I have a piece in our latest issue that tries to answer that question. The turning point seems to come in March/April 2005, when longtime CEO Hank Greenberg resigned amid allegations of accounting improprieties and the company lost its triple-A credit rating. From then till the end of the year, AIG Financial Products, under then-CEO Joe Cassano, binged on credit-default swaps related to subprime real estate--which, uh, didn't turn out so well. Here's the relevant passage from my piece:
[The downgrade] was a body blow to AIG-FP, which relied on the rating to secure favorable terms for the contracts it signed. Many were so-called credit-default swaps (CDS)--essentially insurance for bonds that investors had purchased. The weaker its credit rating, the more AIG had to pledge in collateral to grease the deals--money it would have to fork over if the bonds suddenly depreciated. In general, the downgrade made AIG-FP less attractive to customers, who relied on the company's credit rating as a guarantee it would pay up if the insurance were needed.
A colleague recalls that Cassano became enraged by the development. He first turned on Greenberg, blaming his former benefactor and casting himself as a victim who'd been let down by the company. Cassano would rant about the cosmic unfairness of it all and refer to Greenberg as a "shithead" who'd always given him a hard time. He began frantically groping for ways to sell outsiders on the idea that, for all the parent company's problems, AIG-FP had produced enormous returns. Though the immaculate credit rating had been the foundation of his business, Cassano would routinely insist that "there are only a few things we do that are dependent on the triple-A rating." "I remember thinking he just desperately wanted to figure out a way to attract business back to himself," says the colleague.
Most of these efforts were for naught. ... But there was one type of creditdefault-swap customer still keen on doing business with him: the investors then gobbling up bundles of securities backed by subprime real-estate loans. ... Worse, in contrast with the Greenberg era, there was now effectively a vacuum at the top of AIG.
P.S. One of the things that's still a little unclear is when the compensation structure changed at AIG-FP. Greenberg told me that, when he was CEO, AIG-FP split its profits 30-70 with the parent company, and that half of AIG-FP's 30-percent take had to stay with AIG for five years to give the AIG-FPers the right long-term incentives. It's possible that this structure stayed intact until the famous retention bonuses were negotiated in 2008, but maybe not.
Either way, Cassano himself was making a killing. As reported in this excellent Washington Post series (which I cite in my piece), Cassano himself made $43.6 million in 2006 and $24.2 million in 2007. (He was ousted in 2008, though for a while he still received $1 million a month under a "consulting" arrangement.)