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Hedge fund hotel yields up secrets

Date: Tuesday, March 10, 2009
Author: Andrew Clark, Guardian

It is Mayfair's house of financial horrors. Owned by the Abu Dhabi royal family, One Curzon Street is among London's flashiest office blocks. But behind the elegant curves, polished white stone, sweeping windows and panoramic atrium lie billions of dollars in losses that have threatened the global financial system.

Popular with financial enterprises, the building is known as a hedge fund hotel. Its tenants include GLG Partners, one of the City's star funds, which has fallen on hard times, and the struggling Swiss bank UBS, but on the fifth floor can be found the most notorious of the property's troubled tenants - a formerly obscure financial products division of the sprawling American International Group (AIG).

It was in this London office of AIG that big-brained financial whiz-kids created a casino offshoot of the once-mighty insurer that spectacularly wrecked the company, racking up billions of dollars in losses on arcane derivatives, swaps and contracts. Fatally undermined by the unit's wheeler-dealing culture, AIG crashed to the US's biggest corporate loss of $61.7bn (43bn) for the final quarter of 2008 and is limping along the brink of oblivion, saved from bankruptcy by an eye-watering $150bn of emergency aid from US taxpayers.

The Federal Reserve chairman, Ben Bernanke, wasted few words in condemning the division's antics, telling Congress this week: "This was a hedge fund, basically, that was attached to a large and stable insurance company."

The Serious Fraud Office is examining exactly what type of business took place on the fifth floor of One Curzon Street, where a team of some 225 staff were managed by a policeman's son from New York, Joseph Cassano, who boasted a degree in politics from Brooklyn College and lived in a company flat behind Harrods. He was scorned by one California congresswoman, Jackie Speier, as "the golden boy of the casino in London".

The division dates back to 1987, when a small group of former traders from the junk bond firm Drexel Burnham Lambert persuaded AIG's then chairman, Hank Greenberg, that there was a highly lucrative opportunity in offering insurance that would protect banks against default on debt or against fluctuations in the value of derivatives.

AIG had a sought-after selling point: a triple-A credit rating. For a fee, it would stand behind lesser institutions' credit obligations. By lending its gilt-edged rating, it could give clients' investments a higher value and make them easier to trade. Headquartered in Connecticut but largely run from London, the division transacted billions in credit default swaps (CDS) - instruments trading financial risk - which have been dubbed "acts of Satan" by a leading US credit analyst, Christopher Whalen.

"These people were deluded," says Whalen, who views the CDS as a phenomenon dreamt up by those whose obsession with the free market has caused them to lose their grip on reality. "In a world where people believe in market efficiency, in total market completion, things like CDSs make sense. It goes back to Milton Friedman."

Whalen views London's light-touch regulatory regime as enabling such ill-conceived shenanigans to run out of control: "A lot of this kind of structured product came out of London."

CDSs are priced on historical models. Lulled by rising property prices and relatively predictable economic cycles, the AIG bankers were convinced they had hit on a gold mine. Tom Savage, the financial products division's former president, told the Washington Post recently: "The models suggested that the risk was so remote that the fees were almost free money."

They were wrong. A collapse in the US property market, which began in 2007, left AIG's clients with portfolios of toxic mortgage-related securities, and calls on the insurer's guarantees against default rocketed. AIG lost its triple-A credit rating, triggering contractual requirements forcing it to provide billions of dollars in extra collateral it simply did not have. The unit exploded in a mass of red ink, recrimination and buck-passing.

So how did they misjudge the market so badly? Insiders say AIG has always pushed its people to the limit, some seeing Greenberg's legacy as part of the problem. Ron Shelp, a former AIG executive whose book, Fallen Giant, chronicles the insurer's rise and fall, describes AIG as an intense environment where staff were expected to devote much of their lives to business.

"Success bred phenomenal rewards," he says. "In general, it was a freewheeling environment - they'd look for different regulatory regimes and push it right to the edge, looking for something different."

Favoured employees were rewarded with trips to a Connecticut rural bolt hole, Morefar, and with shares held in Star International Co, an offshore company, which were often released only to those who stayed to 65. The head of every profit centre was expected to produce a 15% annual rise in profits and net worth or their position would be under threat.

Just how much AIG's senior executives knew, or understood, about the London office's activities is a moot point. "It's a damned good question," says Mark Keenan, an insurance analyst at Anderson Kill & Olick in New York. "Whatever risk controls were in place, if there even were any, the fact is that someone was not watching what was going on."

If AIG collapses, the US government fears that scores of banks on both sides of the Atlantic could be pushed over the brink. But propping up the company is proving enormously costly. Donn Vickrey, founder of the US research firm Gradient Analytics, reckons the cost to US taxpayers will reach $250bn.

"They thought they were smarter than everybody else - that they knew how to price risk and nobody else did," says Vickrey. "That's hubris. Instinct should have kicked in - the simple logic that there's no such thing as a free lunch."

AIG's new chief executive, Ed Liddy, faces a race against time to raise money by selling unaffected operations before they are fatally infected by association with Cassano's casino in London. Meanwhile, the blame game is running at full tilt. Greenberg, who was pushed out in a 2005 accounting scandal, is suing his successors for wiping out $2bn of value in his personal shareholding. His targets include the Essex-born Martin Sullivan, who began his career as an insurance clerk in London and ended up running AIG between 2005 and 2008.

Greenberg maintains that until his own departure, risk controls were robust. "It wasn't a freewheeling culture," he told CNBC television. "It was competitive, aggressive, but very, very controlled."

Sceptics point out that Greenberg himself left as a result of an accounting controversy that led to AIG restating five years' financial results - and that his regime established the financial products division and recruited its key staff.

Within AIG, the mood is said to be one of gloom and shell shock. Many have lost decades of wealth built up in AIG shares.

"The old-timers are really distressed," says Shelp, "not just about the money they've lost. One of them said to me the other day, 'I bought into the AIG dream.'"

Thanks to an outbreak of financial "innovation" that turned fatally sour, the dream has turned into a nightmare.