AIG's $150B bailout (cont.)

Alas, even five years in close quarters with AIG is way beyond what the government envisioned. The ties that bind these two parties, in fact, bring to mind the 1942 movie classic "The Man Who Came to Dinner," in which Monty Woolley, playing the insufferable Sheridan Whiteside, arrives to dine, injures his hip on the front steps, and stays on for the duration, driving his hosts batty. In today's reality show, AIG is The Company That Came to Dinner, and the trapped, restless host is the government. Don't ask when these two will be parting ways, because there's no date set.

The endpoint, in fact, could be stretched way out by one special AIG troublemaker: a complex noninsurance operation that nobody thinks can be sold but that instead needs to be wound down, a process apt to be both lengthy and expensive. This albatross is AIG Financial Products - FP for short - which is housed in a division called Capital Markets. FP was formed 21 years ago to trade over-the-counter derivatives, and it proceeded to ride the great boom in that business. For most of its history, FP gave longtime CEO Hank Greenberg profits on cue, helping him build a great record of earnings growth - until this streak was rudely smashed several years ago by earnings restatements that involved practically every corner of the company, FP included.

Worse, even as those humiliations were surfacing (and leading as well to Greenberg's departure), AIG got deeply involved with mortgage securities that all too soon were identified as toxic. A nutty investment policy at the company's insurers helped create this problem. But the true agent of doom was FP, which wrote close to $80 billion of credit default swaps - contracts that insure investors against losing principal and interest - on super-senior tranches of collateralized debt obligations (CDOs) that were loaded with mortgage securities, some of them subprime. A financial tsunami then engulfed AIG, which is structurally a holding company - the parent of a webwork of operating insurers. The CDOs fell in value, and credit ratings for the parent company went down with them. This drop in AIG's creditworthiness triggered clauses in the credit default swaps (CDS) that allowed AIG's counterparties to demand collateral, and those calls for cash put the parent in a vise. There you have the internal situation that, in time, shoved AIG into the arms of the government.

The external situation is that AIG may have landed in that house of refuge because Lehman Brothers didn't. In the crisis-ridden week leading up to Monday, Sept. 15, the government decided it could not or would not rescue Lehman but instead would let it go bust. Bankruptcy court records have since shown that Lehman had 900,000 derivatives and financial contracts with other parties, and each creditor holding these realized on Monday morning that its check wasn't going to be in the mail. The hazy financial concept called "systemic risk" immediately became hard reality. Credit markets froze worldwide and stayed frozen on Tuesday, which is the day when AIG was headed toward bankruptcy but didn't get there. The theory around, which all of financialdom seems to accept as received truth, is that the government realized by Tuesday that it had erred grievously in letting Lehman go down and knew that it could not compound the error by allowing AIG to fail a day later.

So AIG lived to become a government ward, and in that guise it is unique. True, it is an infamous match for Fannie Mae and Freddie Mac, which are also owned 79.9% by the government. But the world always knew these fraternal twins to be the unacknowledged children of the feds. Until September, conversely, AIG never had the slightest look - at least publicly - of a company that would need government help, much less emergency rescue. Visualize, in fact, a "too big to fail" list, or as the term often goes in these days of derivatives, a "too interconnected to fail" list. Had several smart, informed, worldly businesspeople been asked in 2007 to name the five top contenders for that list, probably no one would have placed AIG on it. Among onlookers, therefore, AIG's sudden collapse - and its need, my God, for $150 billion! - tends to be one of the great bafflements of the credit crisis. In statements about why it bailed out AIG, the government has simply muttered "systemic risk." But it has never explained why it took this threat so seriously, and the New York Fed, the government's foster parent for AIG, wouldn't discuss the company at all with Fortune.

NEXT: AIG's $150B bailout (cont.)

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