The company's 2007 10-K filing (annual report), released on 2/28/08, is the key to unraveling the mystery:
During the fourth quarter of 2007, certain of AIGFP’s available for sale investments in super senior and AAA-rated bonds issued by multi-sector CDOs experienced severe declines in their fair value. As a result, AIGFP recorded an other-than-temporary impairment charge in other income of $643 million. Notwithstanding AIG’s intent and ability to hold such securities until they recover in value, and despite structures which indicate that a substantial amount of the securities should continue to perform in accordance with their original terms, AIG concluded that it could not reasonably assert that the recovery period would be temporary.[...]Emphasis added. In conjunction with the disclosure of the terms of the "bonus" contracts (I'll explain in a moment why I'm using the scare quotes), we can piece together a pretty good idea about what happened.
The change in fair value of AIGFP’s credit default swaps that reference CDOs and the decline in fair value of its investments in CDOs were caused by the significant widening in spreads in the fourth quarter on asset-backed securities, principally those related to U.S. residential mortgages, the severe liquidity crisis affecting the structured finance markets and the effects of rating agency downgrades on those securities. AIG continues to believe that these unrealized market valuation losses are not indicative of the losses AIGFP may realize over time on this portfolio. Based upon its most current analyses, AIG believes that any credit impairment losses realized over time by AIGFP will not be material to AIG’s consolidated financial condition, although it is possible that such realized losses could be material to AIG’s consolidated results of operations for an individual reporting period.[...]
The most significant component of Capital Markets operating expenses is compensation, which was approximately $423 million, $544 million and $481 million in 2007, 2006 and 2005, respectively. [...] In light of the unrealized market valuation loss related to the AIGFP super senior credit default swap portfolio, to retain and motivate the affected AIGFP employees, a special incentive plan relating to 2007 was established. Under this plan, certain AIGFP employees were granted cash awards vesting over two years and payable in 2013. The expense related to these awards will be recognized ratably over the vesting period, beginning in 2008.
The employees in AIG's Financial Products division (AIGFP) were compensated heavily -- perhaps almost exclusively -- via incentive-based compensation. That is, the employees got a profit share -- a rather generous 30 percent share -- of the earnings their division made by trading credit default options (CDOs) and related assets.
In the fourth quarter of 2007, the market for CDOs went completely to hell, an early casualty of the mortgage crisis. AIG, to that point, had already accumulated about $643 million in bad assets on its books. (Note AIG's use of the euphemism "other-than-temporary" to describe the writing off of these assets; that's a bit like calling Louie Anderson "other-than-skinny"). AIG must have anticipated that it was going to spend most of 2008, and perhaps most of 2009, merely climbing out of its hole rather than turning any sort of profit.
This must have posed something of a problem for the employees in the Financial Products division, since their compensation relied on these trades being profitable. So AIG struck a deal with these employees. It guaranteed them, for 2008 and 2009, the same level of incentive-based compensation that they received in 2007 (except for senior executives, who took a 25 percent haircut), regardless of how the division actually performed. The only requirements were that the employees couldn't quit and couldn't be fired for cause (a much stricter standard than the usual conditions of at-will employment.)
This turned out to be an other-than-good deal for AIG. But at the time, AIG must have believed that its hand was forced. At that point in early 2008, the market for the sorts of assets that AIGFP dealt in had crashed, but the broader asset markets hadn't yet. Many of these employees were highly skilled, and could plausibly find employment at another company that traded in other, relatively healthier types of commodities. But AIG evidently felt it needed them in order to minimize its losses and unwind its positions.
The thing about these "bonuses", however is that they're not really bonuses, which we usually think of as incentive-based compensation. On the contrary, they are something the opposite of bonuses: they took compensation that had been incentive-based and guaranteed it. It's precisely because that compensation was guaranteed -- not incentive-based -- that it is difficult to undo.
The fundamental issue here what I call asymmetrical agency bias. We as human beings tend to attribute our results to skill when we are performing well, but (bad) luck when we are performing poorly. Thus, AIG was willing to pay its Financial Products employees plenty when their trades were going well (assigning them agency for their profits), but was willing to make plenty of excuses for them ("the severe liquidity crisis", "the effects of rating agency downgrades") once things began to unravel. The employees, likewise, may have felt entitled to some large fraction of the incomes that they had "earned" before, and probably didn't regard themselves as culpable for the losses their trades had begun to take.
As someone who is alert to asymmetrical agency bias -- it is an extremely common phenomenon in both poker and baseball, two fields with which I am intimately acquainted -- I tend to be unusually sympathetic to the position that the individual traders at AIG were not especially responsible for the fact that their deals had begun to lose money. Even the most skilled and honest trader probably could not have done better than to limit his losses once the CDO market began to collapse in 2007. By the same token, however, I tend to be unusually unsympathetic in my assessment of how much alpha these traders were responsible for on the upside; any idiot could have made money trading credit default swaps in 2005 or 2006.
For this reason, I'm just not all that excited about confiscating the "bonuses" paid to the AIGFP employees. Rather, I'm interested in compensation and incentivization structures in general. Aggregate compensation throughout the financial services industry, I would guess, is much higher than is economically optimal (there is a lot of evidence that this is true of CEO pay). A lot of people are getting paid for what is thought to be skill but is really just luck (or economic rent).
If, as at most hedge funds, the employees are buying in with their own capital and bearing a lot of the downside risk, that is one thing. At a publicly-traded company, however, those employees are taking profits out of the shareholders' hands. And at a publicly-traded company that happens to be owned by the taxpayers, they're taking money out of the taxpayers' hands.
The compensation paid to AIG's employees, however, is less a moral failure than a market failure. We don't like to admit to market failures because they indict our collective judgment; instead we scapegoat and move on. But there are some ways to address these market failures; the more time we spend focusing on those, and the less on AIG, the more money we the taxpayers will save ourselves in the end.