Propping Up a House of Cards

Next week, perhaps as early as Monday, the American International Group is going to report the largest quarterly loss in history. Rumors suggest it will be around $60 billion, which will affirm, yet again, A.I.G.’s sorry status as the most crippled of all the nation’s wounded financial institutions. The recent quarterly losses suffered by Merrill Lynch and Citigroup -- "only" $15.4 billion and $8.3 billion, respectively -- pale by comparison.

At the same time A.I.G. reveals its loss, the federal government is also likely to announce -- yet again! -- a new plan to save A.I.G., the third since September. So far the government has thrown $150 billion at the company, in loans, investments and equity injections, to keep it afloat. It has softened the terms it set for the original $85 billion loan it made back in September. To ease the pressure even more, the Federal Reserve actually runs a facility that buys toxic assets that A.I.G. had insured. A.I.G. effectively has been nationalized, with the government owning a hair under 80 percent of the stock. Not that it’s worth very much; A.I.G. shares closed Friday at 42 cents

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To be sure, most of A.I.G. operated the way it always had, like a normal, regulated insurance company. (Its insurance divisions remain profitable today.) But one division, its "financial practices" unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities. Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.

These exotic instruments acted as a form of insurance for the securities. In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too. That was the ratings arbitrage. "It was a way to exploit the triple A rating," said Robert J. Arvanitis, a former A.I.G. executive who has since become a leading A.I.G. critic.

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