SFO goes after AIG

Various press reports this afternoon along the following lines:

The Serious Fraud Office has launched a preliminary inquiry into the UK operations of US insurance giant American International Group's finance arm. The inquiry relates to overseas finance deals made by AIG Financial Products Corporation. The SFO is working with US authorities who are already conducting separate, independent investigations involving conduct at the firm.
SFO director Richard Alderman said: "It is right for us to look into the UK operations of AIG Financial Products Corporation to determine if there has been criminal conduct. "We will use our full range of powers to seek information and to speak to those with an inside knowledge of the company's operations." The SFO said both AIG and the subsidiary in question are cooperating with its inquiries.
City watchdog the Financial Services Authority is also involved in the investigation.

OK stop right there! The SFO should be looking at the FSA's failure to regulate AIG. AIG was writing credit default swaps in a UK subsidiary that was neither regulated as an insurance company nor as a financial trader. Size of the book? Several hundred billion. The SFO should pin this one on AIG, the FSA, the Bank of England and PwC (auditors). Since AIG’s collapse in September 2008, insurance regulators in various jurisdictions have played pass the parcel, all trying to distance themselves from the firm’s London business.

Adair Turner, the FSA’s chairman, has declined to answer questions about AIG’s London operation, AIG Financial Products (AIG FP), because he says it falls outside the FSA's jurisdiction. The FSA considers AIG FP to be an “internal treasury operation” and, like the internal treasury operations of other companies, is not regulated. The FSA does have regulatory oversight responsibility for a number of AIG units in London, including a company called AIG FP Capital Management registered at 1 Curzon Street.

There is no doubt that the US authorities consider London to be the cause of the AIG disaster. It was staffed by executives from Drexel Burnham Lambert. Remember them? Drexel’s junk bond king, Michael Milken, was investigated for insider trading in the 1980s and pleaded guilty to six charges. By the end of 2007 AIG had $562bn of CDS contracts on its books, and in their October 7, 2008 testimony before the House Oversight Committee company executives acknowledged that this business was based at 1 Curzon Street. In contrast to market practice, however, AIG FP did not hedge its exposure to a possible fall in the CDS market. In a footnote to AIG’s 2007 accounts, the company declared: “In most cases AIG FP does not hedge its exposures to credit default swaps it has written.”

In November 2007, when PwC asked the insurer to change the way it valued CDS’s, the world suddenly saw how little capital AIG FP used to build a mountain of business. The mortgage deals it was supporting with its CDS's looked shaky. The market took fright. AIG was downgraded from AAA to AA, and AIG's counterparties on the CDS's made cash calls (as they were entitled to do). AIG ran short of cash and the rest (including AIG's independence) was history.

How long did PwC fail to correct AIG's accounting?

Why did the FSA treat AIG FP as an internal treasury unit when it was clearly booking the unhedged risk on third party trades, and why didn't PwC point out this anomalous behaviour to the FSA?

How long will it be before the FSA turn round and say, "If only we had known about this"?