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AIG is a Symptom, Not the Cause, of a More Serious Disease

Michael Lewis's dissection of the collapse of AIG in the latest issue of Vanity Fair contains no bombshells, but it does bring into relief the confluence of factors that laid the insurer low. It also makes a key, and often overlooked, point: AIG wasn't the problem.

As usual in the financial world, the blame diffuses into a rather more complex set of circumstances. The main culprit is the tide of financial "innovation" that swept over Wall Street beginning in the late-1990s, as AIG swan-dived into the emerging market for credit-default swaps. As Lewis notes, however, it could've been some other AAA-rated financial giant taking the plunge, such as GE Capital.

The other thing about innovation -- whether in the world of derivatives, or say, Internet code -- is that it produces unintended effects, sometimes known as other innovations. AIG extended its highly profitable business of insuring corporate bonds into insuring consumer debt, such as credit cards, student loans and (eek!) subprime.

Trouble is, every market is ruled by its own financial dynamics. Strategies that safely mint money in one quadrant of the financial universe may create huge risks in another zone. Or, as one AIG trader Lewis quotes, puts it, "The problem is that something else came along that we thought was the same thing as what we'd been doing."

Which is where issues of good management enter the picture. Joseph Cassano, the former chief of AIG Financial Products, the now notorious unit that led the company into the darker corners of structured finance, seems to have been almost completely unsuitable for the job. In Lewis's telling, Cassano was bullying, autocratic and -- worst of all -- clueless about AIG's business of insuring billions of dollars in sub-prime mortgage risk. And who put him there? Why, legendary -- and now defrocked -- AIG boss Hank Greenberg, along with the company's board of directors, which included financial all-stars such as Harvard economist Martin Feldstein.

That mixture of financial alchemy and poor leadership would've been less flammable had AIG not been able to exploit the gaping hole in U.S. financial rules. As an insurance firm, the company was exempt from the capital-reserve and other regulatory restraints on banks, which put it in ideal position to back-stop mortgage risk. By the turn of the last century, Congress was also gutting the Glass-Steagall Act, inviting the bulge-bracket banks into riskier lines of business, and passing laws such as the Commodity Futures Modernization Act, which curtailed regulation of newfangled financial instruments.

Let's see. Weak management -- check. Faulty governance -- check. Defective regulation, mind-bending complexity -- check, check. Something's missing.... Ah, greed and fear. For lubricating the financial gimcrackery and feckless government oversight were the vats of cash that quants and bankers alike were making. Fear that the money would eventually stop flowing kept most people from asking to many questions. By the end, during the fall of 2007, the players were all in on every hand. Cassano walked away with a $315 million paday before leaving the company in March 2008.

AIG's fall is, as others have said, a cautionary tale. But not about the risks that individual corporate actors pose to the financial system. The real risk lies in the danger that the system, when we lose hold of it, poses to itself.