For months, several executives at AIG Financial Products had pulled apart the data, looking for flaws in the logic. In phone calls and e-mails, at meetings and on their trading floor, they kept asking themselves in early 1998: Could this be right? What are we missing?
Their debate centered on a consultant's computer model and a new kind of contract known as a credit-default swap. For a fee, the firm essentially would insure a company's corporate debt in case of default. The model showed that these swaps could be a moneymaker for the decade-old firm and its parent company, insurance giant AIG, with a 99.85 percent chance of never having to pay out.
The computer model was based on years of historical data about the ups and downs of corporate debt, essentially the bonds that corporations sell to finance their operations. As AIG's top executives and Tom Savage, the 48-year-old Financial Products president, understood the model's projections, the U.S. economy would have to disintegrate into a full-blown depression to trigger the succession of events that would require Financial Products to cover defaults.
If that happened, the holders of swaps would almost certainly be wiped out, so how could they even collect? Financial Products would receive millions of dollars in fees for taking on infinitesimal risk.
The firm's chief operating officer, Joseph Cassano, had studied the model and urged Savage to give the swaps a green light. "The models suggested that the risk was so remote that the fees were almost free money," Savage said in a recent interview. "Just put it on your books and enjoy the money."
Initially, the credit-default swaps business would amount to a fraction of the half-billion dollars in Financial Products' revenue that year. It didn't seem to them like a major decision, and certainly not a turning point.
They were wrong.
The firm's entry into credit-default swaps would evolve into insuring more volatile forms of debt, including the mortgage-backed securities that helped fuel the real estate boom now gone bust. It would expose AIG to more than $500 billion in liabilities and entangle dozens of financial institutions on Wall Street and around the world.
When the housing market tanked, a statistically improbable chain of events began to unfold. Provisions in the swaps kicked in, spurring collateral calls on swaps linked to $80 billion in questionable assets, requiring the firm and AIG to come up with billions of dollars in cash. They scrambled for almost a year to stave off the calls, but there were too many deals with too many counterparties.
In September, the Bush administration concluded that AIG's position at the nexus of the deals meant that it could not be allowed to fail, triggering the most expensive rescue of a private company in U.S. history. So far, the government has invested $152 billion in its efforts to save AIG.
Federal investigators are sifting the carnage.
Credit-default swaps exemplify the contradictions of modern finance. At a basic level, they serve as insurance, but they aren't regulated as such. They have allowed companies to free up untold amounts of capital that otherwise would be tied up as collateral for loans. They were sold both to reduce risk and, in some cases, to give clients room to take on more risk — a key component to making money on Wall Street.
But in the end, neither the buyers nor sellers truly understood the risks they created. Anyone could sell such a swap, and anyone could buy one, even if he had no stake in the transaction. Some buyers used them to bet against failing companies, prompting a debate among state regulators about whether this type of swap was a form of gambling.
Credit rating is sacredAIG's chairman, Maurice "Hank" Greenberg, had once warned Savage that he would come after him "with a pitchfork" if Financial Products did anything to harm AIG's AAA rating. But no one saw credit-default swaps as anything on that scale.
After conversations that included AIG Vice Chairman Edward Matthews and other AIG executives, Greenberg blessed the line of business. "There was a long discussion about it," Savage recalled recently, "and he said it was fine."
Another of the biggest advocates for credit-default swaps was Joseph Cassano, the feisty, hard-working son of a Brooklyn cop who later rose to the top job at Financial Products. Cassano didn't have the pedigree of Financial Products' three founders, who hailed from places such as Bell Labs and the Wharton School. But he had worked with the trio at the junk-bond firm of Drexel Burnham Lambert and had been one of 10 original recruits who left Drexel to start Financial Products.
Cassano, 42, a Brooklyn College graduate, was smart and aggressive — sometimes too aggressive, some executives thought. He had a mercurial temper, occasionally screaming at an underling.
"He was very, very good," Ed Matthews recalled. "But he was arrogant."
Cassano first became the group's chief financial officer and was put in charge of the Transaction Development Group, a new unit hunting for business involving energy products and tax credits. Cassano's portfolio included deals involving credit, so he played a key role in the credit-default swap debate going on inside the company.
Financial Products' drive to keep ahead of its competitors led Cassano and his Transaction Development Group to coal. At first, it seemed like an odd turn, but it played to the company's strength — discovering gaps in regulations and markets and exploiting them.
A 1980 law, generated by President Jimmy Carter's administration, offered tax credits to companies as incentives to design and use synthetic fuel systems. The aim was to reduce U.S. dependence on foreign oil.
Associates at the Transaction Development Group had discovered that many energy companies were not making enough money to benefit from the tax breaks. But Financial Products' profitable parent, AIG, could use those credits to reduce its tax bill.
"One thing AIG had was ample income," Savage said. "So what we did is, we went out and we bought synthetic coal facilities."
The firm had no intention of becoming coal processors. Instead, it arranged to install the equipment — bought for more than $225 million, Savage recalls — at coal facilities and power plants. The facilities leased and operated the machines at a discount, while AIG got millions in tax credits.
Financial Products hedged aspects of the deals, and checked with government officials to make sure the arrangements qualified for the breaks. Savage said the idea was bold as well as clever.
"We had the gumption to go out and take seven of these plants that were sitting around doing nothing," he said. "We carted (the machines) off to where they could be used, and it went on."
Greenberg, too, was taken with the gambit. "It was opportunistic," he said recently. He once joked that he wanted to ride shotgun in the truck carting the machines around, Savage said.
Over the next few years, AIG reaped $875 million in benefits from the deals. It was a coup for Cassano and his group. Although it wasn't Cassano's idea, Savage said, he guided it from concept to reality.
"He says he thought about it for six months," said Savage, who came to appreciate Cassano's single-minded focus. "He made a lot of money for the company."
Savage steps downIn fall 2001, Savage decided to call it quits. He had moved his family to Florida, and briefly considered whether he could manage the commute. The Sept. 11 terror attacks made that sort of arrangement seem impossible. He told Greenberg of his plan to leave.
Cassano emerged as Greenberg's candidate to take over. Some colleagues questioned his qualifications to manage a team that was heavily dependent on quantitative skills. Though he was now the firm's chief operating officer, some colleagues thought he wasn't as conversant with the complex calculations of risk that remained at the heart of the business. Beyond that, few liked his chip-on-the-shoulder demeanor.
Greenberg had come to know Cassano through board meetings over the years. Cassano had won his confidence. The two shared a number of qualities. Both were strong-willed and disliked criticism.
Cassano had one other virtue that helped him land the top job: He followed directions from Greenberg and Matthews, the parent company's leaders. "He told us that in no uncertain terms that he was — that all of his people up there were — smarter than anybody we had at AIG," Matthews said. "And he made it clear that he listened only to two people: He listened to Hank Greenberg and he listened to me."
Cassano would need all the smarts he could muster. He was taking the reins at a challenging juncture. Financial Products was now a $1 billion operation with 225 employees working on a multitude of derivatives deals for clients, involving hundreds of billons of dollars in obligations. But in early 2002, when he replaced Savage, the derivatives industry was coming under a shadow.
A high-flying financial company called Enron was just starting to melt down. Because Enron had systematically abused derivatives as part of its fraudulent corporate accounting, some kinds of derivatives became the focus of regulatory scrutiny and fell out of favor. Structured deals for corporations were a large part of Financial Products' business.
The firm would need to make up lost revenue. "The response to Enron really reduced the toolbox for Financial Products," Savage said. "It wasn't at all clear to me where the profits were going to come from."
Under Cassano, Financial Products would grow, take on more risk and become more top-down than before. The culture that had characterized the firm from the outset — one that relied on informed skepticism in which just about anyone could question dubious aspects of a trade — would change, according to people who worked at the firm.
Cassano disputes the notion that the culture had changed, says Warin, his lawyer. "FP worked closely and had healthy discussions with its internal auditors so they would fully understand the business and investments," Warin said. "Mr. Cassano encouraged this oversight, review and open communication."
Clearing the wayIn 2002, some regulators had a hard time seeing the financial value in certain swaps — especially in deals used to remove debts from a corporation's books.
But those regulators were fighting a lost cause. In the waning days of the Clinton administration, Congress had passed the Commodity Futures Modernization Act, which pre-empted derivatives from oversight under state gaming laws and excluded certain swaps from being considered a "security" under SEC rules.
While some regulators had expressed concerns about the act, President Bill Clinton's economic team had agreed that derivatives should not be regulated. Clinton signed the measure, which was part of a larger bill.
"By ruling that credit-default swaps were not gaming and not a security, the way was cleared for the growth of the market," Eric Dinallo, the superintendent of New York state's insurance department, told a Senate committee during recent hearings on the role of derivatives in triggering the financial crisis.
"None of this was a problem as long as the value of everything was going up and defaults were rare. But the problem with this sort of unregulated protection scheme is that when everyone needs to be paid at once, the market is not strong enough to provide the protection everyone suddenly needs."
In August 2002, one Financial Products innovation caught investigators' attention. The year before, Financial Products had been pitching a new way for companies to shed bad debts, and it had found a customer in PNC Financial Services Group, which had $762 million in underperforming assets it wanted to unload.
Ordinarily, the bank would need to account for the falling value of those assets, which would mean a hit to its profits. Associates at Financial Products, working with accountants, thought they had found a way to solve PNC's problem: create "special purpose entities" to take on the unwanted assets.
Federal investigators alleged, however, that the deals were a sham. To make the transactions look legitimate, Financial Products had set up a company to "invest" in the entities, while receiving an equivalent amount in the form of fees, according to the investigators. Structuring the deal this way violated securities laws, FBI agent Randy Tice asserted in an affidavit filed in federal court as part of the simultaneous settlement of a criminal case and an SEC civil complaint.
AIG and two Financial Products subsidiaries agreed to pay an $80 million fine and give back $39.8 million in the fees that it had earned, plus $6.5 million in interest. PNC paid a $115 million fine.
The government announced the settlement on Nov. 30, 2004. In the wake of Enron, the investigators were sending a message. "We are pleased that AIG has accepted responsibility," said Christopher Wray, an assistant U.S. attorney general. "There is no place in our markets for financial transactions that lack economic substance."
The case had another consequence for Greenberg. It brought AIG into the sights of another skeptical investigator: New York Attorney General Eliot Spitzer.
A secret tipster strikesAfter the PNC case became public, a tipster approached Spitzer's office. Insurance companies, the tipster said, were selling policies known as "finite insurance." The tipster thought the policies were a fraud. The tipster urged Spitzer's office to examine finite insurance and suggested several companies for scrutiny, including AIG and Gen Re, another large insurance company.
Not long afterward, a black binder from another tipster arrived at Spitzer's office in Lower Manhattan. The 4-inch-thick binder held confidential Gen Re documents. The documents appeared to show that Greenberg had arranged bogus transactions with Gen Re that made it look as if AIG had $500 million more in insurance revenue than it had actually earned.
Spitzer and his people could not believe their luck. It was a case on a silver platter. The next morning, Spitzer told his people to begin work on a Greenberg subpoena.
The end of Greenberg's reign at AIG came with a phone call March 13, 2005. The AIG board had called a meeting to consider allegations from Spitzer that Greenberg had been personally involved in the fraudulent deal with Gen Re.
The board had asked Greenberg to call. Frank Zarb, a veteran Wall Street executive and member of the board's audit committee, told Greenberg that Spitzer had issued an ultimatum: Greenberg had to resign.
"I had no choice," Greenberg said recently. "No choice."
Last year, four Gen Re executives and an AIG employee were found guilty on federal charges related to the investigation Spitzer had launched. AIG restated its 2000-04 earnings.
Greenberg, referred to anonymously in the federal case as "unindicted co-conspirator number 1," maintains that what "we did, from AIG's perspective, was perfectly proper." In a recent interview, he tore into Spitzer: "He destroyed a company. And for what?"
Spitzer said recently that the activities at AIG were too important to ignore. Events have solidified his view as the U.S. economy unraveled last year. "AIG, as we have now all seen," Spitzer said, "was at the center of the web of the entire financial system."
Washington Report: Modifying Loan Terms
Success with Short Sales
Troubled firm will sell 3 famous retail centers
Suit claims Amerigo owes $8.5M
