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Innovators led AIG unit's striking rise

A complex, disciplined system minimized risk and maximized profit, but it wouldn't last.

December 30, 2008|Robert O'Harrow Jr. and Brady Dennis | O'Harrow and Dennis write for the Washington Post.

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.

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