A Prisoner’s Dilemma: AIG and Goldman Sachs Game Each Other And PwC

Jimmy Dell: I think you’ll find that if what you’ve done for them is as valuable as you say it is, if they are indebted to you morally but not legally, my experience is they will give you nothing, and they will begin to act cruelly toward you.
Joe Ross: Why?
Jimmy Dell: To suppress their guilt.

The Spanish Prisoner, Written and Directed by David Mamet, 1997

From Wikipedia:

“The prisoner’s dilemma is a fundamental problem in game theory that demonstrates why two people might not cooperate even if it is in both their best interests to do so….If we assume that each player cares only about minimizing his or her own time in jail, then the prisoner’s dilemma forms a non-zero-sum game in which two players may each cooperate with or defect from (betray) the other player. In this game, as in most game theory, the only concern of each individual player (prisoner) is maximizing his or her own payoff, without any concern for the other player’s payoff.”

Gretchen Morgenson and Louise Story of the New York Times told us on February 6, 2010 that Goldman Sachs aggressively pushed AIG to the edge of liquidity by repeatedly demanding cash. A longstanding dispute over the value of securities that were covered by credit default insurance sold by AIG to Goldman Sachs had reached a crucial climax:

“Billions of dollars were at stake when 21 executives of Goldman Sachs and the American International Group convened a conference call on Jan. 28, 2008, to try to resolve a rancorous dispute that had been escalating for months.

A.I.G. had long insured complex mortgage securities owned by Goldman and other firms against possible defaults. With the housing crisis deepening, A.I.G., once the world’s biggest insurer, had already paid Goldman $2 billion to cover losses the bank said it might suffer.

A.I.G. executives wanted some of its money back, insisting that Goldman — like a homeowner overestimating the damages in a storm to get a bigger insurance payment — had inflated the potential losses. Goldman countered that it was owed even more, while also resisting consulting with third parties to help estimate a value for the securities.

After more than an hour of debate, the two sides on the call signed off with nothing settled…”

Finally, on September 15, 2008, AIG cried uncle and capitulated, admitting they could not meet all collateral demands. The federal government bailed out AIG and taxpayer assistance to the company currently totals $180 billion. Some have already disputed several assertions in the Morgenson/Story piece on the basis, primarily, that Goldman Sachs was proved right in the end. Lucas van Praag, Goldman Sachs’ spokesperson, refuted most of it in a piece published in the Huffington Post.

Morgenson/Story do a great job of documenting that the dispute between AIG and Goldman Sachs had been going on for a while. Their neato graphic says that AIG first sold Goldman Sachs insurance on the securities in 2003 and that Goldman Sachs first started asking for more collateral in July of 2007 to respond to what they saw as declines in the value of the underlying securities.

I told you in my previous post that AIG had been struggling with issues over valuations for a while.

“AIG Crisis One litigation [SDNY, Case No. 04cv8141] 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 at AIG 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…”

When the Audit Committee of the Board of Directors of AIG met on January 15, 2008, about two weeks prior to the conference call the New York Times cites in the story above, minutes from the meeting say all the big names showed up:

Present: Messrs. Michael H. Sutton, Chairman, George L. Miles, Jr., Morris W. Offit, Robert Willumstad, ex-oficio. Also present were Director Frank G.Zarb,a non-voting member of the Committee, Messrs. Tim Ryan, Dennis Nally, Henry Daubeney and Michael McColgan from PricewaterhouseCoopers LLP (‘PwC’), Mr. James Cole of Bryan Cave LLp, Mr. James Gamble of Simpson Thacher & Bartlett, LLP, President and Chief Executive Officer Martin J. Sullivan, Executive Vice President and Chief Financial Officer Steven J. Bensinger, Executive Vice President and General Counsel Anastasia D. Kelly, Senior Vice President and Comptroller David Herzog, Senior Vice President and Chief Risk Officer Robert E. Lewis, Senior Vice President and Director of lntemal Audit Michael E. Roemer, Senior Vice President Secretary and Deputy General Counsel Kathleen E. Shannon, Vice President-Corporate Governance Eric N. Litzky, Paulette Mullings-Bradnock of lnternal Audit, and, for portions of the meeting, Edward diPaolo, John French, Joseph Nocera and Alfred Panasci of lnternal Audit.

For the benefit of those playing at home, the PwC attendees’ roles and responsibilities were/are:

Based on my reading of the Audit Committee minutes, I believe that PwC was aware of weaknesses in internal controls over the AIGFP super senior credit default portfolio throughout 2007 and prior.  Why were they pussy footing around still on January 15, 2008 as to whether these control weaknesses were a significant deficiency (which would not have to have been disclosed) or a material weakness (which eventually was)? In fact, at this meeting, PwC was still more concerned about what it saw as an almost inevitable material weakness in controls over AIG’s financial close process instead. And for those of you who thought AIG’s only significant issue was with Goldman Sachs, I have to tell you, regrettably, this is not so.  AIG had a hornet’s nest of nagging issues that clearly required high level attention.

Mr. Ryan commented that the significant deficiency in controls over the financial close process is the most significant deficiency and recapped that at the end of the second quarter there were concerns that without additional management procedures and a reduction in late adjustments and new errors, the financial close significant deficiency could rise to the level of material weakness. He indicated that the company had responded in the third quarter financial close and sustaining the fourth quarter close efforts will be important in the year end analysis.

Mr. Bensinger then indicated that he, Mr. Sullivan and Messrs. Ryan and Nally had been meeting regularly to discuss the control matters and he had asked Mr. Ryan to update the Committee on those discussions. Mr. Ryan then provided the Committee with background on the issues, much of which had been discussed with the Committee in December and in follow-up sessions thereafter with Mr. Sutton. Mr. Ryan commented that following the third quarter close, the PwC team debriefed and assessed a number of issues that had occurred…

PwC then goes on to second guess both the 2nd Q disclosures and 3rd Q 2007 disclosures as a result of the financial close control weaknesses and other major problems mentioned that had not been disclosed to Executive Management, according to PwC, until it was too late.

“…the collateral issues could have been escalated to the AIG level earlier in the process.”

And, in contrast to what the NYT article stated, AIG seems to have been trying to defend their position on valuations in all AIG business units with subprime exposures.  AIG hired KPMG and Deloitte to conduct an independent review of their Enterprise Risk Management and AIG operations with subprime exposure and to make recommendations on improving the risk function and on ways to obtain more information on pricing and valuation. But PwC would only respond that, “…further consideration of the super senior credit derivative valuation process is required.” I did not receive any response to my requests to KPMG and Deloitte spokespersons for information about this review and its results.
By February 7th, the next Audit Committee meeting, PwC had come to the conclusion that a material weakness was going to be cited for the internal controls over the valuation process and not the weaknesses in the financial close process. Senior management was already preparing the ratings agencies, in particular, for a material weakness disclosure. There was grave concern that a ratings downgrade once this disclosure was made would cause additional, perhaps untenable, liquidity stress.

“Mr. Sullivan asked Mr. Bensinger to update the Committee on the discussions with the ratings agencies in connection with AIG’s proposed filing of a Current Report on Form 8-K regarding AIG’s disclosures in connection with the valuation of the AIGFP super senior credit default swap portfolio and PwC’s views that there was a material weakness in financial control over the valuation process. Mr. Bensinger reported that he and Ms. Watson and Messrs. Dooley and Habayeb had telephone conferences with each of the ratings agencies… Standard & Poors in particular, having a good understanding of these credit markets, put the disclosure in proper perspective, with their head analyst indicating the belief that other companies would also have to deal with a material weaknesses.”

However, I do not recall any other company, and certainly no other PwC client such as JP Morgan, Bank of America, or Goldman Sachs, admitting that their valuation process had been, and still was, weak.  Why did PwC decide to point the finger at AIG?  Neither AIG nor Goldman Sachs had been willing to defect or betray each other thus far, per the prisoner’s dilemma, even to save them both.  The dispute had been going on for more than a month, more than a quarter, more than a year.  It may have been excusable for PwC to allow a mismatch in valuation on the same assets in two of their clients for a month or a quarter due to timing differences in access to information.  But a serious, contentious mismatch for more than a year, through several 10Q’s, and now going on two 10K’s?

So why the push now?

What came next is telling:

“Mr. Bensinger said that pricing inputs had been a spirited discussion topic, with PwC holding the view that AIGFP’s assessment does not include enough consideration of market participants’ views on pricing.”

Market participants’ views on pricing = Goldman Sachs views, in my opinion.

“Mr. Bensinger described the differences of opinion with Goldman Sachs on the pricing of the underlying collateral, noting Goldman’s acknowledged desire to obtain as much cash as possible from their collateral calls. He pointed out that Goldman was unwilling or unable to provide any sources of their determinations of market prices.”

Mr. Bensinger made this statement in front of PwC  – Messrs. Daubeney, Robert Sullivan, the Global Banking and Capital Markets Leader and Bob Moritz, the US Assurance Leader and Managing Partner of the NY Metro Region and now US Chairman and Senior Partner.  Plus or minus Dennis Nally and the Goldman Sachs specific Global Relationship and Engagement partners, how much you want to bet these were some of the same guys sitting in on every Goldman Sachs Audit Committee meeting and hearing the other side of this “difference of opinion” during most of 2007 and all of 2008?

In fact, PwC discouraged AIG from digging too deep into the pricing issue.  They wanted AIG to simply adopt the “market participants’ view”:

“Mr. Bensinger emphasized that Management’s objective is to obtain the best estimate of valuation, not necessarily the highest estimate. Mr. Sullivan agreed, noting that AIG had been working diligently to find observability for the spread differential which everyone believes exists.  He added that extensive efforts, which he believed were appropriate to meet management’s fiduciary responsibility to shareholders, were not necessarily seen as a positive by PwC, but when it became clear that PwC did not consider the evidence AIG gathered to be adequate from a market observability standpoint, Management decided that the December 31 losses would not include an adjustment for the spread differential.”

In fact, Andrew Ross Sorkin told us in his book, Too Big To Fail, Goldman Sachs was still not satisfied in June of 2008 that PwC was pushing AIG hard enough to consider “market participants’ views” on pricing on a timely or suffiicient basis so Goldman could “obtain as much cash as possible from their collateral calls”:

…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.

I still have not heard a specific explanation for how PwC could preside over a long running dispute between two of its most important global clients, a dispute that was material to at least one of them, obviously, that had the attention of its highest level partners, and not force a resolution based on consistent application of accounting standards sooner.

I mean… We are talking about valuation of the same assets!

I’ve been writing almost as long as I’ve been writing here that PwC should resign as AIG’s auditor.  Was it not enough that PwC had been sued by AIG shareholders more than once for its role in accounting errors and restatements?  Was it not enough that AIG never got corporate governance right and PwC let them get away with it forever?  Is it not enough that now PwC has its own partners testifying against their client on behalf of plaintiffs they settled with in order to extricate themselves from ongoing expensive litigation?

Is it not enough that PwC was clearly torn between two clients (and maybe more who would have been impacted) who held enormous financial sway and lost its independence and objectivity? I think PwC finally succumbed to Goldman Sachs, selling out AIG while still tippy-toeing around the necessity to finally say which one was closest to complying with standards. Actually taking a consistent stand would potentially implicate other clients such as JP Morgan and Bank of America as well as Freddie Mac in a mark-to-model or rather “mark to make it happen” scandal?

Will someone eventually come forward and tell us that Goldman Sachs sat PwC down in the summer of 2008 and told them, “Listen you dweebs, tell those AIG SOBs to cough up! You do whatever you have to do to make them fold! You hear me you milquetoast, muckety-muck, risk averse wienies?”

And what of the possible collusion amongst the various parties to prop up market prices in the meantime by roundtripping some assets at month- and quarter-end in order to avoid writedowns as long as possible and, therefore, collect those hefty commissions and incentive bonuses?

Stay tuned…

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  2. […] is included in the discussions of AIG’s problems and the AIG and Goldman Sachs collateral dispute but these stories have already appeared in detail elsewhere. The report describes PwC’s final […]

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