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Was AIG Watchdog Not Up To The Job?

 This story was co-published with MSN Money.

U.S. regulators responsible for supervising American International Group now acknowledge that they failed to grasp the impact of provisions in the complex derivative contracts that pushed the world's largest insurance company to the brink of collapse.

Terms of the insurance-like contracts, called credit-default swaps, required AIG to post billions of dollars in collateral in the event of a market slide or credit downgrade.

"We missed the impact" of the collateral triggers, said C.K. Lee, who ran a little-known team in the U.S. Office of Thrift Supervision, or OTS, which oversaw AIG's finance unit. He said the swaps were viewed as "fairly benign products" until they overwhelmed the trillion-dollar company.

The government announced this morning that it had restructured and expanded its aid package for AIG, bringing the total to $150 billion ($) in loans and investments.

Though Lee's team had red-flagged the AIG unit that handled swaps, sampled some of the contracts and knew about collateral provisions, no one recognized the extent of the risk, he said.

Instead, examiners mostly concurred with the company's repeated assurances that any risk in the swaps portfolio was manageable. They went along in part because of AIG's huge capital base, Lee said, and because securities underlying the swaps had top credit ratings.

"We were looking at the underlying instruments and seeing them as low-risk," he said. "The judgment the company was making was that there was no big credit risk."

Lee's comments offer the most detailed insight to date of the role U.S. supervisors played in advance of the biggest financial rescue in history. They also highlight how the OTS, mainly a savings-and-loan regulator, may have been miscast as watchdog for a huge global conglomerate.

Because AIG bought a small savings and loan nine years ago, the OTS became responsible for supervising AIG's parent company. Its duties expanded when European regulators in January 2007 conferred on the OTS the authority to supervise the company's overseas operations. A report by the U.S. Government Accountability Office last year said the OTS lacked the needed expertise.

Simply put, the job of the OTS was to make sure AIG did not take on too much risk and to assess the overall risk environment for the company and other global financial companies it oversaw.

But records show that, for several years before the bailout, numerous problems had surfaced with AIG's derivatives business, among them major accounting errors. More recently, a 2007 dispute with trading partner Goldman Sachs touched off a series of reviews and disclosures questioning the value of AIG's swaps.

Despite such signals, the OTS never took formal enforcement action. Lee said his office periodically raised concerns with AIG managers but wasn't worried about whether the swaps could put the company in a liquidity bind. "The risk of collateral calls was fairly low," he said.

It wasn't until March, after AIG once again disclosed significant valuation problems, that Lee sent a letter to the company asking for a "corrective action plan" in 30 days.

But Lee left his post in April to become a regional director in Dallas. His unit inside the OTS, formed specifically to take on global entities such as AIG, was quietly disbanded. AIG missed its deadline for a corrective plan, and the one it later submitted couldn't stop the company's decline.

Born in the savings-and-loan scandal

The OTS already has been targeted by critics who say its inaction, along with that of other regulators, contributed to the failures of Washington Mutual and IndyMac, both federal banks. Earlier this year, Treasury Secretary Henry Paulson proposed abolishing the agency, with a $250 million budget and 1,000 employees, as part of a broad overhaul of financial oversight. Democrats in Congress have said reforming financial regulation will be a priority next year.

An earlier financial crisis gave birth to the OTS.

Savings and loans, or thrifts, used to be supervised by the Federal Home Loan Bank Board. But after the industry imploded in a late 1980s scandal -- and the quality of supervision was found to be wanting -- Congress terminated the board and replaced it with a new agency, the OTS.

The office supervises a range of commercial and financial companies that own savings and loans, part of a patchwork of oversight that includes the Federal Deposit Insurance Corp., Federal Reserve and Office of the Comptroller of Currency, which also oversee national banks. Besides AIG, other companies with thrifts under the OTS include General Motors, General Electric and some parts of the investment banks Merrill Lynch, Lehman Bros. and Morgan Stanley.

As the economy purred through the 1990s, few outsiders paid attention to OTS regulatory work. But within the financial-services industry, the agency stood as the preferred supervisor.

In 1999, Congress passed legislation allowing banks, insurance companies and securities firms to compete with each other. The new law allowed for a range of possible regulators, from the Federal Reserve to the Securities and Exchange Commission, depending on the mix of financial services a company chose to offer. Holding companies that owned one or more thrifts had the possibility of being regulated by the OTS.

"There was a stampede by commercial and financial firms to get a thrift charter," said Bart Dzivi, a former counsel to the Senate Banking Committee and now a financial-institutions lawyer in Northern California, "so that OTS could be their consolidated supervisor."

AIG, like other companies, fell under grandfathering provisions in the 1999 bill and received approval late that year from the OTS to own a thrift in Delaware.

The OTS focused on its traditional mission of helping thrifts make home loans. But by then, the global financial landscape was changing.

European countries wanted to ensure that any financial conglomerate operating on their turf was supervised by someone with equivalent competence to EU regulators. The concern traced to the 1991 collapse of the Bank of Credit and Commerce International, then the largest bank failure in history. BCCI had been supervised by Luxembourg regulators who acknowledged they were clueless about secret offshore dealings that sank the bank.

The OTS, seeking to meet the challenge and gain the prestige of being "internationally recognized by foreign regulators," beefed up its examination guidelines in 2003. The agency set up the special office that Lee would later run, called Complex and International Organizations, to better scrutinize companies such as AIG. According to OTS statements, officials repeatedly met with European counterparts to convince them the OTS was worthy of international supervision.

A similar effort was under way at the SEC, where, in response to concerns by investment banks about European regulations, the commission adopted a voluntary program to supervise a brokerage firm's parent. A September report by the commission's inspector general sharply criticized the program and SEC supervision of Bear Stearns, which collapsed earlier this year.

A seal of approval from the Europeans meant a company such as AIG could forgo direct scrutiny by a foreign regulator such as the United Kingdom's Financial Services Authority, which has considerable expertise in financial markets. For the past few years, the U.K. agency had been publicly raising concerns about the risks in credit derivatives, unlike the OTS.

Lee said that without the OTS designation, AIG would have been required to set up a new holding company in Europe to continue doing business there. Banking lawyers say U.S. companies prefer home-country supervisors, especially the OTS, which stressed minimizing red tape and other burdens, according to agency budget documents.

In May 2006, OTS Director John Reich addressed the issue at a congressional hearing. Reich said he was working to ensure that the financial companies under his watch wouldn't be burdened by added "regulatory scrutiny" in Europe. Among other things, he said the OTS designation meant U.S. companies operating in Europe could avoid testing "the qualifications of key personnel" and requirements to keep more cash and assets in reserve to cushion against losses.

The efforts by the OTS paid off. Between late 2004 and early 2007, the Europeans conferred equivalency to the OTS for supervision of GE and AIG as well as another conglomerate, Ameriprise Financial.

The agency's victory soon came under critical scrutiny. In a March 2007 report on financial regulation, the Government Accountability Office looked at the OTS and found "a disparity between the size of the agency and the diverse firms it oversees." The report noted a lack of specialized skills at the OTS, which had just one insurance specialist to oversee several insurers such as AIG.

Weaknesses emerge in derivatives portfolio

The unit of AIG that handled derivatives, called AIG Financial Products, was nominally based in Wilton, Conn., but conducted much of its business in Paris and London, where longtime President Joseph J. Cassano worked. Cassano, who retired in March, did not return a call for comment. An AIG spokesman also declined comment for this story, saying executives familiar with the history of the OTS and European regulators had left the company.

As the OTS was beefing up its resources, AIG fended off a slew of investigations into its insurance and financial practices by, among others, the SEC, the FBI, the Department of Justice and the attorney general of New York. The company settled by paying large fines, ousting CEO Maurice "Hank" Greenberg and promising to install new controls.

The most serious charges against AIG, in a 2004 criminal complaint by the Justice Department, accused a subsidiary of the financial products division with aiding and abetting securities fraud. The case involved a series of transactions, some of which involved swaps. As part of a deferred prosecution, the financial unit agreed in 2004 not to publicly contradict the criminal complaint and also paid an $80 million fine.

Cassano's unit managed AIG's portfolio of derivatives -- financial instruments with a value derived from some other asset. Credit-default swaps, a widely used form of derivative, allow the transfer of risk from one party to another. In effect, the holder of a bond or debt buys protection or insurance in event of a default, just as people buy health insurance to transfer the financial risk of illness. Derivatives tied to shaky subprime mortgages are a major factor in the financial crisis.

In theory, derivatives and swaps help companies and investors manage risks. And for many years AIG's financial products unit generated large profits. But depending on market conditions, such instruments can also force parties to raise large sums as collateral or accept huge losses.

That is ultimately what happened at AIG, and its fall was preceded by a string of serious accounting and risk management issues that arose following the 2004 case.

Lee said the OTS was well aware of these issues and raised them in meetings with AIG executives. He said the OTS also met periodically with French and British regulators about AIG.

In 2005, the company reported accounting errors and weaknesses related to derivatives totaling about $2.5 billion. In 2006, AIG reported "out-of-period adjustments," including a $300 million reduction in derivative-related assets. Former SEC chief accountant Lynn Turner told Congress last month that the adjustments were "another way of saying (AIG) continued to have errors in its financial statements."

AIG's total portfolio of derivatives had approached $1.5 trillion by 2006; from 2005 to 2007 its credit-default swaps increased from $387 billion to $527 billion. (The amounts are so-called notional values based on the face amounts of underlying securities; potential losses to parties in swaps are typically only a small fraction of notional amounts.)

The company, in public filings, said the risks in the credit swaps were manageable and caused only minimal losses. AIG also said risk from its $61 billion portfolio of swaps involving U.S. subprime mortgages was manageable because the underlying debts were high-quality.

Losses mount

By the end of 2005, the company had limited its exposure to subprime mortgage defaults by no longer selling mortgage swaps. But vulnerability from older deals remained, including clauses that AIG post collateral should mortgage values or the company's credit rating drop.

In mid-2007, Goldman Sachs, a counterparty to some of AIG's swaps, demanded more collateral. That got the attention of AIG's outside auditors, and by early November, the financial unit's third-quarter losses had increased from $45 million to $350 million, according to AIG documents released last month by a House committee.

About that time, a key insider quit.

Joseph St. Denis, a former top SEC accountant and derivatives expert, was installed as a vice president in AIG's financial unit in June 2006 to address the weaknesses identified in earlier investigations and audits.

St. Denis' appointment helped convince AIG management the company had effective controls in place, and in early 2007 they told investors a "material weakness" in AIG's derivatives portfolio had been fixed.

But St. Denis, according to a written statement to Congress, resigned from the company in September 2007. St. Denis said Cassano had told him he was being "deliberately excluded" from evaluating AIG's swaps because he "would pollute the process."

Shortly after he quit, St. Denis talked to AIG's chief auditor and the company's outside accountants. By the beginning of 2008, accountants found new errors in the swaps portfolio, totaling $800 million, and determined once again that there was a "material weakness."

At the OTS, Lee said, he had no personal dealings with St. Denis but that his examiners might well have been aware of his situation. His team viewed the swaps as "fairly benign," he said, because they sold for a "low premium" and were highly rated.

By early 2008, the company disclosed that it had obtained a "third-party analysis" that put losses for its credit-default portfolio at $9 billion to $11 billion. Nonetheless, AIG in its public filings cited its own forecast of $1.2 billion to $2.4 billion in losses.

The New York State Insurance Department met with the company in early February to make sure the side of AIG that it regulates was not exposed to investment losses.

It wasn't until March -- three years after repeated and significant misstatements and serious weaknesses, and one month after the latest set of errors -- that Lee wrote to AIG saying it needed to better manage its risk from credit-default swaps and report back with a corrective plan.

Lee described the letter as an "informal enforcement action" or "a first step on the enforcement ladder." Other steps at his agency's disposal include cease-and-desist orders, supervisory agreements and financial penalties.

Lee said derivatives hadn't been much of an issue for most of the banks the OTS supervises but acknowledged that they pose a real risk for several of the other large entities it oversees. The annual report for the OTS, released last December, does not mention derivatives in its 48 pages.

Yet the unraveling of AIG can be traced directly to its derivatives.

As credit markets deteriorated, AIG collateral requirements increased from $850 million in June 2007 to a total of $16.5 billion one year later, filings show. Although AIG had assets on its balance sheet, especially with its insurance units, they couldn't be turned to cash quickly. Lee said the fact that AIG held $75 billion in highly rated assets was reassuring to his agency.

By Sept. 16, facing a further credit downgrade, the hole grew deeper. AIG couldn't post an estimated $18 billion in additional collateral, according to congressional testimony. That is when the Treasury moved in, eventually offering AIG the rescue package which now stands at $150 billion.

Lee said one of the chief lessons from AIG is the need for examiners to pay more attention to liquidity. Others have made the same observation as both U.S. and European policymakers debate how best to restructure global financial regulation in years ahead.

Lee defended his office's performance, saying that in the end it focused attention on AIG's most vulnerable unit. But he said there was no way to see the financial tsunami rising ahead.

"When the calamity occurred, it came from a place where we had been," he said. "We put our finger on a significant issue for the company, but we didn't anticipate the perfect storm."

Jeff Gerth

Jeff Gerth was a senior reporter at ProPublica. Previously, Gerth worked as an investigative reporter at The New York Times. He has twice been awarded the Pulitzer Prize.

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