E-mails have become the Holy Grail for investigators and prosecutors working to unearth criminal culpability in questionable financial behavior, providing smoking gun evidence of possible wrongdoing.

The latest target in this line of inquiry is American International Group, as government investigators try to figure out whether key executives were simply inept when they allowed the company to nearly go bankrupt, or perpetrated criminal fraud by deceiving investors.

The longtime bane of the insurance industry, Eliot Spitzer (New York's former attorney general and governor), along with Frank Partnoy (professor of law at the University of San Diego) and William Black (a professor of economics at the University of Missouri-Kansas City) wrote an op-ed column in The New York Times on Dec. 20 demanding that investigators thoroughly examine the e-mail exchanges between executives before allowing AIG to pay off its loans and release itself from the government's leash.

They apparently fear that AIG, free of government supervision, could once again become a menace to the financial system if the secret to its near collapse remains unresolved, and those responsible for it remain unaccounted for and unrepentant about their failure.

The Washington Post, on Dec. 30, ran a piece on the e-mails between AIG's Joe Cassano, the head of its Financial Products division, and other executives within the company. The reporter gained access to some of the e-mails the Justice Department is examining, where assuredly officials are asking if Mr. Cassano and other AIG executives in the unit didn't just do something wrong, stupid or short-sighted, but perhaps something criminal.

There are undoubtedly more than a few investors in AIG who would like the government to get to the bottom of this, one way or the other. If criminal conduct is uncovered, they would certainly expect some justice to be done (possibly in the form of scarlet letters, such as "AIG," branded on the foreheads of the wrongdoers). Civil lawsuits would be sure to follow.

However, as the Post article pointed out, the key point prosecutors are trying to determine is whether what happened at AIG was criminal behavior or simple gross misjudgment.

The Post helpfully posted a link to a few of the internal e-mails between Mr. Cassano and other executives who were questioning the company's mortgage default swap exposure. Mr. Cassano at times seemed to be dismissive of those challenging his trading decisions, and he appeared to instruct his subordinates to send reassuring replies to concerned queries.

What the Post focused on was the qualms some AIG executives had about trading credit default swaps, and the unwavering confidence executives in the Financial Products division had in selling these instruments.

As it turned out, Mr. Cassano and others in Financial Products had it wrong. They not only managed to bring AIG to its knees but almost took the United States and the world financial system down with them.

There is a lot of carping about the bailout of the company, but considering the fragility of the financial system at the time, AIG was just too big to fail. Many experts are certain that its implosion would have undermined the rest of the economic system, and we would not be talking about a slow recovery today but breadlines.

However, what struck me while reading the e-mails, and not touched on by the Post, was why AIG's Financial Products executives appeared to be so certain their portfolio was immune to dramatic losses. Could it have been an unwavering faith in their financial models?

According to one e-mail, executives were confident that the company's ultimate exposure would be limited to a few million dollars, easily coverable by the behemoth organization.

However, reality soon set in, and somehow what started out as a manageable loss in a financial game of cards turned out to be a multibillion-dollar blunder.

Indeed, AIG executives–at face value, at least–held blind faith in the reliability of their financial models, even as the banks that purchased their credit default swaps were calling in their chips, which ultimately translated into well over $100 billion for federal taxpayers.

Ultimately, we can debate the merits of the government's action, which no doubt will remain particularly controversial through the November elections.

However, I still can't help but feel that as imperfect as the remedy has been, the alternative–allowing AIG to fail–would have led to a crisis of faith in the economy that would have had us staring down the bleak hole of a depression, instead of the slow emergence from a severe recession.

Cutting off AIG in that context would indeed have meant cutting off our nose to spite our face.

What I find most intriguing, however, about this whole sordid affair is the apparent blind faith in the models that failed.

The insurance industry has learned a thing or two about models, especially following Hurricane Katrina. Modelers say they have improved their products, allowing carriers to better estimate probable maximum loss and price accordingly.

In AIG's case, one can guess investigators are trying to figure out whether the models were flawed, bogus, or designed to dupe others into believing the credit default swaps were secure.

In the middle of a property and casualty soft market, there is a growing chorus of industry watchers saying the industry cannot stay on its current course.

A hard market has to be around the corner, it's said, because insurers are undervaluing risks, and too many have released reserves that could at some point affect their ability to pay claims in the event of a major loss–just like AIG's unanticipated exposure. (Credit default swaps were not insurance in the traditional sense, but try explaining that to a layman.)

Not knowing the outcome of the AIG investigation, there may be one lesson coming out of this whole debacle for the insurance industry. That lesson is not how p&c insurers withstood the financial crisis, but the fact they must be more skeptical about all their models, as well as thorough enough to ask the right questions, wherever the answers may lead.

Special Reports /

Questions Remain About What Went Wrong At AIG

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