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The Crash: What Went Wrong?

The Washington Post examines the origins of the economic crisis.

Risk and Regulation  |  The Frenzy  |   Full Report

THE CRASH | What Went Wrong

Downgrades And Downfall

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By Robert O'Harrow Jr. and Brady Dennis
Washington Post Staff Writers
Wednesday, December 31, 2008

Third of three parts

The contracts were flying out of AIG Financial Products. Hardly anyone outside Wall Street had ever heard of credit-default swaps, but by early 2005, investment banks were snapping them up to insure all kinds of deals in case of default, fueling one of the great financial booms in U.S. history.

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During twice-monthly conference calls that originated from the company's headquarters in Wilton, Conn., president Joseph Cassano would listen as marketing executive Alan Frost listed the latest swap transactions for associates in the firm's offices in London, Paris and Tokyo.

Once a small part of the firm's business, the increasingly popular contracts had helped boost the company's profits to record levels. The company's computer models continued to show only a minute chance that the firm would ever pay out a dime on the contracts, and it turned down deals that didn't meet its standards. After their reviews, Cassano and his team would consult with AIG executives, sometimes including chairman and chief executive Maurice "Hank" Greenberg. "We rode pretty tight rein on them," Greenberg recalls.

But the swaps also exposed Financial Products and its parent AIG, the global insurance titan, to billions of dollars in possible losses. By spring 2005, some Financial Products executives were questioning the surge in volume. Among them was Cassano, an early advocate for the swaps business who ran the firm from its London office.

"How could we possibly be doing so many deals?" one executive recalls Cassano asking Frost, the firm's liaison with Wall Street dealers, during one conference call.

"Dealers know we can close and close quickly," Frost said. "That's why we're the go-to."

Efficiency wasn't the only reason. Frost didn't have to say aloud what everyone at the firm already appreciated. Financial Products had become the "go-to" for credit-default swaps in part because of its knowledge and reliability, but also because it had AIG's backing. The parent company's top-drawer, Triple A credit rating and its deep pockets assured customers that they could rest easy.

Their comfort turned out to be illusory. The credit-default swaps became a primary force in the disintegration of AIG as a private enterprise and a massive government rescue aimed at preventing catastrophic damage to the world's financial system. Never in U.S. history has the government invested so much money trying to save a private company.

Even as Frost spoke, trouble was brewing for AIG. On March 14, 2005, Greenberg stepped down amid allegations about his involvement in a questionable deal and accounting practices at AIG. The next day, the Fitch Ratings service downgraded AIG's credit rating to AA. The two other major rating services, Moody's and Standard & Poor's, soon followed suit.

The initial fallout came swiftly, as AIG's annual report to federal regulators disclosed. The downgrades had triggered provisions in Financial Products' existing transaction, the report said, requiring its parent company to post $1.16 billion in collateral for the deals.

The company also warned that the downgrades could erode confidence in Financial Products, a crucial element in the unit's phenomenal success. "Historically, AIG's triple-A ratings provided AIGFP a competitive advantage. The downgrades will reduce this advantage and [some] counterparties may be unwilling to transact business with AIGFP except on a secured basis," AIG reported to the Securities and Exchange Commission in May 2005.


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