As we delve into the back-story behind the collapse of AIG, we thought it might be useful to lay out some key factual information about the firm’s Financial Products unit, known as AIGFP, whose disastrous credit default swaps brought the company to its knees. How and when did AIG Financial Products get started? Who ran it, and from where? How did it get into credit default swaps, and what exactly are they, anyway? And how did this group of derivatives traders eventually wind up bringing down one of the most admired financial firms in the world?
From a Humble Start, A Swift Rise
– AIGFP was founded on January 27, 1987, when three Drexel Burnham Lambert traders, led by finance scholar Howard Sosin, convinced AIG CEO Hank Greenberg to branch out from his core insurance business by creating a division focused on complex derivatives trades that took advantage of AIG’s AAA credit rating.
– In addition to his two partners, Randy Rackson and Barry Goldman, Sosin brought 10 other staffers from DBL with him — including future AIGFP CEO Joseph Cassano. The team of 13 set to work in a windowless makeshift room, at first without full-size desks and chairs, in an accounting office on Third Avenue. AIGFP’s first significant deal, made in July 1987, was a $1 billion interest-rate swap with the Italian government.
– In its first 6 month of existence, the unit earned more than $60 million. Under the agreement that Greenberg and Sosin had signed, 38 percent of that went immediately to AIGFP, with the remaining 62 percent going to AIG proper. Crucially, the agreement also called for AIGFP received its profits up front, even though its deals generally took years to play out. AIG itself, not AIGFP, would be on the hook down the road if things went wrong. This arrangement would be modified, but only partially, after Sosin left in 1993.
– AIGFP soon moved to a swanky Madison Avenue office. A few years later, it would relocate again to Wilton, Conn, which remains the unit’s headquarters today.
– By 1990, AIGFP had expanded, opening offices in London, Paris and Tokyo.
– In 1993, Sosin left AIGFP, in part thanks to a strained relationship with Greenberg. (He got a reported $150 million payout). Tom Savage — a Midwestern math whiz who had joined AIGFP in 1988, after beginning his career at First Boston writing computer models for collateralized mortgage obligations, the very instruments that would later help cause the current crisis — soon took over as CEO.
– By that year, AIGFP employed 125 people, and was consistently raking in more than $100 million each year.
– By 1998, the unit had a revenue of $500 million. But it still had never made a single credit default swap.
The Seed Of Ruin Is Planted
– That year, JP Morgan approached AIG, proposing that, for a fee, AIG insure JP Morgan’s complex corporate debt, in case of default. According to computer models devised by Gary Gorton, a Yale Business Professor and consultant to the unit, there was a 99.85 percent chance that AIGFP would never have to pay out on these deals. Essentially, this would happen only if the economy went into a full-blown depression, in which case, the AIGers believed, the counter-parties would be wiped out, and therefore would hardly be in a position to demand payment anyway. With the backing of Cassano, then the COO, Savage greenlighted the deals. Credit default swaps were born.
– In 2000, Congress passed the Commodity Futures Modernization Act, which further reduced the already weak regulation of derivatives like credit default swaps*.
– Later that year, Cassano, now based in London, who in addition to serving as COO had been running AIGFP’s Transaction Development Group, replaced Savage as CEO. Cassano, the scrappy son of a Brooklyn cop, was no expert in the sophisticated computer models that assessed risk, but he had a gift for credit and accounting, and a fierce drive to succeed. At this time, the unit brought in $1 billion a year, and had 225 employees. By 2005, it would have 400.
– In 2002, the Justice Department charged that AIGFP had illegally helped another firm, PNC Financial Services, to hide bad assets from its books. To do so, AIGFP had set up a separate company, known as a “special purpose entity” to take on the assets. It had violated securities law, the Feds alleged, by setting up sham “companies” to invest in the entities, making them appear real. In 2004, AIG settled the charges by paying an $80 million fine, and gave back over $45 million in fees and interest it had earned on the deal. By the terms of its “deferred prosecution” agreement, it was placed on a short leash by the Justice Department. There is no evidence that anyone at AIGFP was formally sanctioned as a result of the episode.
– In March 2005, Greenberg, who had run AIG since 1968, stepped down as CEO, amid an investigation by New York Attorney General Eliot Spitzer into questionable accounting practices at the firm. Though the issue was unrelated to AIGFP, the unit would soon feel the ripple effects: the credit ratings agencies responded to Greenberg’s departure, and the allegations of irregularities, by downgrading AIG’s rating from AAA to AA. That, in turn triggered provisions in some of AIGFP’s credt default swaps, requiring AIG proper to over $1 billion in collateral for the deals. It was the beginning of the end.
– Later that year, an AIGFP exec named Eugene Park took a close look at the firm’s credit default swaps portfolio, and became alarmed. Many of the CDOs that were being insured contained too large a proportion of sub-prime mortgages, meaning the risk of default was high if the housing market collapsed. And with AIG proper’s credit rating having been downgraded, there was an increased chance that it would have to come up with collateral to cover those bets. Park told Cassano and others about his concerns.
– In response, Cassano worked with researchers from the investment banks to assess the risk form subprime mortgages, and decided in late 2005 it was time to stop making credit default swaps. But he couldn’t undo the nearly $80 billion worth of collateralized debt obligations that AIGFP had made swaps on that were already on its books*.
– Still, as late as August 2007, Cassano was sanguine about the deals, telling investors on a conference call: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.”
Things Fall Apart
– But that same month, with the housing market collapsing and sub-prime assets plummeting in value, Goldman Sachs demanded $1.5 billion in collateral from AIG, to cover the mortgage-backed securities that AIG’s credit default swaps had insured. Under the terms of its contract, AIGFP was required to post more collateral than it would have had its credit rating remained at AAA. By October, it had posted almost $2 billion, and other counter-parties were beginning to make their own collateral demands.
–Between early October and mid November, AIG’s stock price fell 25 percent. That month, AIGFP reported that its swaps portfolio had lost $352 million. A month later, Cassano put the figure at $1.1 billion
– Late that month, Pricewaterhouse Coopers, AIG’s auditing firm, told AIG CEO Martin Sullivan that no one knew whether AIGFP’s valuation of its derivatives portfolio was accurate. That process had been led by Casssano, who, it appears, had shut out the firm’s internal accountant, Joseph St. Denis. (St. Denis would describe Cassano’s high-handed behavior and unwillingness to allow AIGFP’s transactions to be properly audited, in a letter (pdf) to congressional investigators sent the following year.)
– And yet, Cassano and Sullivan were continuing to paint a rosy picture for investors. At a December 5 presentation, Cassano declared: “It is very difficult to see how there can be any losses in these portfolios.” Sullivan added: “”AIG has accurately identified all areas of exposure to the US residential-housing market … we are confident in out markets and the reasonableness of our valuation methods.” This presentation is currently being scrutinized by the Feds as evidence of possible fraud.
– In February 2008, AIG announced estimated losses of $11.5 billion, and that it had posted $5.3 billion in collateral.
– The following day, Sullivan announced that Cassano would step down, effective March 31. Only later, during a congressional investigation, did it come out that Cassano would get a $1 million a month consulting contract (the contract was cancelled in September 2008). It was also revealed that Cassano had made $43.6 million in salary and bonuses in 2006, and $24.2 million in 2007.
– That summer, it was reported that the Justice Department was investigating AIGFP for possible criminal fraud. The UK’s Serious Fraud Office would later announced its own probe.
– In September 2008, AIG executives learned that the ratings agencies planned to downgrade the company’s rating again. That would trigger more collateral calls, which AIG knew it couldn’t begin to cover. Desperate negotiations to keep the company afloat — including a possible $75 billion bridge loan from Goldman and JP Morgan, both major counter-parties on the credit default swaps — ensued. Tim Geithner, then the head of the New York fed, called in. But in the following days, it became clear that AIG’s level of exposure to its credit default swap losses was higher than anyone had yet understood. On Sept 16, the Federal Reserve Board, announced that it would take a nearly 80 percent equity stake in AIG — effectively taking over the firm — and would provide an $85 billion “loan”.
– In October 2008, Gerry Pasciucco, a vice chair at Morgan Stanley, was brought in to wind down AIGFP. The unit, Pasciucco found, had $2.7 trillion worth of swap contracts and positions, and 50,000 outstanding trades with 2000 different firms, and 450 employees in six offices around the world.
– In March 2009, amid outrage over multi-million dollar bonuses for those employees, AIGFP would post armed guards outside Wilton headquarters.
* This sentence has been corrected from an earlier version.