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A new theory of the AIG catastrophe.

What went wrong at AIG? Since the uproar over the firm's bonuses, it's become fashionable to distinguish between the masters of the universe at AIG Financial Products, the subsidiary that nearly torched the global economy, and the working stiffs at the rest of the company. So compelling is this dichotomy, in fact, that even the AIG basher-in-chief has invoked it. "You've got a company, AIG, which used to be just a regular old insurance company," President Obama explained during his recent "Tonight Show" appearance. "Then they decided--some smart person decided--let's put a hedge fund on top of the insurance company and let's sell these derivative products to banks all around the world."

There's clearly something to this. At the very least, the marriage between the two was hardly a natural fit. The derivatives-meisters worked in lavish digs, had Ph.D.s from prestigious universities, and made gobs of money using powerful computer models. The insurance men hailed from no-name schools and prided themselves on paying less in claims then they collected in premiums. "It was different. That's why we never had them in the building," recalls Hank Greenberg, who ran AIG for more than 35 years before resigning in 2005.

But, these differences notwithstanding, it actually was pretty smart to put a hedge fund on top of an insurance company--at least for a while. For more than 15 years, the arrangement racked up big profits for AIG without exposing it to excessive losses. The real problem was more fundamental: Companies that deal in risk have a natural tendency to take on too much of it, whether they're arranging homeowner's policies or elaborate arbitrages. Over time, a steady march of profits desensitizes them to the dangers they once sweated; even institutional checks begin to weaken.

Which is why the difference between a successful risk enterprise and an unsuccessful one often has less to do with the complexity of its schemes than with its leaders' fanaticism about discipline. It was, among other things, the lack of such leadership at AIG in recent years that made the company a ward of the state.

AIG Financial Products began life in the mind of Howard Sosin, a Stanford-trained Ph.D. who once worked with junk-bond king Michael Milken at Drexel Burnham Lambert. In the mid-1980s, Sosin dreamt of leaving Drexel to start a company that would accept risk from people looking to unload it in exchange for a hefty fee. For example, a state government might pay Sosin's hypothetical firm to lock in an interest rate so as to avoid a potential increase down the road. (The contract, known as a "swap," would obligate Sosin to offset a higher interest payment, but allow him to pocket the difference if the interest payment fell.) Sosin would then turn around and unload the risk himself using a series of contracts called hedges, so that he would make money regardless of which way interest rates moved.

The only catch was that, in order to arrange all these contracts on favorable terms, Sosin needed the financial backing of an extremely reliable, deep-pocketed benefactor. When Sosin went looking for one, an associate put him in touch with former Connecticut senator Abraham Ribicoff--a friend of Greenberg's. Ribicoff brokered an introduction, and, in early 1987, the two men settled on a joint venture: Sosin would furnish the nerds and the algorithms, Greenberg would provide his company's triple-A rating, and the two sides would share the profits.

In the early days, many within AIG viewed Sosin's methods as something akin to alchemy. The AIG officials nominally overseeing his operation knew almost nothing about swaps, and they were dismissive of what they didn't understand. But, within months, AIG-FP was bringing in tens of millions of dollars. Suddenly, top AIG officials took notice. Worse, in light of all the revenue, it began to dawn on Sosin's AIG overseers that his terms were overly generous. "AIG probably thought, 'This thing--it's some Drexel wise guy. It'll make a little bit of money,'" recalls a former AIG-FP employee. "Instead, the thing was minting money. Suddenly ... [it was like]: 'You cut what kind of deal with him?'"

Over the next few years, Greenberg and AIG would revisit their contract with Sosin, but to little avail. Still, for all the haggling about money, the bigger divide was cultural. Greenberg was famously hard-charging, but he had modest tastes. He'd lived in an unremarkable three-bedroom apartment on Park Avenue for years after becoming CEO. His three sons had shared a single bedroom when they came home from college or boarding school. By contrast, Sosin's primary residence was a five-story mansion replete with elevator, squash court, and indoor pool, according to a Wall Street Journal article at the time. His neighbors in Fairfield, Connecticut dubbed it "the castle," and he'd paid a king's ransom for it--$5 million in cash.

Some of these differences bubbled over into business philosophy. Greenberg's was fundamentally conservative; Sosin's less so. For example, it was customary to offer large signing bonuses to lure executives from investment banks. Sosin was obliging, but Greenberg opposed this on principle and went along only grudgingly. Greenberg also wanted more of a say over major deals, something the independent-minded Sosin fought.

By 1993, the partnership was over. Greenberg had been gradually building a team of replacements, and, when Sosin balked at another proposed renegotiation, the two sides went their separate ways. A lawsuit stemming from the breakup revealed that AIG-FP had made more than $1 billion in profits between 1987 and 1992--a staggering sum in those days.

Greenberg put AIG-FP on a tighter leash after Sosin's departure, but several of Sosin's top lieutenants stayed behind, and its character remained intact. According to a Washington Post series in late December, Sosin had created a committee when he launched AIG-FP to vet every single transaction the firm undertook at the close of each day. The idea was to weed out the deals that didn't hold up to withering scrutiny. Under Sosin's successor, a mathematician named Tom Savage, the firm continued to apply an "academic rigor" to each deal, Savage told the Post.

But, when Savage left in 2001, Greenberg elevated a less obvious candidate to run the unit on his recommendation: Joe Cassano, its chief financial officer. Cassano didn't have a background in math or finance, nor did he have a pedigree to match Sosin or Savage. He'd attended Brooklyn College and made his name at the firm overseeing what the former AIG-FP official calls "plumbing." Cassano supervised the employees who set up contracts and accounts for each deal, who routed payments to the right parties, and who made sure AIG-FP and its customers were honoring their contracts (for example, by posting collateral if necessary). The lawyers and accountants all reported to him.

These were the least glamorous parts of the enterprise, but Cassano performed them ably. Colleagues respected his competence, and Greenberg respected his drive. "He was smart, tough, aggressive. Those are not bad characteristics," Greenberg told me. And, though Cassano sometimes alienated co-workers with his vulgar, in-your-face style, he treated the CEO with genuine reverence. He was fond of telling colleagues about a relative who knew almost nothing about AIG but nonetheless advised him: "Don't ever sell the stock unless something happens to Mr. Greenberg."

Cassano quickly demonstrated an aptitude for, if not financial wizardry itself, then selling financial wizardry. One Wall Street analyst recalls attending an AIG "investor day" early in Cassano's tenure and watching him tout various AIG-FP ideas. In one case, Cassano explained how AIG-FP could help banks operate with less capital than regulators typically demanded by essentially insuring their loan portfolios. And the best part was that the deal exposed the company to "no risk." When Cassano spoke, the once-inscrutable company always made perfect sense. Unfortunately, the feeling rarely lasted. "I get back to my desk at the investment house to write up what I learned," the analyst says, "and it's like, 'Tell me again how you take trillions of dollars of notional risk and not actually have any risk?'"

Was it a mistake to hand AIG-FP over to someone with such a weak conceptual grasp of the business? Greenberg maintains that there were enough people around Cassano with quantitative backgrounds to set his mind at ease--and that officials at the corporate parent scrutinized AIG-FP transactions exhaustively. (Former employees basically agree with this.)

But, in March 2005, Greenberg resigned from AIG amid allegations of accounting improprieties. Within three weeks, AIG saw its precious triple-A credit rating downgraded. This 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. In a conference call about AIG's results from the fourth quarter of 2005, a Wall Street analyst grilled Cassano on why his revenue and profits were down. 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. Between March, when Greenberg left AIG, and the end of 2005, Cassano's division issued more than $40 billion in credit-default swaps (essentially insurance) for portfolios of securities backed by subprime mortgages. This was more than half of all the insurance of this type the company had on its books.

Worse, in contrast with the Greenberg era, there was now effectively a vacuum at the top of AIG. Greenberg's successor, Martin Sullivan, was a traditional, meat-and-potatoes insurance man who "didn't have the ability to figure out what was going on there," says another former AIG official. And, even if he'd been able to scrutinize it, Sullivan didn't consider AIG-FP a priority. "He saw his role as going around, meeting every state regulator in the country, and saying, 'We intend to cooperate fully with all investigations of [the] company,'" says this person. For his part, chief financial officer Steve Bensinger found himself completely preoccupied with AIG's accounting statements, whose revision it fell to him to oversee.

The man in charge of keeping an eye on Cassano was a well-respected executive named Bill Dooley. But, former colleagues say, Cassano rebuffed Dooley at every turn, often aggressively. (Greenberg believes Dooley should have appealed to AIG's board if Sullivan didn't support him. Sullivan, Bensinger, Dooley, and Cassano did not respond to requests for comment.) Years of only really answering to Greenberg seem to have convinced Cassano that there was no one else at the company worth listening to.

AIG-FP finally put the brakes on its subprime spree in late 2005. According to the Post, some of Cassano's subordinates began to worry that the assets were far, far riskier than AIG-FP had believed and persuaded him to reconsider. At the same time, another AIG division called American General Financial Services, which was actually in the mortgage business, had become alarmed by the subprime market and was balking at approving new subprime loans. One former official says word spread from American General to AIG-FP that the subprime business was a minefield.

Whatever the reason for the decision, Cassano made it extremely grudgingly. It pained him to give up a large source of profits, and, as late as August 2007, he still seemed miffed over the development. "It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions," he famously told analysts. Alas, by the following February, the market value of the subprime securities would plummet, and the losses wouldn't be one dollar but ... billions. Like that relative said, Cassano should have sold his AIG stock when something happened to Mr. Greenberg.

Noam Scheiber is a senior editor at The New Republic.