Gerry Pasciucco, hired from Morgan Stanley in November to shut the unit that sold credit-default swaps, said positions were reduced to almost $1.5 trillion at the end of the first quarter of 2009, from $2.7 trillion at the start of 2008. While many of the remaining positions are protected by hedging, billions of dollars of holdings remain vulnerable, Pasciucco said in an interview.

“I’m not going to say that we’re not going to have losses,” Pasciucco said April 13. New York-based AIG’s $61.7 billion loss in the fourth quarter was the worst in U.S. corporate history, with errant bets on credit-default swaps helping to push the full-year deficit to $99.3 billion.

AIG needs to stanch those losses so the insurer, once the world’s biggest, can reimburse the U.S. for the four bailouts received since September valued at $182.5 billion. Another rescue may be needed if the swaps aren’t neutralized, according to a Congressional report. Chief Executive Officer Edward Liddy blamed the Financial Products unit for almost bankrupting AIG and said creating the business was the insurer’s worst mistake.

Pasciucco said winding down positions that include almost $200 billion in credit-default swaps with European banks will take at least until the end of 2010, and closing out some 50- year options written on interest rates and equities will take even longer.

Buried by Bonuses

The unit’s 44,000 open trades were reduced to 28,000 as of March, Pasciucco said, adding that AIG’s success in cutting risk and winding down Financial Products has been overshadowed by controversy surrounding $450 million in retention bonuses promised to some employees.

“This is something that has been entirely missed because of all the drama around this place,” he said.

AIG remains vulnerable to losses on swaps that insure the value of mortgages and corporate loans held by European banks, he said. The value of that portfolio was reduced to less than $200 billion from about $400 billion at the start of last year, Pasciucco said.

In an interview last December, Pasciucco said those swaps would mature over time without loss and faced very little risk. AIG later reported it suffered $1.3 billion in losses on those swaps in the fourth quarter. Pasciucco said he still believes any future losses will be limited.

Prospect for Losses

Congressional auditors said in a March 18 Government Accountability Office report that the remaining swaps and other unspecified AIG investments may produce more losses that could require a fifth round of U.S. funding. The taxpayer-backed bailout has committed $70 billion in capital plus loans and asset guarantees.

“Given that several hundred billion in notional value is still outstanding, I don’t see how the losses on credit-default swaps could possibly be over at this point,” said Donn Vickrey, executive vice president of Gradient Analytics, a research firm in Scottsdale, Arizona. “Even if it were the case, the company still faces substantial losses in other areas of its business.”

Credit-default swaps allow investors to buy protection that covers losses on bonds or other securities if an issuer doesn’t pay its debts. The contracts typically pay the holder face value if the issuer defaults. As the market expanded, speculators who didn’t own any of the underlying securities started using swaps to bet on a borrower’s creditworthiness.

Collateral Calls

When the value of the securities covered by the swaps declined, AIG was forced by some of the contracts to post billions of dollars in collateral. That left AIG short on cash last September, and the company was hours away from bankruptcy on Sept. 16 when it accepted a U.S. bailout. Liddy joined the company days later to help salvage the insurer.

AIG said in a fourth-quarter report it may suffer additional collateral calls on the European swaps, triggered by declines in the insurer’s credit rating or deterioration in the value of the underlying assets.

Pasciucco, 48, plans to keep a staff including traders to manage the open positions or hand them off to the parent company. Twenty employees quit after the dispute over retention bonuses, Pasciucco said.

President Barack Obama joined lawmakers and regulators who criticized AIG for giving retention pay to employees of the unit, which they said was most responsible for the company’s distress and the taxpayer-funded bailout. Some of the staff later returned all or part of the money at Liddy’s request.

Inside Knowledge

About 20 percent of the unit’s 370 employees were traders, and only some were involved in creating the money-losing positions, Pasciucco said. Most of the rest are accountants, systems experts, assistants and other staff personnel, he said. It’s less risky to keep the original traders on staff because they understand the portfolio better than outsiders, and their relationships with financial institutions help AIG avoid more losses by selling, unwinding or hedging the positions, he said.

“I like this team,” Pasciucco said, citing their knowledge of how AIG’s holdings work. “There are a whole host of idiosyncrasies that you just need sherpas for.”

Pasciucco said that when he arrived last November he reorganized the unit’s positions into 22 portfolios by type of security. Most of the financial value was contained in four of those portfolios -- equities, commodities, interest rate-related positions and foreign exchange-related positions.

The other portfolios include positions tied to holdings such as asset-backed securities, commercial mortgage-backed securities and swaps, he said.

Fed’s Role

Almost all the losses stemmed from just one of the 22 portfolios, involving swaps that covered multisector collateralized-debt obligations, he said. These were swaps insuring the value of complex bonds made of large pools of mortgages, many of them subprime mortgages that have suffered high default rates.

Assets backed by the swaps were acquired by a special financial entity set up by the Federal Reserve, which reduces the possibility of future losses for AIG. The Fed now keeps representatives inside Financial Products, and the unit provides daily and weekly risk reports to the Fed, according to Mark Herr, an AIG spokesman. Fed officials also participate in governance committees at the Financial Products unit, Herr said.

“A number of assurances about AIG, including its ability to repay the initial bailout by selling its assets, have been revised over time, so it certainly comes as no surprise that the company is now changing its tune on this,” said Representative Elijah Cummings, a Maryland Democrat on the House Oversight and Government Reform Committee. “The sooner the FP division winds down, the better for everyone involved.”

 SOURCE: Bloomberg