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.