Inadequate cover: la (triste) historia de AIG

By Francesco Guerrera in New York and Andrea Felsted in London

Financial Times | October 6 2008 19:53

Soon after the historic visit by Richard Nixon to Mao Zedong’s China in 1972, Ron Shelp, a senior employee at American International Group, was summoned to Hank Greenberg’s office.

The chief executive of the insurance giant, which had started as a Shanghai-based underwriting agency before being kicked out by the communist regime, had a simple message to convey. “Nixon has opened up China,” Mr Shelp recalls him as saying. “I wanna go back, Ron, I wanna go back first.”

Throughout more than three decades at the top of AIG, Mr Greenberg, a D-Day and Korean war veteran, showed an uncompromising desire to be first. At its apogee, AIG had nearly $1,000bn in assets, made $14bn in annual net profits and employed 106,000 people in 130 countries.

Today, three years after Mr Greenberg – now 83 and still AIG’s largest shareholder – left under pressure from regulators, his edifice totters. The combination of an epochal financial crisis, outsized bets on exotic securities, in­adequate internal controls and poor regulatory supervision forced AIG last month to accept an $85bn loan from the Federal Reserve that places it in government hands.

‘He could see around corners … He could see where the insurance industry was going before anybody else’. Hank Greenberg in his New York office in 2004, shortly before his ousting from AIG

Last week, in a desperate effort to repay the loan and save itself from extinction, AIG’s caretaker management team announced huge disposals. If the divestment programmes is successful, AIG will become a shrunken shadow of its former self. If it fails, the company faces oblivion.

How could this happen? The events of the past few months, in which a relatively small AIG unit racked up huge paper losses on a swath of unregulated derivatives, were clearly the catalyst for so ruinous a fate. But the roots of AIG’s implosion can be traced back to its unique history and idiosyncratic structure.

AIG’s founder, a former ice-cream seller from California called Cornelius Vander Starr, had emigrated to China in search of a better future. His notion of making money by selling insurance policies to markets that rivals would not touch – in his case Chinese people and businesses – was to become a core part of AIG’s corporate culture.

Mr Greenberg, who succeeded Starr in 1968, reinforced this pioneering ethos, expanding AIG by creating a web of political, business and regulatory relationships in the US and abroad that led one analyst to brand the company a “sovereign corporate nation”. His high-powered networking and aggressive pursuit of profits worked wonders for shareholders. Until the latest crisis, its shares had been one of the best-performing on the New York Stock Exchange, fuelled by Mr Greenberg’s pledge to increase earnings by 15 per cent annually.

“He could see around corners,” says Edward Matthews, one of Mr Greenberg’s most senior lieutenants at AIG and then at C.V. Starr, his investment vehicle. “He could see where the insurance industry was going before anybody else.”

But AIG’s development as a loose collection of companies unified only by the central figure of Mr Greenberg had drawbacks. Mr Greenberg declined to comment for this article but former and current AIG executives say that its structure, with businesses insuring anything from broken bones in South Korea to collateralised debt obligations on Wall Street, was cumbersome and opaque. One former senior executive sighs when recalling that AIG has more than 4,300 legal entities scattered around the world, a set-up that made both internal co-ordination and outside scrutiny virtually impossible.

Another former employee notes that the sheer amount of numbers to be crunched by AIG’s finance department often delayed the release of quarterly earnings until several weeks after the end of its reporting period.

Indeed, most observers agree that only Mr Greenberg and a handful of aides had a clear view of the group. “The whole company came together at Hank, and Hank only,” says another former executive. Mr Greenberg gave different units ample leeway to run their own affairs, with one caveat: they had to “make their numbers” and send the cheque back to headquarters. “There was a decentralised spirit: everybody could go on and do their own thing, as long as you made money,” says Mr Shelp, who left AIG in 1985.

But Mr Greenberg was far from entirely hands-off. Former colleagues recall an almost obsessive attention to detail. When, early in his tenure, he noticed that senior underwriters liked to lubricate their lunches in AIG’s canteen with several martinis, he issued a memo imposing a one cocktail per meal limit. “Mr Greenberg was hands-on,” says Mr Matthews. “He managed three layers down the organisation.”

Hence, when Mr Greenberg decided to launch into a whole new business in 1986 no one raised an eyebrow. His move to diversify was based on a conviction that, after a few bumper years, the insurance cycle was turning. “We can no longer go against the tide: we are the tide,” Mr Matthews recalls him as saying. “We need to develop into financial services.”

Mr Matthews hired a team from Drexel Burnham Lambert, the failed investment bank associated with Michael Milken, the junk bond king, and created AIG Financial Products (AIGFP). “It was a world unto itself,” says one person involved at the time. The venture deployed AIG’s triple-A credit rating to make derivative deals that at first involved relatively simple products such as hedging currency and interest rate risks.

After some years, leadership passed to Joseph Cassano, a tough, Brooklyn-born trader and Drexel veteran. Mr Cassano ran the business from London, where he lived in a grand town house a stone’s throw from Harrods. Mr Cassano could not be reached. A neighbour, describing him as a “delightful person”, says he still lives there.

According to an AIG investor presentation in May last year, the “watershed” event for its financial unit came in 1998 when bankers from JPMorgan came to AIGFP and asked it to participate in what they called “bistro trades”. These were precursors to CDOs, the pools of mortgage-backed securities that were to wreak havoc on the global financial system years later .

In some respects, writing credit default swaps – insurance against bond default – was a natural extension for a company that prided itself in pricing difficult risks. AIG came to specialise in insuring holders of what it believed were the safest CDOs, known as “super-senior” tranches (see below). Backed by AIG’s huge balance sheet and pristine credit rating, the London unit thrived. AIG insiders estimate that between 1987 and 2005, the unit netted more than $5bn in profits – a rich dividend for AIG and the AIGFP team, who shared a slice of the profits and had some of their own money at risk.

An important part of the business was writing credit protection for banks. By buying insurance against defaults on corporate debt and residential mortgages, banks could reduce the amount of idle capital they had to hold on their balance sheet. Mr Matthews – who was present at AIGFP’s quarterly board meetings and the weekly Monday meetings chaired by Mr Greenberg, also receiving regular updates from AIG’s credit risk department – said that by March 2005, when both he and Mr Greenberg left, no signs of trouble in the unit’s business were evident.

Mr Greenberg, who remains embroiled in a civil fraud lawsuit brought by Eliot Spitzer, the former New York attorney-general, was replaced by Martin Sullivan, a Briton. But in Mr Greenberg’s absence neither Mr Sullivan nor anyone else appeared able to get a grip on all AIG’s businesses.

In the view of several present and former AIG executives, Mr Sullivan was a brilliant insurance man but the group had become much more than an insurance company and he lacked a deep understanding of the financial side. “Martin’s was a battlefield promotion,” says a former executive, who adds that only Mr Greenberg was really in command of both the insurance and financial arms. “He was thrown off the dock and asked to swim in deep water.” Mr Sullivan could not be reached for comment.

Just a few months after Mr Sullivan’s appointment, at the end of 2005, Mr Cassano decided to stop offering credit protection on CDOs with subprime mortgage exposure, amid fears over the state of the US housing market. He was right. The US economy was slowing and a housing bubble was about to burst. Yet, based on mid-2007 figures, AIG had $465bn in super-senior credit default swaps. Its annual premium from this business was $200m-$250m.

As the US property market turned increasingly sour last year, AIG remained confident its CDS portfolio would weather the storm. Bob Lewis, AIG’s chief risk officer, indicated that it would take events of “Depression proportions” for AIG to suffer. Mr Cassano was even blunter, telling investors in August 2007 that “without being flippant” the company could not envisage a scenario that would “see us losing $1 in any of those transactions”.

When last autumn brought a rash of writedowns by banks as the value of their holdings of these complex instruments plunged, AIG continued to reassure. In a December 5 presentation – the subject hastily changed from life assurance to AIG’s mortgage exposure – Mr Sullivan insisted the situation was “manageable”.

But in the following weeks AIG and its auditors at PwC began to have doubts about the way the insurer was valuing CDOs, which in turn determined the value of the credit protection AIG had provided. AIG had assumed that the insurance would be valued more highly than the CDOs. With wild swings in CDO prices, it could no longer take this as given. A decision to change its valuation basis increased losses on the credit default swap portfolio from $1bn to almost $5bn for October and November.

By that time, the illiquidity in credit markets had begun to infect the protection AIG had written on securities other than those backed by subprime. In February PwC dropped a bombshell, declaring there was a “material weakness” in the way the insurer valued its exposure. Shortly afterwards, AIG and Mr Cassano parted company.

The writedowns continued to escalate. By midyear, AIGFP had racked up about $25bn of cumulative losses on its credit default protection. This emboldened Mr Greenberg and a group of investors led by the billionaire Eli Broad to attack AIG’s management and demand boardroom changes. They claimed that risk management controls had weakened, allowing AIGFP and a unit that lent securities and invested in mortgage-backed assets to run wild.

AIG insiders deny the allegations, pointing out that Mr Greenberg created the unit and appointed Mr Cassano. Very little business was written after Mr Greenberg’s ousting, they add. In their view, AIGFP was undone by the failure to predict the rapid collapse of the US housing market and the subsequent meltdown in the value of mortgages underlying the CDOs.

Nevertheless, in June the rebel shareholders got their wish. Mr Sullivan was replaced by Bob Willumstad, a former Citigroup banker who had been AIG’s chairman. He aimed to sell assets and raise capital. Mr Willumstad told investors he would unveil his plan by early September.

He would not get to do so. AIG came under pressure from regulators worried about the effects of a failure on the thousands of banks and pension funds that had become intertwined with the company. The final blow came when AIG’s debt was downgraded, meaning counterparties could demand $14.5bn in collateral, according to a regulatory filing in August. The move led to the frenzied weekend of talks that culminated in the Fed-backed rescue and the decision to sell off most of AIG’s assets.

The one person whose enthusiasm for the company appears undimmed is Mr Greenberg. After complaining of having lost billions of dollars through the collapse in AIG shares, he has made no secret of his desire to buy as large a chunk as possible of his former empire. He has told close associates he sees this as his chance to save the company and his own standing.

Mr Greenberg hopes to “enhance and restore his reputation”, says Mr Shelp. “That is what he wants, in my view, more than anything else.”

Additional reporting by Joanna Chung



When Martin Sullivan (below) met investors in AIG last December, the man who succeeded Hank Greenberg as chief executive spent much of the time discussing the esoteric topic of “super-senior” debt, writes Gillian Tett.

No wonder. One of the most bitter ironies of the AIG saga is that it was not gambles on ultra-risky assets that brought down the mighty insurance group. Instead, the main cause was an instrument previously considered so secure that bankers dubbed it “more than triple A” debt – implying that this product was safer even than, say, US Treasury bonds.

The “super-senior” concept evolved on Wall Street almost a decade ago, when banks such as JPMorgan and Credit Suisse started creating complex bundles of derivatives and bonds, known as collateralised debt obligations (CDOs) and then sold investors pieces of this debt, ranked according to different levels of risk.

The instruments at the top of the capital structure were called “super- senior” notes, since they would suffer losses only if every other type of investor had been wiped out first – a scenario that seemed extremely unlikely. Indeed, in 2001 Alan Greenspan, then chairman of the US Federal Reserve, even suggested that “nearly riskless” products such as super-senior could replace Treasuries in asset managers’ portfolios.

Hence groups such as AIG happily accumulated large volumes of them, collecting returns of 4-11 basis points over Treasury yields. AIG also earned fees by insuring triple A securities held by banks. This it considered to be extremely low-risk. In the case of US mortgage debt, AIG calculated that super-senior paper would suffer losses only if 40 per cent of homeowners defaulted on their debt and about half the value of those homes was destroyed.

But the past two years have shattered these assumptions, for two reasons. First, it has emerged that the assets inside many CDOs are not representative of the housing market as a whole but are skewed towards the worst types of loan. The second mistake centres on price. Super- senior instruments, which had traded near face value, collapsed last autumn to between 40 and 80 per cent of that.

Initially, bankers thought this slide was temporary. However, that hope may be wrong. Apart from defaults, another factor dragging down prices is that banks created these products (and wrote insurance on them) to exploit regulatory loopholes. But regulators are scrambling to plug those. That could make it hard for banks to produce CDOs in the future. It could also depress the price of super-senior debt, and associated insurance, for a long time. Hence the writedowns at banks and at AIG.


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