Howard Sosin was the kind of Wall Street dealmaker who flourished in the footloose days of the mid-80s. As the founder of AIG Financial Products, he invented many of the complex financial instruments blamed for changing the rules of risk and wrecking the global economy. Now Sosin says he has a plan to fix America’s banks and restore confidence in the markets. Can a guy who got rich structuring derivatives save the global economy?
The story begins in 1986 (and is documented in full in a Washington Post story from last year called The Beautiful Machine) when Sosin, working with two other partners at the infamous junk-bond firm Drexel Burnham Lambert, conceived of an elaborate scheme to create attractive long-term, derivative-backed deals—theoretically immune to market fluctuations—that could be sold to Wall Street’s top financial institutions. It was a plan well suited for the hyper-deregulatory environment of the 1980s—Sosin realized you didn't have to be a bank to get into the derivative game and that operating under a different structure made the process much more efficient.
Sosin and his team knew it would never fly at Drexel; they needed to find a big-name benefactor with a stellar credit rating to provide the financial backing, and one adventurous enough to let them pursue their plans without restriction.
Sosin found his way to American International Group chief Hank Greenberg whose insurance firm had a coveted AAA credit rating and plenty of cash. Sosin convinced Greenberg it was time to update his business practices and, in a marked departure for the venerable 67-year-old firm, Greenberg agreed. With that, the pair founded the now infamous AIG Financial Products.
Over the course of the next few years, the company redefined finance for an increasingly globalized world and raked in millions. Their new way of doing business was risky but lucrative and the relationship between Greenberg and Sosin was turbulent but mutually beneficial. Things changed when Financial Products lost $100 million on a deal in 1992 and Greenberg got nervous. The AIG chief moved to oust Sosin but retain control over the computational models that the former Columbia Business School professor had created.
When Sosin pushed back, Greenberg reacted by setting up a shadow computer system to track Financial Products’ every move. In 1993, Sosin left and later settled with AIG for a reported $150 million. With a rudimentary knowledge of Sosin’s calculus, Greenberg retained Financial Products and soon gave it subsidiary status. What was an ingenious scheme of derivatives and managed risk under Sosin became a Pandora’s box of super high-risk global deals with little oversight. For the next 15 years, AIG let Financial Products take on massive amounts of risk, which led to the company’s partial collapse last September and the costliest government bailout of a private firm in the history of capitalism.
Howard Sosin may have helped devise some of the complicated financial instruments that triggered the global recession, but he says he would never have approved the kinds of deals made after his departure from AIG. He calls the deals that happened under his watch “trivial” compared to the tail that wagged the dog—trading a little money for huge risk—in the years that followed. In an exclusive interview with Big Think, Sosin unveiled a new plan—one to rescue the same banks that eagerly gobbled up risky Financial Products—and perhaps save the entire global economy. It involves a heavy hand from the U.S. government—the same institution whose light hand made Financial Products possible in the first place.
Sosin told Big Think that the fundamental fact that the previous and current administrations don’t understand is that the “multiplier effect” that traditionally applies to capital doesn’t apply to toxic debt—meaning that $750 billion won’t come close to fixing the problem. Yesterday’s stress tests results confirm that. Citing Paul Krugman’s assertion that the problem was toxic banks, not just toxic securities, Sosin deconstructs the government’s proposed TARP [Troubled Asset Relief Program] and PPIF [Public-Private Investment Funds] and introduces two new ideas, both involving the government’s temporary ownership of restructured banks.
In his proposal, Sosin writes that the government’s efforts at resuscitating America’s banks with major subsidies and the purchase of troubled assets benefit creditors and equity holders instead of taxpayers. Using Citibank as an example, he demonstrates how the federal purchase of preferred stock has yet to bring banks back to solvency and that pricing and fairness difficulties compromise the PPIF program because the government and private sector share a 50/50 stake in toxic asset purchases.
Sosin’s first proposed alternative involves a Good Bank/Bad Bank distinction, separating good assets from bad. Inserting their own management team, the government’s separate Good/Bad divisions negate the need for PPIF, allowing toxic assets to run their course away from the marketplace. In addition, the bad bank could receive a structured neutral-rate loan, securing its assets and ensuring that the government [not bond holders] would be the top-priority claimant.
With two banks now operating where there was one, the insolvent “bad bank” could avoid immediate bankruptcy in favor of winding down naturally. By selling its bad loans to the bad bank at book value, the good bank’s solid balance sheet now allows it to make responsible loans to spur economic growth.
Sosin attempts to rectify any potential flaws in the Good Bank/Bad Bank solution with his second proposal: the Backstop Guarantee Takeover. With the government guaranteeing that all assets taken over from the bank with special equity be wiped out, the bank’s level of capital would not shrink, allowing it to make new loans, spurring economic growth and ultimately bringing it back to profitability.
With the government entitled to first rights to all bad asset payments and toxic assets expected to return to lower levels than those imposed by TARP, Sosin sees both the Good Bank/Bad Bank and Backstop Guarantee as favorable alternatives. Citing the Backstop Guarantee as the better of the two, his ultimate goal is to rehabilitate the country’s financial fortunes while benefitting Main Street over Wall Street.
Discuss
Emmet McDonnell on May 9, 2009, 4:14 PM
So when the cigarette corps we’re in trouble because they knowingly produced a harmful addictive product they had to come up with a plan too. Lets create an anti-smoking campaign. Gums, patches, pills, hypnotism, etc… Whatever…
Now that the entire financial/monetary system is being exposed for it’s flaws we have every finance expert coming out with their ideas backed by their reputation.
Can we please have something fresh and completely different other than propping up the system only to fail again in the future? THIS ISN’T ABOUT US, IT’S ABOUT THE CHILDREN. Ideas of sustainability would be great. Maybe in today’s society we should be shying away from a monetary based debt system and focus more on an energy based economy that rewards everyone for creativity. We might need more engineers/scientists and less business folk. Reading the idea from this very well accomplished man is confusing to most people and that’s the problem – It’s gotten too complicated.
Quentin McKenna on May 9, 2009, 7:16 PM
I think Sean misrepresents the financial problem when he attributes it to “lack of regulation” by government. The problem was created an environment that was largely underwritten by the taxpayers. Knowing that the taxpayer would underwrite much of the risk encourages greater risk-taking to increase profits.
Sosin’s “solution” then is entirely consistent with that original scenario of government dependence. He feels that the taxpayer should be in the forefront, once again, to “repair” the system rather, than take the lumps from full re-structuring.
This is statism run amock!
It’s also ironic that the “experts” who have weighed in on this topic are statists in their own right. I don’t see a free market thinker in the bunch.
Emmet McDonnell on May 9, 2009, 9:45 PM
I hope to not sound like a statist. I believe, from my analysis in our society & economy, that we are at a critical point of advancement in thought & science. We have the ability to feed, clothe, and educate the world – but we don’t. Economic concerns and propping up/protecting an identity of the system has taken presidence. We have the chance to learn from a very large mistake in the makup of the current society only to advance to a higher quality of life for everyone. This takes awareness and effort from everyone tough. What do I know, I"m just a 27 year old untraditionally educated trader with an eye for solutions to problems without experience. I have high ambitions in thought of a future without a debt system that has kept a stranglehold on everyone for years. When there is a revolution it has to start with the individual then move to education then action. The underlying reason as to why we are in this whole mess is DEBT. If there wasn’t any debt there wouldn’t be any money! Debt = Slavery. As long as there is growing debt there will be large swings in an economy. Just end the debt, it’s that simple. The human spieces will always evolve to new ideas if they are accepted by the masses.
Michael Gray on May 9, 2009, 10:20 PM
Mr Sosin’s elaborate plan for restoring the financial industry is, to my mind, simply another variation on a bailout – and a very complicated one. It is dependent on assigning values to multiple, interdependent variables that are just as speculative as predicting next week’s weather. Like his Drexel and AIG computer models if one or two values change in an unforeseen direction or variables pop up that weren’t even considered (e.g. housing prices actually declining), it blows his model and forcasts to hell.
Separating bad assets from good whether they become a government owned entity, sold at a discount to investors with some or much of the risk underwritten by the government, held by the banks/insurance companies in some type of subsidiary and using federal money as a guarentee that the debt will be worked off and the government repaid, using market values or Fed values, blah, blah, blah. It’s all packaging.
Bottom line – Joe Sixpack needs to be assured that the world is not coming to an end and he will not be completely screwed. So, for political/emotional/ perception reasons a reinvigorated Fed and SEC need to manage the process. Putting in yet another Sosin computer formula will a) scare the hell out of just about everybody except quant gameplayers; b) be not understood by everybody (including the gamers) with accompanying ignorance and fear tearing everything apart; c) and, by Sosin’s own admission, hidden multipliers will keep the model in a permanent state of flux.
When a model is developed that can accurately predict human behaviors in all types of economic scenarios rather than simply quantify amortization ratios vis-a-vis the prime – give me a call.
Quentin McKenna on May 11, 2009, 3:58 PM
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