AIG's $150B bailout (cont.)

Our reporting suggests, though, that fears of systemic risk certainly weren't crazy. FP, in particular, is a breeding ground for this dreaded contagion, because of the derivatives links it has to counterparties around the world. Catch the horrified reaction of a New York currency trader when she heard in September that AIG might go bankrupt: "No!" she said. "AIG would be lots worse than Lehman. AIG is everywhere."

Today FP has around $2 trillion of derivatives, not a big book in this world (J.P. Morgan Chase has more than $80 trillion) but one known to be loaded with particularly complex and long-dated contracts. The most infamous among these derivatives are the $80 billion of credit default swaps described above, for which the counterparties were around 25 financial institutions in the U.S. and at least seven other countries. All of the counterparties, of course, were wrung out by the credit crisis and vulnerable to a domino effect if AIG went under. Liddy proves himself a master at understatement in describing the threat to the counterparties: "That would have backed up into their capital adequacy and could have caused a problem."

The remaining $1.9 trillion of FP's derivatives, many of them commonplace items like interest-rate swaps and currency futures, got little attention as AIG was swooning. But the fact is that these derivatives linked AIG to countless financial and industrial counterparties around the world - among them the one in which that alarmed currency trader works, for example - and could have hung at least some of these institutions out to dry. Another operation in FP had guaranteed $20 billion of municipal investment agreements, in which FP was in effect holding the funds of U.S. states and cities. An AIG bankruptcy would have made these municipalities general creditors of AIG and probably stung them with losses. Money market funds were also big holders of AIG debt.

Then there is the uncertainty of what a bankruptcy would have done to AIG's insurance companies. Making his own list of AIG systemic risks one day, the superintendent of the New York State insurance department, Eric Dinallo, wrote down the thought that the failure of a company once seen as impregnable might cause a general loss of confidence in the insurance industry. That danger indeed acquired a certain substance on AIG's fateful day of Sept. 16, when news spread globally that the company's operating insurers were set to send $20 billion of rescue money to parent AIG. In Singapore, some customers promptly rushed to AIG offices and sought to cash out their policies. AIG's public relations people panicked at this insurance version of a run, putting out a weird press release that assured the world - and specifically Asia - that the company's operating insurers would husband their cash for themselves.

In the end, says Dinallo, "it was incalculable as to what the ramifications of a bankruptcy were going to be." The matter, in any case, became moot on Sept. 16. By saving AIG, the federal government preempted the question of what would have happened had it gone down, and moved the argument to what happens now.

Ed Liddy, 62, the man charged with the Herculean task of making AIG valuable again, retired in April as chairman of Allstate, a Chicago company, and became a partner in the private equity firm of Clayton Dubilier & Rice, a job he thought might provide him "a little less intense life." Then Henry Paulson called on September 16th to ask him to take over AIG, assuring him he had just the right combo of insurance and restructuring experience - and besides, "Your country needs you." Well, says Liddy, "you can sit on the sidelines, or you can get in the game and try to help."

Liddy's home base remains Chicago, to which he says he tries to get back every second or third week. Talking to Fortune, he stressed that he flies commercial, booking coach and hoping for an upgrade. This declaration is clearly the result of biting criticism that AIG has received, notably from Congress, for holding expensive junkets for agents and financial planners. Liddy defends the general idea of those as being good for business, but he's grown acutely conscious of AIG's need, in its taxpayer-owned status, to be frugal. About one customer event, a partridge shoot that certain high-placed AIG executives staged in England, Liddy expresses real disgust: "That was wrong. And those people have been severely taken to task. We've reprimanded them, we've shorted their pay."

The hold on costs extends to Liddy's compensation. In salary he's a $1-a-year-man, and he'll get no bonus for 2008, though one might come in 2009. The same pay arrangements apply to Liddy's biggest hire, his new vice chairman for restructuring, Paula Reynolds, 52, who had been CEO of insurer Safeco until she closed its sale to Liberty Mutual last September. Her next plan was to spend several months cleaning her closets. Then Liddy, whom she had known for years, called, and she signed up. Like Liddy, she's kept a distant home-base - hers is Seattle - to which she tries to get back every so often, flying commercial, of course.

But the work around AIG is consuming these days and, more often than not, darkened by the prospect that this struggling company, with its uncertain future, will lose its best people and customers. Liddy has tried to make light of losses on both fronts. Still, news of employees defecting from AIG continues to surface, and sometimes the departures are consequential. In December, Liddy lost both the CEO, Kevin Kelley, and the COO, Shaun Kelly, of Lexington Insurance, one of AIG's biggest property and casualty companies; both went to Bermuda insurer Ironshore. AIG has also lost people to another Bermuda company, Ace Ltd., which is run by Hank Greenberg's son, Evan Greenberg.

Many of the people remaining at AIG, most of whom of course had nothing to do with its financial sins, are surely demoralized, both by emotional and financial blows. Over the years, valued employees have been paid in part in AIG stock and encouraged by moral suasion or directive to keep it. Reynolds tells the story of a meeting recently at which one person broke down, choking out an explanation that it was hard to focus on work "because we have been wiped out."

The customer story is at this moment uncertain: This article went to press just as AIG was confronting the key date for policy renewals, Jan. 1, at which big-deal moment many commercial buyers of insurance were going to be casting an economic yes or- yes or- no vote about this insurer. The risk manager at one Fortune 500 company said recently that he'd be keeping AIG in his picture but reducing its participation in his coverage. That's a result, Liddy says, he can live with: "What's important is that we keep the relationship." Another AIG customer, a New York broker who places commercial policies, said he'd found certain risk managers and their bosses - treasurers and the like - split over AIG. The risk managers, he said, favored hanging tight to AIG's insurance expertise, while their superiors were leaning toward "Get me out of here."

Short term, the Jan. 1 results will be critical for AIG. Longer term, the main question before the house is Reynolds's restructuring sales, which essentially leave her cleaning out AIG's closets instead of her own. Reynolds, who is nothing if not frank, describes a sales process that sounds on the verge of lunatic - and, yes, expensive: "Everybody's feeding on the company like it was a bankruptcy carcass. Everybody's meter is running. We've got too many bankers, too many consultants. You can't get any work done because there's so much noise - so many people running around." For the record, Blackstone is AIG's primary global advisor. Another consultant, BlackRock, is helping AIG Financial Products value its assets, and McKinsey & Co. is also a consultant to FP.

Through it all, the specter of Hank Greenberg, CEO of AIG for 37 years, haunts the job of redoing the immensely complex company he built (see "Hank's Last Stand," on Fortune.com). A special sales obstacle, says Reynolds, is that AIG has 4,000 subsidiaries and other legal entities, with all manner of cross-ownership among them. "With all due respect to our former chairman," she says, "a lot of things were done around the 1986 tax act." This is a U.S. law that tightened up tax rules applying to financial services income earned overseas. Reynolds says that while the law's provisions were later effectively repealed, a lot of ownership structures that AIG had built weren't taken down. So simplification is today badly needed, she says, and a big team of lawyers is on the case.

To get warm bodies for that team, Reynolds pulled in help from AIG's operating companies. These are a spread-out collection of silos linked to a holding-company center that is staffed with relatively few people - too few for the job at hand now, say both Reynolds and Liddy. Of course, Greenberg never clustered people at his side. He ran AIG out of his head, seemingly unfazed by an accounting system so inefficient that AIG is notorious among ex-executives for always getting just under the wire when making its SEC filings. The accounting systems plagued the CEOs who followed Greenberg - Sullivan and Willumstad - and remain a trial today. Says Reynolds: "The best businesses are run by people who kick their tires every day. We don't even know where the tires are, much less get to kick them. If we can get back to the size of a company where we can intelligently kick our tires every day, that would be a wonderful outcome."

The misadventures that AIG's silo architecture can create are sharply illustrated by the company's disasters in mortgage securities. These problems certainly were spawned in AIG Financial Products. But the fact is that FP had a moment of enlightenment in late 2005, when it began to believe that the housing boom was nearing an unfortunate end and decided to stop selling credit default swaps on super-senior tranches of CDOs. It had a few deals in the pipeline, however, so total "multisector" CDS - AIG's name for these spiffy items - climbed a bit further in early 2006, to a total of nearly $80 billion. Later, as 2006- and 2007-vintage mortgages turned toxic, AIG talked proudly to analysts about its wise decision to pull out before trouble hit. The company proved to be excruciatingly wrong in thinking it was safe, of course, since earlier vintages have been creamed too. But the point is that by August 2007 - the start of the credit crisis - CEO Martin Sullivan and FP's boss, Joseph Cassano, were saying to everybody who'd listen that FP had ducked the mortgage bullet by avoiding the 2006 and 2007 securities that were by that time viewed as poisonous.

Various other AIG silos, unfortunately, weren't listening. The regulatory statements filed by AIG's operating subsidiaries show that a raft of these companies, and particularly the life insurers among them, were still loading up on late-vintage residential mortgage-backed securities (RMBS) in December 2007 - months after AIG had begun congratulating itself on ducking the mortgage bullet. Why, Liddy is asked, would one arm of AIG be buying mortgage securities while another is pronouncing them dangerous? As if there might be someone in AIG's empire he didn't care to offend, Liddy states his answer carefully: "You know, the company is a highly decentralized, far-flung enterprise. And different pieces of the company took different risks. Let me just leave it at that."

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

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