Complex deals veiled risk for AIG

For months, several executives at AIG Financial Products had pulled apart the data, looking for flaws in the logic. They kept asking themselves: Could this be right? What are we missing?

Their debate, in early 1998, 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 American International Group, with a 99.85% 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 Financial Products president, understood the model's projections, the U.S. economy would have to disintegrate into a full-blown depression for Financial Products to face having 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 earn millions 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 recently.

Initially, credit-default swaps would provide a fraction of Financial Products' revenue that year. It didn't seem like a big decision.

But all the upbeat predictions 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 financial institutions 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 September, the Bush administration concluded that AIG's position at the nexus of the deals made it too important to be allowed to fail, triggering the most expensive rescue of a private company in U.S. history, $152 billion so far.