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Key Argument for Incentives Questioned
Payouts Came After Worst Had Passed, With Riskiest Bets Settled by December

By Binyamin Appelbaum and Brady Dennis
Washington Post Staff Writers
Thursday, March 19, 2009

The work of defusing the most dangerous bets placed by American International Group was largely concluded by December, according to documents and interviews, long before the company gave bonuses to employees it said it needed to retain to avoid a financial meltdown.

AIG used almost $50 billion from the Federal Reserve to end contracts with other financial firms by the end of 2008, a massive and far-reaching bailout designed to remove the company from a central role in the financial system with minimal collateral damage. The largest beneficiaries included Goldman Sachs and Bank of America.

The government relied on AIG employees to carry out much of this work. The most explosive contracts largely were the creations of AIG's Financial Products unit, and employees of that division -- the recipients of the controversial bonuses -- worked through the fall to unwind old deals.

By the end of December, the outstanding volume of the riskiest kind of bet, on highly complex derivatives, had been reduced to roughly $13 billion from $78 billion, according to the company's financial filings. The Federal Reserve has since completed its planned purchases of assets from AIG's trading partners.

Two Financial Products executives said the hardest work has been completed and their focus has shifted to the resolution of a vast but less risky portfolio of bets on more straightforward financial instruments. One said most of those trades are protected against loss and have caused few problems.

That progress contrasted with the testimony before Congress yesterday of the company's chief executive, Edward M. Liddy, who said the payment of $165 million in retention bonuses last week was necessary because the departure of key employees could result in catastrophic losses.

"The risk assessment was we've made great progress in winding down this business, but there is still $1.6 trillion of stuff in that portfolio. There's risk that that could blow up. And if it were to explode, it can cause irreparable damage to that progress that we've already made," Liddy said. "I know $165 million is a very large number. It's a very large number. In the context of $1.6 trillion and the money that's already been invested in us, we thought that was a good trade."

The company in recent statements has credited Financial Products with making "substantial progress," and a spokeswoman said yesterday that Liddy simply wanted to underscore the seriousness of the remaining challenge. The division began with bets valued at about $2.7 trillion, which it divided into 22 portfolios. The five riskiest portfolios are basically unwound, but AIG says the remaining portfolios still pose significant risks.

The two executives, who spoke on the condition of anonymity, said they were particularly concerned that the loss of experienced employees would reduce the company's ability to secure the best prices in negotiations with other financial firms.

"We're unwinding all of our businesses. We're going out of business, and all of our counterparties know that," one executive said.

A former Financial Products executive, however, said the employees already are less inclined to haggle because they are playing with government money. He said that government officials, who are closely involved in the process, also have favored pricing that helps other financial firms by giving them more money.

"It doesn't look like the government is trying to protect AIG," the former executive said, adding that paying full price on the amounts demanded by trading partners "is a way of lending them money."

AIG, once the world's largest insurer, traded on its reputation for stability in order to sell a much wider range of financial products. Firms around the world came to depend, to a degree that was not fully appreciated at the time, on the company's promises. But the financial crisis quickly exposed that AIG had made more promises than it could keep. The government took control of the company in September to preserve the health of many of other financial firms.

The unit at the heart of the troubles was Financial Products, and none of its products were more problematic than its sales of insurance-like contracts called credit-default swaps.

Companies bought the insurance from AIG on the performance of investments called collateralized debt obligations, which ultimately depend on borrowers to repay loans. At the end of 2007, the division had guarantees outstanding of about $78 billion. If enough borrowers defaulted and the investors lost money, AIG was on the hook.

Under the government's rescue plan, the Federal Reserve created a special entity to buy the insured investments from AIG's customers, allowing the company to cancel the contracts. The entity was called Maiden Lane III, after the street that runs alongside the headquarters of the Federal Reserve Bank of New York.

A collapse in the market for such assets has massively depressed prices, but the companies were compensated at the full original value. The Fed did not pay the full price. AIG had already provided other assets to the companies as collateral for its guarantees. The companies were allowed to keep those assets, and the Fed made up the difference between the value of the original asset and the value of the collateral.

Through the end of December, the government and AIG had paid about $62.1 billion for assets valued in December at $29.6 billion, basically rewarding the former holders of AIG insurance policies with more than $30 billion in value they would not have received if the assets had defaulted and AIG was unable to meet its obligations.

The Fed expects to get a return on the investment by holding the assets until they recover their full value.

The greatest beneficiaries were the French bank Societe Generale, which got more than $16 billion for assets valued at about $8 billion in December, and Wall Street giant Goldman Sachs, which was paid almost $14 billion for assets valued in December at about $6 billion. Other large beneficiaries included Deutsche Bank and Merrill Lynch, which was acquired by Bank of America. Goldman Sachs and other banks have said that they were separately protected against losses related to these AIG contracts and therefore they would not have been damaged if AIG had not bought the assets at full value.

A second Fed vehicle, Maiden Lane II, also has completed its purchases of about $22.4 billion in mortgage-related securities. AIG still can borrow money from the Fed to meet collateral calls from other trading partners, but the Fed's work with the company is substantially complete.

Dennis reported from Wilton, Conn.

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