A Crack in The System

2: 'A Watershed Event'

One of the firm's biggest advocates for credit-default swaps was Joseph Cassano.

Cassano, the feisty, hardworking son of a Brooklyn cop, did not have the pedigree of Financial Products' three founders, who hailed from places such as Bell Labs and the Wharton School. Cassano had worked with the trio at the junk-bond firm of Drexel Burnham Lambert, and had been one of 10 original recruits who left Drexel to start Financial Products.

A Brooklyn College graduate, the 42-year-old Cassano was not one of the "quants" who had mastered the quantitative analysis and risk assessment on which the firm had been built. He had no expertise in the art of hedging. But he had excelled in the world of accounting and credit -- the "back office," as it is known on Wall Street.

The founders of Financial Products made him the firm's chief financial officer. From the start, Cassano gained respect, in part because he and his team rarely made mistakes processing trades. He was smart and aggressive -- sometimes too aggressive, some executives thought. He had a mercurial temper, occasionally screaming at an underling. He swore, berated and moved on, sometimes leaving hard feelings in his wake.

"He was very, very good," recalled Edward Matthews, AIG vice chairman. "But he was arrogant."

He also was ambitious. He made plain to his bosses that he wanted more than the back office.

In 1994, Cassano got a chance.

The firm's founders had left in a bitter dispute with Greenberg, and Savage had taken the reins. He put Cassano in charge of the Transaction Development Group, a new unit hunting for business involving energy products and tax credits in the United States and abroad. He was also made chief operating officer.

Cassano's portfolio included deals involving credit, so he played a key role in the credit-default swap debate going on inside the company. In 1998, when the investment bank J.P. Morgan came to Financial Products, seeking a credit-default swap arrangement, Cassano was among the most interested. After studying the proposals, he passed on the first deal. But he soon became a leading proponent.

J.P. Morgan wanted to package a variety of debt on its books and resell it. The debt would be turned into bond-like securities, and layered like a wedding cake so that investors in the top tiers were first to get their money back in case of default. Investors in lower tiers earned a higher interest rate for taking greater risk.

The "structured" deal had an unwieldy name, the Broad Index Secured Trust Offering, so it was called "Bistro" for short. Because the debt in Bistro was diverse, the investment was considered exceedingly safe; if one kind of debt went into default, it was unlikely other kinds would go under at the same time. As an extra measure of safety, the Bistro organizers wanted Financial Products to write credit-default swaps on the top tiers to further reassure skittish investors.

As private contracts, deals like Bistro could be financed with greater amounts of borrowed money than regulators would allow if the deals were publicly traded. This high degree of leveraging would come back to haunt the industry later.