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WEDNESDAY, DECEMBER 30, 2OOg
TheAIGe-moiltruil
@tlehutflrrgton port
Behindthepublicdeclarations of optimismin 2007,monthsof internaldiscordancl doubt headquarterswho appeared unsatisfled with Cassano'sasser_ tions that the sinking subprime The probing e-mailscamefrom Tortglg-e market posedno longevery direction inside insurance term risk to the firm. giant American International 'More love notes from Elias." Group during the summer and Cassano wrote to his subordinates fall of 2002 all with the sameun_ as he forwarded another set of derlying question: ..please go {abafgb questions. Could Joe Cassanoback up his through the same drill of draftiig assurances- to auditors, rating answers. . ." companies,colleaguesand share_ ' The Cassano-Habayebcorre_ holders- that his Financialprod- spondence, along with thousands ucts unit wasn,tin trouble? o_fother e-mails obtained.by The . Cassanogrew weary at times of Washingtonpost, as well as supthe seemingly endless inquiries, porting interviews, reveal a corit_ even as he set about answering pany wracked by more division, doubt and turmoil than anyone ilt"*. Y9 was parricularly impi tient with the repeatedrequests on the outside realized auring from Elias Habayeb,an AIG exec- those tensemonths in 2002 a full utive at the parent company,s year before the federal govern_ . ayBRAnyl)nrvwrs
ment undertookone ofthe largest corporatebailouts in U.S.historv to preventAIG'scollapse. The Financial products unit had made AIG billions of dollars in the largely unregulatedworld of fi nancialderivatives,operating pnmanty from Wilton, Conn., and London. But as the subprime mortgage boom beganto deflate in 2007,some e-mails from New York took on an unfamiliar tone ofconcern. "\Mhileeveryoneis comfortable with the conclusionsreachedin the past," Habayebtold Cassano as the date neared for the com_ pany's third-quarter filing to the Securitiesand ExchangeCommis_ AIc
CoNTINIIEO or.rA9
As crisis closed in at ArG, Joe cassano ffelded inquiries about the healtr of its Financiar hoducts NEWSCO|\/4
unit.
erc rnolr Al sion, "the question is whether something different needs to be done come SeptemberSO,2OO7, given the current dislocationand turmoil in the marketplace." "This has become the hottest subject at 70 Pinej' Habayeb wrote in a subsequente-mail,employing company shorthand for AIG headquartersin Manhattan. While the e-mails offer the most revealing look yet at AIG's inner struggles,they also underscorethe main obstacleto federal prosecutorsassessingindividual culpability for the flnancial crisis. In a Wall Streetculture definedbv salesmanshipand secrecy,divining the difference between opti mism and deceit can be a legal morass - e.speciallywhen it comes to conv'incinga jury that the line hasbeencrossed. Last month, a New york jury madethat point clear when it acquitted two former Bear Stearns hedge-fundmanagersin a criminal casethat relied, in part, on email. The jurors were unswayed by the prosecution'sclaim that a key exchange - between private e-mail accounts,outside the Bear Stearnse-mail system- was evidenceofa deliberateeffoil to hide infonnation from investor.s.
Attorneys fiu' .zariousAIG exec_ utives,including Cassano,had no comment for this article, citing the ongoing investigations. AId also declined to comment. The companybwritten responseto a lawsuit filed by shareholdersin a New York federal court, however, offers a glimpse into a potentia.l defenseto civil or criminal chargThe suit allegesthat AIG exec, utives ignored warnings and intentionally downplayed the extent of the company'stroubles. In lts response,AIG concededthat its executiveswere optimistic, but denied any intent to deceive.,,Being wrong or even unwise. in hindsiglrt, is not the sameas violating the securities lawsi the companywrote. Whether any violations occurred, the e-mails shovuAIG ex_ ecutives laboring to unclerstand the flaws in !'inancial products' once-vauntedmathematicalmod_ els and debating what and how much to discloseto investors. Publiclt., Cassanoand othor. AIG executives - includ.ing Habayeb - presented a unified.-front of confidence.That optimism was unremarkable at the time, when the Dow was pushing 1.tr,000, AIc's stock price remained relatively strong and most Anrericans had no inkJingof thc subprimecalamity just around the corner.
Privately, lrowever',executives found themselvesin the financial equivalentofthe fog ofwar, asone of the world's most successful companies began its descent to the epicenterof last year'sfinancial collapse. Uncharted waters The eight nren summoned to the 2oth floor of 7OPine on July 12, 2OO7,knew this was no ordinary meeting. Morris Offit, an AIG director serving on the board's audit and finance committees, had questionsabout the companyb exposureto the mortgage markets and systemic risks at AIG. Cassanoand Andrew Forster, a Cassano deputy, had worked up a presentationto reassureOffit about the dealsat Fin$rcial Products. According to a memo of the meeting,. the two men offered data showingthat the firmt exposure to the deteriorating mortgagemarket did not representundue risk to AIG. Their bottom line: Financial Products' derivatives-basedportfolio was "largely immune to principal loss," they told otfit. "Thanks for yesterday," AIG's
chiefcredit officer,Kevin McGinn. e-mailedForsterthe next dav.,,Offit was very pleasedand boih Joe and you were clear and incisive, as always." But Offit3 queries were far from the only ones.A July ll email describedthe three maior credit rating companies- whose rankings signi$' various types of creditworthiness- as ..peppering us with questions"aboutAlGb exposureto the subprimemortgage markets.That e-mail,which went to more than a dozencompanyexecutives,suggested.,briefcalls,'to the rating companiesto explain "why this is not a major issui for us.-Other e-mailsrevealsimilar inquiries from dG's auditor, pricewaterhouseCoopers, alrd its principal federal regulator, the Office of Thrift Supervision. The etnails, nlany consumed with technicaldetailsof the firm's deals,reflect an ongoing internal debateabout how best to characterize the conrpanybsubprime exposure."Of course,I want to put the best face on the subject,,, McGinn assured Forster in his July 13 e-mail. In another. McGinn wrote, "I am giving highry edrted versions of AIG subpnme exposure material to the rating agencies. . . unlessthev explicitly requestit."
Cassano, in one e-mail exchangeduring this period, pointedly told McGinn and othersthat Financial Productshad not withheld any information from the rating agenciesand would "continue to fully disclosethe precise nature of.ourrisk." A key elementof the debateinsideAIG involvedthe accuracyof complex mathematical models that Financirl Products had developedto assessthe risk of deals involving derivatives known as credit-default swaps. The swaps, which were private contractsthat were not listed on any exchange, essentiallyworked like insurance in caseofdefault. For a hefty fee, Financial Productswould insure certain forms of debt, including portions of exotic mortgagebacked securities, which were fueling the real estateboom. In late July, Goldmal Sachs, one of the firm's largest trading partners, challenged Financial Products'numbers,assertingthat Goldman3calculationsshoweda significantdrop in the swaps'value. That drop, Goldmancontended, triggered provisions in the swapscontractsrequiring AIG to post hundreds of millions of dolIars in collateralto protect Goldmau againstthe apparentescalation in risk. "They are not budging and are acting irrationali Tom Athan, a Financial Products executive, wrote on Aug. 2 to Forsterafter a tense conferencecall with Goldman employees."I feel we need Joe [Cassano]to understand the situation 1007oand let him decide how he wants to proceed." Athan added,"This isn't what I signedup [for]. Where arethe big trades,high fives and celebratory closingdinnersyou promised?" The Goldman collateral call raisedeyebrowsat AIG headquarters. The r4antra at Financial Productshad alwaysbeenthat the credit-default srvaps were safe; the models showed a 99.85 percentchanceofneverhavingto pay out. But noq accounting issues cameinto play,especialiyas other companies had begr.rnto write down their mortgage-backedinvestments,conceding a drop in values. AIG would have to acknowledgeany declinesin value on paper,even if the swapswere nevermeantto be sold. In early August, a colleaguee-
mailed a wire story based on a Wall StreetJournal article, headlined,'AIGMight Be DeceivingItself on Derivatives Risks, WSJ Says."Cassanoreplied:"Hopefully peoplejust ignore it. It is a real non storyJ' Instead, the pressure intensified. Tlvo days later, the Moody's credit rating company sent a list of lenghy questions;another set followed from credit rating company AM Best.Then internal inquires arrived from Pricewaterhouseand executivesatAlG,wondering whether Financial Products had accessto enough cash to handle new collateral calls. In the face of the mounting questions, Cassano'sreplies reflected frustration rather than worry. "There must be something in the air or the coffeeat 70 Pine," he wrote on Aug. 31 to Habayeb and others at AIG's headquarters, adding that "in many ways for us this is old hat stuff . . . We have beenvery careful about husbanding our liquidity resourcesand I am comfortable that we will be ableto seethis crisisthrough." Habayeb,who had publicly defended AIG's valuations weeks earlier,kept up his questioningas the third-quarter SEC filing loomed. 'TV'eneed to have a pretw robust analysisto support the number that is reflectedin AIG'sfinancial statementsrepresentingthe fair value of" the credit swaps, Habayeb wrote to Cassano on Sept. 20. 'We need to be able to demonstratethat we haveconsidered all available information . . . this will require more work than previouslydone." Cassano remained upbeat about his firm's long-terrn prospects.In a late October e-mail to Habayeb,AIG chief risk officer Robert tewis and others,he proposeda passagefor an upcoming presentationsaying"the continuing turmoil and generalrisk aversions" had left the firm with "significant opportunities" and'tell positionedfor continued revenue growth as competitors' appetite for certain transactions wanes." In an SECfiling on Nov. Z the company estimated a $352 million decline in the value of its credit-default swap portfolio, addingthat the "bestestimatecifa further decline"in the valueofthe swapsduring October"is approrimately $550million." The following day, Cassano spoke to investors about the
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"opacity in the market," noting that sonle trading partners had valued certain dealsat 55 cents on the dollar, while others valued them as high'as 95 cents. If the lower number were to prove correct, it could foreshadow huge write-downs for AIG. Still, Cassano said, '!ou should be rest assured" that "we haveplenty of resources,and more than enough resourcesto meet any of the collateral callsthat might comein." Later in Novembeq auditors from Pricewaterhousetold AIG executives that the company "could havea material weakness" becauserisk managerslackedadequate insight into severalbusiness units, including Financial Products. The auditors' use of the phrase was potentially significant. A material weakness reflects uncertainty about the accuracy of a company's financial statements. Under SECrules,companiesmust disclosea material weaknessto its investors,if one exists. Meanwhile. collateral calls pouring in from Goldman, Merrill Lynch,Flenchbank Soci6t6G6nâ‚Źrale and others had reachedinto the billions of dollars. In paft to quell the fears of investors already anxious about AIG3 exposure to the mortgage market, the companyannounced it would hold a public conference call Dec.5.As the call approached, Lewis,AIG'schief risk officer,sug-
gested that Cassanotalk in more depth about the exposureFinancial Productshad in the subprime mortgagemarket. Cassano expressed concerns about such an approach. "The questionis how to include this in the presentation without overly complicatingor confusing"investors, Cassanoreplied in his Nov. 28 e-mail. 'No other companyof our ilk - dealers,bank etc have gone into explaining these exposuresin any detail,this is just normal course businesswith highly rated counterparts. Attempting to explain this segmentof the businessbriefly I worry will only add to the confusionof the audience." On the day ofthe call, Cassano, Iewis and AIG chief executive Martin Sullivan maintained a bullish confidence."Becausethis business is carefully underrritten," Sullivan said of the creditdefault swaps, '\ve believe the probability that it will sustain an economiclossis closeto zero." And yet, within Financial Products, a more uncertain tone prevailed as mounting collateral calls threatened to sap the firm's resources.Daysafter the Dec.5 call, Tbm Athan commiseratedby email with a colleague as they wrestled with yet another collateral call. 'TV'eare in uncharted watersl' he wrote, adding a hopeful note: '.\Me'llall get bettertogether."
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ko,tt\&) Delusion or dishonesty? The Dec. 5 conferencecall remains at the heart of an ongoing federal investigation, according to people familiar with the inquiry. JusticeDepartmentand SECofficials have met at length with Cassano'sattorneys. They have made the caseto prosecutorsthat the record clearly shows Cassanohid nothing, disclosed Financial Products'financialcondition in a timely way and pushed to make sure the firm's models better refl ected changing conditions. Prosecutors find themselves faced with a difficult question: Wheredoesdelusionend and dishonestybegin? In defending itself against the shareholders' lawsuit, AIG focused on that very issue."Statements of optimism about the future . . . that turn out to be wrong are simply not actionable," the companywrote."Evenin times of market turmoil, the company neednot presumethe worst about its market prospects." The government could opt to pursue civil charges, which require a lower standard of Proof than the "beyond a reasonable doubt" criterion of a criminal trial. Earlier this month, the SEC filed civil chargesagainst former executivesat New CenturyFinancial, one of the nalion's largest subprime lenders before it went bankrupt in April 2007.The SEC suit alleges that New Century's former chief executive and two other top executivesmisled investorsabout the firm's financial condition as itwas imploding. In the recentBearStearnscase, prosecutors went the criminal route,accusingformer executives Ralph Cioffr and Matthew Tbnnin of giving investors an overly optimistic view of their funds' ability to withstand the subprime crisis, while privately harboring serious reservations. Central to the government's casewas a Thnrtin e-mail, sent to the Gmail accountof Cioffi'swife. Thnnin wrote that the subPrime market "looked pretty damn uglY" and that, if a recent financial report provedcorrect,"then the entire subprime market is toast." Prosecutorsjuxtaposed that email. with a conference call daYs later in which Thnnin told investors that 'Ve're very conrfortablewith exactlywherewe are."
But when jurors sarvthc entire e-mail, it suddenly seemed less clear-cut and less damning. Thnnin wrote at length about different coursesofaction the company could take in regard to the funds, and he seemedto be agonizing over making the wisestdecision. Jurors, after the trial, said that the men had given an unrealistically optimistic picture of reality about the state of their funds, but that having private anxieties did not amount to fraud. "The entire market crashed." one juror told a reporter. 'You can't blame that on two people."
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'Quitea mess' By early 20O8,the optimism of the previousfall at AIG no longer seemedplausible.The e-mailsreflect an internal changein tone. 'We have to be doubly sure that, if Bob [Lewis] is still goingto assureinvestorswe will not incur an economicloss from any of the deals, we can support the assertion with very solid analysis," McGinn, the AIG chief credit officer, wrote to Gary Gorton, the architect of Financial Products' mathematicalmodels,on Jan. 21. "Ifwe haveto hedgethe previous assertion.let's do it now." On Feb. 1r, AJG disclosedthat its auditors had concluded that the company "had a material weaknessin its internal control over financial reporting and oversight relating to the fair value valuation" of its swapsportfolio. "Quite a mess,"Cassanowrote to colleaguesafter learning that Pricewaterhousehad made the case for a material weakness to the AIG board. In follow-up emails, he added that the disclosure had led to "new calls from our counterpartsstating that they can no longer acceptour pricing methodology" and that it had 'teakened our negotiation position as to collateral calls." He was right. Thading partners smelled blood in the water. and collateralcalls poured in. On Feb. 28, AIG's year-end SECfiling reported that its collateralpostings had reached $5.3 billion. Paper losseshad ballooned to an estimated $11.5billion. The filing retained some optimism, however,saying that "management believes" it could raise the billions of dollars needed to meet "anticipated cash requirements."Sevenmouths later, however, only a government rescue eventuallytotaling $180billion in cashand loanswould savethe insurancegiant.
Questions,questions, questions.. . Oneof the AIGe-mailsfrom2O07: From:Cassano,.Joseph Sent: Friday,Aug 31",2OO7 ,4:38 a.m. To:Habayeb, Elias;McGinn,Kevin Cc: Forster, Andrew;Dooley,William Subject: Yourquestions Theremustbe somethingin the air or the coffeeat 70 Pine.In a short periodof time we havehad inquiry from the two of you and Henry Daubneyregarding our funding vehicles. Hereis the quickstory. Curzonis a fullyguaranteed fully consolidatedprogram.At the beginning of the "recenttroubles"we issuedand extendedthe maturities in Curzonas bestwe could.At the time we thoughtmidSeptember wouldbe a reasonableperiodfor the currentrssuesto pass. * To readmoreof AIGe-mails,visit washingtonpost.com/busi ness
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(coot)d) pU Distinguishingfraud from failure: A prosecutorialprimer lf publicsentimentdictatedhow prosecutorsmade decisions,executivesat manyof the nation's banks,investmenthousesand mongagelenderswouldprobablybe facingchargesby now.But angerisn'tone of the criteriacited in the lawsthat governwhat constitutesillegalbehaviorin the securitiesworld. To bringeithercivilor criminalchargesagainstindividualexecutiveswhoseactionsmay have contributedto the financialcrisis,federalauthoritieswill most likelyturn first to a favoritetool of regulatorsand prosecutors: the Securitiesand ExchangeCommission'sRule10b-5.
Elements needed for a proseeutlon under Rule 1Ob-E(ailthreemustbe present): (D Euid"n."of wrongful intent, eitherintentionalfraud(criminalor civil)or recklessdeceptiveconduct(civilonly). Evidencethat a companyor its executivesissuedan untrue statGment abouta materialfact, or that they omitted materialfacis. p
Evidencethat the untruestatementor omissionmisled Inveetors in their purchasesor salesof securities.
No prosecution Beingmistakenor relentlessly optimisticis not evidence of wronâ‚ŹIulintent. (lf prosecutorscan show recklessness, that couldbe groundsfor civilcharge.)
Buildlnga case Thekey is state of mlnd. Provethat a defendanttook concretestepsto , hide or lie abouta materialfact, and you can bringa civilor criminal caseunderRule10b-5.(Anraterial fact is information that a reasonable shareholderwouldconsiderto be importantin makingan investment decision.)
:"i:'..."basedon,..*,.""4F ;:'::H",.".'rlll'
conduct,prosecutors need evidenceof behaviorthat is "highly unreasonable" and an "extreme departure"fromthe ordinarycare that investorswouldexpectfrom an executive. TheSEChasadditional remediesbeyondjail time,suchas barringsomeonefromworkingin the securitiesindustry,civilfines that can go to wrongedinvestorsor forcinga defendantto payback illegalprofits.
evidencethat a defendant ivillfully violated the securitieslaws,a significantlyhigherstandard than recklessness. That's why the governmenttends to bringmanymorecivil casesthan criminalones.
Whlchroute to take? Thequalityof the evidenceoftendeterminesthe route.Civilcharges havea lowerburdon of proof, requiringonlya "preponderance of the evidence"- meaningit's more likelythan not that the defendant violatedthe law.Criminalcasesrequirethe tougher"beyonda reasonabledoubt"standard. Civiland criminalchargescan be filed on the sameconduct. SOURCE:Washrngto ltsr rL'tr),l|,g
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