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Unwinding at AIG prompts Pasciucco to ponder systemic failure

Gerry Pasciucco stared out from his office on midtown Manhattan's 48th Street, weighing the riskiest trade of his life. Over a 26-year career, he had risen to managing director at investment bank Morgan Stanley (NYSE: MS) and earned a seven-figure-plus pay package. Now Edward Liddy, the new chief executive of insurer American International Group Inc. (NYSE: AIG), had just asked Pasciucco to head the AIG subsidiary at the vortex of the world financial cataclysm: AIG Financial Products Corp.

The mission: unwind AIGFP's portfolio of 44,000 often complex, long-dated derivatives with a notional value of $2 trillion, close the unit, then fire what remained of its 428 employees and resign.

Pasciucco, 48, says his one overarching concern was, “How afraid of the unknown should I be?”

The answer turned out to be -- very afraid. In March, four months after Pasciucco started the job, he was sucked into a maelstrom of criticism after AIG paid $165 million in retention bonuses to his AIGFP employees. The company was pounded by Congress.

Protesters picketed the homes of AIG staff members, while the company received a barrage of letters and e-mails, some of which read like death threats.

Pasciucco maintains that the bonuses were justified. “We are a company of 44,000 contracts,” he says. “We honored these contracts too.”

The efforts by Pasciucco, a Boston native with degrees from Williams College and Harvard Business School, to unwind AIG's gargantuan gambles will be a test of the ability of Washington and Wall Street to repair the damage to the system and restore public confidence.

“It's ground zero in terms of what regulation is going to look like going forward -- whether government intervention is viewed as a success or a failure,” Pasciucco says.

It was AIG's gambits on mortgage-related debt that brought the world’s largest insurance company to the edge of bankruptcy. On Sept. 15, 2008, the company lost its AA- credit rating -- it had already been downgraded from AAA in 2005.

The downgrade forced the firm to hand over billions of dollars in collateral to its trading partners. It didn't have the money.

The U.S. government stepped in on Sept. 16, when the Federal Reserve extended an $85 billion credit line to the company in exchange for 79.9 percent of AIG stock.

While the credit crunch is predominantly a banking crisis, it is AIG, not a major bank, that's the biggest recipient of government largesse. The Fed and the Treasury have paid out or guaranteed a total of $182.5 billion for AIG, more than four times the $45 billion Bank of America Corp. (NYSE: BAC) and Citigroup Inc. (NYSE: C) each got through the Treasury’s Troubled Asset Relief Program, or TARP. The U.S. has committed as much as $70 billion of TARP money to AIG.

AIG, more than any other institution, has thrown a spotlight on the tangled world of derivatives -- securities whose value is derived from underlying stocks, bonds, currencies or commodities -- and especially on credit-default swaps. CDSs are lightly regulated insurance-like contracts used to protect investors against the default or loss in market value of a security they hold.

The government rescued AIG -- run for four decades by the iron-fisted Maurice “Hank” Greenberg -- to avert “systemic failure,” Federal Reserve Chairman Ben S. Bernanke said at the time. If AIG had collapsed, a dozen other big financial companies that were counterparties in its derivative trades and insurance contracts might have gone down along with it, Bernanke told Congress in March.

What brought the company down, Pasciucco says, was its exposure to fewer than 200 insurance contracts that were sensitive to AIG's credit ratings and the value of the collateralized debt obligations they insured. CDOs are agglomerations of subprime housing loans and other debt that are sliced into tranches, each of which has a different risk and income stream.

Pasciucco's job is to extricate AIG from tens of thousands of derivatives contracts entered into by what amounted to a hedge fund within the insurance company -- one whose managers worked independently and took home 30 percent of the profits. No winding down on this scale has ever been attempted.

AIGFP was in effect a multistrategy hedge fund engaged in a variety of businesses. In addition to CDSs, it wrote and traded equity, currency and commodity derivatives. It even owned a collection of solar power plants in Spain.

In an interview, Pasciucco brandishes a report showing that the value of the derivatives still to be unwound had fallen 16.7 percent to $1.5 trillion as of May 12. The number of trade positions was down 24 percent, to 26,700 from 35,000, during the same period. “The risk in the book is down far more than the trade count,” he says. “That's because the trades we’re unwinding have been the riskier trades.”

The daily task for AIGFP's 350 employees -- located in Wilton, Conn., London, Paris, Tokyo and Hong Kong -- is to find buyers for its positions. AIGFP’s mathematicians and computer programmers have databases that keep track of the holdings of thousands of counterparties, making it easier to find those interested in taking over AIG’s side of trades. “That gets us much better pricing,” Pasciucco says.

Pasciucco expects to get out of the vast majority of AIGFP's positions by year-end. He plans to leave by the end of 2009, whatever happens, to go back to Wall Street or write a book. The wisecracking executive has a message for the friends who advised him to accept the AIG challenge: “I’m holding all those people responsible for the position I find myself in today.”

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