How AIG Became Too Big to Fail

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That hedge-fund-like unit built up a portfolio of $2.7 trillion in derivatives. AIG FP eagerly offered to insure billions of dollars in derivative portfolios, building up potential liabilities many times its capacity to pay out if the portfolios defaulted. Few financial experts ever imagined the scope of the impending defaults. Neither did regulators. AIG's uncollateralized insurance combine was regulated by Washington's Office of Thrift Supervision, whose task is to watch over savings-and-loan companies, not global insurers. And it wasn't watching.

AIG, like other institutions, was making a mint dealing in derivatives tied to the U.S. real estate market. The boom was financed in part by collateralized debt obligations (CDOs), securities based on subprime mortgages that have come to define toxic asset. Companies that held CDOs could offset their risk by buying CDSs from AIG FP. Or they could simply speculate with the instrument. It all worked fine until overbuilding by housing firms and overleveraging by consumers caused the bubble to burst. Which in turn caused the value of CDOs to plunge. Which caused holders of CDSs on such securities to demand payment from AIG.

Although a CDS is, in its simplest form, an insurance policy, AIG was selling something far more exotic. Say you buy a house and insure it. The insurer doesn't offer the same policy on your house to everyone else in the neighborhood; if it did and your house went up in flames, the insurer could get wiped out. In its CDS contracts, though, AIG wrote multiple insurance policies covering the same underlying package of increasingly toxic assets. In essence, it was underwriting systemic risk. This is the opposite of what insurance companies are supposed to do: diversify risk across the universe of policyholders. "One thing about the insurance model: it relies on diversification as its means to exist," says a top exec at an AIG competitor. "If an insurance company plays in a field where they underwrite systemic risk, that's a totally different experience." Is it ever. Insurance companies can handle catastrophic risk but not systemic risk. That's why you can buy hurricane insurance from private companies but not terrorism insurance. Only a government can take on that risk. At its most basic, AIG took on colossal risks that it could not afford.

With its high credit rating, AIG FP wasn't required to stockpile reserves, or collateral, as traditional insurers must to cover potential losses. As the CDOs that AIG insured began to crater, the counterparties began asking for more collateral to back their policies, which was written into the contracts. Cassano said in August 2007 that he couldn't imagine a situation in which AIG would "lose one dollar in any of these transactions." He was right. AIG didn't lose a dollar; it lost billions of them.

In a rare interview, former CEO Greenberg, who is suing AIG and being sued by the company over financial-management issues, tells TIME that once the company lost its top credit rating, AIG FP should have stopped writing swaps and hedged, or reinsured, its existing ones. But Cassano's unit doubled down after the spring of 2005, writing more and more subprime-linked swaps as the ratings plunged, which made the possible need for collateral enormous in the event its debt was downgraded. The downgrades occurred in 2008. "Of course they were going to run out of money," says Greenberg. He adds that as the liquidity crunch hit in 2008, AIG FP should have renegotiated terms with the banks to ease their demands on collateral. "You can renegotiate almost anything, anytime."

Last September, with global stock markets collapsing and credit markets frozen, Geithner, then head of the New York Fed, and Bernanke believed AIG was too close to collapse to do anything other than stop the bleeding. Failure by AIG to pay might have threatened its counterparties — for instance, Citigroup and, in turn, Citi's counterparties. A bond or a derivative is, after all, a promise to pay someone, and if there is no confidence in its fulfillment, the financial system ceases to function. It is not a fear that has gone away simply because AIG has been stabilized.

Bailing Out the Bailed Out
Keeping the financial system fluid might explain why so many banks got paid in full, which strikes some as a scandal way bigger than the bonus payouts. Many experts wondered why AIG paid 100 cents on the dollar. Among the biggest beneficiaries of the AIG pass-through, at $12.9 billion, was Goldman Sachs, the investment-banking house that has been the single largest supplier of financial talent to the government. Critics have been quick to note — and not favorably — the almost uncanny influence of former Goldman executives. Initial phases of the rescue were orchestrated by ex–Goldman chairman Hank Paulson, who was recruited as Treasury Secretary in part by former White House chief of staff and Goldman senior exec Josh Bolten. Goldman's current boss, Lloyd Blankfein, was invited to participate in meetings with the Fed. AIG's Liddy is a former Goldman director and an ex-CEO of Allstate. Another alum, Mark Patterson, once a Goldman lobbyist, serves as chief of staff at the Treasury, while Neel Kashkari, who runs TARP, was a Goldman vice president.

Goldman has repeatedly declared that its exposure to AIG was "immaterial" and fully hedged. But some rivals point to the fact that Goldman had uncharacteristically piled into contracts with a single counterparty. "I am shocked that Goldman had this much exposure [with AIG]," says an analyst at a competing bank. "This was a major failing, but they got bailed."

Goldman got bailed twice: first on its CDS exposure and a second time, to the tune of $4.8 billion, for another AIG fiasco, losses on its securities-lending business.

Securities-lending is supposed to be a sort of Christmas club of high finance. Companies like insurers, which own tons of equities and Treasury bonds that they are holding long term, lend them out short term, often overnight, to borrowers who need the shares to fulfill other commitments. For instance, if hedge funds want to sell shares short, they borrow them, putting up cash collateral that includes a small spread to the lender. Typically, the owner of the shares takes that collateral and invests it in something with low risk and of short duration, like commercial paper. The lender is exposed to some risk, but it usually isn't catastrophic. However, AIG took the collateral and invested in longer-term, higher-risk mortgage- and asset-backed securities. "Crap," as a portfolio lending expert describes them. When those securities crashed in value, so did AIG.

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