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AIG's Tangled Web Unwinds Slowly

When asked to describe details from a typical contract unwind, Nacey responded: "You're kind of opening Pandora's Box."

Overall, AIG's trades have lost a significant amount of money, because the insurer had been very bullish about a financial market that was soon at the brink of destruction, and an economy that would soon be in a recession. Most deals were set up so that AIG protected the top-level, "super senior" layer of risk -- meaning it only needed to pay out funds once lower layers of equity and debt had accrued losses.

Yet, most of the trades were linked to subprime mortgage bets, and as that market collapsed, losses soon ate through riskier tranches. As a result, AIG's capital-markets business posted $40.5 billion in pre-tax losses in 2008.

"A lot of people are basically equating these problems to credit default swaps [by saying they] are like insurance," says Edward Grebeck, a debt-market strategist and CEO of Tempus Advisors, who has worked with structured vehicles at JPMorgan Chase (JPM - Get Report) and General Electric's (GE - Get Report) GE Capital division. "Well, I say they aren't. The people who say they are like insurance are usually the people who mispriced them in the first place."

The complexity of these trades are all part and parcel of CEO Robert Benmosche's battle with the Obama administration over employee compensation. AIG points out that FP employees know contract terms, market conditions and hedging strategies, as well as AIG's complex proprietary trading systems, better than anyone else. The firm also argues that the departure of key traders and executives would make the unwind more difficult because counterparties in negotiations with them would be spooked by signs of instability.

FP employees earned $98 million last year, or 19% of operating expenses. Another $153 million was paid out for pre-existing retention plans and related expenses.

"AIG FP not only had numerous trades on its books, but extraordinarily complex trades, a substantial number of which were long-dated, making for a daunting challenge on its face," says Herr. "Layer onto that unprecedented market conditions and we faced a tremendous challenge. Despite all of this, the men and women at FP were persistent, diligent and, most important, committed to seeing the unwind through, and we have achieved, by any measure, remarkable success."

Though AIG isn't expected to recoup all of its subprime losses, its capital-markets business showed muted signs of improvement last year, earning $180 million in pre-tax income as the markets improved. If borrowers start repaying overdue debt, or if market values gain more ground -- both big "ifs" -- AIG will be reimbursed a requisite portion of its counterparty payments as well, for contracts that are still active.

Gerry Pasciucco was brought on in October 2008 to wind down the FP division in its entirety. But rather than race to extinguish all of FP's positions, he now plans to retain $300 billion to $500 billion in derivative trades.

-- Written by Lauren Tara LaCapra in New York.
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