Payback time for Wall Street (pg. 3)

On Sept. 16, 2008, AIG was saved from bankruptcy by a taxpayer-funded bailout. It is currently being propped up with federal loan commitments and investments potentially totaling $150 billion. It acknowledges being under scrutiny by the U.S. Department of Justice and the SEC and says it's cooperating fully.

Though AIG's core (and heavily regulated) insurance businesses are healthy, the company appears to have been sunk by its small, formerly lucrative financial products unit. This group, headed by Joseph Cassano, effectively insured the holders of certain bonds against default by writing contracts known as credit default swaps. In particular, it insured the safest "super-senior" tranches of collateral debt obligations (CDOs), which, though backed in part by subprime mortgages, were originally considered very safe by credit-rating agencies and rated AA .

In August 2007, a month after those agencies downgraded hundreds of CDOs, Cassano spoke to investors in a conference call. "It is hard for us, without being flippant," he said, "to even see a scenario ... within any kind of realm of reason that would see us losing $1 in any of these transactions."

In a sense, Cassano's prognostication was not as far off as one would think. Even today very few CDO tranches insured by AIG FP have actually stopped paying as anticipated. But what Cassano and AIG were not disclosing - and at that stage might not themselves have appreciated - was that if market confidence in the CDOs fell sufficiently, AIG could be forced to post billions of dollars in cash collateral to protect the counterparties to its credit default swaps. It would also face writedowns in the value of its credit default swap portfolio, causing huge quarterly losses, sending the company's stock price lower, threatening its own credit rating, and making it harder for the company to raise new capital. Thus, even without cash losses, the unit's portfolio could start the company on a downward spiral to oblivion.

The question that civil plaintiffs lawyers are homing in on - and, it stands to reason, that government investigators would also look at - is precisely when AIG's officers began to appreciate that risk and whether they made sufficient disclosure at that point. Thus, while Cassano's statement above, 13 months before the bailout, might have been defensible, as time passed it might have become less so. Corporate officials have an ongoing duty to update old information that "remains alive in the marketplace," if an investor might reasonably rely on it.

Based on documents made public at an Oct. 7 hearing before the House Committee on Oversight and Government Reform, supplemented by additional disclosures in a New York Times article of Sept. 28 and a Wall Street Journal article of Oct. 31, the timeline looks like this:

In early September 2007, AIG internal auditor Joseph St. Denis learned that AIG had received a multibillion-dollar collateral call on its credit default swaps, according to a letter he wrote to the House oversight committee this past October. Alarmed, St. Denis sought more information about the valuation of the credit default swaps. In late September 2007, Cassano allegedly refused him access to it, saying, "I have deliberately excluded you from the valuation of [the swaps in question] because I was concerned that you would pollute the process," according to St. Denis's letter.

St. Denis resigned. As collateral calls continued, Cassano's unit concluded that writedowns were necessary on the swaps portfolio. But there was no accepted way to assign value to the novel and illiquid instruments.

In its third-quarter earnings statement AIG reported a modest loss attributable to the swaps write-downs. It also acknowledged - without quantification, to be sure - that it was having some differences of opinion with counterparties about how much collateral it needed to be posting for those swaps.

Then, on Nov. 29, a PricewaterhouseCoopers partner addressed AIG's audit committee, with AIG CEO Martin Sullivan present, and related certain concerns the auditor had about possible "material weaknesses" in the accounting valuation process AIG's financial products unit was using.

Just six days later both Sullivan and Cassano addressed investors at New York's Metropolitan Club, giving an in-depth, generally reassuring presentation about AIG's credit default swaps portfolio. Sullivan stressed that AIG "has accurately identified all areas of exposure to the U.S. residential housing market," that "we are confident in our marks and the reasonableness of our valuation methods," that "we have ... a high degree of certainty in what we have booked to date," and that "AIG's exposure levels are manageable."

Cassano also spoke, saying, "We are highly confident that we will have no realized losses on these portfolios during the life of these portfolios." There was no explicit warning about the dire impact that the collateral calls and unrealized losses might have in themselves. Still, Cassano did give a detailed presentation of the valuation methodology his unit was using to price the portfolio for purposes of the write-downs.

Two months later, on Feb. 11, AIG disclosed in an SEC filing that its outside auditor was declaring that there were "material weaknesses" in that valuation process. A bout two weeks after that, AIG issued its results for the last quarter of 2007 using a different valuation technique. It resulted in a $5.3 billion net loss, driven in large part by more than $11 billion in write-downs on its credit default swaps portfolio. The rest, as they say, is history.

A spokesman for AIG declined to comment, and lawyers for Cassano and Sullivan did not respond to detailed messages seeking comment.

Lehman's parent company filed for Chapter 11 protection on Sept. 15, 2008, the largest bankruptcy in history. Officials of the company are now under scrutiny by federal prosecutors in Brooklyn, Manhattan, and Newark.

U.S. Attorney Campbell's office, in Brooklyn, is scrutinizing statements that Lehman executives CEO Dick Fuld Jr. and then-CFO Ian Lowitt made in an emergency conference call to preannounce third-quarter earnings on Sept. 10, 2008, just five days before the bankruptcy filing, according to a person familiar with the situation. The call was convened after word had leaked out the day before that talks between Lehman and the Korean Development Bank about a possible investment had broken down. Among other things, Fuld assured investors that "we are on the right track to put these last two quarters behind us," while Lowitt stressed, "Our liquidity pool also remains strong at $42 billion." The question today is essentially, How does $42 billion vanish in five days, and did Lehman officers know then of any harbingers of doom that they weren't sharing?

The Manhattan federal prosecutor's office, meanwhile, is focused on whether Lehman was overvaluing its commercial real estate holdings shortly before bankruptcy (even though it had already marked them down significantly), according to a person familiar with the situation. The former head of Lehman's global real estate group, Mark Walsh, is therefore among the executives coming under the microscope.

In Newark the U.S. Attorney's office, together with New Jersey state regulators, is looking at a major capital-raising effort Lehman launched in June 2008, just three months before bankruptcy, when it issued $4 billion in common stock and $2 billion in preferred. Among the big investors was the fund that provides pensions for New Jersey's state and municipal employees, which invested $180 million, of which it has already lost at least $115.5 million.

It is not unusual for corporate officers to meet officers of big investors personally before such capital raisings, so any oral representations made to fund officials will presumably be closely scrutinized, as will all the SEC filings and conference call statements prior to the filing, including statements by CEO Fuld, then-CFO Erin Callan, and Callan's predecessor, Christopher O'Meara, who was then chief risk officer.

A spokesperson for Lehman Brothers said the company is cooperating fully, but otherwise declined to comment. Attorneys for Fuld and Walsh declined to comment, while a lawyer for Callan did not answer detailed messages seeking comment. Lowitt and O'Meara could not be reached.

Both Fannie Mae (FNM, Fortune 500) (the Federal National Mortgage Association) and Freddie Mac (FRE, Fortune 500) (the Federal Home Loan Mortgage Corp.) were placed into conservatorship on Sept. 7, 2008, in what was then the largest federal bailout in history. Each has since acknowledged that it is under investigation by federal prosecutors and the SEC, and says it is cooperating fully. Though it is still unclear what the focus of the probes is, the companies' former CEOs, Daniel Mudd and Richard Syron, have been accused of fraud in civil suits for making reassuring statements, which proved ill founded, about their companies' capitalization levels.

Civil lawyers alleging fraud have also been incensed by Fannie Mae's preferred stock offering in May 2008 - just four months before it was seized - because Fannie assured investors then that it was more than adequately capitalized, and provided only very perfunctory, opaque warnings about an accounting rule change that the Federal Accounting Standards Board had proposed in April. It wasn't until July 7, two months after the offering, that bank analysts at Lehman published a report explaining that the change, if adopted, would bring $2.27 trillion in mortgage-backed securities onto Fannie's balance sheet for the first time, meaning that Fannie would need to add $46 billion to meet its capital requirements - an unattainable sum.

Though the analysts predicted that Fannie would "probably" get an exemption from the rule before it took effect, the damage was done, as it fueled the perception that Fannie (and Freddie too, which would need $29 billion in additional capital under the rule change) was already insolvent and was being sustained only by an accounting mirage.

Fannie's stock fell about 20% that day and lost more than half its value over the ensuing week. A t the end of that month Congress gave the Treasury Department authority to seize Fannie and Freddie if necessary. Two months later the Treasury did.

Spokespeople for Fannie Mae and Freddie Mac declined to comment, as did counsel for Mudd. Syron did not return phone messages.

Needless to say, several of the subprime or low-documentation mortgage originators - ground zero for today's crisis - are reportedly under criminal and SEC scrutiny, including New Century Financial Corp., American Home Mortgage Investment, Countrywide Financial Corp., Golden West Financial, and Washington Mutual. In the civil shareholder suits that have already been filed against them, their officers have generally stressed that they genuinely believed their companies were advancing the noble goal, actively promoted by both the Clinton and Bush administrations, of making the American dream of homeownership a reality for less-well-off citizens. They were overtaken, they insist, by seismic market forces whose speed, breadth, and severity nobody foresaw, and which have already caused the failures of more than 300 lending institutions since 2006.

The problems will arise where the executives tried to distinguish their companies from the pack by highlighting their allegedly superior underwriting techniques, higher-quality portfolios, early anticipation of the downturn, or other purported advantages that proved to be insufficient at best and fictitious at worst. Some officials, like CEO Angelo Mozilo of Countrywide Financial, portrayed the growing market turmoil as an opportunity: "This will be great for Countrywide at the end of the day," Mozilo told CNBC's Bartiromo in March 2007, "because all the irrational competitors will be gone."

In all these cases, prosecutors and the SEC will likely be scrutinizing the executives' stock sales as the crisis played out, looking for both insider trading and evidence of the executives' true state of mind. Civil plaintiffs accuse Countrywide's officers, for instance, of selling $848 million in stock during the year and a half before the company's sale to Bank of America (BAC, Fortune 500) in January 2008, including $474 million worth sold by CEO Mozilo alone. In a particularly unseemly twist, most of the stock was allegedly sold back to the company itself as part of a $2.4 billion buyback program initiated in October 2006. (Neither Mozilo's counsel nor the Countrywide press office responded to detailed inquiries.)"

NEXT: Payback on Wall Street (pg. 4)

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