Innovators led AIG unit’s striking rise
Howard Sosin and Randy Rackson conceived their financial revolution during lunchtime walks along the Manhattan waterfront. They refined their ideas at late-night dinners after their busy days as traders at the junk-bond firm Drexel Burnham Lambert.
Sosin, a reserved 35-year-old finance scholar, projected an aura of brilliance and fierce determination. Rackson, a soft-spoken 30-year-old computer wizard, arrived on Wall Street with a Wharton School pedigree and a desire to create something memorable.
They combined forces with Barry Goldman, a Drexel colleague with a doctorate in economics and a genius for constructing complex financial transactions. “Imagine what we could do,” Sosin would tell Rackson and Goldman as they brainstormed in the spring of 1986.
The three men had earned plenty of money through short-term deals known as interest-rate swaps, clever transactions designed to protect banks, corporations and other clients from swings in interest rates that threw uncertainty into the cost of borrowing money.
They believed their revolution could never happen if they stayed at Drexel. Swaps in those days typically lasted no longer than two or three years. The trio envisioned deals lasting decades that would lock in profits and manage risks with unprecedented precision. But the junk-bond firm’s inferior credit rating sharply raised its borrowing costs, making it a dubious and risky partner for such long-term deals.
Sosin and his team needed the backing of a company with deep pockets, a burnished reputation and a AAA credit rating. One name topped their wish list: American International Group Inc., or AIG, the global insurance conglomerate considered one of the world’s safest investment bets.
They would find a partner for their venture. They would create an elegant and powerful system that earned billions of dollars, operating in the seams and gaps of the market and federal regulation. They would alter the way Wall Street did business, and eventually they would test Washington’s growing belief that capitalism could safely thrive with little oversight.
Then, they would watch in disbelief as their creation -- by then in the hands of others -- led to the most costly rescue of a private company in U.S. history, triggering a federal investigation and making AIG synonymous not with safety and security but with risk and ruin.
Over the last two decades, their enterprise, AIG Financial Products, evolved into an indispensable aid to investment banks such as Goldman, Sachs & Co. and Merrill Lynch & Co., as well as governments, municipalities and corporations worldwide. The firm developed new methods for clients to free up cash, get rid of debt and guard against rising interest rates or currency fluctuations.
Financial Products unleashed techniques that others rushed to emulate, creating vast, interlocking deals that bound together financial institutions in ways that no one fully understood. In the panic of mid-September’s crash, the Bush administration said that AIG had grown too intertwined with the global economy to fail and made the extraordinary decision to take over the reeling giant. The bailout stands at $152 billion and counting.
Many of the most compelling aspects of the economic cataclysm can be seen through the story of AIG and its Financial Products unit: the failure of credit-rating firms, the absence of meaningful regulation, the mistaken belief that private contracts did not pose systemic risk, the veneration of computer models and quantitative analysis.
At the end, though, the story of Financial Products is a parable about people who thought they could outwit competitors and market forces, and who behaved as though they were uniquely positioned to sidestep the disasters that had destroyed so many before them.
‘We are the tide’
Sosin, Rackson and Goldman could hardly contain themselves as they labored over a business plan at Sosin’s kitchen table in late 1986. Their timing was exquisite. The staid Wall Street of their fathers’ generation was gone, replaced by an anything-goes culture that applauded the kind of path they were charting.
Their plan fit perfectly with another revolution in Washington. Ronald Reagan’s unwavering belief in free markets had spread through the government. “The United States believes the greatest contribution we can make to world prosperity is the continued advocacy of the magic of the marketplace,” Reagan told a United Nations audience that fall.
As eager as the three dreamers were, they had to confront certain realities. They had no backing, no inside track to the top levels of the corporate world that controlled the money they needed.
They had passed AIG headquarters, a few blocks from Drexel’s offices, many times. Now, they wanted an entree to the 18th floor, where legendary 61-year-old Chairman and Chief Executive Maurice “Hank” Greenberg presided over the nation’s largest insurance company, which had operations in scores of countries. Greenberg was proud and protective of his company’s AAA credit rating, which would be a pivotal factor in Financial Products’ success.
When Greenberg took the reins in 1968, AIG was privately held and hardly known outside actuarial circles. Greenberg had a badger’s temper, a gift for growth and a restless mind. He transformed AIG into a global titan and now wanted to do more.
Few people thought of AIG as a financial innovator. Greenberg had kept his stockholders happy by striving for an annual 15% increase in profit. He instructed his deputy, Vice Chairman Edward Matthews, to explore how AIG could get more involved in Wall Street’s realm.
“This is never going to get any better than it is today,” Greenberg told Matthews. “We’re so big, we’re never going to swim against the tide. We are the tide.”
Creating the system
Sosin made his pitch to Greenberg at a meeting arranged by law firm Kaye Scholer in Manhattan.
Sosin came to the table with conditions. He wanted the kind of autonomy Greenberg rarely granted. Greenberg wanted assurances that Sosin’s venture would do nothing to harm the gold-plated rating he had spent two decades building.
Greenberg had little extra time for the nuts-and-bolts details that Sosin sought to negotiate. “I don’t really know much about this,” he told Matthews. “You go talk to these people.”
AIG and Sosin signed their joint venture agreement on Jan. 27, 1987. Sosin, Rackson and Goldman took 10 of their Drexel colleagues along and made it worth their while. At Financial Products, they would keep a handsome 38% of the profit, with Greenberg and AIG getting 62%. (Greenberg remembers AIG’s share as 65%.)
Sosin and Rackson hoped everyone would get rich, but they had their sights set on something more. They wanted to tear down walls they saw as impediments to innovation, the “fiefdoms” that were standard practice at other Wall Street firms. Their vision required a collaborative culture and a computer system that no one else had. For six months, the group worked on constructing “the position analysis and storage system,” or PASS.
It enabled Financial Products to bring a rare discipline to complex trades. By maintaining market, accounting and transaction details in one place, Sosin and his people could track the constantly changing value of a trade’s components.
Their integrated system could price and value a variety of asset classes -- bonds, equities, loans and all their derivatives -- finding opportunities that others couldn’t, squeezing out profits where no one had before and protecting themselves in the process.
They exploited the developing realm of derivatives, contracts to be settled in the future but based on something trading now. A futures contract is a common derivative: A farmer might agree to sell wheat next spring for a price set today. If the price goes up, the farmer misses out on greater profits; if it goes down, he is protected against loss.
Financial Products created more-lucrative and longer-term derivative deals tied to all sorts of underlying assets. Behind each transaction was the cushion of AIG’s AAA rating.
Precision was the key to managing the risk of these derivatives. Using another computer program to monitor minute fluctuations in various rates, Financial Products could place offsetting trades on all sides of a transaction, so it almost didn’t matter what the markets did. The firm couldn’t lose, as long as it stuck to its commitment to hedge its bets.
Sosin and his colleagues worked to create a finely balanced system that married technology, intelligence, verve and cultural discipline.
“We were all kind of artists,” Rackson said recently. “The excitement of it wasn’t the money. The money was the score card. The drive behind it was creating something new.”
An auspicious start
In July 1987, Sosin phoned Ed Matthews. Financial Products was about to close its first significant deal, a $1-billion interest-rate swap with the Italian government, 10 times larger than the typical Wall Street swap deal in those days.
The contract involved an exchange of floating and fixed rates that gave Italy advantages in how it paid bondholders. Financial Products engaged in a separate set of transactions to offset the risk it was taking on. As Sosin explained to Matthews, the firm made money on the spread between the cost of the deal and the cost of its hedge.
This one swap, Sosin told him, would pay the firm more than $3 million -- as much as AIG’s two other small financial operations each earned in a year.
“I was stunned,” Matthews said.
Financial Products brought in $60 million in the first six months alone, as Sosin recalls.
As competitors hustled to keep pace, Sosin pressed to find niches where others weren’t playing. The firm moved into more-exotic deals, involving stocks, currency and municipal bonds.
By 1990, Financial Products had added offices in London and Tokyo.
As in the Italian deal, the transactions were hedged and, if necessary, hedged again. The hedges involved precisely calibrated transactions, including the purchase of Treasury bonds or other swaps, that brought a cash flow in almost direct proportion to the money going out.
But with success came tension. Greenberg’s love of his joint venture’s revenue could not overcome his desire for greater control. He worried he had given Sosin too much freedom.
One detail in particular nagged at Greenberg. Under the joint-venture agreement, Financial Products received its profits upfront, even if the transactions took 30 years to play out. AIG would be on the hook if something went wrong down the road.
Greenberg’s unease grew into distrust. Greenberg was a wink-and-handshake guy, while Sosin relied on the written agreement as his bible. If Greenberg asked for something that wasn’t stipulated, Sosin wouldn’t comply.
“We ran our company very openly,” Greenberg said. “Our word was our bond.”
Sosin said the agreement gave both sides a clear understanding of the arrangement.
Early in 1990, Greenberg summoned Sosin to his office. Drexel had just imploded amid allegations of fraud and insider trading, and Greenberg had recruited several executives to start an AIG unit specializing in currency trading.
Sosin, who interpreted the joint agreement as giving his firm exclusive rights to that business, objected.
“Howard, that isn’t wise,” Greenberg responded.
Days later, on March 13, 1990, Greenberg and Matthews sent Sosin a letter announcing their intention to terminate the agreement.
Under the agreement, Sosin could take a duplicate of his computer system and his team with him. He began looking for backing from another AAA company. Greenberg heard about Sosin’s efforts and had second thoughts. After a series of meetings, they patched it back together in May 1990, reasoning that there was too much money still to be made.
But the peace wouldn’t last.
Parting company
In late 1992, Greenberg again summoned Sosin to AIG headquarters. He was livid over two recent Financial Products deals with entities controlled by Edper Group.
The first involved the purchase of bonds, which amounted to a loan to one of the Edper entities. The firm occasionally ventured into such credit deals as part of larger transactions, but only with highly rated companies and with provisions that allowed it to get out if the bonds started to default. “We want to be the first rat to leave the sinking ship,” Sosin told his troops, reflecting his unease with credit deals, which their system couldn’t tame.
When this ship sank, Financial Products sold out as quickly as it could, but lost $100 million.
The second deal, involving a swap with extra layers of complexity, was going fine. But the $100-million loss in the first deal and the intricate machinations in the other had spooked Greenberg.
Greenberg demanded that Sosin stop doing some of the deals that had made Financial Products a Wall Street darling.
Greenberg handed Sosin a document that would change the terms of their venture. Greenberg was daring Sosin to flinch. Sosin walked out.
He visited his lawyer.
“I said, ‘What can I do?’ And he said, ‘Cave or terminate.’ ”
Sosin notified Greenberg that he wanted out.
Greenberg knew that Sosin’s departure could cost AIG millions. But that wasn’t his main concern. He didn’t have a thorough understanding of how Sosin’s system worked, and he wasn’t going to let him get away without finding out.
In March 1993, as the two sides launched a bitter arbitration battle, Greenberg formed what would be known as a shadow group. The group built a parallel computer system to track the firm’s trades. Greenberg also held surreptitious conversations with some of Sosin’s colleagues, recruiting them to stay.
Sosin believes that Greenberg and Matthews were envious of the profit he and his colleagues kept for themselves. “It was peculiar to have something go so well and for him to have such suspicion,” Sosin said.
Finally, in August 1993, the AIG board of directors installed a new leadership team at Financial Products and Sosin and Rackson took some colleagues with them to start another firm.
And so Greenberg and AIG gained control of Financial Products and the beautiful machine. In the coming years, the firm would accelerate its profit-making ability, while forging into ever riskier territory.
Change of terms
In spring 1994, Tom Savage stood before a room of anxious colleagues at the Four Seasons resort in Dallas, eager to reassure them that Greenberg was not going to pull the plug on their money-making machine.
Savage, a 44-year-old Midwestern math whiz, had just been named the new president of Financial Products. With the honor came explicit expectations, which Greenberg made clear: “You guys up at FP ever do anything to my triple-A rating, and I’m coming after you with a pitchfork.”
On the surface, nothing much had changed since Sosin had left the previous summer.
In just seven years, Financial Products had grown into a 125-person operation with annual profit above $100 million.
Like his predecessors, Savage knew the enterprise could not thrive without AIG’s AAA rating.
“AIG has given us the license to work,” Savage told his colleagues that day. “We have to honor the trust they have given us.”
The catch? Financial Products would have to take more direction from Greenberg.
With a doctorate from Claremont Graduate University, Savage remained committed to running Financial Products under the same rigorous, risk-reducing code that Sosin’s group had cultivated. But not everything stayed the same. Under a new operating agreement imposed by Greenberg, AIG owned Financial Products as a subsidiary, and the parent company received 70% of the profit, up from the 62%.
Greenberg also wanted to change the way Financial Products divided its share of the profit. Savage agreed that Financial Products employees, who previously took their profit upfront, should defer half of their compensation for several years, depending on the length of the deals being done -- an arrangement that would still yield hefty paychecks as the firm’s profit soared in the coming years.
More experiments
In time, Financial Products found its profit margins shrinking on some transactions as competitors succeeded in duplicating its services. Savage urged his talented team to devise ever-more-complicated transactions, often in untapped areas.
The firm pushed further into structured investments, hedge fund deals and guaranteed investment contracts, or GICs. The GIC deals involved loans from municipalities that had temporary surpluses of cash. Financial Products reckoned it could borrow that cash, pay state and local governments more than they could make otherwise and then use the money for lucrative deals for itself, somewhat like a bank.
The firm also began applying its complex formulas to the movement of single stocks, allowing clients, such as Microsoft Corp., to better manage their stock prices. Financial Products more than doubled its profit in three years to $323 million in 1998 from $140 million in 1995.
A new unit, the Transaction Development Group, did its part by taking advantage of gaps between securities regulation and tax laws in the United States and other countries.
Financial Products associates noticed, for instance, that they could make money by exploiting differences between the U.S. and British definitions of stocks and bonds. A security that met the definition of stock in Britain could pay tax-free dividends to shareholders. The same security in the U.S. was regarded as a bond that provided tax-deductible payments. A Financial Products client would get both tax breaks.
Even as Financial Products experimented, Savage said, he continued to stress the need to minimize risk. “That was one of the things that really marked this company, was the rigor with which it looked at the business of trading,” he said.
Though the emphasis on caution was the same, the firm’s drive toward novel and ever-more-lucrative deals led down the path of greater risk. The beautiful machine was about to crack.
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Post writer Bob Woodward contributed to this report.
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BEGIN TEXT OF INFOBOX
About this series
This is the first of a three-part series on how American International Group became a fulcrum in the global economic crisis. AIG’s impending collapse in September triggered the most costly bailout of a private company in U.S. history.
The series by the Washington Post recounts the 21-year history of AIG Financial Products, a powerful current in the larger flow of events that led to the crisis. Today’s story deals with events from 1987 to 1998.
The stories are based on internal records, public documents such as Securities and Exchange Commission filings, transcriptions of investor calls and conferences, and interviews with current and former employees of AIG and its Financial Products unit, as well as government officials.
Descriptions of specific events come from the recollections of participants or transcripts. In some instances, Financial Products and AIG employees provided information or guidance but did not want to be quoted by name.
