Feds Zeroing In On Cassano’s Valuation Of Credit Default Swaps

Yesterday we told you that federal investigators are now zeroing in on two other AIG staffers, in addition to Joseph Cassano, as part of their probe into potential criminal wrongdoing at AIG. But a report (sub. req.) in the Wall Street Journal, which confirmed that information, also began to flesh out the more interesting question of just what the Feds suspect Cassano and his crew may have done wrong.

We knew that that December 2007 presentation, at which Cassano and others reassured investors that everything was basically fine, was drawing particular scrutiny from investigators. But the Journal adds some meat to that bone.It notes that, at that presentation, “Cassano said write-downs tied to the swaps had reached an estimated $1.6 billion,” before reporting:

Authorities are looking at whether Mr. Cassano should have disclosed to investors that the figure would have been higher by several billion dollars if not for the aid of a value adjustment known as “negative basis,” according to people familiar with the matter. Several months later, when AIG disclosed that its auditor, PriceWaterhouseCoopers, found a “material weakness” in its accounting of the swaps, it said it would abandon the adjustment, according to company filings.

What does “negative basis” entail, and how deceptive was Cassano — an accounting expert — being by not mentioning that he was using it? It’s worth finding out…

Additionally, the paper reports:

One issue for investigators concerns how AIG valued the CDOs, which drives both the value of the credit default swaps and the amount of collateral AIG must essentially hand over to the buyer of the swap if the value of the CDO declines, according to people familiar with the matter. A key question is whether executives, amid the credit crisis, made improper adjustments to the model they used to value the firm’s swaps after receiving indications that the value should be lowered, these people said.

And:

Investigators are also focusing on whether people at AIG failed to disclose to PwC market indications that the credit-default swaps’ value should have been lower, people familiar with the matter said. Those indications came in the form of price quotes for the CDOs that people at AIG attempted to get in November 2007 as well as demands for AIG to hand over collateral around that time, the people said.

So: Wrapping these details together — and adding what CBS reported yesterday, that the Feds are also looking at AIG’s quarterly report and earnings statement, put out in November 2007 — it looks like the question of the precise method that AIG’s financial products unit was using to value those credit default swaps in the fall of that year is at the heart of the issue. And it’s worth noting that it was exactly this area of operations that Cassano appears to have schemed to maintain control over.

As we’ve written, Joseph St. Denis, an AIGFP auditor, has told congressional investigators that he resigned after Cassano in effect prevented him from having any input on that process of valuing the swaps. According to St. Denis, Cassano told him: “I have deliberately excluded you from the valuation of the Super Seniors [ CDS’s] because I was concerned that you would pollute the process.”

So things may be getting a bit clearer…

One other quick note: We mentioned yesterday, accurately, that investigators have reportedly looked at the role of AIG’s CEO, Martin Sullivan. But the Journal says it’s now hearing that Sullivan isn’t a target of the probe.

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