Credit rating woes sent AIG spiraling

The contracts were flying out of AIG Financial Products. Hardly anyone outside Wall Street had ever heard of credit-default swaps, but by early 2005 investment banks were snapping them up to insure all kinds of deals in case of default, fueling one of the great financial booms in U.S. history.

During twice-monthly conference calls that originated from the company’s headquarters in Wilton, Conn., President Joseph Cassano would listen as marketing executive Alan Frost listed the latest swap transactions in the firm’s offices in London, Paris and Tokyo.

Once a small part of the firm’s business, the increasingly popular contracts had helped boost the company’s profit to record levels. But they also exposed Financial Products and its parent, American International Group, the global insurance titan, to billions of dollars in possible losses.

The company’s computer simulations continued to show only a minute chance that the firm would ever pay out a dime on the long-term contracts. But by spring 2005, some Financial Products executives were questioning the surge in volume. Among them was Cassano, an early advocate for the swaps business who ran the firm from its London office.

“How could we possibly be doing so many deals?” one executive recalls no-nonsense Cassano asking Frost, the firm’s liaison with Wall Street dealers, during one conference call.

“Dealers know we can close and close quickly,” Frost said. “That’s why we’re the go-to.”

Efficiency wasn’t the only reason. Everyone at the firm already knew that Financial Products had become the “go-to” for credit-default swaps not only because of its knowledge and reliability but also because it had AIG’s backing. The parent company’s top-drawer, AAA credit rating and its deep pockets assured customers that they could rest easy.

Their comfort turned out to be illusory. The credit-default swaps became the primary factor in the disintegration of AIG as a private enterprise and a massive government rescue aimed at preventing catastrophic damage to the world’s financial system. Never in U.S. history has the government invested so much money trying to save a private company.

Even as Frost spoke, trouble was brewing for AIG. On March 14, 2005, its legendary chairman and chief executive, Maurice “Hank” Greenberg, stepped down amid allegations about his involvement in a questionable deal and accounting practices at AIG. The next day, Fitch Ratings downgraded AIG’s credit rating to AA for the first time in Financial Products’ 18 years. The two other major rating services, Moody’s and Standard & Poor’s, soon followed suit.

The fallout came swiftly, as AIG’s next quarterly report to federal regulators disclosed. The downgrades had triggered provisions requiring Financial Products’ parent company to post $1.16 billion in collateral with their counterparties, their partners in the swaps.

When the housing market began to unravel in 2007, it set off a chain of events that would prove disastrous: downgrades in the ratings of securities that Financial Products had insured; demands by Financial Products’ counterparties for billions of dollars in collateral; AIG’s desperate search for cash to meet the collateral calls; a panicky weekend of negotiations in New York and Washington; and, finally, Treasury Secretary Henry M. Paulson’s conclusion that AIG could not be allowed to collapse.

The taxpayer-funded rescue of AIG stands at $152 billion, consisting of $60 billion in loans, a $40-billion investment in AIG preferred stock and a $52-billion purchase of troubled AIG assets that the government hopes to sell off to recoup its investment.

Meanwhile, federal investigators are examining statements made last year by the company and its executives to determine whether shareholders received misleading information.

The CDO revolution

By 2005, the world of debt had changed dramatically since Financial Products wrote its first credit-default swap in 1998. Back then, the swaps involved corporate debt, essentially the bonds that corporations use to finance their operations. There was a wealth of historical data about corporate debt, which gave Financial Products’ executives a high degree of confidence in its computer models.

Financial Products had built itself on exhaustive data analysis and a culture of healthy skepticism.

Over the years, the firm had stayed ahead of competitors by finding innovative ways to manage and minimize the risks it took on for clients. Financial Products executives made fortunes as the firm created markets in untapped areas -- such as buying synthetic coal equipment to capitalize on energy tax breaks.

Now, with credit-default swaps, Wall Street investment banks were discovering how to turn consumer debt into a moneymaker, churning out bond-like securities backed by mortgages and other assets. Credit-default swaps helped attract institutional investors to mind-bendingly complex deals known in Wall Street jargon as collateralized debt obligations, or CDOs.

CDOs defined a revolution in corporate finance called securitization that had fueled an unprecedented boom in available credit. Wall Street saw any income stream as a candidate for securitizing: mortgages, credit card payments, car loans, even airplane leases. The investment banks would bundle these loans, and the monthly payments that came with them, into a new security for investors looking for steady but higher yields than Treasury or corporate bonds.

CDOs had been around for years, but the real estate boom suddenly made mortgages one of the hottest investments on Wall Street. The mortgage industry turned into the equivalent of a giant assembly line, lubricated by fees from one end to the other. New lenders sprung up by the month, offering loans to first-time buyers as well as existing homeowners who wanted to move up to more square footage. For people with shaky credit, the industry provided subprime loans, with higher rates that some borrowers now cannot repay.

Banks packaged and resold the mortgages in pools, which became the basis for mortgage-backed securities. Wall Street scooped them up. The CDO market took off, ballooning to $557 billion issued in 2006 from $157 billion in 2004.

The CDO structure depended on the concept of layered risk. The securities in the “super senior” top tier were considered low risk and attracted the highest ratings. In return for their safety, these bonds paid the lowest interest rate. The lower tiers, meanwhile, absorbed the first losses in the case of loan defaults. For accepting extra risk, investors in these tiers earned a higher interest rate.

The lower tiers acted as buffers for the top tier. Financial Products made its money selling credit-default swaps on only the top tier. It seemed a good bet: Cassano once declared super senior securities safe even “under worst-case stresses and worst-case assumptions.”

Financial Products executives said the swaps contracts were “like catastrophe insurance for stuff that would never happen.”

Hedging, the firm’s hallmark, seemed largely unnecessary.

A contrarian voice

In fall 2005, Eugene Park was asked to take over Alan Frost’s responsibilities at Financial Products. Frost had done exceedingly well in marketing the credit-default swaps to Wall Street, and was getting a promotion. Park had been at the firm for five years and ran the North American corporate credit derivative portfolio.

But he wanted no part of the swaps business. He was worried about the subprime part of the CDO market. He had examined the annual report of a company involved in the subprime business and was stunned.

The subprime loans underlying many CDOs formed too large a part of the packaged debt, increasing the risk to unacceptable levels. Those loans could default at any time because the underwriting processes had been so shoddy. The diversification was a myth -- if the housing market went bust, the subprimes would collapse like a house of cards.

Park spelled out his reasoning to colleagues over the next several weeks. It was as if he had scratched the needle across an old record album at full volume.

Cassano agreed the firm should dig deeper. Financial Products executives began working with researchers from investment banks to examine the subprime threat.

They discovered that the subprime exposure had been growing since early 2004 when the composition of the CDOs became dominated by mortgages rather than other kinds of debt.

Cassano decided it was time to stop. Gorton explained the decision to investors during the December 2007 webcast: “We stopped writing this business in late 2005 based on fundamental analysis and based on concerns that the model was not going to be able to handle declining underwriting standards.”

By then, the firm had $80 billion worth of CDOs that included subprime mortgages as underlying assets and its exposure was still significant. If additional downgrades occurred, either in AIG’s credit rating or in the CDO ratings, Financial Products would have to come up with tens of billions in collateral it did not have.

‘Not a lot of risk’

In May 2007, Cassano stepped before a friendly crowd of hundreds of entrepreneurs in Manhattan and turned on the salesmanship. “My colleagues and myself have $500 million invested in the company,” he said. “So we’ve become very, very good caretakers of the value of the 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 mortgage defaults.

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 his trademark 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 chimed in: “That’s why I am sleeping a little bit easier at night.”

Days after Sullivan’s comment, a wave of collateral calls would begin, eventually swamping AIG.

The first came from Goldman Sachs & Co., 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 AAA days. AIG disputed the amount but agreed to post $450 million.

On top of AIG’s other problems, the 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 an additional $1.5 billion.

These and other events sent AIG’s stock price tumbling. In six weeks, from early October to mid-November, it fell more than 25%, 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. 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 such as 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 said swaps weren’t traded, so the mark-to-market value essentially had no meaning. “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. In the next month’s webcast, 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.”

Federal investigators are examining the December 2007 webcast to determine whether Cassano, Sullivan and others at the company misled investors about how dire the situation had become.

On Feb. 11, 2008, AIG disclosed that its auditors had found that 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 Cassano, the Financial Products president, had resigned effective March 31.

The worst was still to come.

Heading off disaster

The urgent phone call that alerted Eric Dinallo to the extent of the financial meltdown came Friday, Sept. 12, as he drove to his family’s weekend home in the Hudson Valley, north of Manhattan.

Dinallo, head of New York state’s insurance department, got a briefing about AIG, where panicked executives were desperately trying to come up with a huge infusion of cash. They had heard the bond-rating agencies were going to downgrade the company’s already sagging credit grade, which would trigger more collateral calls. “And if downgraded -- even like one notch -- they didn’t have sufficient liquidity” to meet the calls, Dinallo said recently.

Dinallo recognized the danger. AIG had operated for so long at the center of the world’s financial web, with so many counterparties, that its collapse would be felt in every corner of the globe. As insurance superintendent, Dinallo was aware of the previous calls. But he was still taken by surprise. “I never realized things were as bad as they were,” he said. “I didn’t realize how deep the hole was they had created.”

AIG was going to try to sell some of its life insurance affiliates. AIG officials also made a pitch for a $20-billion loan from the state insurance department. “They said, ‘We will pay this loan quickly,’ ” Dinallo recalled.

Dinallo cut short his weekend and headed back to Manhattan. By noon Saturday he had assembled a small team at AIG headquarters, which pored over AIG’s books, looking for ways to raise money.

Meanwhile, Goldman Sachs and JP Morgan Chase & Co. set to work on a $75-billion bridge loan from a syndicate of major financial institutions, which was intended to give AIG cash until it could sell enough assets to bail itself out.

The urgency and tension were palpable. New York’s governor, David Paterson, called in. So did Timothy Geithner, head of the New York Federal Reserve. Geithner was swamped that day with the imminent collapse of Lehman Bros. Holdings Inc., but he wanted constant updates.

By Sunday night, no solution had emerged and AIG executives were worried that the company’s stock would take another hit when the market opened Monday.

The state did not want to provide a $20-billion loan. But Monday morning Paterson announced he would relax insurance regulations so that AIG could borrow up to $20 billion from its subsidiaries to cover operating expenses. Meanwhile, the Goldman-JP Morgan effort on the bridge loan wasn’t coming together.

Hour by hour, it became clear that AIG was far more exposed by Financial Products’ commitments than anyone realized. The next day, sensing disaster, the Federal Reserve, with the backing of the U.S. Treasury Department, stepped in and took control of what had been one of the most successful private enterprises ever.

In October, SEC Chairman Christopher Cox appeared at a discussion the agency was hosting at its Washington headquarters. He delivered a tough, grim message: The federal government had failed taxpayers by not regulating the swaps market.

“The regulatory black hole for credit-default swaps is one of the most significant issues we are confronting in the current credit crisis,” Cox said, “and it requires immediate legislative action.”

He tried to put the regulatory failure into context. He noted that the market for credit-default swaps was barely 10 years old and had doubled in size in just two years. “It has grown between the gaps and seams of the current system,” he said, “where neither the commission nor any other government agency can reach it. No one has regulatory authority over credit-default swaps -- not even to require basic reporting or disclosure.”

He went on: “The over-the-counter credit-default swaps market has drawn the world’s major financial institutions and others into a tangled web of interconnections where the failure of any one institution might jeopardize the entire financial system. This is an unacceptable situation for a free-market economy.”

Epilogue

On Nov. 11, Gerry Pasciucco arrived at AIG Financial Products headquarters. For much of Pasciucco’s career on Wall Street, Financial Products had drawn some of the smartest, most ambitious people in the business. It had a reputation for being an exhilarating place to work.

Now, it was in ruins.

Just weeks before, the 48-year-old Pasciucco, a vice chairman at Morgan Stanley, had heard from colleagues working with federal authorities that AIG was looking for someone to clean up the mess at Financial Products.

Pasciucco was invited to a meeting in which current AIG Chief Executive Edward Liddy spelled out what he needed: someone to identify Financial Products’ outstanding obligations, resolve those transactions as profitably and quickly as possible, and then close the doors and turn out the lights.

Pasciucco had his doubts. Liddy told him to think about it. Pasciucco did more homework. The organization was in desperate need of leadership and a game plan for unwinding its enormous book of transactions. Pasciucco came to believe that he could make a difference and decided to take the job.

He dived into the company’s books. What he found was fascinating and daunting: Financial Products had $2.7 trillion worth of swap contracts and positions; 50,000 outstanding trades; 2,000 firms involved on the other side of those trades; and 450 employees in six offices around the world. The majority of the firm’s trades had been hedged, essentially along the lines that its founders had laid out two decades before.

But Pasciucco soon found evidence of a fatal miscalculation. It seems that as Financial Products ramped up its credit-default swap business, its leaders assumed that its parent, AIG, would always be as strong as it was the day it backed the firm’s first big trade in 1987. They had failed to prepare for the possibility of a downgrade in AIG’s credit rating.

The executives who had pushed or approved the credit-default swap business had placed too much faith in the math that told them the worst would never happen, that AIG and its deep pockets would always be there to usher them through the trouble.

“When the unexpected happens and you have the biggest credit crisis since 1929, you have to be prepared to deal with it, and they weren’t,” Pasciucco said. “There was no system in place to account for the fact that the company might not be a AAA forever.”