All The Devils Are Here: Unmasking the Men Who Bankrupted the World (16 page)

Starting a derivatives business at AIG was one of the very few moneymaking ideas that had not sprung, fully formed, from Hank Greenberg’s fertile mind.
This also explains why he didn’t control it at the start. Although, as an insurance company, AIG was in the risk business, it did not necessarily follow that insurance companies were diving into derivatives. Insurance companies were generally conservative institutions; if they used derivatives at all, it was as a customer of a big bank like J.P. Morgan, trying to hedge an interest rate or a currency risk. Under Greenberg, AIG had built a reputation for its willingness to take on unusual, one-of-a-kind risks: AIG wrote kidnapping insurance, it insured satellites, it even wrote insurance on the first ostrich farm in Texas. Greenberg used to boast that AIG’s balance sheet was so big that it could take on risks other companies couldn’t. But derivatives? Greenberg hadn’t really thought of it as a potential new line of business.

It was Sosin who brought the idea to Greenberg. Sosin was the prototypical modern Wall Streeter. A native of Salt Lake City, he had gotten a PhD from Stanford, taught finance at Columbia Business School, and put in a stint at Bell Laboratories before joining Drexel Burnham Lambert in the early 1980s. He was, in other words, a quant. Drexel in those days was best known for its most infamous executive, Michael Milken, the man who popularized junk bonds and built a huge business around them. Sosin wasn’t interested in junk bonds; instead, like any good quant, he gravitated toward complex derivatives, becoming one of the pioneers in developing ever more complicated forms of swaps.

The problem for Sosin was that, at Drexel, derivatives were never going to replace junk bonds as the firm’s bread and butter. Drexel also didn’t have a particularly good credit rating, which meant its borrowing costs were higher than its competitors’. This made it difficult to run a profitable derivatives desk. Sosin had big ideas about doing swap deals that no one had ever done before, with durations of fifteen or twenty or even thirty years, instead of the much shorter durations that were then the norm. He needed to find a different corporate parent to make that happen.

By the fall of 1986, Sosin and several Drexel colleagues were searching for a company that could back them. They were particularly interested in companies with lots of heft and capital, and a triple-A credit rating. Then, as now, there were fewer than a dozen companies with triple-A ratings. Warren Buffett’s conglomerate, Berkshire Hathaway, and General Electric both had triple-A ratings; so did AIG, a fact in which Greenberg took immense pride—and which he jealously guarded.

Sosin was introduced to Greenberg through former Connecticut senator Abraham Ribicoff. (Ribicoff and Greenberg were old friends.) Greenberg
was clearly enamored with Sosin, but because this was a realm outside his area of expertise, he took a backseat in the negotiations that ensued. Ed Matthews was his point man in dealing with Sosin.

What Sosin wanted was complete autonomy—and, of course, coming from Wall Street, a piece of whatever profits he generated for AIG. And that’s what he got: the contract he signed with AIG in January 1987 called for the formation of a joint venture, with AIG owning 80 percent and Sosin 20 percent. Sosin and his team got to command 38 percent of FP’s profits, which were designated “incentive compensation.” Sosin, in turn, would have “sole discretion” in distributing his share of the pie to his staff. In truth, part of the reason Greenberg was willing to cut such a sweet deal was that he didn’t really comprehend just how profitable FP was going to be. Besides, as someone who was there would later recall, “Hank liked getting married and never thought about getting divorced.”

Almost immediately, the new joint venture was taking on larger risks than most other swap dealers. Without question, the key to the business was the triple-A rating and the enormous balance sheet of the parent company, which not only gave FP cost advantages, but made it a very desirable counterparty. Nobody worried that AIG would have problems if it lost money in a derivatives trade. It was also extremely well run. Sosin kept close tabs on FP’s risk profile, which, in turn, allowed him to take larger risks—and generate larger profits. (FP built special computer systems that could track the ever-changing value of its swap deals far more closely than anybody else in the business, for instance.) Under Sosin, FP did indeed specialize in swaps that went out as far as thirty years, controlling the risks by using a technique called dynamic hedging, which involved constantly recalibrating—and rehedging—its positions. (“The hedging challenges are extraordinary at thirty years,” one competitor told the
Wall Street Journal
in 1993. “We haven’t done [them]….they’re too risky.”) But FP’s willingness to do long-dated deals also allowed it to charge higher fees than its competitors. In its first six months, FP generated $60 million. Greenberg was amazed.

There are other things people remember about the early years at FP. One was that as controlling as Sosin was, the environment he created was far more collaborative than other AIG businesses. Greenberg liked people to say, “How high?” when he said, “Jump.” Sosin wanted people who were willing to question deals, and he created a culture where people could express skepticism without fear of being reprimanded. Sosin also instilled in his troops a sense that they were an elite vanguard, battling bigger and more powerful
forces. To some degree, they were. Despite AIG’s strong balance sheet and triple-A rating, FP was much smaller than other players with big derivatives desks, lacking the built-in client base of a Goldman or a J.P. Morgan. So it had to be more creative. Marketers at FP would come up with some exotic new product, sell it to clients, and then ride it as hard as they could for two or three years. Eventually, though, the big boys at Goldman Sachs and J.P. Morgan would come out with their own version of the FP product, at which point the profit margins would be squeezed and FP would move on to something even more exotic. Sosin’s propensity for pushing the edge of the derivative envelope caused the
Wall Street Journal
to label him the “Dr. Strangelove of derivatives.”

The other thing that traders noticed was that Hank Greenberg was simply not part of their lives. Elsewhere in the company, Greenberg had no compunction about calling a midlevel manager in some division somewhere to find an answer to a question he had. That never happened at FP. The special computer system Sosin had built for FP was not shared with the rest of AIG; on the contrary, he had a clause in his contract stipulating that if he ever left the company, he could take the whole system with him. Any time Greenberg did anything that Sosin considered meddling, he would erupt. In 1990, for instance, Drexel imploded and Greenberg quickly snatched up a handful of Drexel traders, with the idea of having them create a new currency trading operation for AIG. When he told Sosin what he had done, Sosin replied that under the terms of their joint venture, only FP could engage in currency trading for AIG. He refused to allow it.

Greenberg responded by sending Sosin a letter informing him that AIG planned to terminate its joint venture agreement. Sosin reacted by undertaking a search for another triple-A company to back him, knowing that he had the contractual right to take his computer system with him. When Greenberg heard through the grapevine what Sosin was doing, he blinked. Within two months, he had patched things up with Sosin and brought him back into the fold—though he did get Sosin to lower the incentive compensation pool from 38 to 32 percent. “AIG Chairman Greenberg announced renewed agreement with Howard Sosin on AIG financial products,” read the headline of the press release announcing the deal, making it sound as if Sosin had simply re-upped. No one had any idea Sosin had almost walked out the door.

Why was Greenberg so worried about Sosin leaving AIG? Money, of course. In 1991—just four years after it had opened for business—FP generated $105 million in profits, according to
BusinessWeek
, and was the fastest-growing
part of AIG. (The article also claimed that Sosin was taking home between $3 million and $5 million, an amount that was almost certainly too low.) In a legal brief filed in 1995 by Randall Rackson, who served for many years as Sosin’s right-hand man before falling out with him, Rackson reported that FP’s cumulative profits between 1988 and 1992 were “in excess of” $1 billion.

To journalists and stock analysts, AIG had always been something of a black box. Quarter after quarter its earnings went in only one direction—up—no matter what calamities had taken place around the globe. Hurricanes, floods, earthquakes, big lawsuits—all the bad things that insurers wrote insurance against crushed their profits when the disasters finally struck. Except at AIG. People who followed AIG often chalked this up to the business genius of Hank Greenberg, who seemed to be able to will the company into the kind of double-digit earnings that investors craved. “I thought of him as a great CEO,” says one former analyst, “but I didn’t quite get how he did it.”

The author of that
BusinessWeek
article, though, put forth another explanation. AIG’s diversified units protected it from having to take the big earnings hits that other insurers regularly suffered. The magazine singled out AIG’s various financial services divisions, which it said were generating some 25 percent of AIG’s profits. “Although AIG, too, has been hit,” the magazine wrote, “suffering $150 million in property-damage claims from Typhoon Omar and Hurricanes Andrew and Iniki, it has been shielded by the cash its life insurance and finance arms continue to churn out.” As it turns out, this wasn’t the whole truth, either, though it would take another dozen or so years for people to figure that out.

It is nearly impossible for derivatives dealers to never lose money, no matter how careful they are or how well hedged. Under Sosin, FP had had a remarkable run, writing some $80 billion worth of long-dated contracts and then hedging them brilliantly as circumstances changed. But in 1993, Sosin made his one big mistake: he lost a lot of money on a swap contract.

By then, Sosin had become extraordinarily wealthy. Unlike Greenberg, who lived well but not extravagantly, Sosin used his new wealth to fund a lavish lifestyle. Among his residences was one in Fairfield, Connecticut, a five-story mansion that locals called “the castle.” According to a
Wall Street Journal
account at the time, “It boasts an elevator, indoor and outdoor swimming pools, a squash court and an elaborate security system, including metal
gates and a guard at the end of the driveway.” The FP offices in Connecticut and London were every bit as lavish—true to his control-freak self, Sosin had overseen every detail—which stood in marked contrast to AIG’s shabby headquarters near Wall Street.

Given how events transpired, it seems pretty clear that Greenberg had been waiting for Sosin to slip up. The fact that Greenberg had had to back down in 1990 was an intolerable situation. There was only one indispensable person at AIG, after all, and it wasn’t Howard Sosin.

Two years after Sosin had signed his new deal, FP lost $100 million in a complicated deal with Edper, the holding company of the Canadian billionaires Edward and Peter Bronfman. According to the
Washington Post
, FP had a second deal with Edper, which was not losing money but nonetheless “spooked” Greenberg. Greenberg had a document drawn up that gave AIG more control over the joint venture and “placed restrictions on transactions into which AIG-FP could enter,” according to the Rackson lawsuit. In February 1993, Sosin sent AIG his “notice of termination,” which he set for the end of the year. If he stayed through 1993, he would retain control of FP’s incentive compensation, which he estimated at $250 million.

This time, however, Greenberg was ready. He set in motion a secret plan, one that “verged on a covert operation,” the
Washington Post
would later write. Enlisting the company’s auditors at PricewaterhouseCoopers, Greenberg set up a secret office near FP’s Connecticut office. There, they built a computer system from scratch that was able to, in effect, reverse engineer FP’s trades. Sosin’s secret sauce was now Greenberg’s as well.

Then, when Sosin began an arbitration proceeding against AIG, as part of his effort to stay on until the end of the year, Greenberg hit back hard. He accused Sosin of fraud and breach of duty—exactly the kind of allegations that, if proven, would strip Sosin of his right to any of the $250 million. The two sides fought over FP’s executives, with Greenberg offering them promotions and Sosin dangling the prospect of a big chunk of whatever incentive compensation he won. Most of the executives stayed loyal to Sosin.

In November, the two sides settled, with Sosin agreeing to take $200 million, a portion of which he paid to the executives who had left with him.
^*
A month before the settlement, the
Wall Street Journal
published a lengthy article about the dispute, reporting that Sosin “was holed up with his team in a secluded office in Westport, Conn., plotting a comeback.” But to make
a comeback, Sosin needed another triple-A-rated company to back him, and that he never found. He was never again a factor in the derivatives business.