Notes On AIG Downfall

Published on WashingtonPost.com. Downgrades And Downfall

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• 4: 'Not a Lot Of Risk'
  
  In May 2007, Cassano stepped before a crowd of entrepreneurs in Manhattan.
  
  Financial Products was itself an entrepreneurial success story, with the numbers to prove it: an investment portfolio in excess of $50 billion; a trading operation that dealt in dozens of currencies, 18 commodities and a host of credit and equity services; a reputation for finding innovative ways to assess and manage the risks in interest rates, equities and other deals for its clients.
  
  "And who are our clients?" Cassano asked. "It's a broad global swath of mostly high-grade institutions, mostly high-grade entities around the world and it includes banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals."
  
  Cassano went on. "My colleagues and myself have $500 million invested in the company," he said. "And so we've become very, very good caretakers of the value of the company."
  
  As a company with billions of dollars riding on arcane financial transactions such as derivatives, Financial Products certainly faced challenges, Cassano said. He then alluded to the debate within the firm over credit-default swaps.
  
  "Credit risk is the biggest risk our group has. It's the single biggest risk that we manage," he said. "But with a AA plus/AA credit portfolio, there's not a lot of risk sitting in there. And so while it is the largest risk, it's not by any stretch a risky business."
  
  Three months later, in a conference call with investors, AIG chief executive Martin Sullivan struck a different note, acknowledging the growing unrest over defaults in the U.S. mortgage market.
  
  The 52-year-old Sullivan had taken the reins at AIG after Greenberg's ouster in March 2005. He was an AIG veteran, with more than 35 years at the company, primarily on the insurance side. His rise to the top was an exclamation point on a career that began at 17, when he joined AIG's London office as a clerk.
  
  Cassano joined Sullivan on the call. Asked by a Goldman Sachs analyst about the stability of Financial Products' huge portfolio of credit derivatives, Cassano responded with calm and confidence.
  
  "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," Cassano said.
  
  Sullivan added: "That's why I am sleeping a little bit easier at night."
  
  5: Collateral Calls
  
  After Sullivan's comment to investors, a wave of collateral calls would begin, swamping AIG.
  
  The first came from Goldman Sachs, the venerable Wall Street investment bank and one of Financial Products' biggest counterparties. Citing the plummeting value of some subprime assets underlying securities that Financial Products had insured, Goldman demanded $1.5 billion to help cover its exposure.
  
  The 2005 downgrade of AIG to a AA company now came into play. Under the swaps contracts, AIG had to post more collateral than in its Triple A days.
  
  AIG disputed the amount but had no choice but to negotiate. It agreed to post $450 million.
  
  As if AIG didn't have enough problems, the rapidly crumbling real estate market was causing the ratings services to downgrade the securities in CDOs, including the top layers that investors had been led to believe were safe. Those downgrades also made AIG more vulnerable under the swaps contracts.
  
  In October, Goldman came calling again, demanding $3 billion. AIG balked once more, but agreed to provide another $1.5 billion.
  
  These and other events sent AIG's stock price tumbling. In six weeks, between early October and mid-November, it fell more than 25 percent, contributing to the perception that AIG was in trouble.
  
  The collateral calls also set off alarms at PricewaterhouseCoopers, AIG's outside auditing firm. The auditors told Sullivan on Nov. 29 that they had found serious oversight problems and "that AIG could have a material weakness" relating to risk management. More ominously, they said, no one knew whether the value that Financial Products placed on its portfolio of derivatives was accurate. That meant the losses in market value could be much worse.
  
  About the same time, the SEC required companies like AIG to adopt an accounting standard known as "mark-to-market," designed to give investors a better sense of the current values of a company's assets. As the housing market declined, and the rate of defaults increased, the swaps looked at greater risk. That allowed counterparties to ask for more collateral.
  
  Greenberg questioned the merits of the rule. "Mark-to-market accounting, I would argue, probably caused a great deal of the trauma that the financial industry is in today," he said.
  
  On paper, the value of the credit-default swaps was sliding. In November, the company reported the portfolio had lost $352 million. At the December 2007 webcast for investors, Cassano reported a higher number, $1.1 billion.
  
  Sullivan, Cassano and others at the company remained bullish on their ability to weather the calls, and in the long run, even recover the collateral they had posted. "But because this business is carefully underwritten," Sullivan said, "we believe the probability that it will sustain an economic loss is close to zero."
  
  AIG's chief risk management officer, Robert E. Lewis, reminded investors of the company's culture. "If you look at AIG's history," Lewis said, "I think you can realize that AIG in its culture does not have an appetite for undue concentrations of risk."
  
  Cassano made the case that Financial Products would survive the storm because it had one of the world's best companies behind it.
  
  "Clearly this is a time where it's a huge benefit to be part of the AIG family," he told the investors. "It's these crises and these points in time that give us the wherewithal right now to stand here with you and say on the back of giants, on the back of everybody at AIG who has built the capital that AIG has, the AIGFP unit is able to withstand this aberrant period."
  
  Federal investigators are examining the December 2007 webcast as part of their effort to determine whether Cassano, Sullivan and others at the company misled investors about how dire the situation had become.
  
  Two months later, on Feb. 11, AIG disclosed that its auditors had found the company "had a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation of the AIGFP super-senior credit-default swap portfolio." On Feb. 28, AIG announced that its estimate of paper losses had spiraled to $11.5 billion. The company also acknowledged that its collateral postings had reached $5.3 billion.
  
  The next day, Sullivan announced that the Cassano era was over. The Financial Products president had resigned, effective March 31. Sullivan did not reveal that Cassano would get $1 million a month as a consultant. That fact came out months later during congressional hearings on AIG's near-collapse. AIG had also provided a record of Cassano's compensation history to the committee, showing that he received $43.6 million in salary and bonuses in 2006, and $24.2 million in 2007.
  
  "Joe has been a very valuable member of the AIGFP senior management team for over 20 years," Sullivan said in making the announcement. "He has had a great career with us, and we wish him the very best in the future."
  
  The worst was still to come.

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