By Brady Dennis
Washington Post Staff Writer
Wednesday, December 30, 2009; A01
The probing e-mails came from every direction inside insurance giant American International Group during the summer and fall of 2007, all with the same underlying question:
Could Joe Cassano back up his assurances -- to auditors, rating companies, colleagues and shareholders -- that his Financial Products unit wasn't in trouble?
Cassano grew weary at times of the seemingly endless inquiries, even as he set about answering them. He was particularly impatient with the repeated requests from Elias Habayeb, an AIG executive at the parent company's headquarters who appeared unsatisfied with Cassano's assertions that the sinking subprime mortgage market posed no long-term risk to the firm.
"More love notes from Elias," Cassano wrote to his subordinates as he forwarded another set of Habayeb questions. "Please go through the same drill of drafting answers . . ."
The Cassano-Habayeb correspondence, along with thousands of other e-mails obtained by The Washington Post, as well as supporting interviews, reveal a company wracked by more division, doubt and turmoil than anyone on the outside realized during those tense months in 2007, a full year before the federal government undertook one of the largest corporate bailouts in U.S. history to prevent AIG's collapse.
The Financial Products unit had made AIG billions of dollars in the largely unregulated world of financial derivatives, operating primarily from Wilton, Conn., and London. But as the subprime mortgage boom began to deflate in 2007, some e-mails from New York took on an unfamiliar tone of concern.
"While everyone is comfortable with the conclusions reached in the past," Habayeb told Cassano as the date neared for the company's third-quarter filing to the Securities and Exchange Commission, "the question is whether something different needs to be done come September 30, 2007, given the current dislocation and turmoil in the marketplace."
"This has become the hottest subject at 70 Pine," Habayeb wrote in a subsequent e-mail, employing company shorthand for AIG headquarters in Manhattan.
While the e-mails offer the most revealing look yet at AIG's inner struggles, they also underscore the main obstacle to federal prosecutors assessing individual culpability for the financial crisis. In a Wall Street culture defined by salesmanship and secrecy, divining the difference between optimism and deceit can be a legal morass -- especially when it comes to convincing a jury that the line has been crossed.
Last month, a New York jury made that point clear when it acquitted two former Bear Stearns hedge-fund managers in a criminal case that relied, in part, on e-mail. The jurors were unswayed by the prosecution's claim that a key exchange -- between private e-mail accounts, outside the Bear Stearns e-mail system -- was evidence of a deliberate effort to hide information from investors.
Attorneys for various AIG executives, including Cassano, had no comment for this article, citing the ongoing investigations. AIG also declined to comment. The company's written response to a lawsuit filed by shareholders in a New York federal court, however, offers a glimpse into a potential defense to civil or criminal charges.
The suit alleges that AIG executives ignored warnings and intentionally downplayed the extent of the company's troubles. In its response, AIG conceded that its executives were optimistic, but denied any intent to deceive. "Being wrong or even unwise, in hindsight, is not the same as violating the securities laws," the company wrote.
Whether any violations occurred, the e-mails show AIG executives laboring to understand the flaws in Financial Products' once-vaunted mathematical models and debating what and how much to disclose to investors.
Publicly, Cassano and other AIG executives -- including Habayeb -- presented a unified front of confidence. That optimism was unremarkable at the time, when the Dow was pushing 14,000, AIG's stock price remained relatively strong and most Americans had no inkling of the subprime calamity just around the corner.
Privately, however, executives found themselves in the financial equivalent of the fog of war, as one of the world's most successful companies began its descent to the epicenter of last year's financial collapse.Uncharted waters
The eight men summoned to the 20th floor of 70 Pine on July 12, 2007, knew this was no ordinary meeting. Morris Offit, an AIG director serving on the board's audit and finance committees, had questions about the company's exposure to the mortgage markets and systemic risks at AIG. Cassano and Andrew Forster, a Cassano deputy, had worked up a presentation to reassure Offit about the deals at Financial Products.
According to a memo of the meeting, the two men offered data showing that the firm's exposure to the deteriorating mortgage market did not represent undue risk to AIG. Their bottom line: Financial Products' derivatives-based portfolio was "largely immune to principal loss," they told Offit.
"Thanks for yesterday," AIG's chief credit officer, Kevin McGinn, e-mailed Forster the next day. "Offit was very pleased and both Joe and you were clear and incisive, as always."
But Offit's queries were far from the only ones. A July 11 e-mail described the three major credit rating companies -- whose rankings signify various types of creditworthiness -- as "peppering us with questions" about AIG's exposure to the subprime mortgage markets. That e-mail, which went to more than a dozen company executives, suggested "brief calls" to the rating companies to explain "why this is not a major issue for us."
Other e-mails reveal similar inquiries from AIG's auditor, PricewaterhouseCoopers, and its principal federal regulator, the Office of Thrift Supervision.
The e-mails, many consumed with technical details of the firm's deals, reflect an ongoing internal debate about how best to characterize the company's subprime exposure. "Of course, I want to put the best face on the subject," McGinn assured Forster in his July 13 e-mail. In another, McGinn wrote, "I am giving highly edited versions of AIG subprime exposure material to the rating agencies . . . unless they explicitly request it."
Cassano, in one e-mail exchange during this period, pointedly told McGinn and others that Financial Products had not withheld any information from the rating agencies and would "continue to fully disclose the precise nature of our risk."
A key element of the debate inside AIG involved the accuracy of complex mathematical models that Financial Products had developed to assess the risk of deals involving derivatives known as credit-default swaps. The swaps, which were private contracts that were not listed on any exchange, essentially worked like insurance in case of default. For a hefty fee, Financial Products would insure certain forms of debt, including portions of exotic mortgage-backed securities, which were fueling the real estate boom.
In late July, Goldman Sachs, one of the firm's largest trading partners, challenged Financial Products' numbers, asserting that Goldman's calculations showed a significant drop in the swaps' value. That drop, Goldman contended, triggered provisions in the swaps contracts requiring AIG to post hundreds of millions of dollars in collateral to protect Goldman against the apparent escalation in risk.
"They are not budging and are acting irrational," Tom Athan, a Financial Products executive, wrote on Aug. 2 to Forster after a tense conference call with Goldman employees. "I feel we need Joe [Cassano] to understand the situation 100% and let him decide how he wants to proceed."
Athan added, "This isn't what I signed up [for]. Where are the big trades, high fives and celebratory closing dinners you promised?"
The Goldman collateral call raised eyebrows at AIG headquarters. The mantra at Financial Products had always been that the credit-default swaps were safe; the models showed a 99.85 percent chance of never having to pay out. But now, accounting issues came into play, especially as other companies had begun to write down their mortgage-backed investments, conceding a drop in values. AIG would have to acknowledge any declines in value on paper, even if the swaps were never meant to be sold.
In early August, a colleague e-mailed a wire story based on a Wall Street Journal article, headlined, "AIG Might Be Deceiving Itself on Derivatives Risks, WSJ Says." Cassano replied: "Hopefully people just ignore it. It is a real non story."
Instead, the pressure intensified. Two days later, the Moody's credit rating company sent a list of lengthy questions; another set followed from credit rating company AM Best. Then internal inquiries arrived from Pricewaterhouse and executives at AIG, wondering whether Financial Products had access to enough cash to handle new collateral calls.
In the face of the mounting questions, Cassano's replies reflected frustration rather than worry. "There must be something in the air or the coffee at 70 Pine," he wrote on Aug. 31 to Habayeb and others at AIG's headquarters, adding that "in many ways for us this is old hat stuff. . . . We have been very careful about husbanding our liquidity resources and I am comfortable that we will be able to see this crisis through."
Habayeb, who had publicly defended AIG's valuations weeks earlier, kept up his questioning as the third-quarter SEC filing loomed.
"We need to have a pretty robust analysis to support the number that is reflected in AIG's financial statements representing the fair value of" the credit swaps, Habayeb wrote to Cassano on Sept. 20. "We need to be able to demonstrate that we have considered all available information . . . this will require more work than previously done."
Cassano remained upbeat about his firm's long-term prospects. In a late October e-mail to Habayeb, AIG chief risk officer Robert Lewis and others, he proposed a passage for an upcoming presentation saying "the continuing turmoil and general risk aversions" had left the firm with "significant opportunities" and "well positioned for continued revenue growth as competitors' appetite for certain transactions wanes."
In an SEC filing on Nov. 7, the company estimated a $352 million decline in the value of its credit-default swap portfolio, adding that the "best estimate of a further decline" in the value of the swaps during October "is approximately $550 million."
The following day, Cassano spoke to investors about the "opacity in the market," noting that some trading partners had valued certain deals at 55 cents on the dollar, while others valued them as high as 95 cents. If the lower number were to prove correct, it could foreshadow huge write-downs for AIG. Still, Cassano said, "you should be rest assured" that "we have plenty of resources, and more than enough resources to meet any of the collateral calls that might come in."
Later in November, auditors from Pricewaterhouse told AIG executives that the company "could have a material weakness" because risk managers lacked adequate insight into several business units, including Financial Products.
The auditors' use of the phrase was potentially significant. A material weakness reflects uncertainty about the accuracy of a company's financial statements. Under SEC rules, companies must disclose a material weakness to its investors, if one exists.
Meanwhile, collateral calls pouring in from Goldman, Merrill Lynch, French bank Société Générale and others had reached into the billions of dollars.
In part to quell the fears of investors already anxious about AIG's exposure to the mortgage market, the company announced it would hold a public conference call Dec. 5. As the call approached, Lewis, AIG's chief risk officer, suggested that Cassano talk in more depth about the exposure Financial Products had in the subprime mortgage market.
Cassano expressed concerns about such an approach. "The question is how to include this in the presentation without overly complicating or confusing" investors, Cassano replied in his Nov. 28 e-mail. "No other company of our ilk -- dealers, bank etc have gone into explaining these exposures in any detail, this is just normal course business with highly rated counterparts. Attempting to explain this segment of the business briefly I worry will only add to the confusion of the audience."
On the day of the call, Cassano, Lewis and AIG chief executive Martin Sullivan maintained a bullish confidence. "Because this business is carefully underwritten," Sullivan said of the credit-default swaps, "we believe the probability that it will sustain an economic loss is close to zero."
And yet, within Financial Products, a more uncertain tone prevailed as mounting collateral calls threatened to sap the firm's resources. Days after the Dec. 5 call, Tom Athan commiserated by e-mail with a colleague as they wrestled with yet another collateral call.
"We are in uncharted waters," he wrote, adding a hopeful note: "We'll all get better together."Delusion or dishonesty?
The Dec. 5 conference call remains at the heart of an ongoing federal investigation, according to people familiar with the inquiry. Justice Department and SEC officials have met at length with Cassano's attorneys. They have made the case to prosecutors that the record clearly shows Cassano hid nothing, disclosed Financial Products' financial condition in a timely way and pushed to make sure the firm's models better reflected changing conditions.
Prosecutors find themselves faced with a difficult question: Where does delusion end and dishonesty begin?
In defending itself against the shareholders' lawsuit, AIG focused on that very issue. "Statements of optimism about the future . . . that turn out to be wrong are simply not actionable," the company wrote. "Even in times of market turmoil, the company need not presume the worst about its market prospects."
The government could opt to pursue civil charges, which require a lower standard of proof than the "beyond a reasonable doubt" criterion of a criminal trial. Earlier this month, the SEC filed civil charges against former executives at New Century Financial, one of the nation's largest subprime lenders before it went bankrupt in April 2007. The SEC suit alleges that New Century's former chief executive and two other top executives misled investors about the firm's financial condition as it was imploding.
In the recent Bear Stearns case, prosecutors went the criminal route, accusing former executives Ralph Cioffi and Matthew Tannin of giving investors an overly optimistic view of their funds' ability to withstand the subprime crisis, while privately harboring serious reservations.
Central to the government's case was a Tannin e-mail, sent to the Gmail account of Cioffi's wife. Tannin wrote that the subprime market "looked pretty damn ugly" and that, if a recent financial report proved correct, "then the entire subprime market is toast." Prosecutors juxtaposed that e-mail with a conference call days later in which Tannin told investors that "we're very comfortable with exactly where we are."
But when jurors saw the entire e-mail, it suddenly seemed less clear-cut and less damning. Tannin wrote at length about different courses of action the company could take in regard to the funds, and he seemed to be agonizing over making the wisest decision.
Jurors, after the trial, said that the men had given an unrealistically optimistic picture of reality about the state of their funds, but that having private anxieties did not amount to fraud.
"The entire market crashed," one juror told a reporter. "You can't blame that on two people."'Quite a mess'
By early 2008, the optimism of the previous fall at AIG no longer seemed plausible. The e-mails reflect an internal change in tone.
"We have to be doubly sure that, if Bob [Lewis] is still going to assure investors we will not incur an economic loss from any of the deals, we can support the assertion with very solid analysis," McGinn, the AIG chief credit officer, wrote to Gary Gorton, the architect of Financial Products' mathematical models, on Jan. 21. "If we have to hedge the previous assertion, let's do it now."
On Feb. 11, AIG disclosed that its auditors had concluded that the company "had a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation" of its swaps portfolio.
"Quite a mess," Cassano wrote to colleagues after learning that Pricewaterhouse had made the case for a material weakness to the AIG board. In follow-up e-mails, he added that the disclosure had led to "new calls from our counterparts stating that they can no longer accept our pricing methodology" and that it had "weakened our negotiation position as to collateral calls."
He was right. Trading partners smelled blood in the water, and collateral calls poured in. On Feb. 28, AIG's year-end SEC filing reported that its collateral postings had reached $5.3 billion. Paper losses had ballooned to an estimated $11.5 billion.
The filing retained some optimism, however, saying that "management believes" it could raise the billions of dollars needed to meet "anticipated cash requirements." Seven months later, however, only a government rescue eventually totaling $180 billion in cash and loans would save the insurance giant.
Staff writer Robert O'Harrow and database developer Ryan O'Neil contributed to this report.