"AIG and two Financial Products subsidiaries agreed to pay an $80 million fine and give back $39.8 million in the fees "

Here's the first two parts of the Washington Post story on AIG:

"The Beautiful Machine
Greed on Wall Street and blindness in Washington certainly helped cause the financial system's crash. But a deeper explanation begins 20 years ago with a bold experiment to master the variable that has defeated so many visionaries: Risk.

By Robert O'Harrow Jr. and Brady Dennis
Washington Post Staff Writers
Monday, December 29, 2008; A01

First of three parts

Howard Sosin and Randy Rackson conceived their financial revolution as they walked along the Manhattan waterfront during lunchtime outings. They refined their ideas at late-night dinners and during breaks in their busy days as traders at the junk-bond firm of Drexel Burnham Lambert.

Sosin, a 35-year-old reserved finance scholar who had honed his theories at the famed Bell Labs, projected an aura of brilliance and fierce determination. Rackson, a 30-year-old soft-spoken computer wizard and art lover, arrived on Wall Street with a Wharton School pedigree and a desire to create something memorable.

They combined forces with Barry Goldman, a Drexel colleague with a PhD in economics and a genius for constructing complex financial transactions. "Imagine what we could do," Sosin would tell Rackson and Goldman as they brainstormed in the spring of 1986.

The three men had earned plenty of money through short-term deals known as interest-rate swaps, a clever transaction designed to protect banks, corporations and other clients from swings in interest rates that threw uncertainty into the cost of borrowing the money necessary for their business operations."( I SEE THE STRATEGY AS HEDGING OR BALANCING OR COUNTERACTING )

Here's what Interest Rate Swaps are via Pimco:

(((Interest-rate swaps have become an integral part of the fixed-income market. These derivative contracts, which typically exchange – or swap – fixed-rate interest payments for floating-rate interest payments, are an essential tool for investors who use them to hedge, speculate, and manage risk.

This article aims to explain why swaps have become so important to the bond market. It begins with a basic definition of interest-rate swaps, outlines their characteristics and compares them with more familiar instruments, such as loans. Later, we examine the swap curve, some of the uses of swaps, and the risks associated with them.

What is a Swap?
An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter.

The most commonly traded and most liquid interest rate swaps are known as “vanilla” swaps, which exchange fixed-rate payments for floating-rate payments based on LIBOR, the interest rate high-credit quality banks (AA-rated or above) charge one another for short-term financing. LIBOR, “The London Inter-Bank Offered Rate,” is the benchmark for floating short-term interest rates and is set daily.) Although there are other types of interest rate swaps, such as those that trade one floating rate for another, plain vanilla swaps comprise the vast majority of the market.

By convention, each participant in a vanilla swap transaction is known by its relation to the fixed rate stream of payments. The party that elects to receive a fixed rate and pay floating is the “receiver,” and the party that receives floating in exchange for fixed is the “payer.” Both the receiver and the payer are known as “counterparties” in the swap transaction.

Investment and commercial banks with strong credit ratings are swap market-makers, offering both fixed and floating-rate cash flows to their clients. The counterparties in a typical swap transaction are a corporation, a bank or an investor on one side (the bank client) and an investment or commercial bank on the other side. After a bank executes a swap, it usually offsets the swap through an interdealer broker and retains a fee for setting up the original swap. If a swap transaction is large, the interdealer broker may arrange to sell it to a number of counterparties, and the risk of the swap becomes more widely dispersed. This is how banks that provide swaps routinely shed the risk, or interest-rate exposure, associated with them.

Initially, interest rate swaps helped corporations manage their floating-rate debt liabilities by allowing them to pay fixed rates, and receive floating-rate payments. In this way, corporations could lock into paying the prevailing fixed rate and receive payments that matched their floating-rate debt. (Some corporations did the opposite – paid floating and received fixed – to match their assets or liabilities.) However, because swaps reflect the market’s expectations for interest rates in the future, swaps also became an attractive tool for other fixed-income market participants, including speculators, investors and banks.

As a result, the swap market has grown immensely in the past 20 years or so; the notional dollar value of outstanding interest rate swaps globally was $230 trillion at the end of 2006, according to the Bank for International Settlements. Swap volume is termed “notional” because principal amounts, although included in total swap volume, are never actually exchanged. Only interest payments change hands in a swap, as described below.

Characteristics of Interest Rate Swaps
The “swap rate” is the fixed interest rate that the receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time. At any given time, the market’s forecast of what LIBOR will be in the future is reflected in the forward LIBOR curve.

At the time of the swap agreement, the total value of the swap’s fixed rate flows will be equal to the value of expected floating rate payments implied by the forward LIBOR curve. As forward expectations for LIBOR change, so will the fixed rate that investors demand to enter into new swaps. Swaps are typically quoted in this fixed rate, or alternatively in the “swap spread,” which is the difference between the swap rate and the U.S. Treasury bond yield (or equivalent local government bond yield for non-U.S. swaps) for the same maturity. Swap spreads are discussed in more detail in the next section.

In many ways, interest rate swaps resemble other familiar forms of financial transactions, and it is helpful to think of swaps in these terms:

• Exchanging Loans. Early interest rate swaps were literally an exchange of loans, and this model still provides an intuitive way to think about swaps. Consider two parties that have taken out loans of equal value, but one has borrowed at the prevailing fixed rate and the other at a floating rate tied to LIBOR. The two agree to exchange their loans, or swap interest rates. Since the principal is the same, there is no need to exchange it, leaving only the quarterly cash flows to be exchanged. The party that switches to paying a floating rate might demand a premium or cede a discount on the original fixed borrower’s rate, depending on how interest rate expectations have changed since the original loans were taken out. The original fixed rate, plus the premium or minus the discount, would be the equivalent of a swap rate.
• The Financed Treasury Note. Receiving fixed rate payments in a swap is similar to borrowing cash at LIBOR and using the proceeds to buy a U.S. Treasury note. The buyer of the Treasury will receive fixed payments, or the “coupon” on the note, and be liable for floating LIBOR payments on the loan. The concept of a “financed Treasury” illustrates an important characteristic that swaps share with Treasuries: both have a discrete duration, or interest rate sensitivity, that depends on the maturity of the bond or contract.

The Swap Curve
The plot of swap rates across all available maturities is known as the swap curve, as shown in the chart below. Because swap rates incorporate a snapshot of the forward expectations for LIBOR and also reflect the market’s perception of credit quality of these AA-rated banks, the swap curve is an extremely important interest rate benchmark.

Although the swap curve is typically similar in shape to the Treasury yield curve, outright swap rates are generally higher than Treasury yields with corresponding maturities, as the chart above illustrates. This premium, or “swap spread” at any given maturity, mostly reflects the incremental credit risk associated with the banks that provide swaps compared to Treasuries, which are viewed as risk-free. While the swap spread can be also be driven by short-term supply and demand fundamentals and other factors within the swap market, the overall level of swap spreads across maturities can also offer a broad reading of the creditworthiness of the major banks that provide swaps.

Because the swap curve reflects both LIBOR expectations and bank credit, then, it is a powerful indicator of conditions in the fixed income markets. In certain cases, the swap curve has supplanted the Treasury curve as the primary benchmark for pricing and trading corporate bonds, loans and mortgages.

Uses for Swaps
Interest rate swaps became an essential tool for many types of investors, as well as corporate treasurers, risk managers and banks, because they have so many potential uses. These include:

• Portfolio management. Interest rate swaps allow portfolio managers to add or subtract duration, adjust interest rate exposure, and offset the risks posed by interest rate volatility. By increasing or decreasing interest rate exposure in various parts of the yield curve using swaps, managers can either ramp-up or neutralize their exposure to changes in the shape of the curve, and can also express views on credit spreads. Swaps can also act as substitutes for other, less liquid fixed income instruments. Moreover, long-dated interest rate swaps can increase the duration of a portfolio, making them an effective tool in Liability Driven Investing, where managers aim to match the duration of assets with that of long-term liabilities.
• Speculation. Because swaps require little capital up front, they give fixed-income traders a way to speculate on movements in interest rates while potentially avoiding the cost of long and short positions in Treasuries. For example, to speculate that five-year rates will fall using cash in the Treasury market, a trader must invest cash or borrowed capital to buy a five-year Treasury note. Instead, the trader could “receive” fixed in a five-year swap transaction, which offers a similar speculative bet on falling rates, but does not require significant capital up front.
• Corporate finance. Firms with floating rate liabilities, such as loans linked to LIBOR, can enter into swaps where they pay fixed and receive floating, as noted earlier. Companies might also set up swaps to pay floating and receive fixed as a hedge against falling interest rates, or if floating rates more closely match their assets or income stream.
• Risk management. Banks and other financial institutions are involved in a huge number of transactions involving loans, derivatives contracts and other investments. The bulk of fixed and floating interest rate exposures typically cancel each other out, but any remaining interest rate risk can be offset with interest rate swaps.
• Rate-locks on bond issuance. When corporations decide to issue fixed-rate bonds, they usually lock in the current interest rate by entering into swap contracts. That gives them time to go out and find investors for the bonds. Once they actually sell the bonds, they exit the swap contracts. If rates have gone up since the decision to sell bonds, the swap contracts will be worth more, offsetting the increased financing cost.

Risks Associated with Interest Rate Swaps
Like most non-government fixed income investments, interest-rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps market as counterparty risk.

Because actual interest rate movements do not always match expectations, swaps entail interest-rate risk. Put simply, a receiver (the counterparty receiving a fixed-rate payment stream) profits if interest rates fall and loses if interest rates rise. Conversely, the payer (the counterparty paying fixed) profits if rates rise and loses if rates fall.

At the time a swap contract is put into place, it is typically considered “at the money,” meaning that the total value of fixed interest-rate cash flows over the life of the swap is exactly equal to the expected value of floating interest-rate cash flows. In the example shown in the graph below, an investor has elected to receive fixed in a swap contract. If the forward LIBOR curve, or floating-rate curve, is correct, the 5.5% he receives will initially be better than the current floating 4% LIBOR rate, but after some time, his fixed 5.5% will be lower than the floating rate. At the inception of the swap, the “net present value,” or sum of expected profits and losses, should add up to zero.

However, the forward LIBOR curve changes constantly. Over time, as interest rates implied by the curve change and as credit spreads fluctuate, the balance between the gray zone and the blue zone will shift. If interest rates fall or stay lower than expected, the “receiver” of fixed will profit (gray area will expand relative to blue). If rates rise and hold higher than expected, the “receiver” will lose (blue expands relative to gray).

If a swap becomes unprofitable or if a counterparty wishes to shed the interest rate risk of the swap, that counterparty can set up a countervailing swap – essentially a mirror image of the original swap – with a different counterparty to “cancel out” the impact of the original swap. For example, a receiver could set up a countervailing swap in which he pays the fixed rate.

Swaps are also subject to the counterparty’s credit risk: the chance that the other party in the contract will default on its responsibility. Although this risk is very low – banks that deal in LIBOR and interest rate swaps generally have very high credit ratings of double-A or above – it is still higher than that of a risk-free U.S. Treasury bond.

Conclusion
The interest rate swaps market started decades ago as a way for corporations to manage their debt and has since grown into one of the most useful and liquid derivatives markets in the world. Vanilla swaps, which are most common and involve the exchange of floating-rate LIBOR for a fixed interest rate, are used across the fixed-income markets to manage risks, speculate, manage duration and lock in interest rates.

Because swaps are highly liquid and have built-in forward rate expectations as well as a credit component, the swap rate curve has become an important interest-rate benchmark for credit markets that in some cases has supplanted the U.S. Treasury yield curve.)))

"They believed their revolution could never happen if they stayed at Drexel. Swaps in those days typically lasted no longer than two or three years. The trio envisioned deals lasting decades that would lock in profits and manage risks with unprecedented precision. But the junk-bond firm's inferior credit rating sharply raised its borrowing costs( I DON'T LIKE THIS REASONING ), making it a dubious and risky partner for such long-term deals( WHY? ).

Sosin and his team needed the backing of a company with deep pockets, a burnished reputation and the very top credit rating, a Triple A institution as unlikely to default as the U.S. Treasury itself( FOR COVER ). One name topped their wish list that fall: American International Group, or AIG, the global insurance conglomerate considered one of the world's safest bets.

They would find a partner for their venture. They would create an elegant and powerful system that earned billions of dollars, operating in the seams and gaps of the market and federal regulation( YES ). They and their firm would alter the way Wall Street did business, particularly in the use of derivatives, and eventually test Washington's growing belief that capitalism could safely thrive with little oversight.

Then, they would watch in disbelief as their creation -- by then in the hands of others -- led to the most costly rescue of a private company in U.S. history, triggering a federal investigation into AIG's near-collapse and making AIG synonymous not with safety and security, but with risk and ruin.

Over the past two decades, their enterprise, AIG Financial Products, evolved into an indispensable aid to such investment banks as Goldman Sachs and Merrill Lynch, as well as governments, municipalities and corporations around the world. The firm developed innovative solutions for its clients, including new methods to free up cash, get rid of debt and guard against rising interest rates or currency fluctuations.

Financial Products unleashed techniques that others on Wall Street rushed to emulate, creating vast, interlocking deals that bound together financial institutions in ways that no one fully understood( ALREADY THEN FIDUCIARY MISMANAGEMENT ) and contributed to the demise of its parent company as a private enterprise. In the panic of mid-September's crash, the Bush administration said that AIG had grown too intertwined with the global economy to fail and made the extraordinary decision to take over the reeling giant. The bailout stands at $152 billion and counting -- almost 10 times as large as the rescue for the American auto industry.

Many of the most compelling aspects of the economic cataclysm can be seen through the story of AIG and its Financial Products unit: the failure of credit-rating firms( CONFLICT OF INTEREST AND COLLUSION ), the absence of meaningful federal regulation( REGULATOR SHOPPING AND COLLUSION ), the mistaken belief that private contracts did not pose systemic risk( LTMC ), the veneration( CLEAR MISUNDERSTANDING, BUT THERE WERE PLENTY OF PLACES TO READ UP ON THEIR PROBLEMS ) of computer models and quantitative analysis.

At the end, though, the story of Financial Products is not about math and financial formulas. It is a parable about people( IT IS ONLY ABOUT PEOPLE ) who thought they could outwit competitors and market forces alike, and who behaved as though they were uniquely positioned to sidestep the disasters that had destroyed so many financial dreams before them.

2: 'We Are The Tide'

Sosin, Rackson and Goldman could hardly contain themselves as they labored over a business plan at Sosin's kitchen table in his apartment on Manhattan's Upper East Side. Their timing happened to be exquisite. The staid Wall Street of their fathers' generation was gone, replaced by an anything-goes culture that applauded the kind of path they were charting during the final months of 1986.

Their plan fit perfectly with another revolution they saw unfolding in Washington. Ronald Reagan's unwavering belief in free markets -- and his distaste for regulation that put hurdles in the way of entrepreneurs -- had steadily spread through the government. "The United States believes the greatest contribution we can make to world prosperity is the continued advocacy of the magic of the marketplace," Reagan told a U.N. audience that fall( THIS IS WHY, FOR BETTER OR WORSE, THIS CRISIS IS SEEN BY MANY AS A FAILURE OF FREE MARKETS ).

As eager as the three dreamers were, they had to confront certain realities. They had no backing, no inside track to the top levels of the corporate world that controlled the money they needed.

They had passed AIG headquarters at 70 Pine St., a few blocks from Drexel's offices, many times. Now, they wanted an entrée to the 18th floor, where legendary 61-year-old chairman and chief executive Maurice "Hank" Greenberg presided over the nation's largest insurance company, with operations in scores of countries. Greenberg was proud and protective of his company's AAA credit rating, one of only a handful in the world.

The AAA, awarded after an examination by the bond-rating firms, sent a resounding signal to clients that they could always sleep well at night, that AIG was in no danger of failing. The more secure a company, the more cheaply it could borrow money -- a fact that would be pivotal to Financial Products' success( TRUE ).

AIG's roots went back to 1919 and Shanghai, where founder Cornelius V. Starr built a business around a lucrative, relatively untapped insurance market. Starr's company later received an unorthodox boost when he worked with the U.S. Office of Strategic Services during World War II to create an intelligence unit that gleaned information from insurance documents.

When Greenberg took the reins in 1968, AIG was a privately held company. Greenberg, a compactly built son of a taxi cab driver, eventually became a figure in both New York and Washington, where he counted Henry Kissinger and Reagan CIA director Bill Casey among his confidantes. The World War II and Korean War veteran had a temper, a gift for growth and a restless mind. He had transformed AIG into a global titan and now wanted to do more.

Few people thought of AIG as a financial innovator. Greenberg kept his stockholders happy by striving for an annual 15 percent increase in profits. He instructed his deputy, vice chairman Edward E. Matthews, to explore how AIG could get more involved in Wall Street's realm.

"This is never going to get any better than it is today," Greenberg told Matthews. "We're so big, we're never going to swim against the tide. We are the tide."

3: 'It Wasn't The Money'

At the law offices of Kaye Scholer in Midtown Manhattan, former Sen. Abraham Ribicoff had a match to make.

Sosin had come to the firm -- where the 76-year-old Ribicoff was a senior adviser -- seeking guidance on how to leave Drexel. As he mentioned his interest in getting AIG's backing for a new venture, a Kaye Scholer lawyer told him to see Ribicoff, an old Greenberg friend.

Ribicoff was happy to introduce the inventive Sosin to the ambitious Greenberg, and let them figure out whether they could do business together. But he warned Sosin that any partnership, no matter how productive, can sour. "I'll only call Greenberg if you let us plan your divorce while we're planning your marriage," Sosin remembers Ribicoff saying.

Sosin came to the negotiation with conditions. He wanted the kind of autonomy that Greenberg rarely granted. Greenberg wanted assurances that Sosin's venture would do nothing to harm the gold-plated rating he had spent two decades building.

Greenberg had little extra time for the nuts-and-bolts details that Sosin sought to negotiate. "I don't really know much about this," he told Matthews. "You go talk to these people."

The morning after AIG and Sosin signed their joint venture agreement, Jan. 27, 1987, word spread rapidly through Drexel's trading floor in lower Manhattan: Sosin, Rackson and Goldman were leaving. Discreetly, the three men had invited some of their colleagues to a recruitment meeting. Ten eventually signed up for the ride.

Michael Milken, the junk-bond king who was Drexel's star trader, tried to stop the breakaways. But the pull of innovation, and the promise of even greater pay, was too strong.( I KNOW IT ISN'T FAIR, BUT I DON'T LIKE THIS DREXEL CONNECTION )

At Drexel, Sosin, Rackson and their band of brainy followers didn't have much say in how bonuses were doled out. At Financial Products, they would keep 38 percent of the profits, with Greenberg and AIG getting 62 percent. (Greenberg remembers AIG's share as 65 percent.)

Their revolution began with a whisper. They set up shop in a windowless, makeshift room at an accounting firm on Third Avenue. Until the rental furniture arrived, they sat on cardboard boxes. When it finally showed up, someone had made a mistake and so for a short time, they perched on children's chairs and worked at tiny tables. When Matthews escorted Greenberg there for a visit, the chief executive chewed him out. "You can't have them in such terrible quarters," Greenberg said.

Sosin and Rackson hoped that everyone would get rich, but they had their sights set on something more. They wanted to tear down walls they saw as impediments to innovation, the "fiefdoms" that were standard practice at other Wall Street firms. Their vision required a collaborative culture and a computer system that no one else had. For six months, the group worked on constructing "the position analysis and storage system," or PASS. They called it simply "the system."( THAT'S SCARY )

It enabled Financial Products to bring a rare discipline to complex trades. By maintaining market, accounting and transaction details in one place, Sosin and his people could track the constantly changing value of a trade's components in a way no other firm could( IT IS INTERESTING ).

Put more simply, they could see opportunities in the marketplace for taking on risk that others couldn't, squeeze out profits where no one had before and protect themselves in the process( THROUGH ARBITAGE? HOW? ).

They exploited the developing realm of derivatives, financial jargon for a contract settling in the future that is based on something trading now. A futures contract is a common derivative: A farmer might agree to sell wheat next spring for a price set today. If the price goes up, the farmer misses out on greater profits; if it goes down, the farmer is protected against loss. Essentially, the contract guarantees enough money to keep the farm going.

For its clients, Financial Products found ways to create more lucrative and longer-term derivative deals tied to all sorts of underlying assets, neutralizing( AS I SAID, BALANCING, HEDGING, COUNTERACTING ) the constant gyrations of prices in stocks, currencies and commodities. Behind each transaction was the cushion of AIG's AAA rating.

Precision was the key to tamping down the risk of these derivatives to the firm. Using another computer program to monitor the minute fluctuations in various rates, Financial Products could place offsetting trades on all sides of a transaction, so it almost didn't matter what the markets did. That was the beauty of their evolving machine: The firm won either way, as long as it stuck to its commitment to keep hedging its bets( AS I SAID ).

But it took more than technology to realize their vision. It took a culture of skepticism. The firm set up a committee to examine all transactions at the end of each workday, searching for flaws in logic, pricing and hedges. "Everyone kind of understood what the nature of the game was. . . . This was not a company that involved speculating," said Tom Savage, a mathematician from Drexel who joined the firm in 1988. "So it was everybody's job to criticize and double-check other people's opinions about what was appropriate business and what wasn't."( GOOD IDEA )

Sosin and his colleagues worked to create a finely balanced system that married technology, intelligence, verve and cultural discipline.

"We were all kind of artists( THIS IS CORRECT. NOT SCIENTISTS )," Rackson said recently. "The excitement of it wasn't the money. The money was the scorecard. The drive behind it was creating something new."

4: 'We Regret to Inform You . . .'

In July 1987, Sosin phoned Ed Matthews at his vacation house in the Adirondacks, where the AIG executive often went to escape Manhattan's summer heat. It was a phone call both would remember for a long time.

Financial Products was about to close its first significant deal, a $1 billion interest-rate swap with the Italian government, 10 times larger than the typical Wall Street swaps deal in those days.

The elements of the transaction might seem arcane to those outside the financial world. The contract involved an exchange of floating and fixed rates that gave Italy advantages in how it paid bondholders. Financial Products engaged in a separate set of transactions to offset the risk it was taking on( THAT'S THE WHOLE POINT ). As Sosin explained to Matthews, the firm made money, over the life of the contract, on the spread between the cost of the deal and the cost of its hedge.

This one swap, Sosin told him, would pay the firm more than $3 million -- as much as AIG's two other small financial operations each earned in a year.

"I was stunned," Matthews said.

That first year, Financial Products brought in millions for the company -- $60 million in the first six months alone, as Sosin recalls. He and his team left behind their ad hoc digs for a swanky Madison Avenue address, a temporary stop en route to their eventual headquarters in suburban Connecticut.

Competitors hustled to keep pace. Sosin pressed to find niches where others weren't playing and provide cost-saving solutions for clients. Standard interest-rate swaps were no longer enough. The firm moved into more exotic deals, involving stocks, currency and municipal bonds.

By 1990, Financial Products had offices in London and Tokyo. It would soon set up a small bank in Paris to improve its image and lower the cost of some European deals.

As in the Italian deal, the transactions were hedged and, if necessary, hedged again. The hedges involved precisely calibrated transactions, including the purchase of Treasury bonds or other swaps, that brought a cash flow in almost direct proportion to the money going out.

But with success came tension. Greenberg's love of his joint venture's revenue could not overcome his desire for greater control. He chafed at the deal, worrying that he had given Sosin too much freedom.

One detail in particular nagged at Greenberg. Under the joint-venture agreement, Financial Products received its profits upfront, even if the transactions took 30 years to play out. AIG would be on the hook if something went wrong down the road, not Sosin and his team, who took their pay immediately( THAT DOES SEEM RIDICULOUS ).

Greenberg's uneasiness grew into distrust, and not just about the numbers. Greenberg was a wink-and-handshake guy, while Sosin relied on the written agreement as his Bible. If Greenberg asked for something that wasn't stipulated, Sosin wouldn't comply.

"We ran our company very openly," Greenberg said. "Our word was our bond."

For his part, Sosin said the agreement gave both sides a clear understanding of the arrangement.

Early in 1990, Greenberg summoned Sosin to his office. Drexel had just imploded amid allegations of fraud and insider trading, and Greenberg had recruited several executives to start an AIG unit specializing in currency trading. That was a problem: Sosin interpreted the joint agreement as giving his firm exclusive rights to that business. Greenberg disagreed, and hoped to finesse the conflict.

"Howard, I'm sure you won't mind," Greenberg said.

"Mr. Greenberg, I mind very much," Sosin said.

"Howard, that isn't wise," Greenberg responded.

Days later, on March 13, 1990, Matthews sent Sosin a letter on Greenberg's behalf announcing their intention to terminate the agreement. "We regret to inform you. . . " the letter began.

Under the agreement, Sosin could take a duplicate of his computer system and his team with him. He began looking for backing from another AAA company. Greenberg heard about Sosin's efforts and got cold feet. After a series of meetings, including one at Greenberg's Florida retreat in Ocean Reef, they patched it back together, reasoning that there was too much money still to be made.

Greenberg's next letter had a different tone. "It is with great pleasure that, with this letter, we revoke any and all of our prior notices of termination," he wrote on May 31, 1990.

The peace wouldn't last.

5: 'Cave or Terminate'

In late 1992, Greenberg once again summoned Sosin to AIG headquarters. He was livid over two recent Financial Products deals with entities controlled by the Edper Group, a giant Canadian holding company owned by billionaires Edward and Peter Bronfman.

The first involved the purchase of bonds, which amounted to a loan to one of the Edper entities. The firm occasionally ventured into such credit deals as part of larger transactions, but only with highly rated companies and with provisions that opened an exit ramp if the bonds started to default. "We want to be the first rat to leave the sinking ship," Sosin told his troops, reflecting his unease with credit deals, which their system couldn't tame.

When this particular ship sank, Financial Products sold out as quickly as it could, but not before it lost $100 million. The second deal, involving a swap with extra layers of complexity, was going fine. But the $100 million loss in the first deal and the intricate machinations in the other had spooked Greenberg.( IT SHOULD HAVE )

Sitting in an anteroom to his office, in a favorite red leather chair, Greenberg demanded that Sosin stop doing some of the deals that had made Financial Products a Wall Street darling.

Greenberg handed Sosin a document that would change the terms of their joint venture. Greenberg was daring Sosin to flinch. Instead, Sosin walked out.

He visited his lawyer, Ronald Rolfe, at Cravath Swaine & Moore in New York.

"I said, 'What can I do?' And he said, "Cave or terminate.' "

6: No Reconciliation Possible

Under the agreement, either man had the right to terminate the joint venture. Sosin notified Greenberg that he wanted out.

Greenberg knew that Sosin's departure could cost him and AIG millions. But that wasn't his main concern. He didn't have a thorough understanding of how Sosin's system worked, and he wasn't going to let him get away without finding out.

In March 1993, as the two sides commenced a bitter arbitration battle, Greenberg formed what came to be known as a "shadow group." It verged on a covert operation. The group included AIG's auditors, now known as PricewaterhouseCoopers, which set up an office near Financial Products -- now in Connecticut -- and built a parallel computer system to track the firm's trades. Greenberg also held surreptitious conversations with some of Sosin's colleagues, recruiting them to stay.

Years later, Greenberg and Matthews still chafe visibly at the mention of Sosin. "One of the most difficult individuals I have ever dealt with in my entire life. Hands down," Matthews said. "Howard was in it for Howard."

Sosin, too, remains sensitive about what happened. "Greenberg took this very personally," he said. "He likes to be able to step in at any point and change things at his whim."

In Sosin's view, Greenberg and Matthews were envious of the profits that he and his colleagues were keeping for themselves. "It was peculiar to have something go so well," Sosin said, "and for him to have such suspicion."

In August 1993, with no reconciliation possible this time, the AIG board of directors installed a new leadership team. Sosin and Rackson took some employees with them to start another firm. Sosin later settled with AIG for a reported payout of more than $150 million; Rackson later received a share of the settlement.

Greenberg and AIG gained control of Financial Products and the beautiful machine. In the coming years, the firm would accelerate its profit-making ability, while forging into uncharted -- and ever riskier -- financial territory.

7: 'Honor the Trust'

Tom Savage stood before a room of anxious colleagues at the Four Seasons resort in Dallas, eager to reassure them that Greenberg was not going to pull the plug on their money-making machine.

Savage, a 44-year-old Midwestern math whiz, had just been named the new president of Financial Products. With the honor came explicit expectations, which Greenberg made clear: "You guys up at FP ever do anything to my Triple A rating, and I'm coming after you with a pitchfork."

It was spring 1994 and, on the surface, nothing much had changed since Sosin left the previous summer. Financial Products had come a long way from the days of sitting on cardboard boxes. The Dallas meeting was opulent in a way that had become customary for the firm: Lavish meals, open bars, luxurious rooms and rounds of golf, which was Savage's particular passion. Dallas's international airport allowed dozens of associates to fly direct from the firm's far-flung outposts.

The employees couldn't understand why there was any doubt about the firm's future. In just seven years, it had grown into a 125-person operation with annual profits comfortably above $100 million.

Like his predecessors, Savage knew the enterprise could not thrive without AIG's AAA rating, which continued to provide the leverage( YES ) it needed to stay ahead.

"AIG has given us the license to work," Savage told his colleagues that day. "We have to honor the trust they have given us."

The catch? Financial Products would have to take more direction than ever from Greenberg.

8: 24 Hours A Day

Greenberg called Savage most days that first year. "I'd be changing a diaper at home," Savage recalled. "He'd say, 'What are you doing?' I'd say, 'Changing the diaper.' He'd say, 'Well, I don't think I can help you with that.' But he would say, 'What are you thinking about? What's going on?' He was always taking my temperature."

Savage knew that Greenberg hadn't been 100 percent sure about his ability to run Financial Products. Greenberg had told him as much when they sealed the deal at a Vermont ski resort that AIG owned in Stowe. "I don't know if you have all the buttons for this job," the AIG chairman had said. Greenberg managed the company by both charming and intimidating his subordinates. He said of himself recently, "I suffer fools very badly."

Greenberg also had no patience for anyone who didn't share his relentless work ethic. "You don't build a company like AIG from nine to five, five days a week. It just doesn't happen," Greenberg said recently. "And you've got to surround yourself with a group of people who share the same values, the same aspirations that you do. When I traveled, I could call somebody, I don't care what time it was, maybe two, three in the morning. As far as I'm concerned, I'm working 24 hours, they're working 24 hours."

Savage understood that, but he came at the job with a mathematician's love of the numbers and how they worked. He was among a growing number of "quants" -- short for quantitative thinkers -- who had worked their way into the heart of Wall Street. With a PhD from Claremont Graduate University in California, Savage had started his career at First Boston in 1983, where he wrote computer models for a then-arcane type of security called a collateralized mortgage obligation, or CMO. It is the kind of asset-backed security at the core of the current meltdown.

Savage respected Sosin, but saw no reason to follow Sosin and Rackson out the door. "I think what was clear was that, however things should work out, there was a business at AIG Financial Products and Sosin didn't need to be there for it to be successful," Savage said.

Immediately after Sosin's ouster, Savage and three others -- soon dubbed the Gang of Four -- ran Financial Products on an interim basis, with Matthews assigned to keep tabs on them. Savage remained committed to running the place under the same rigorous, risk-reducing code that Sosin's group had cultivated.

But not everything stayed the same. Under a new operating agreement imposed by Greenberg, AIG owned Financial Products as a subsidiary, and the parent company received 70 percent of the profits, up from 62 percent.

Greenberg also wanted to change the way Financial Products' employees divvied up its share of the profits. Under the previous arrangement, Sosin and his crew had the right to book immediate profits on the long-term deals. Greenberg thought there was a powerful incentive to go after millions of dollars in short-term gains while leaving AIG and its shareholders responsible for potential losses for years to come.

Savage agreed with Greenberg that Financial Products employees should defer half of their compensation for several years, depending on the length of the deals being done -- an arrangement that would still yield hefty paychecks as the firm's profits soared in the coming years.

Savage said he welcomed Greenberg's input. "I would give Greenberg a lot of deference," Savage said. "Hank Greenberg's a great man. And I'm willing, when I talk to him, to say, you know, I'm in the presence of a great man and that's worth something."

9: 'We're Not Hiding Anything'

Financial Products found its profit margins shrinking on some transactions as competitors succeeded in duplicating its services. Like Sosin, Savage urged his talented team to devise ever more complicated transactions, often in untapped areas.

Financial Products was becoming a chameleon, taking on the coloration of whatever problem it was solving for its diverse clients. The firm pushed further into structured investments, hedge fund deals and guaranteed investment contracts, or GICs. The GIC deals involved loans from municipalities that had temporary surpluses of cash. Financial Products reckoned that it could borrow that cash, pay state and local governments more than they could make otherwise and then use the money for lucrative deals for itself, somewhat like a bank."

Here about GICs:

((( Guaranteed investment contracts are similar to certificates of deposit that can be purchased at banks; however, they are sold by insurance companies. Like money market funds, they're very safe investments; and like all investments that are considered to be "very safe", they won't make you very much money. Also known by other names – fixed-income fund, stable value fund, capital-preservation fund, or guaranteed fund, for example -- they generally pay interest from one- to five years. Like CDs, a GIC's value remains stable, not fluctuating up and down the way stock and bond prices might. When the GIC's term ends, it can be renewed at then-current interest rates.

GICs are not without their detractors among the investing and financial-planning set. Some of the more common complaints are that GICs are often saddled with high fees and their fixed rates don't always beat inflation. Critics also contend that too many people put too much of their retirement money into guaranteed investment contracts, thereby shying away from the stock market, which is generally where the larger profits are located. This locks them into minimal gains as well as the very real possibility of reaching retirement with far less money than will be needed to maintain the lifestyle that they've grown accustomed to.

But perhaps the worst accusation that's levied against GICs is that the word "guaranteed" in their names is misleading to the inexperienced investor. They aren't backed by the full faith and credit of the United States government, as Treasury securities are. Nor do they have the luxury of being insured by the Federal Deposit Insurance Corporation as deposit accounts and bank-sold CDs do. (While banks can't issue GICs, they can and do issue BICs, or bank investment contracts. Unlike GICs, these instruments are FDIC-insured up to $100,000 per depositor.) Generally, guaranteed investment contracts are guaranteed only by the insurance companies that issue them, which could certainly be problematic. For instance, if the insurance company becomes insolvent, your GIC investment may well end up being worthless, as well. For this reason you should periodically check the financial stability of the company that's issuing the contract.)))

Back to our post:

"The firm also began applying its complex formulas to the movement of single stocks. Using such structured finance enabled clients, such as Microsoft, to better manage their stock prices. It also helped Financial Products to more than double its profits in three years -- to $323 million in 1998, from $140 million in 1995.

A new unit, called the Transaction Development Group, did its part by taking advantage of gaps between securities regulation and tax laws( HERE WE GO. TRY REGULATING THIS ) in the United States as well as in other countries. Financial Products associates noticed, for instance, they could make money by exploiting differences between the U.S. and British definitions of stocks and bonds. A security that met the definition of stock in Britain could pay tax-free dividends to shareholders. The same security in the United States was regarded as a bond that provided tax-deductible payments. A Financial Products client would get both tax breaks. The firm used the capital raised from that line of business, in part, to finance other operations.

"We're the guys there who are going to try to exploit that," Savage said. "We dot our i's, we cross our t's, we tell everybody what we're doing. We're not hiding anything. . . . However, we're getting different treatments in different jurisdictions and we're making money as a result."

But even as Financial Products experimented, Savage said, he continued to stress the need to minimize risk. "That was one of the things that really marked this company, was the rigor with which it looked at the business of trading. . . . There was an academic rigor to it that very few companies match," he said.

"It was Howard Sosin who said, 'You know, we're not going to do trades that we can't correctly model, value, provide hedges for and account for.' "( MAKES SENSE )

Though the language of caution was the same, the firm's drive toward novel and ever more lucrative deals led down the path of greater risk. The beautiful machine was about to crack.

Tuesday: The dangerous fork in the road

Staff writer Bob Woodward contributed to this report.

A Crack in The System
By 1998, AIG Financial Products had made hundreds of millions of dollars and had captured Wall Street's attention with its precise, finely balanced system for managing risk. Then it subtly turned in a dangerous direction.

By Brady Dennis and Robert O'Harrow Jr.
Washington Post Staff Writers
Tuesday, December 30, 2008; A01

Second of three parts

For months, several executives at AIG Financial Products had pulled apart the data, looking for flaws in the logic. In phone calls and e-mails, at meetings and on their trading floor, they kept asking themselves in early 1998: Could this be right? What are we missing?

Their debate centered on a consultant's computer model and a new kind of contract known as a credit-default swap. For a fee, the firm essentially would insure a company's corporate debt in case of default. The model showed that these swaps could be a moneymaker for the decade-old firm and its parent, insurance giant AIG, with a 99.85 percent( WOW ) chance of never having to pay out.

The computer model was based on years of historical data about the ups and downs of corporate debt, essentially the bonds that corporations sell to finance their operations. As AIG's top executives and Tom Savage, the 48-year-old Financial Products president, understood the model's projections( WHICH WERE ONLY THAT ), the U.S. economy would have to disintegrate into a full-blown depression to trigger the succession of events that would require Financial Products to cover defaults.

If that happened, the holders of swaps would almost certainly be wiped out, so how could they even collect? Financial Products would receive millions of dollars in fees for taking on infinitesimal risk.

The firm's chief operating officer, Joseph Cassano, had studied the model and urged Savage to give the swaps a green light.

"The models suggested that the risk was so remote that the fees were almost free money," Savage said in a recent interview. "Just put it on your books and enjoy the money."

Initially, the credit-default swaps business would amount to a fraction of the half-billion dollars in Financial Products' revenue that year. It didn't seem to them like a major decision and certainly not a turning point.

They were wrong. The firm's entry into credit-default swaps would evolve into insuring more volatile forms of debt, including the mortgage-backed securities that helped fuel the real estate boom now gone bust. It would expose AIG to more than $500 billion in liabilities and entangle dozens of financial institutions on Wall Street and around the world.

When the housing market tanked, a statistically improbable chain of events began to unfold. Provisions in the contracts kicked in, spurring collateral calls( A CALLING RUN ) on swaps linked to $80 billion in questionable assets, requiring the firm and AIG to come up with billions of dollars in cash. They scrambled for almost a year to stave off the calls, but there were too many deals with too many counterparties.

In September, the Bush administration concluded that AIG's position at the nexus of the deals meant that it could not be allowed to fail, triggering the most expensive rescue of a private company in U.S. history. So far, the government has invested $152 billion in its efforts to save AIG. Federal investigators are sifting the carnage( GOOD ).

Credit-default swaps exemplify the contradictions of modern finance. At a basic level, they serve as insurance, but they aren't regulated as such. They have allowed companies to free up untold amounts of capital that otherwise would be tied up as collateral( THAT'S IT. THEY HAVE LOWER CAPITAL REQUIREMENTS. ) for loans. They were sold both to reduce risk and, in some cases, to give clients room to take on more risk -- a key component to making money on Wall Street.

But in the end, neither the buyers nor sellers truly understood the enormous risks( HERE I DON'T BUY IT. CYA. ) they were creating. Anyone could sell such a swap, and anyone could buy one, even if he had no stake in the transaction. Some buyers used them to bet against failing companies, prompting a debate among state regulators about whether this type of swap was a form of gambling( I'VE POSTED ON THIS ISSUE ).

The very nature of credit-default swaps put Financial Products at odds with itself, requiring it to deviate from the disciplined system that had made it a pathbreaker. Everything about the company -- its technology, its people, its rigorous culture of transparency and caution -- was designed to minimize the various risks that it shouldered while solving problems for clients.

That meant hedging whenever possible, a Wall Street term for making offsetting trades to balance risk. For transactions involving credit and loans, it also meant building an escape route so that the firm could get out early if it saw a deal going bad.

With credit-default swaps, there was no way out, and the risk was so minute that hedging was considered unnecessary, as well as problematic. Savage remembers discussions about whether the firm's vaunted computer system could even come up with the proper values needed for the trades that hedging relied on.

All of that made Savage and the others wary. Skepticism was hard-wired into the company's culture, part of its mantra: Hedge if you can. Don't make speculative trades. Above all, protect AIG's reputation and its top-drawer Triple A credit rating, which gave Financial Products credibility and the ability to borrow money at the cheapest rates. The rating was the fuel for Financial Products' innovation and success.

AIG's chairman, Maurice "Hank" Greenberg, had once warned Savage that he would come after him "with a pitchfork" if Financial Products did anything to harm AIG's AAA rating. No one saw credit-default swaps as anything on that scale. After conversations that included AIG executives, Greenberg blessed the new line of business. "There was a long discussion about it," Savage recalled recently, "and he said it was fine."

Greenberg said recently, "I don't think going into it in '98 was wrong." During his tenure, he said, he and his risk managers kept close watch on the swaps and the exposure they created.

Savage retired from Financial Products in 2001. When he left, credit-default swaps were still a small portion of the firm's business. Not long ago, in the dining room of his golf club in Florida, he reflected on the significance of the decision that he and his colleagues made in 1998.

Like his bosses at AIG, he still thinks it made perfect sense to give swaps a try. "The credit derivative business had just begun and because of our role in the derivatives business, it was very natural for us to have some minimal participation," he said.( I THINK THAT THIS IS SOUND )

Savage says he now sees that the decision sent Financial Products down a path at odds with its guiding principles. The firm's success had been built on assessing data daily, recalibrating assumptions constantly, counterbalancing one risk against another and making the hedges. The credit-default swaps didn't require that sort of attention( COME ON ).

"The different nature of those trades from any other trades that FP had done," Savage said, "opened the door to all the problems that came about."

He added later: "In retrospect, perhaps those deals should never have been done."

2: 'A Watershed Event'

One of the firm's biggest advocates for credit-default swaps was Joseph Cassano.

Cassano, the feisty, hardworking son of a Brooklyn cop, did not have the pedigree of Financial Products' three founders, who hailed from places such as Bell Labs and the Wharton School. Cassano had worked with the trio at the junk-bond firm of Drexel Burnham Lambert, and had been one of 10 original recruits who left Drexel to start Financial Products.

A Brooklyn College graduate, the 42-year-old Cassano was not one of the "quants" who had mastered the quantitative analysis and risk assessment on which the firm had been built. He had no expertise in the art of hedging. But he had excelled in the world of accounting and credit -- the "back office," as it is known on Wall Street.

The founders of Financial Products made him the firm's chief financial officer. From the start, Cassano gained respect, in part because he and his team rarely made mistakes processing trades. He was smart and aggressive -- sometimes too aggressive, some executives thought. He had a mercurial temper, occasionally screaming at an underling. He swore, berated and moved on, sometimes leaving hard feelings in his wake.( JUST TELL ME WHAT HE DID TOLSTOY )

"He was very, very good," recalled Edward Matthews, AIG vice chairman. "But he was arrogant."

He also was ambitious. He made plain to his bosses that he wanted more than the back office.

In 1994, Cassano got a chance.

The firm's founders had left in a bitter dispute with Greenberg, and Savage had taken the reins. He put Cassano in charge of the Transaction Development Group, a new unit hunting for business involving energy products and tax credits in the United States and abroad. He was also made chief operating officer.

Cassano's portfolio included deals involving credit, so he played a key role in the credit-default swap debate going on inside the company. In 1998, when the investment bank J.P. Morgan came to Financial Products, seeking a credit-default swap arrangement, Cassano was among the most interested. After studying the proposals, he passed on the first deal. But he soon became a leading proponent.

J.P. Morgan wanted to package a variety of debt on its books and resell it. The debt would be turned into bond-like securities, and layered like a wedding cake so that investors in the top tiers were first to get their money back in case of default. Investors in lower tiers earned a higher interest rate for taking greater risk( TRACHES ).

The "structured" deal had an unwieldy name, the Broad Index Secured Trust Offering, so it was called "Bistro" for short. Because the debt in Bistro was diverse, the investment was considered exceedingly safe; if one kind of debt went into default, it was unlikely other kinds would go under at the same time. As an extra measure of safety, the Bistro organizers wanted Financial Products to write credit-default swaps on the top tiers to further reassure skittish investors.

As private contracts, deals like Bistro could be financed with greater amounts of borrowed money( THAT WAS THE POINT ) than regulators would allow if the deals were publicly traded. This high degree of leveraging would come back to haunt the industry later.

The structure was an early form of collateralized debt obligations. CDOs were a hit almost from the start. It would take several years and a housing bubble for CDOs backed by mortgages to catch on. At Financial Products, the credit-default swap was only one of many innovations in play, but Cassano was passionate about how it could help the firm.

"It was a watershed event in 1998 when J.P. Morgan came to us, who were somebody we worked with a great deal, and asked us to participate," Cassano told an investment banking conference in 2007. "These trades were the precursors to what's become the CDO market today."

Even as Cassano spoke, the housing market was collapsing, the lack of diversity of the CDO debt was being exposed, and the risk for Financial Products was rising.

3: 'It's the Hardest Thing'

By summer 1998, after four years as president, Savage found himself thinking even harder about risk, particularly credit risk. It was often difficult to quantify the likelihood that someone would pay back a loan.

Savage kept his distance from developing trades, with the idea that he could better maintain his objectivity about potential pitfalls. He sometimes wondered whether Cassano's enthusiasm for the credit deals colored his ability to assess them. Cassano's lawyer, F. Joseph Warin, said in a recent interview that Cassano took care to follow procedures that minimized risk.

Greenberg, too, kept at Savage about the risk, even while keeping on the pressure for greater profits. On Wall Street, investment banks and other financial institutions were mad for private contracts called derivatives, Wall Street's jargon for a contract based on something trading now, but settling in the future. (A credit-default swap is a kind of derivative in which one company takes on the future credit risk of another.)

Derivative contracts accounted for more of the world's financial activity by the day. Some in Washington had taken notice, and thought investors and regulators needed to know more about these privately arranged deals that were cloaked from outside scrutiny and clouded by complexity.

Brooksley Born, the 57-year-old head of the Commodity Futures Trading Commission, argued forcefully for a public debate about whether derivatives posed an unknown and growing risk to the world's financial system. She testified at least 17 times before Congress on the subject.

Her campaign gained no traction. More powerful regulators, including Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert E. Rubin and Securities and Exchange Commission Chairman Arthur Levitt, opposed Born. They and others said her agency had no authority over derivatives and that her call for action was casting a "shadow of regulatory uncertainty over an otherwise thriving market."

Greenspan, in particular, argued a free-market view. He saw derivatives as a mechanism that unlocked efficiency, allowing dormant capital to flow into the system, greasing the gears of the world's economy. The Clinton administration and many congressional Democrats endorsed the notion that too much regulation stymied growth.

Greenspan pushed the idea that the marketplace was self-correcting, a view that he often espoused in speeches at economic conferences around the world. He invited Greenberg to attend one such meeting in Basel, Switzerland. Greenberg couldn't go, so he arranged for Savage to go. Chief executives of banks, investment firms and insurance companies, as well as U.S. and German regulatory officials, filled the room.

Greenspan, already celebrated as an economic guru, commanded attention every time he spoke. The question he posed that day resonated with Savage for a long time.

"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( SEE, THIS IS A CALLING RUN. FROM THIS POINT ON, EVERYONE KNEW THAT IT WAS POSSIBLE ) 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."( THAT WOULD BE WISE )

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( TRUE ).

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( FRAUD ) 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( YEP ).

Some regulators had a hard time seeing the financial value in certain swaps( THERE IS FOR THE PARTIES INVOLVED ) -- 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. ( CAN YOU PROVE THAT THIS WOULD HAVE ENDED EVERYTHING? )

While some regulators had expressed concerns about the act, President Clinton's economic team had agreed that derivatives should not be regulated( HOW? ). 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( CALLING RUN ), 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( FRAUD ). 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.( A CRIME. GET IT. )

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( THIS PART I AGREE WITH )." 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. ( CRIME )

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.( 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.

Here's Finite Insurance:

(((Overview: To accounting skeptics, finite insurance can look like a way for a corporation to retain risks without really retaining them and transfer risks without really transferring them. To be sure, there's little doubt that finite coverage can enable executives to spruce up their companies' financials if they can record the arrangements as insurance rather than as deposits. Indeed, until recently such balance-sheet cleansing was a prime selling point of finite-insurance marketers. CFOs and risk managers should be particularly careful to account properly for finite policies that insure past events rather than future probabilities, experts say.)))

Back to the post"

"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( FRAUD ). 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."