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.
Credit-default swaps exemplify the contradictions of modern finance. They serve as insurance but aren't regulated as such. They have allowed companies to free up capital that otherwise would be tied up as collateral for loans. They were sold both to reduce risk and, in some cases, to let clients take on more risk.
But, neither the buyers nor sellers truly understood the risks they were creating.
The very nature of credit-default swaps put Financial Products at odds with itself, requiring it to deviate from the disciplined system that made it a trailblazer. Everything about the firm -- its technology, its people, its culture of transparency and caution -- was designed to minimize risk while solving problems for clients.
That meant hedging -- making offsetting trades to balance risk -- whenever possible. For transactions involving credit and loans, it also meant building an escape route so that the firm could get out early if it saw a deal going bad.
With credit-default swaps, there was no way out, and the risk was so minute that hedging was considered unnecessary, as well as problematic.
AIG'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 credit rating, which gave Financial Products the ability to borrow big sums of money at the cheapest rates.
No one saw credit-default swaps as a large-scale venture. After talks that included AIG Vice Chairman Edward Matthews and other executives, Greenberg blessed the new line of business.
Greenberg said recently, "I don't think going into it in '98 was wrong."
Savage says he now sees that the decision contradicted Financial Products' guiding principles.
"The different nature of those trades from any other trades that FP had done opened the door to all the problems that came about," Savage said. He added later: "In retrospect, perhaps those deals should never have been done."
Back office climber
One of the firm's biggest advocates for credit-default swaps was Cassano, who had worked with Financial Products' three founders in their days at the junk-bond firm of Drexel Burnham Lambert.
A Brooklyn College graduate, Cassano had no expertise in the art of hedging. But he had excelled in accounting and credit -- the back office, as it is known on Wall Street.
The founders of Financial Products made him the firm's chief financial officer. He was smart and aggressive, sometimes too aggressive, some executives thought. "He was very, very good," recalled Matthews. "But he was arrogant."