July 1 (Bloomberg) -- Gerry Pasciucco stared out from his fourth-floor office at the hurly-burly of midtown Manhattan’s 48th Street, weighing the riskiest trade of his life. Over a 26- year career, he had risen to managing director at Morgan Stanley and earned a seven-figure-plus pay package. It was October 2008, and Edward Liddy, the new chief executive officer of insurer American International Group Inc., had just asked Pasciucco to head the 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 called friends and former colleagues for advice. “Go do it,” Morgan Stanley co-president Walid Chammah, a longtime mentor, told him. “Make the decision and don’t look back.”

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 the financial products unit’s employees. The company was pounded by the U.S. Congress and threatened with a subpoena by New York Attorney General Andrew Cuomo.

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.

‘Ground Zero’

New York-based AIG’s gargantuan gambles have become synonymous with the near collapse of the global financial system and the ensuing worldwide economic slump. The efforts by Pasciucco, a Boston native with degrees from Williams College and Harvard Business School, to unwind those trades 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.

Restoring credibility will be a long-term process. “AIG’s collapse set a precedent in its size and scale,” says George David Smith, a business historian at New York University’s Stern School of Business. “This has shaken the investing community and the broader public’s faith in the financial system. It will take many years for that system to regain the stature it once had.”

Rating Downgrade

It was AIG’s gambits on mortgage-related debt that brought the world’s largest insurance company to the edge of bankruptcy last September. On Sept. 15, 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. and Citigroup Inc. 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.

CDS Tangle

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 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.

By the end of 2008, more than $60 billion was paid to AIG counterparties that had bought CDSs from AIG. In a May 2009 filing to the Securities and Exchange Commission, AIG disclosed for the first time the full extent of those payments, including cash that had flowed to banks before AIG’s bailout.

Big Payout

Paris-based Societe Generale got $16.5 billion in collateral and other payments from late 2007 through 2008; New York-based Goldman Sachs Group Inc. received $14 billion; Frankfurt-based Deutsche Bank AG, $8.5 billion; and Merrill Lynch & Co., $6.2 billion.

The payments were triggered by the credit-rating downgrades of AIG and declines in the market value of the assets protected by the swaps. The most volatile of those assets were collateralized-debt obligations, or CDOs, which are agglomerations of subprime mortgages and other debt that are divided up and sliced into tranches, each of which has a different risk and income stream.

The filing, which is heavily redacted and uses abbreviations for counterparty names, reveals the extent to which Goldman Sachs was the leader in demanding -- and receiving -- collateral on the problem CDOs that AIG had insured. It got $5.9 billion before the insurer was forced into the government’s arms on Sept. 16, more than any other counterparty. Goldman Sachs spokesman Michael DuVally declined to comment.

‘No Reason to Pay’

“There was no reason to pay the contracts in full,” says Janet Tavakoli, founder of Tavakoli Structured Finance Inc. in Chicago and author of “Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street” (Wiley, 2009). “We’ve run roughshod over the interests of the American taxpayer; we’ve bailed out the Wall Street creditors; we’ve used AIG as a huge slush fund.”

In September, Moody’s Investors Service, Standard & Poor’s and Fitch Ratings all downgraded AIG two or three grades in response to its accelerating cash crunch. The company was rated AAA from 1983 to March 2005, when it lost that designation after CEO Maurice “Hank” Greenberg was forced to resign.

The September downgrades sealed the firm’s fate by triggering the collateral calls by Goldman Sachs and the other banks to which AIGFP had sold swaps.

McKinsey Swarm

In the weeks after the government rescue, dozens of McKinsey & Co. consultants hired by the Fed swarmed AIGFP’s headquarters in Wilton, Connecticut. After Pasciucco arrived, they worked with him and FP employees to sort the subsidiary into 22 component businesses, most of them involving derivatives.

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 underlying CDOs.

Pasciucco’s job is to extricate AIG from tens of thousands of derivatives contracts, or trades, 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. The effort that comes closest may be the dismantling of hedge fund Long-Term Capital Management LP, which in 1998 lost more than 90 percent of its value amid the Russian bond default.

‘Marvelous Global Company’

The Fed assembled a consortium of banks to rescue LTCM, and it took 15 months, from September 1998 to January 2000, to negotiate their way out of trades tied to more than $1 trillion in bets.

“The AIG portfolio is much more complex,” says David Rogers, who was drafted from Goldman Sachs to help close out LTCM. He is now CEO of hedge fund JD Capital Management Inc.

What Pasciucco -- pronounced pah-SHOO-koh -- is doing is part of a larger dismantling of parent AIG, which comprises 200- plus subsidiaries in more than 30 countries. At its peak in 2006, AIG posted annual net income of $14 billion and had a market value of $186.4 billion. “It was one of the iconic global institutions,” NYU’s Smith says. “It was a marvelous global company of great innovations.”

After taking over in September, Liddy, a former Allstate Corp. CEO, concluded he had to break AIG into pieces and sell the units to the highest bidder to have any shot at paying back the government. He has created a holding company for AIG’s property and casualty operations called AIU Holdings Inc.

Selling AIG’s Pieces

And he’s also transferring preferred equity in two of AIG’s big life insurance companies, American International Assurance Co. and the American Life Insurance Co., to the Federal Reserve Bank of New York as part of a plan to get them ready for sale. The transactions will reduce AIG’s debt by $25 billion.

AIG’s International Lease Finance Corp., the world’s largest jet-leasing company, is also on the block, with a group that includes buyout firms Onex Corp. of Toronto and Rye, New York-based Greenbriar Equity Group LLC as the favored bidder, according to people familiar with the situation. It may fetch less than $7.8 billion, the unit’s book value, one person says.

As of mid-June, AIG had struck deals to sell sundry insurers, banks, credit card and fund companies around the world for a total of at least $6.6 billion -- a small step toward repaying loans included in the $182.5 billion rescue. AIG owes about $40 billion on its $60 billion Fed credit line.

“We are working hard to determine the destiny of the component parts of AIG,” Liddy told a House committee on May 13. “Our plan contemplates that AIG’s best businesses will establish separate identities from the parent holding company. The parent company will become smaller. The financial products unit will cease to exist.”

Liddy Leaving

CEO Liddy, who is also AIG’s chairman, announced in May that he would leave AIG as soon as replacements could be found for his positions, which will be filled separately. “We believe there is an excellent chance we can repay the government,” Liddy told investors at AIG’s annual meeting yesterday.

The breakup of AIG will be remembered as the epilogue to one of history’s great business stories -- how a two-room insurance agency founded by Cornelius Vander Starr in Shanghai in 1919 grew into one of the world’s largest financial conglomerates. Starr’s successor, Greenberg, who hired on at AIG in 1960, led the insurer through nearly four decades of growth into new territories and businesses -- including the derivatives that undid the firm.

‘Management Fell Asleep’

Greenberg’s AIG was one of the first firms to write CDSs back in 1998. They were the newest product to come out of AIGFP, which had already been around for a decade creating and trading derivatives. In April, Greenberg said in congressional testimony that the subsidiary had generated more than $5 billion in profits for AIG before he left the firm.

Greenberg, 84, was ousted by the AIG board in March 2005 amid an investigation by then-New York Attorney General Eliot Spitzer into bogus reinsurance. The executive who replaced him, Martin Sullivan, proved incapable of managing the risk taken on by Greenberg and aggravated it by allowing new derivative bets on CDOs. AIGFP could have protected itself, as other sellers of CDSs did, by shorting subprime mortgage indices.

“This was not some technical problem,” says Charles Calomiris, a finance and economics professor at Columbia Business School in New York. “They didn’t understand the meaning of risk management.”

Greenberg says that most of the damage was done after he resigned. “Management fell asleep after I left the company,” he told the congressional committee. He declined to be interviewed for this article.

‘Highly Confidential’

Pasciucco’s job of winding down AIGFP has turned into a grueling exercise carried out in the public spotlight. He lightens his work with a patter of wisecracks. Pasciucco says he 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.”

During an interview in Manhattan in late May, Pasciucco reaches into his briefcase, pulls out a dog-eared presentation on the AIGFP portfolio that’s marked “highly confidential” and slides it across a conference room table. It details the scale of the winding down of AIGFP -- as well as the progress made.

In the course of the 2008 government bailout, the Federal Reserve Bank of New York bankrolled a special-purpose vehicle called Maiden Lane III, named for the Fed’s location in lower Manhattan, that bought insured CDOs from FP’s counterparties with a par value of $62.1 billion. The counterparties got to keep their collateral and AIGFP got to tear up its swap agreements. The government gets two-thirds of the upside from that portfolio, with AIG getting the rest.

Power Plants

That left derivatives with a notional value of some $1.8 trillion for Pasciucco to deal with at year-end.

The report that Pasciucco brandishes shows 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.

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.

Most of the trades were profitable, Pasciucco says, and many of them still are. The blowup happened only because AIG couldn’t come up with the collateral on fewer than 200 CDO swaps. Even today, 97 percent of the underlying CDOs continue to pay, Pasciucco says.

The daily task for AIGFP’s 350 employees -- located in Wilton, London, Paris, Tokyo and Hong Kong -- is to find buyers for its positions.

Gross Vega Down

Pasciucco’s first goal when he took over AIGFP was to exit the riskiest trades. He points to the portfolio’s gross vega, a measure of risk that in its simplest application gauges the dollar impact of an increase in volatility. Vega, Pasciucco explains, was down 38 percent as of May 12, to $770 million from $1.25 billion.

“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.”

Some of the most treacherous deals are also the longest dated. In the first quarter, the number of trades lasting more than 50 years was cut to 11 from 67. Pasciucco notes that his predecessors didn’t shy away from complicated derivatives.

“They were often combining commodity risk with equity risk and with puts and calls,” he says. “They were very comfortable with complexity.”

‘Tearing Up’ Trades

When it comes to the disposition of a specific trade, Pasciucco and his colleagues have three courses of action. The firm can decide to let the trade expire according to its normal terms, an option Pasciucco has often taken for short-dated positions. Or AIG can “tear up” the trade, which means negotiating a price to get out of the deal with the counterparty.

The company can also “novate” the trade -- from the Latin novare, to make new. That means it finds another party to take over AIG’s side of a trade. If AIGFP has swaps with Morgan Stanley, Pasciucco says, it will show them to a firm eager to own an offsetting position with Morgan Stanley. “Then we talk to Morgan about a tear-up,” he says.

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 its side of trades. “That gets us much better pricing,” Pasciucco says.

As of mid-June, AIGFP had disposed of 5 of its 22 “books of business,” including the Spanish power plants and several bundles of derivatives.

UBS Deal

In May, it completed the sale of its commodity index business to Zurich-based bank UBS AG for $15 million. The unit maintains indexes that track prices on everything from lean hogs to zinc. AIG started it in 1999 with Dow Jones & Co.

AIGFP’s deal with UBS includes a so-called earn-out, giving the insurer the right to as much as $135 million during the 18 months after the sale closed in May, based on the profits the unit generates for UBS.

One of Pasciucco’s priorities when he took over was to get out of a $7 billion derivatives business called power reverse duals, or PRDs. These were essentially bets against the consensus view on the yen’s strength versus the U.S. dollar. The derivatives are extremely long dated, expiring 30 years or more in the future. The PRDs were costing tens of millions of dollars a year to hedge, which is done by constantly adjusting a variety of offsetting put options, call options and futures.

Managing the Hedge

“It was the biggest problem I saw when I arrived in terms of the cost of managing the hedge,” Pasciucco says.

Options are contracts that provide the right, but not the obligation, to buy or sell a security at a set price within a certain period.

Traders and risk managers worked eight weeks slicing the dollar-yen portfolio into different configurations and negotiating with European banks that were interested in the trades. They were sold or novated to three of those banks. Pasciucco declines to identify the banks or the prices paid.

Given the handicaps, Pasciucco is winning some praise for his efforts. “I think he’s wound down a surprisingly large amount,” says Eric Dinallo, New York state insurance superintendent. “The unwinds are very complicated. I think they hired a very, very competent guy.” Dinallo was scheduled to step down from his post this month.

Before moving to AIGFP, Pasciucco had spent his entire professional career at Morgan Stanley and had never sat on a trading desk.

Boston College High

A graduate of Jesuit-run Boston College High School, he got a degree in economics from Williamstown, Massachusetts-based Williams College in 1982.

He had an entrepreneurial streak. In 1979, when Pope John Paul II visited the United States, Pasciucco printed T-shirts with “Welcome” written in Polish and hawked them in downtown Boston.

After graduation, he did a two-year stretch as an entry- level analyst at Morgan Stanley in New York before returning to Massachusetts to pick up an MBA from Harvard Business School in 1986. Pasciucco was named a George F. Baker Scholar, finishing in the top 5 percent of his class.

Back at Morgan Stanley, he was soon turning heads as a capital markets banker, negotiating terms of bond and equity underwritings with retailers, entertainment companies and airlines.

Rapid Rise

Those skills helped Pasciucco rise rapidly. He was named a vice president of the capital markets division in 1991, a principal in 1993 and managing director in 1995. By 2004, Pasciucco was chairman of the capital commitment committee: His job was to make sure the terms agreed to reflected the risk when the firm’s capital was at stake.

“I admired his courage to stand up to people like me or John Mack or clients,” says Zoe Cruz, former co-president of Morgan Stanley, of which Mack is CEO. “He’d come back beet red from having been berated by clients, but he was no pushover.”

Pasciucco started his new job on Nov. 11, 2008, when he said goodbye to his wife at their Georgian-style home in Greenwich, Connecticut, and drove his black Porsche Cayenne along the winding Merritt Parkway for the 15-minute commute to Wilton, where AIGFP had moved its offices in 2002.

Sophisticated Contracts

AIGFP’s headquarters are on the second floor of a nondescript building in a redbrick office park. In May, no sign was posted identifying the firm as a tenant.

For nearly two decades AIGFP was a profit-generating juggernaut and the envy of Wall Street. The business was the brainchild of Howard Sosin, a Stanford University business Ph.D. who once headed the interest-rate arbitrage unit at New York- based Drexel Burnham Lambert Inc., professional home of junk bond king Michael Milken.

In 1986, Sosin and Drexel colleagues Randall Rackson and Barry Goldman hatched a plan to write sophisticated contracts that let big multinationals reduce their exposure to interest rate risks through swaps, which can be used to replace variable and volatile interest-rate streams with stable, fixed rates.

The key to the venture would be the backing of a financially strong company, one with a credit rating of AAA. That would give it a big competitive advantage in the markets and keep financing costs low.

Sosin, 58, approached AIG’s Greenberg and struck a deal. With the backing of AAA-rated AIG, Sosin and his colleagues soon rented offices on Madison Avenue in New York. At the beginning, FP was a joint venture between AIG and Sosin, with Sosin taking 38 percent of the profits generated, nearly double what hedge fund operators typically get.

Do No Harm

Greenberg agreed to the setup with a key condition: that Sosin and his crew do nothing to imperil AIG’s AAA credit rating, according to Sosin. They didn’t, taking care to minimize risk, according to Sosin and former colleagues. All trades were hedged. The average counterparty was rated AA. Any bond falling below BBB was immediately sold.

In addition to interest-rate swaps, the firm wrote currency swaps -- which let a buyer insure against volatility in the foreign exchange market -- and moved into equity derivatives, which are instruments tied to the price of an underlying stock or index. AIGFP helped finance its operations by selling guaranteed investment contracts, or GICs, which provide municipalities a place to park cash in exchange for a guaranteed return.

Growing Tension

“We were a group of intelligent people who could solve other people’s problems,” Sosin says.

Sosin was a “visionary,” says Marc Holtz, a former head of AIGFP’s new product group who’s now in charge of risk management at Structured Portfolio Management LLC in Stamford, Connecticut. “Howard was fair, brilliant and demanding,” Holtz says. “It was an exciting institution.”

By 1990, tension was growing with Greenberg, Sosin says. Though his business was highly profitable, Sosin says he couldn’t get face time with Greenberg to discuss expansion and other matters.

In late 1992, AIGFP stumbled, losing what Sosin says was about $50 million on some Canadian bonds. Greenberg was furious, Sosin says, and demanded that he agree to fundamental changes in the terms of the joint venture. Sosin refused, and terminated the joint venture. AIG’s board fired both Sosin and Rackson.

Soaring Earnings

Sosin’s final payment was settled in arbitration, in which he was awarded $125 million and proceeds from some notes, according to a court document.

AIG then took control of AIGFP and eventually put Tom Savage, a former Drexel analyst and math Ph.D., in charge. AIGFP’s share of the profits was cut to 30 percent.

Under Savage, AIGFP earnings soared, rising from $150 million in 1993, when Savage took over, to $323 million in 1998 and then to $758 million in 2001, according to AIG filings.

Working with Savage was chief financial officer Joseph Cassano. As part of his duties, Cassano, part of the original Drexel team, ran the firm’s back office, the operational part of the business that settles trades and deals with accounting matters. According to former AIGFP employees, he also oversaw credit risk matters.

Cassano had attended Brooklyn College, according to an AIG biography, not Wharton or Harvard. He’s the son of a New York police officer. While several former AIGFP employees describe Cassano as an exceptional back office manager, they say he did not have the quantitative background of Savage or Sosin.

European Banks

In 1998, Savage and Cassano oversaw AIGFP’s first foray into CDSs. The swaps it sold are sometimes referred to as regulatory capital trades because they’re designed to reduce a bank’s obligation to hold capital against its loans, according to AIG’s 2008 annual report. By buying credit insurance on those loans, banks could reduce their capital requirements, the report says.

The first AIGFP CDSs were sold to European banks through AIG’s Banque AIG subsidiary in Paris. Greenberg deemed them sufficiently safe that he considered it unnecessary to hedge them, according to his congressional testimony. By Sept. 30, 2008, AIG had $250 billion in net notional CDS exposure to such loans, and has had no material losses on them, Pasciucco says.

In 2001, Savage retired and Greenberg tapped Cassano as his replacement. By 2003, according to his AIG bio, Cassano was running the AIGFP operation from Paris. He later moved to the AIG London office, though AIGFP’s base remained in Connecticut.

Key facts concerning when and how rapidly Cassano expanded the derivatives exposure are in dispute. Greenberg told the Washington Post that AIGFP wrote only $7 billion worth of swaps on CDOs before he was ousted.

Subprime Crisis

“There is no question that management took their eye off the ball and that risk management was not getting the right instructions, and that’s what led to the downfall,” Greenberg told Congress.

AIG spokesman Mark Herr says that AIG’s potential CDO exposure rose to $40 billion under Greenberg.

Several qualities of AIG’s swaps on CDOs made them perilous deals, according to current and former AIGFP employees. First, they were mostly unhedged, and by the time the subprime crisis began to gather steam in 2007, it would have been prohibitively expensive to hedge them, the employees say.

The swaps’ terms required AIG to post billions of dollars of collateral if its credit rating was cut. AIG was downgraded in 2005 and several times in 2008. AIG also agreed to post collateral if the market value of the CDOs it insured fell, even if there were no credit downgrades or defaults on the CDOs.

‘Laughingstocks’

Once highly rated insurers such as Ambac Financial Group Inc., which competed with AIGFP, seldom agreed to such terms in their swap agreements, according to a person familiar with the situation.

“The people at AIG were basically the laughingstocks of derivatives desks around the country,” Tavakoli says.

Ambac and its rivals were rocked last year by multiple credit downgrades that required them to post collateral on other derivatives and guaranteed investment contracts.

As late as August 2007, Cassano had failed to recognize the danger. “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing a dollar in any of those transactions,” he told AIG investors that month on a conference call.

$1 Million a Month

It was barely more than a year later that the government moved in to take over AIG. By that time, Cassano was gone. He resigned on March 31, 2008. At that point, AIGFP’s CDO swap exposure was $77.5 billion. CEO Sullivan retained Cassano as a $1-million-a-month consultant until June of that year. And Sullivan himself took home a pay package worth $29.2 million for the first six months of 2008, according to a company proxy. He left the firm in June of that year.

When Pasciucco arrived in November 2008 to take over AIGFP, he didn’t get a rousing welcome. “I had expected there to be a gathering, a speech,” he says. Instead, he was greeted by an AIG executive from New York and a human-resources person.

He made most of his introductions to the downcast staff by himself. “The place felt rudderless, leaderless,” he says.

Pasciucco found there was no regular schedule of meetings, no firmwide financial reporting standard and no support staff to generate reports. “It really was like a hedge fund where everybody was a frontline person,” he says.

He started up a financial management group, under Diane Cenci, to impose new procedures for keeping track of the various business lines’ profits and losses, and to track the winding down.

Pasciucco got a taste of his predecessor’s management style on his first visit to the London operation.

Carpet Conundrum

Upon Pasciucco’s arrival at the Mayfair office, an executive asked him to choose the pattern for some carpet that needed replacing.

“Why are you asking me?” Pasciucco says he responded. “Who normally makes these decisions?”

“Joe used to make them,” the executive said.

Cassano, Pasciucco learned, had made all the decisions. “He was in charge of replacing light bulbs and what was served for lunch, as well as how many CDOs on subprime we were going to do,” Pasciucco says. “And you know, that sounds a little bit like that other guy, Hank Greenberg.”

A lawyer for Cassano didn’t return repeated phone calls seeking comment.

Pasciucco set up an operating committee of 18 people to help make decisions previously made by Cassano alone.

‘Piano Wire’

The bonus uproar set back his work by weeks, Pasciucco says. Over a two-month period, AIG received hundreds of phone calls a day, as well as more than 6,000 e-mails, many of them threatening. One example: “Your top people have some surprises in store for them.” Another: “All the executives and their families should be executed with piano wire around their necks.”

The firestorm took a psychological toll on AIGFP employees. “I can’t describe to you how many senior people who had been through a lot broke down on the trading floor with 200 people watching,” Pasciucco says.

Says Jim Shepard, president of the AIGFP’s Banque AIG subsidiary in Paris: “Everyone felt like we were being personally vilified.”

Pasciucco maintains that the bonuses were justified. “We are a company of 44,000 contracts,” he says. “We honored these contracts too.” Pasciucco says the retention plan was instituted in early 2008, under previous AIG management, and covered the 12 months the AIGFP employees had already worked.

‘Go Take the Hill’

When he arrived, Pasciucco says, he didn’t encourage any AIGFP employees to leave, even if they had been involved in CDO swaps. “Their institutional knowledge was irreplaceable,” he says.

Moreover, some of the swaps on CDOs made money, and some of the people who wrote those swaps had campaigned to start shorting the subprime mortgage market as early as 2006, only to be overruled by Cassano, Pasciucco says.

Pasciucco keeps his staff motivated by delegating and then standing back. “We say, ‘Take this narrow group of trades for this line of business and focus on that,’” he says. “‘This is your mission. Go take the hill.’”

Still, Pasciucco is looking for ways to reduce the firm’s head count. One method is to persuade firms that take over AIG’s positions to also hire its staff. When UBS bought AIGFP’s commodity index business, it hired 14 AIGFP personnel to manage it.

Austrian Derivatives

Another group of traders worked for eight weeks to put together data on the risk-reward dynamics of a group of 50-year derivatives linked to the Austrian stock market. A nonbank financial institution expressed interest in taking over the trades, yet said it lacked the trading expertise to manage them. Pasciucco offered the buyer the expertise of several AIGFP employees to do the job.

“That solves a problem for me, too,” Pasciucco says. “I move a bunch of people off the payroll.”

Pasciucco expects to get out of the vast majority of AIGFP’s positions by year-end. If necessary, he may shepherd any remaining trades to the parent company. He plans to leave by the end of 2009, whatever happens, to go back to Wall Street, work at a hedge fund or write a book.

Meanwhile, the AIG fiasco has helped inspire a raft of new plans to regulate derivatives. Under pressure from the administration of U.S. President Barack Obama, derivatives dealers in March began moving the most actively traded contracts through a new clearinghouse operated by Atlanta-based Intercontinental Exchange Inc. Dealers also agreed to make public all derivative trades in the CDS market by July 17.

Obama Plan

On June 17, Obama and Treasury Secretary Timothy Geithner announced an overhaul of financial regulation, under which all derivatives will be overseen by Washington and all dealers will also be subject to government supervision.

Obama said in an interview with Bloomberg News on June 16 that “what is lacking right now is the resolution authority so that when a single institution like an AIG breaks down there is an ability to unwind that individual institution without bringing down the entire system.”

None of the regulatory changes are likely to save AIG from its inglorious legacy as a trigger for financial catastrophe and government bailouts. The system itself may never be the same, NYU’s Smith says.

“After AIG, people will be able to go back to Wall Street to make money,” he says. “But it will be a long time before they enjoy the respect and status they once had.”

To contact the reporters on this story: Richard Teitelbaum in New York at rteitelbaum1@bloomberg.net; Hugh Son in New York at hson1@bloomberg.net.

Last Updated: July 1, 2009 00:01 EDT