The complex instruments at the heart of the financial meltdown, and the way two giant companies were wrapped around them and entwined with each other, are being examined by the special panel investigating the origins of the economic crisis.
The Financial Crisis Inquiry Commission is turning its focus to derivatives at two days of hearings starting Wednesday. On the hot seat will be former executives of American International Group Inc., the insurance conglomerate saved from collapse by a $182 billion taxpayer bailout, and current officials of Goldman Sachs Group Inc., the finance powerhouse that has been one of Wall Street's biggest derivatives dealers.
Traded in an opaque global market valued at around $600 trillion, derivatives have caught a big part of the blame for the financial crisis that ignited in late 2008. The value of derivatives hinges on an underlying investment or commodity — such as currency rates, oil futures or interest rates. The derivative is designed to reduce the risk of loss from the underlying asset.
After the subprime mortgage bubble burst in 2007, derivatives called credit default swaps, which insured against default of securities tied to the mortgages, collapsed. That brought the downfall of Lehman Brothers and pushed AIG to the brink. New York-based AIG got an initial $85 billion infusion from the government in September 2008.
Goldman Sachs profited from its bets against the housing market before the crisis, and continued to ring up huge profits after accepting federal bailout money and other government subsidies. The firm's dealings in another type of derivative, known as collateralized debt obligations, have brought it harsh scrutiny by a Senate panel and in the case of one $2 billion CDO, civil fraud charges from the Securities and Exchange Commission.
A CDO is a pool of securities, tied to mortgages or other types of debt, that Wall Street firms packaged and sold to investors at the height of the housing boom. Buyers of CDOs, mostly banks, pension funds and other big investors, made money off the investments if the underlying debt was paid off. But as U.S. homeowners started falling behind on their mortgages and defaulted in droves in 2007, CDO buyers lost billions.
In early June, the congressionally chartered crisis inquiry panel issued a subpoena for documents from Goldman Sachs, accusing the firm of stonewalling its investigation. Goldman said it had cooperated.
The panel is looking at the relationship between the two financial giants.
"They had very substantial dealings with each other," commission chairman Phil Angelides said in a conference call with reporters Tuesday.
Much of the federal rescue money for AIG went to meet the company's obligations to its Wall Street trading partners on credit default swaps. The biggest beneficiary of the AIG money was Goldman, which received $12.9 billion.
Among the executives expected to testify: two former CEOs of AIG, Joseph Cassano and Martin Sullivan; and Gary Cohn, Goldman's president and chief operating officer.
When AIG posted a loss for the fourth quarter of 2007, it pinned the blame on an $11 billion writedown related to the credit default swaps held by its Financial Products unit. If AIG couldn't make good on its promise to pay off the contracts, regulators feared the consequences would pose a threat to the whole U.S. financial system.
Cassano left AIG in 2008, shortly after the $11 billion loss was reported.
He was interviewed by the inquiry panel staff for five hours.
"He was at the center of this," Angelides said Tuesday.
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