sept. 28 amended filing to recover losses from the settlement and restatement.

“Many companies involved with corporate scandals have changed their auditors to regain investor trust,” said Lynn Turner, a former chief accountant at the U.S. Securities and Exchange Commission. … “disappointed” AIG kept “the auditor who failed investors by giving a clean bill of health on misleading financial statements.”

 

PwC gets reappointed as auditors, so that a few months later, they can tell AIG what a screw-up they’ve been. In my opinion, it’s too little too late.  But what’s really going on here?

Crisis One litigation is still very much alive. After PwC’s material weakness determination in early 2008, for the 2007 financials, there was an attempt to amend the ongoing suits to include a CDO/CDS cause of action.  Research to support this request showed that PwC had been dealing with closely related accounting issues as far back as 2002, centered mostly around EITF 02-3 valuation issues. The research revealed deep, longstanding internal controls issues that were now becoming painfully apparent.

Between Crisis One and Crisis Two (i.e., the 2004 and prior accounting irregularities that ousted Maurice Greenberg, and then the 2007 AIGFP mess), the players on both the AIG management side, and the PwC engagement team side, were pretty much totally traded out.

On the PwC side, Global Relationship Partner Barry Winograd and Engagement Partner Richard Mayock stepped down after the 2004 audit year and Tim Ryan and Mike McColgan took over as Global Relationship Partner and Engagement Partner, respectively. The AIG Expanded Scope Audit, for 2004 and prior, was a Herculean effort for PwC, involving a tremendous amount of interface with AIG’s own internal review, the attorney investigations led by law firms Paul Weiss and Simpson Thacher, as well as ongoing regulatory inquiries.

PwC had to pull out all the stops to come up with enough staff to complete the task – this was Sarbanes-Oxley prime push period and resources were constrained and at a premium. Although Greenberg loudly disagreed at the time, sources tell me most of those who had been, and were then, key members of the engagement team, left the engagement.  While the change-outs at the top were largely political, many of the changes down in the ranks were people who were completely burned out on AIG, and unwilling to continue on that engagement.

At AIG, those managers such as Cassano not affected by Crisis One head chopping, were still in place, and the derivatives business largely missed out on any magnifying glass treatment as a result of Crisis One.   Based on documents obtained during discovery related to Crisis One, it was clear PwC the firm was really red faced that they’d “missed it.” When the replacement audit team moved forward, and then the rumblings of the CDO/CDS mess started being heard, PwC press releases coming out in February 2008 gave the impression that the firm’s leaders were not about to be caught asleep at the wheel again. They threw the “material weakness” flag quite quickly.

And then you read the Washington Post article about the now revealed 2007 internal AIG emails, and follow the timeline in 2007. In retrospect, it’s easy to see that by summer 2007 AIG management had a pretty good idea its risk of drawdowns on the CDS’s is way more likely than the “less than remote” characterization in the footnote description of prior years’ financial.

How much of that early realization got on the PwC new engagement team radar? How many other big things did they miss or pretend not to see?

An AIG presentation dated Nov 2007 was still totally minimizing any prospective increase in risk.

It was during 2007 that AIG’s conflicts with Goldman Sachs over collateral for the CDOs became heated.  I wrote in December, based on reports by Andrew Ross Sorkin in his book, Too Big To Fail:

AIG had publicly disclosed the existence of a collateral dispute with Goldman Sachs over CDOs in November of 2007… AIG Chairman of the Board Bob Willumstad, according to Sorkin, not PwC, originally raised red flags in January 2008 regarding the growth of the collateral gap. Willumstad called in PricewaterhouseCoopers to review the situation and,

“PwC eventually instructed AIG to revalue every one of the credit default swaps… and embarrassingly disclosed that it had found a “material weakness” in [AIG’s] accounting methods.”

…AIG “admitted” that their management may have held back or even lied to the auditors.  AIG had actually given PwC an out, I said, to keep them close in the event of litigation or worse…A few pages later, on page 175, Sorkin describes a Goldman Sachs June 2008 board meeting where the issue of their collateral dispute with AIG boils over.

 

“In a videoconference presentation from New York, a PwC executive (PwC is Goldman Sach’s auditor, too) updates the board on its dispute with AIG over how it was valuing or in Wall Street parlance, “marking-to-market,” its portfolio. Goldman executives considered AIG was “marking to make-believe” as Blankfein told the board…the afternoon session proceeded with upbraiding PricewaterhouseCoopers:

“How does it work inside PwC if you as a firm represent two institutions where you’re looking at exactly the same collatteral and there’s a clear dispute in terms of valuation?”

How does it work, indeed.  Jon Winkelreid, Goldman’s co-president, may or may not have received an answer that day. Sorkin does not report one.  I have never heard one.

It must be tough to be PwC, wedged between two powerful, lucrative, and equally complex clients. The money they’re raking in provides some solace, I’m sure.

Reuters, July 1, 2009

AIG paid PwC a total of $131 million in audit and other fees in 2008 and $119.5 million in 2007. ”I want to know what these fees were paid for,” shareholder Kenneth Steiner of Great Neck, New York said. “Why didn’t anybody know what was going on? What were the accountants doing? Were they sleeping?”

 

For Goldman Sachs, PwC provides not only audit, audit related, and tax advice, they also provide similar services to other entities managed by Goldman Sachs subsidiaries. For 2008, those fees totaled $99.9 million.

 

Audit fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56.0 (2008) $49.2 (2007)

Audit-related fees (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      4.1              3.0

Tax fees (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    1.7               2.3

All other fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      — — — —

PricewaterhouseCoopers LLP also provides audit and tax services to certain merchant banking, asset management and similar funds managed by our subsidiaries. Fees paid to PricewaterhouseCoopers LLP by these funds for these services were $38.1 million in fiscal 2008 and $29.5 million in fiscal 2007.

Regardless of the fact that PwC is making more from AIG right now, both clients are critical and they’re hanging on to both tightly. So it’s not surprising, under those circumstances, that PwC tries to minimize conflict with either unless absolutely necessary.  In fact, even though they may have been taken to the woodshed by both in the past, they’ve escaped any significant public criticism for staying quietly and peacefully in the middle, neutral like Switzerland, when it comes to the disputes and conspiracy theories  about the relationship between the two firms and each with the NY Federal Reserve Bank.

It may be that PwC has learned to play both clients like a fiddle from professional dancing bears like Arthur Levitt. As we discussed earlier, Levitt played a significant role in getting AIG past most of the New York Attorney General’s scrutiny after their actions against AIG.  Part of that healing process included reappointing PwC as auditor.  But Arthur Levitt is also a paid advisor to Goldman Sachs. The Wall Street Journal did not mention his prominent role with AIG when they published a fawning homage to Levitt from Lloyd Blankfein.

And we’re not often reminded post- “Goldman Sachs making out like a bandit as a 100 cents on the dollar AIG counterparty” of the strange choice of Ed Liddy as CEO of AIG to replace Mr. Willumstad of “make PwC revalue the CDO’s and issue a material weakness in internal controls” fame.

The Wall Street Journal, September 16, 2008

By tapping Mr. Liddy as AIG’s next CEO, the government is turning to someone with deep experience in the insurance industry, having served as chief executive of Allstate from 1999 to 2006….Mr. Liddy also has experience pulling apart empires, having helped dismantle Sears, Roebuck & Co. (from which Allstate was spun off) in the 1990s. Before joining Sears, Mr. Liddy worked under Donald Rumsfeld at drug maker G.D. Searle & Co. Mr. Liddy is on the board at Goldman Sachs Group, the investment bank that Mr. Paulson led before becoming Treasury Secretary.

Maybe PwC didn’t stand a snowball’s chance in hell to be a truly independent, objective advocate for shareholders by forcing a true and fair presentation, in all material respects, of the financial position of either one of these companies and the results of their operations and their cash flows in conformity with accounting principles generally accepted in the United States of America. But is there a truly good excuse for PwC to not have been a preemptive strike force, a beacon, an early warning system for shareholders of the financial Armageddon we faced? They had longstanding, thorough, perfect knowledge of both sets of financial statements.

Add to this perfect knowledge the additional capital markets insight PwC has given their audit relationship with other large global financial institutions such as JP Morgan, Bank of America, Freddie Mac, Fortis, Barclays, Northern Rock…

Well, you get the idea.

Why didn’t PwC speak up, act more strongly to match mismatched valuations between entities like AIG and Goldman Sachs, raise their hand and shout fire, or at least warn of suffocating black smoke obscuring woefully inadequate risk management and of pricing “models” strung together like so many holiday lights electrical cords, faulty wiring and all, ready to blow the circuits?

Was it the fees?

Well, there’s certainly $230 million plus reasons in 2008 to play nicey-nice between the two clients.  But that explanation would be too simple.

“ Yves” at NakedCapitalism.com described the syndrome well when referring to the New York Federal Reserve and their lousy deal with AIG.

No matter which way you look at it, the picture that is emerging of the Federal Reserve, as revealed by the ongoing probes into its AIG bailout, is singularly unflattering.

The explanations for its actions can only support one of two interpretations: that the Fed was a chump, taken by the financiers, or a crony, and was fully aware that it was not just rescuing AIG, but doing so in an overly generous way so as to assist financial firms in a way it hoped would not be widely noticed or understood.

I wrote similarly about PwC with regard to the Satyam fraud.

The dilemma for the PwC Global senior leadership “crisis team” now in India is that the answer to the burning question, “How could Price Waterhouse India let this happen at Satyam?” has four possible answers:

a) Price Waterhouse India audit technique and “quality” standards demonstrate the epitome of incompetence and professional negligence,

b) Price Waterhouse India partners colluded with Satyam management to commit the fraud,

c) Price Waterhouse India partners were “duped,”

d) Some combination of all three.

None of the answers will win PricewaterhouseCoopers  International Limited a prize.

For an example of incompetence, over and above that which PwC and their client have already admitted to, let’s talk about one element of PwC’s audit process at AIG.

From a source:

Staff Accounting Bulletin No. 99 talks about that elusive concept of “materiality.”  In its guidelines, SAB 99 says an omission or misstatement of an item in a financial report is material “…if, in light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”  i.e., qualitative materiality.

 

The element of auditor judgment and adequate subjective “professional skepticism” was lacking, and it allowed the frauds leading to the 1999-2004 restatements, as well as the head-in-the-sand failure to identify the impending catastrophe being created in AIG Financial Products with the CDS / subprime derivative products.  Year after year, the applicable boilerplate footnote in the financials continued to characterize the risk of ANY claims on those products, for the Super Senior tranche AIG was insuring, as “less than remote.”  Until, of course, it was too late.

 

In workpaper after workpaper, PwC whizzes past areas that subsequently became problematic, by relying on the failure of the item to reach the established level of QUANTITATIVE materiality alone, with inadequate subjective analysis of the qualitative.

 

It’s particularly ironic that, in the AIG/PwC assessment of “remediation” needs during the Restatement — which resulted in termination of a number of AIG execs, and demotion or reassignment of others away from responsibilities for financial reporting — Joseph Cassano at AIG FP was given a clean bill of health and allowed to continue unabated down the path toward disaster.  If ever there was a time when “looking under every rock” for more rattlesnakes was called for, it was during the 2005 Restatement.  The fact that PwC failed to get even a sniff of what was coming a couple of years later from AIG FP — even after deploying DA&I and dozens of extra auditors to handle the “Expanded Scope Audit” for 2004 — is very sobering, and brings into question (as you regularly do) why audits and investigations are even bothered with.

I don’t think PwC is a complete dupe for AIG and Goldman Sachs any more than they were in the Satyam fraud case in India.  I heard rumors in December 2007 that Goldman Sachs was thinking of dumping PwC.  Who knew then how angry Goldman was at PwC for their client AIG’s intransigence on the collateral call?  But it all worked out, didn’t it?  I guess Goldman decided, “Keep your friends close….and your lackeys closer.”

Hell, Goldman Sachs is citing PwC’s audit of AIG when criticized as having been unfair and disingenuous in its dealings with AIG.

Bloomberg, January 9, 2010

Hank Greenberg, former chief executive officer at American International Group Inc., said Goldman Sachs Group Inc. is responsible for the collapse of the insurer during the economic crisis, the Wall Street Journal reported… “Mr. Greenberg appears to base his views on news reports rather than facts,” Lucas van Praag, a Goldman spokesman, said in an e-mail to Bloomberg News. “It is interesting that he doesn’t mention the devastating conclusions about AIG reached by the company’s own auditors [PwC].”

I asked Mr. Praag about that comment.  I was surprised and pleased at the mention of an auditor in this context.

Dear Mr. Van Praag,

I found it curious that you cited AIG’s auditors, PwC, in response to criticism of Goldman Sach’s role in the AIG failure. Yes, PwC had something to say, in my opinion too little too late, on AIG’s weaknesses.  But PwC is still AIG’s auditor.  And PwC is also Goldman Sach’s longtime auditor.

Regards / fm

Dear Ms McKenna:

 

I was talking was about Mr Greenberg’s criticism of Goldman Sachs in its relationship with AIG and making the point that his opinion seems to rely on hearsay (news reports) and not facts.

 

Further, his remarks about his former company appear to ignore the fact that, in Dec 2007, PwC, its independent auditors, found that AIG had “material weaknesses in its internal control over financial reporting and oversight relating to the fair valuation of the AIG FP super senior credit default swap portfolio.” This seems to me to make Mr. Greenberg’s comments about our valuation of instruments protected by AIG bizarre, to put it very mildly.

 

Regards / Lucas

PwC has been walking a tightrope between these two powerful clients for a while.  But never doubt that they are, at the same time, always looking out for their own interests. Consider the class action lawsuit against AIG, PwC and others brought by the Ohio Attorney General on behalf of the Ohio Public Employees Retirement System as a result of Crisis One (the 1999-2004 issues). It’s an exquisite example of shrewdness necessitated by incompetence. The case is still moving through the courts and expected to go to trial sometime this year.

Back in October of 2008, PricewaterhouseCoopers agreed to pay $97.5 million to settle this litigation. At the time, the Ohio Attorney General’s office stated that the $97.5 million settlement was “one of the 10 highest settlements to be paid by an accounting firm to settle a securities fraud class action.”  The case was filed back in 2004.

Only one problem…  The class has not yet been certified and the settlement has not yet been finalized.

However, after “settling” with Ohio and extricating themselves unofficially from the suit, PwC quietly agreed to “flip” its witnesses to benefit the plaintiffs while continuing to serve as AIG’s auditors. Messrs. Winograd and Mayock were recently deposed, in support of the plaintiffs.