The two guys who caused the financial collapse

According to a fascinating bit of investigative reporting by Robert O’Harrow Jr. and Brady Dennis in the Washington Post, the cause of the world’s current financial collapse is not so much sub-prime mortgages but two young guys in the late 1980s who, with their computer modeling and sophisticated mathematics, invented a way to master the risk inherent in the marketplace. They partnered with insurance conglomerate AIG (remember them, beneficiary of our biggest bailout so far), and soon their scheme wove virtually all of the world’s financial players together in hedge schemes that would eventually drag everyone down. From the first in the series of articles, aptly titled The Beautiful Machine:

Howard Sosin and Randy Rackson conceived their financial revolution as they walked along the Manhattan waterfront during lunchtime outings. They refined their ideas at late-night dinners and during breaks in their busy days as traders at the junk-bond firm of Drexel Burnham Lambert.

Sosin, a 35-year-old reserved finance scholar who had honed his theories at the famed Bell Labs, projected an aura of brilliance and fierce determination. Rackson, a 30-year-old soft-spoken computer wizard and art lover, 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 PhD 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. . . .

Sosin and his team needed the backing of a company with deep pockets, a burnished reputation and the very top credit rating, a Triple A institution as unlikely to default as the U.S. Treasury itself. One name topped their wish list that fall: American International Group, or AIG, the global insurance conglomerate considered one of the world’s safest 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 and their firm would alter the way Wall Street did business, particularly in the use of derivatives, and eventually test Washington’s growing belief that capitalism could safely thrive with little oversight.