The Story Behind AIG’s Collapse – Bad Mortgages, Credit Default Swaps & Accounting Irregularities

By David Voreacos and Elliot Blair Smith
Bloomberg News
November 26, 2008
Nov. 26 (Bloomberg) — Prosecutors are examining statements by former American International Group Inc. executive Joseph Cassano to see if he misled auditors and investors on subprime mortgage-related losses, said people familiar with the probe.

Investigators are asking auditors at PricewaterhouseCoopers LLP about memos they wrote last fall on how Cassano and other AIG executives valued contracts protecting $62 billion in mortgage-backed securities, the people said. The government is also looking at AIG’s reliance on valuations that have been questioned by auditors and banks.

PWC told Martin Sullivan, then AIG’s chief executive officer, on Nov. 29, 2007, that auditors had challenged the insurer’s financial controls, according to company records. On Dec. 5, Sullivan and Cassano told investors gathered at New York’s Metropolitan Club not to fear losses on AIG’s portfolio of ‘super senior” credit-default swaps, which insured bond losses tied to the U.S. housing market.

“It is very difficult to see how there can be any losses in these portfolios,” said Cassano, 53, according to a transcript of the investor meeting. Though he said the contracts had dropped in value by $1.1 billion in October and November 2007, Cassano told investors the “losses will come back.”

Cassano, who ran AIG’s London-based financial products unit, made no mention of PWC’s concerns at the meeting, according to the transcript. Cassano also didn’t discuss a running dispute with Goldman Sachs Group Inc., one of its counterparties, about valuing the underlying collateral. The securities firm had made collateral calls by the time of the conference.

‘We Are Confident’

“We are confident in our marks and the reasonableness of our valuation methods,” said Sullivan, 54, at the meeting.

On Feb. 11 of this year, AIG said the contracts declined more than sixfold in November, for an unrealized loss of $5.96 billion. AIG also said PWC found a “material weakness” in how it valued the credit-default swaps.

AIG posted what was then its biggest quarterly loss on Feb. 28, writing down $11.1 billion on the swaps. AIG announced Cassano’s resignation as president and CEO of AIG Financial Products a day later.

Cassano’s lawyer said in a statement that his client is cooperating with investigators and acted lawfully.

“His actions were appropriate, including during the valuation of AIG’s credit-default swaps,” said attorney F. Joseph Warin in an e-mailed statement. “He provided full and complete information to investors, his supervisors and auditors.”

Ousted Sullivan

AIG’s board ousted Sullivan on June 15, pegging paper losses on the contracts at $26.1 billion. While the New York- based insurer said it will probably never realize those losses, it got an $85 billion loan from the Federal Reserve in September. The U.S. this month increased the aid to more than $150 billion.

The Justice Department in Washington and the U.S. Attorney’s Office in Brooklyn, New York, have joined with the Securities and Exchange Commission to determine whether AIG executives committed crimes or merely exercised bad judgment, the people said.

PWC spokesman Steven Silber declined to comment on behalf of the auditing firm and its employees.

One way for prosecutors to build a fraud case is to show executives made public statements “inconsistent with what they knew to be true,” said former U.S. prosecutor Joshua Hochberg, now at McKenna Long & Aldridge in Washington.

“Prosecutors will look for as sharp a contrast as they can find between what an executive said and the information he actually had available,” said Andrew Hruska, a former federal prosecutor now at King & Spalding in New York.

Brooklyn College

Cassano graduated from Brooklyn College in 1977 with a degree in political science. He later worked two years at Drexel Burnham Lambert, the defunct investment bank. In 1987, AIG hired him to help found the financial products unit.

Cassano’s business drew attention from authorities. In 2004, he signed an agreement on behalf of the company to defer prosecution on a charge of aiding and abetting securities fraud. U.S. prosecutors alleged the unit helped Pittsburgh-based PNC Financial Services Group Inc. improperly remove assets from its balance sheet. AIG paid $126.4 million to resolve the case.

Cassano’s unit sold credit-default swaps on securities backed by corporate loans, mortgages, auto loans, credit cards and other assets. Those securities, known as collateralized debt obligations, are sliced into layers carrying different risks. AIG sold credit protection on the top layer, or AAA-rated portion, which is typically the last to suffer in a default.

‘Losing $1’

“It is hard for us, without being flippant, to even see a scenario within any kind of realm or reason that would see us losing $1 in any of those transactions,” Cassano said on an Aug. 9, 2007, investor call, according to a transcript.

AIG sold CDO protection worth about $441 billion as of June 30, 2007, including $64 billion backed by subprime mortgages, according to company documents.

AIG paid Cassano $280 million in the eight years before he resigned, according to U.S. Rep. Henry Waxman, chairman of the House Oversight and Government Reform Committee. After Cassano stepped down, the insurer paid him $1 million a month as a consultant.

AIG stopped paying Cassano the $1 million-a-month consulting fee before Waxman’s committee held a hearing about the insurer on Oct. 7, according to company spokesman Nicholas Ashooh.

At the Dec. 5 conference at New York’s Metropolitan Club, Sullivan said AIG’s risk was “very manageable.” Cassano didn’t disclose that Goldman had already made collateral calls when investors asked about demands from trading partners, according to the transcript. A buyer of the credit protection may demand cash from AIG when the value of the underlying CDOs dropped or if their credit ratings were lowered.

‘Collateral Calls’

“We have, from time to time, gotten collateral calls from people,” Cassano said at the meeting, according to the transcript. “Then we say to them, ‘Well, we don’t agree with your numbers.’ And they go, ‘Oh.’ And they go away.”

Former AIG auditor Joseph St. Denis wrote on Oct. 4 of this year to the Waxman committee that AIG should have disclosed more information on collateral calls because it was of “critical importance” to investors. St. Denis also said Cassano told him to avoid the swaps-valuation process before St. Denis’s resignation Oct. 1, 2007.

“I have deliberately excluded you from the valuation of the super seniors because I was concerned that you would pollute the process,” Cassano told St. Denis, according to the letter.

AIG’s valuation of the swaps, and the underlying CDOs, was based on a mathematical model known as the binomial expansion technique developed by Moody’s Investors Service in 1996 to estimate losses on collateral.

BET Methodology

AIG, after refining its BET methodology in late 2007, discovered “substantially higher” paper losses on the swaps portfolio, according to minutes of a Jan. 15 audit committee meeting released by Waxman. Audit committees regularly keep minutes.

“While it provides useful back-of-the-envelope risk metrics, there are much more accurate techniques,” said John Kiff, a structured-finance analyst at the International Monetary Fund in Washington. Kiff co-wrote an analysis in 2004 that concluded the model’s formula understated potential losses.

Moody’s began to phase out the BET technique in 2005. In a technical paper the credit-rating company published on its Web site in September of that year, the company described the replacement model, the correlated binomial method, as able to “better assess” potential losses in mortgage-dominated CDOs.

AIG’s computer modeling was a subject that PWC raised with management at a meeting, according to audit committee minutes.

Prominent Partners

Some of PWC’s most prominent partners attended audit committee meetings. They included two members of its global board, Tim Ryan and Robert Sullivan, and the U.S. chairman and senior partner, Dennis Nally. AIG paid $384 million in fees to PWC between 2004 and 2007, according to company filings.

On Nov. 29, 2007, six days before AIG’s investor conference at the Metropolitan Club, Ryan met Sullivan and then-Chief Financial Officer Steven Bensinger, according to minutes of the Jan. 15 audit committee meeting. Ryan said he worried about a “material misstatement or omission” in AIG’s second-quarter disclosures on securities lending.

On Jan. 15, Ryan told the audit committee that a “significant deficiency” in financial controls at AIG may amount to a “material weakness,” according to the minutes. Ryan said his concerns extended to the insurer’s securities- lending program and the credit-default swap portfolio.

At that meeting, Elias Habayeb, who then was CFO of AIG’s financial services group, said valuing the swaps “is not going as smoothly as it could,” according to the minutes.

AIG Swaps Portfolio

By then, another accounting firm, KPMG LLP, had also begun valuing the AIG swaps portfolio.

When AIG’s audit committee met again Feb. 26, Ryan said a Goldman collateral call after the second quarter led AIG to increase third-quarter losses to $350 million from $45 million, according to the minutes of the meeting.

In the fourth quarter, Ryan said at the meeting, PWC and AIG managers discussed “the subjectivity of the valuation process and key issues such as the impact of the collateral calls on the valuation judgments,” according to the minutes.

When AIG’s full board met May 8, Bensinger told directors that while the insurer’s models estimated the loss at $1.2 billion to $2.4 billion, an independent valuation by JPMorgan Chase & Co. pegged it at $9 billion to $11 billion. JPMorgan assumed sharper declines in housing values, according to minutes of the board meeting.

Cassano discussed collateral calls in detail with investors and “specifically noted that some counterparties had different valuation estimates,” Warin, his lawyer, said in his statement. “We are disappointed by the rehashing of allegations of wrongdoing that are misleading, incomplete, and in some cases just wrong.”

To date AIG has received $180 Billion Dollars Of Taxpayer Money – There may be $2 Trillion in additional bad debt on the AIG books.

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