Yesterday a sensational article shot around the Web declaring that "AIG was a Ponzi Scheme plain and simple". The article, written by one Chris Whalen at his The Institutional Risk Analyst blog, asserted that the impression that AIG was a real company brought down by excessive risk-taking was false and that, "what the fraud Bernard Madoff is to individual investors, AIG is to the global financial community."This characterization was music to the ears of those who can't see any difference between Bernard Madoff and any financial company, of course, explaining why the piece was taken up by countless blogs that cater to that audience. However, the source and the competent, thorough tone of this nearly 4,000 word article resulted in its being taken seriously by more sober readers, several of whom contacted me about it. So what is one to make of its extravagant charges?

To elaborate on those charges, the article paints a picture of a company that habitually used illegitimate structured financial transactions to cook its books and enable other companies to do so. These transactions appeared to take liabilities off the books by transferring risk through reinsurance, but neither party had any intention of such a transfer ever occurring. That understanding was cemented by "side letters"-shadow contracts, essentially-Whalen says, which were passed between the companies essentially overruling the original agreements. Regulators eventually caught wind of these schemes and AIG then shifted the practice to the unregulated world of credit default swaps. The article cites actual cases involving AIG, GenRe and others, and links to an allegedly genuine side letter from a notorious case.

While I have no interest in defending the risk management practices of AIG, I find that the article raises several red flags. For example, the article cites many verifiable facts and known cases, but the argument tying what's known to what is speculative turns out to be very tenuous. Much has been written about AIG's alleged results-rigging and its finite reinsurance transactions, but simply going over this territory doesn't establish that AIG had done more than indulge in questionable risk management practices. There is nothing new in that charge; what is new is that AIG's management knew it was perpetrating an actual Ponzi scheme.

Too much of the article's long-winded arguments ultimately depend on the highly speculative existence of side letters. Just because such things may exist, and have been alleged in a certain case from which the author produces an example, does not establish that such agreements existed for the relevant agreements covered by Whelan's piece.

Furthermore, the very notion of a side letter is problematic: how could a shadow contract be expected to a) have any legal force or b) really do any good except to confirm the parties' fraudulent intentions? If either party would benefit from the original contract, why would they not insist in it being honored? Finally, what in fact has actually happened in the case of AIG's credit default swaps? Did any side letters appear? If not, one has to ask what point they could possibly have.

Houston-based attorney Tom Kirkendall, with whom I exchanged a couple of e-mails yesterday, was extremely skeptical of the article's claims. "Having been involved in criminal prosecutions of structured finance transactions in which undisclosed 'side deals' were purportedly involved, I can tell you with a high degree of certainty that any such 'side deals,' if they exist at all, are unenforceable as a matter of law and, in probably the vast majority of cases, are simply oral assurances that 'things won't go wrong' that business people have been giving to their contractual counterparts for centuries." The real problem with this type of article is that it casts legitimate structured finance transactions in with Madoff-type Ponzi schemes, which is a highly dubious proposition, Kirkendall insists. "Structured finance is not intuitive and is not well-understood outside the people who specialize in such transactions," he says. "However, structured finance has been around in market economies for centuries and provides an important market function in facilitating hedging of risk. Demonizing such transactions on the grounds that widespread, alleged 'side deals' eviscerate their purpose is a highly dubious undertaking in my book."

I would add to Kirkendall's remarks that what is lost in the article is that AIG was indeed brought down by bad risk. That risk was attached to instruments that brought down many other companies, and it was marked as safe by the rating agencies. In other words, these risks were not what they appeared to be. Thus, it is much more plausible that AIG believed that they would not be exposed. That belief may not reflect the most prudent risk management, but nor does it suggest a genuine Ponzi scheme.

Also, with regard to the questionable nature of at least some structured financial transactions, it is important to emphasize-given the author's slippery generalization from a legitimate side letter to speculative ones-that even if some transactions are genuinely deceptive, that may or may not be fraud, but it does not equate to knowingly running a Ponzi Scheme.

It is always dangerous to underestimate human depravity, but far more harm is done by folly than evil. Is it plausible that AIG, a company in business since 1919 would suddenly turn into a Ponzi Scheme? Did Hank Greenberg get caught up in a vicious cycle requiring disastrous falsification of the company's balance sheet? Tom Kirkendall finds Greenberg's own explanation simpler and much more compelling:

"Management installed by avaricious government regulators who didn't know what they were doing negatively [impacted] the management controls that otherwise would have been in place to control the risk that AIG was taking in the CDS market," Kirkendall writes. "That's not as sexy as the theory propounded in the IRA article, but it rings closer to the truth to me."This characterization, in an article by Chris Whalen of the Intitutional Risk Analyst blog, was music to the ears of those who can't see any difference between Bernard Madoff and any financial company, of course, explaining why the piece was taken up by countless blogs that cater to that audience. However, the source and the competent, thorough tone of this nearly 4,000 word article resulted in its being taken seriously by more sober readers, several of whom contacted me about it. So what is one to make of its extravagant charges?