A Crack in The System

"Do you folks find that you have enough information to make credit decisions in your businesses?" Greenspan asked.

Mathis Cabiallavetta, chairman of the board for the giant Swiss bank UBS, responded that his company knew well what it was up against.

Not well enough, as soon became clear.

In September 1998, Long Term Capital Management, a heavily leveraged hedge fund with mountains of derivatives, told Federal Reserve officials that it could not cover $4 billion in losses. Russia, swept up in an Asian economic crisis, had defaulted on its debt, and Long Term was besieged with calls to put up more collateral for its investments. The collapse threatened the fortunes of investors from tycoons to pension funds.

UBS lost hundreds of millions of dollars. Cabiallavetta lost his job.

The exchange in Switzerland, and the Long Term debacle, fueled Savage's unease. His mind kept turning over the problem of how to calculate the risks of credit.

"I've always thought about that," he said. "At the highest level of finance, this is a question of interest. Are you getting enough information about the loans that you're making to corporations? It's the hardest thing. . . . You have to look beyond the credit-rating agencies and make your own decisions."

Savage recalled something that Greenberg had once told him.

"He said to me, 'I want you to understand that no matter what the credit rating is, no matter what other things you might understand, when a CEO owes you $100 million and is supposed to pay you on Friday, sometimes he just doesn't do it.' "

4: Exploiting A Seam

Financial Products' drive to keep ahead of its competitors took the firm in unexpected directions. It developed a reputation as an innovator with one of the most diverse toolboxes in the derivatives business.

That's how Cassano and his Transaction Development Group found coal.

For a group of financial wizards, the coal business seemed an odd turn. But it was a logical extension of what the firm had been doing all along: discovering gaps in regulations and markets.

A 1980 law, generated by the Carter administration, offered tax credits to companies as incentives to design and use synthetic fuel systems. The aim was to reduce U.S. dependence on foreign oil.

Associates at the Transaction Development Group had discovered that many energy companies were not making enough money to benefit from the tax breaks. But Financial Products' profitable parent, AIG, could use those credits to reduce its tax bill.

"One thing AIG had was ample income," Savage said. "So what we did is, we went out and we bought synthetic coal facilities."

The firm had no intention of becoming coal processors. Instead, it arranged to install the equipment -- bought for more than $225 million, as Savage recalls -- at coal facilities and power plants. The facilities leased and operated the machines at a discount, while AIG got millions in tax credits.

Financial Products hedged aspects of the deals and checked with government officials to make sure the arrangements qualified for the breaks. Savage said the idea was bold as well as clever. "We had the gumption to go out and take seven of these plants that were sitting around doing nothing," he said. "We carted [the machines] off to where they could be used, and it went on."

Greenberg, too, was taken with the gambit. "It was opportunistic," he said recently. He once joked that he wanted to ride shotgun in the truck carting the machines around, Savage said.

Over the next several years, AIG reaped $875 million in benefits from the deals. It was a coup for Cassano and his group. Although it wasn't Cassano's idea, Savage said, he guided it from concept to reality.

"He says he thought about it for six months," said Savage, who came to appreciate Cassano's single-minded focus. "He made a lot of money for the company."

5: 'It Would Be Joe'

In fall 2001, Savage decided to call it quits. He had moved his family to Florida and briefly considered whether he could manage the commute. The Sept. 11 attacks made that sort of arrangement seem impossible. He told Greenberg of his plan to leave.

Cassano emerged as Greenberg's candidate to take over. Some colleagues questioned his qualifications to manage a team that was heavily dependent on quantitative skills. Though he was the firm's chief operating officer, some colleagues thought he wasn't as conversant with the complex calculations of risk that remained at the heart of its business. Beyond that, few liked his chip-on-the-shoulder demeanor.

Greenberg had come to know Cassano through board meetings over the years. Cassano had won Greenberg's confidence. The two shared a number of qualities. Both were strong-willed, and both disliked criticism. Greenberg knew that, like him, Cassano had made AIG the center of his life. He knew about Cassano's temper, but he appreciated his grit and drive to make money in the derivatives field, which was becoming more crowded with competition.

Cassano had one other virtue that helped him land the top job: He followed directions from Greenberg and Matthews, the parent company's leaders.

"He told us that in no uncertain terms, that he was -- that all of his people up there were -- smarter than anybody we had at AIG," Matthews said. "And he made it clear that he listened only to two people: He listened to Hank Greenberg and he listened to me."

Cassano would need all the smarts he could muster. He was taking the reins at a challenging juncture. Financial Products was now a $1 billion operation with 225 employees working on a multitude of derivatives deals for clients, involving hundreds of billons of dollars in obligations. But in early 2002, when he replaced Savage, the derivatives industry was coming under a shadow.

A high-flying financial company called Enron was just starting to melt down. Because Enron had systematically abused derivatives as part of its fraudulent corporate accounting, some kinds of derivatives became the focus of regulatory scrutiny and fell out of favor. Structured deals for corporations were a large part of Financial Products' business.

The firm would need to make up lost revenue. "The response to Enron really reduced the toolbox for Financial Products," Savage said. "It wasn't at all clear to me where the profits were going to come from."

Under Cassano, Financial Products would grow, take on more risk and become more top-down than before. The culture that had characterized the firm from the outset -- one that relied on informed skepticism in which just about anyone could question dubious aspects of a trade -- would change, according to people who worked at the firm.

Cassano disputes the notion that the culture had changed, according to Warin, his lawyer. "FP worked closely and had healthy discussions with its internal auditors so they would fully understand the business and investments," Warin said. "Mr. Cassano encouraged this oversight, review and open communication."

6: Clearing The Way

In 2002, the regulatory debate over one of those lines of business, credit-default swaps, was going nowhere. The swaps had fierce critics. Some saw them as insurance deals that ought to be subject to the same regulation that governed the writing of homeowners' policies or car insurance. Others saw certain swaps as gambling: Because anyone could buy a swap, even someone who had no stake in a particular asset, some critics thought those swaps were like a poker game in which spectators placed bets among themselves on who would win the hand.

Some regulators had a hard time seeing the financial value in certain swaps -- especially in deals used to remove debts from a corporation's books.

But those regulators were fighting a lost cause. In the waning days of the Clinton administration, Congress had passed the Commodity Futures Modernization Act, which preempted derivatives from oversight under state gaming laws and excluded certain swaps from being considered a "security" under SEC rules.

While some regulators had expressed concerns about the act, President Clinton's economic team had agreed that derivatives should not be regulated. Clinton signed the measure, which was part of a larger bill.

"By ruling that credit-default swaps were not gaming and not a security, the way was cleared for the growth of the market," Eric Dinallo, the superintendent of New York State's insurance department, told a Senate committee during recent hearings on the role of derivatives in triggering the financial crisis. "None of this was a problem as long as the value of everything was going up and defaults were rare. But the problem with this sort of unregulated protection scheme is that when everyone needs to be paid at once, the market is not strong enough to provide the protection everyone suddenly needs."

7: 'We Made Some Mistakes'

In August 2002, one Financial Products' innovation caught the attention of federal investigators. The year before, Financial Products had been pitching a new way for companies to shed bad debts, and it had found a customer in PNC Financial Services Group, which had $762 million in underperforming assets it wanted to unload.

Ordinarily, the bank would need to account for the falling value of those assets, which would mean a hit to its profits. Associates at Financial Products, working with accountants, thought they had found a way to solve PNC's problem: Create "special-purpose entities" to take on the unwanted assets.

Federal investigators alleged, however, that the deals were a sham. To make the transactions look legitimate, Financial Products had set up a company to "invest" in the entities, while receiving an equivalent amount in the form of fees, according to the investigators. Structuring the deal this way violated securities laws, FBI agent Randy Tice asserted in an affidavit filed in federal court as part of the simultaneous settlement of a criminal case and an SEC civil complaint.

AIG and two Financial Products subsidiaries agreed to pay an $80 million fine and give back $39.8 million in the fees that it had earned, plus $6.5 million in interest. PNC paid a $115 million fine.

The government announced the settlement on Nov. 30, 2004. In the wake of Enron, the investigators were sending a message. "We are pleased that AIG has accepted responsibility," said Christopher Wray, an assistant U.S. attorney general. "There is no place in our markets for financial transactions that lack economic substance."

But authorities demanded more. The settlement also required AIG "to implement a series of reforms addressing the integrity of client and third-party transactions." A group of senior AIG executives would review complex transactions from the previous few years, working with an independent monitor chosen by the Justice Department, the SEC and the company.

In other words, the government had concluded that Financial Products' internal controls -- the disciplined system that had once made the company different from its competitors -- had faltered.

Cassano, who had not arranged the transactions but signed the settlement for Financial Products, later described the PNC deals as an anomaly. "We made some mistakes in those transactions, and we suffered dearly for that," he said in 2007 at an investors conference. "And we've gone to great lengths to correct the things that allowed the transactions to occur."

Greenberg said recently that Financial Products had consulted its legal and accounting experts before going forward with the special entities. The board of directors also had looked it over, Greenberg said. "We thought it was proper," he said.

The settlement is still a source of grief for the former AIG chief executive, who had to swallow the costly settlement and the independent monitor. "I took a bullet for them," he said. "I went out in front. I didn't have to do that. It was their deal."

But the case had another consequence for Greenberg. It brought AIG into the sights of another skeptical investigator: New York Attorney General Eliot L. Spitzer.

8: Foot Faults

After the PNC case became public, a tipster approached Spitzer's office. Insurance companies, the tipster said, were selling policies known as "finite insurance." The tipster thought the policies were a fraud.

Done right, finite insurance expressly limits the losses an insurer can suffer. Done wrong, it isn't insurance at all because neither side takes any risk. Instead, it's an accounting trick that can help both parties improve the appearance of their balance sheets.

The tipster urged Spitzer's office to examine finite insurance and suggested several companies for scrutiny, including AIG and Gen Re, another large insurance company. Spitzer's office sent subpoenas to companies, seeking more information. Not long after, a black binder from another tipster arrived at Spitzer's office in Lower Manhattan. Four inches thick, the binder held confidential documents from Gen Re. The documents appeared to show that Greenberg had arranged bogus transactions with Gen Re that made it look as if AIG had $500 million more in insurance revenue than it had actually earned.

Spitzer and his people could not believe their luck. It was a case on a silver platter. They decided to question Greenberg right away, instead of the usual approach of working slowly toward such a big potential target.

On Feb. 9, 2005, Spitzer told his people to begin work on a Greenberg subpoena.

That afternoon, coincidently, Greenberg announced AIG's latest earnings in a conference call with industry analysts and others. During the call, he complained indirectly about Spitzer's investigation of the insurance industry, suggesting that the probe was overkill and Spitzer was wasting his time.

"When you begin to look at foot faults and make them into a murder charge, then you have gone too far," Greenberg said.

Greenberg's remarks were reported online that afternoon and Spitzer happened to see them. Irked, he asked a deputy how soon the Greenberg subpoena could go out.

That evening, Spitzer was to speak at a dinner with senior executives at Goldman Sachs, in an elegant conference room at the investment bank's headquarters. Among those in the audience: Henry Paulson, then Goldman's chairman and chief executive. The next year, he would become Treasury secretary and head to Washington, where he eventually assumed the central role in dealing with AIG's near-collapse.

As Spitzer waited to deliver his remarks, a deputy came in and whispered into his ear: The Greenberg subpoena had been faxed to AIG. A few minutes later, Spitzer alluded to Greenberg's comments earlier in the day.

"These are not foot faults," Spitzer recalls saying. "But second, too many foot faults and you lose the match."

9: 'No Choice'

The end of Greenberg's reign at AIG came with a phone call March 13, 2005. He was in a private jet on his way back to New York from a visit to Key Largo, Fla. The AIG board of directors had called a meeting that Sunday to consider allegations from Spitzer that Greenberg had been personally involved in the fraudulent deal with Gen Re.

The board had asked Greenberg to call. Frank Zarb, a veteran Wall Street executive and board member, told Greenberg that Spitzer had issued an ultimatum: Greenberg had to resign.

"I had no choice," Greenberg said recently. "No choice."

Earlier this year, four Gen Re executives and an AIG executive were found guilty on federal fraud charges. Later, AIG restated earnings from 2000 to 2004.

Greenberg, referred to anonymously in federal documents as an unindicted co-conspirator, maintains that what "we did, from AIG's perspective, was perfectly proper." In a recent interview, he tore into Spitzer: "He destroyed a company. And for what?"

Spitzer said recently that the activities at AIG were too important to ignore. Events have solidified his view. "AIG, as we have now all seen," he said, "was at the center of the web of the entire financial system."

Greenberg blames others for his company's downfall. He says his forced departure left AIG without the strong hand it needed to protect against future excesses. He said AIG and Financial Products were prepared to hedge any transaction "if we thought there was going to be a potential problem."

Matthews put it this way: "What bothers us about this is we had a climate of risk management which seems to have evaporated after we left."

By then, though, the company had already taken a deeper dive into credit-default swaps, including an expansion into the subprime mortgage market that would eventually trigger the improbable.

The crack in the Financial Products system was about to get a lot wider.

Wednesday: Downgrades and downfall.

Staff writer Bob Woodward contributed to this report.