Infectious Greed

by Frank Partnoy

  BERNHARD: You’re headed for trouble. . . . It’s gonna blow up on you.

  HUDSON: I’m a glutton for punishment, and well, you know, I’m rollin’, man, I gotta make money here.

  BERNHARD: You’re not gonna have a job, you’re not gonna have customers . . . you’re gonna blow them up . . . you’re getting greed-ier as the days roll by.68

  The leverage factors in these trades were so large that the size of the bets was a significant percentage of the entire amount of money the U.S. and German governments borrowed. If P&G elected to close out the trade early—as Gibson had—its actions would rock the world’s government-bond markets.

  As it turned out, Dane Parker at P&G wasn’t the only person unable to figure out the value of these complex swaps. Smooth-talking Kevin Hudson couldn’t do it either, and he admitted as much to Parker, saying he didn’t build the computer models that valued the options in P&G’s trades—a trader had done that.69 As a result, Hudson was taken to the cleaners, too. Incredibly, a Bankers Trust trader squeezed profits from Hudson on the first P&G swap, just as Hudson had squeezed them from P&G.

  Guillaume Henri André Fonkenell began his career as a junior swap trader at Bankers Trust in June 1990.70 He was very successful, and by November 1993 had been promoted to a senior trader in New York.

  During October 1993, Kevin Hudson had been working on the P&G trade with Kassy Kabede, one of Fonkenell’s junior traders. When Kabede left the country on November 1—the day before the first P&G trade—Fonkenell took over. After the swap was done, there was the key question: how much money did Bankers Trust make on the trade? Just as Andy Krieger had needed to come up with a valuation of his trades, Fonkenell needed to determine the value of the complicated put options embedded in the P&G swap.

  When a salesman booked a trade, he obtained a price from the trader. Commissions went to the salesman; trading profits went to the trader. If the trader valued a trade at $90, gave the salesman a value of $95, and the salesman sold it for $100, Bankers Trust would make $10 and the trader and salesman each would make $5.

  But if the trader gave the salesman a higher value (say, $97), then the trader would declare more profit ($7), leaving less for the salesman ($3). Bankers Trust made the same amount of money on the trade either way, but the salesman received less credit for it in the second example. Wall Street is a dog-eat-dog world where, it is said, salesmen wear Milkbone underwear. Traders are the alpha dogs, and they frequently lie to salesmen about trade values, especially on complex deals, when they know the salesmen won’t be able to figure out the valuation themselves. One of a bank manager’s challenges is to keep the traders honest, and to keep the salesmen from killing the traders.

  As with Krieger’s trades, the valuation of the first P&G swap depended on volatility. At the time, volatility was not quoted in the markets. Instead, a trader would select an appropriate volatility measure based on historical data or on the range of prices for options similar to those embedded in the swap. By plugging those prices into an options model, such as Black-Scholes, the trader would get a range of numbers called implied volatilities. Then, the trader would input those volatility numbers into a spreadsheet or computer program to calculate the swap’s value.

  To improve controls at Bankers Trust, Charlie Sanford required that the back-office employees mark to market the bank’s trades every day. That meant someone in the back office would need to report a daily value for the P&G swap. These values were the basis for a ten-page bank-wide risk assessment Sanford received every day. The Krieger incident had made it especially important that those numbers be accurate, and Bankers Trust supposedly had been improving its control systems during the five-and-a-half years since then.

  The value of the first P&G swap depended on two key inputs: the volatility of the 5-year Treasury Yield and the volatility of the 30-year Treasury Price. The swap was so large that a one-percentage-point change in the volatility estimates would change the profit by $3 million.

  Kevin Hudson would be compensated based on the new-deal profit—the profit recorded at the time of the trade. The more Fonkenell could reduce the new-deal profit, the greater his trading profit—and bonus—would be.

  Before the trade, the 5-year volatility was recorded as 18 and the 30-year volatility was 10. Fonkenell then directed the back office to lower each volatility measure by one point, thereby cutting the new-deal profit by about $3 million.

  The day after the trade, Fonkenell told the back office to move the 5-year volatility back up to 18. The back-office worker apparently misunderstood the instruction and moved the 3-year rate instead of the 5-year rate. The mistake, which eventually was corrected, was attributed in part to the fact that employees called the 3-year note “Losh” and the 5-year note “Bosh.” The comic mixing of “Loshes” and “Boshes” sounded more like a Dr. Seuss children’s book than a cutting-edge risk-management operation. In any event, it didn’t look like Sanford’s controls had improved much. A few days later, Fonkenell instructed the back office to move the 30-year volatility back up to 10. Now the trade was worth $3 million more, and that portion of the profit belonged to the traders.

  It is unclear whether Kevin Hudson ever discovered that Fonkenell had jiggered the volatilities. But no one was crying for Hudson, who received a sizeable bonus for 1993, anyway. His total compensation that year was almost $1.5 million.

  Charlie Sanford was rewarded for his efforts, too. His total 1990 compensation, including options, was more than $5 million, based on calculations by Fortune magazine.71 Fortune compared CEO compensation to stock performance, and found that Sanford was the thirteenth most-overcompensated CEO in the United States in 1990, just behind Kenneth Lay of Enron. Sanford received similar compensation in later years.

  Notwithstanding the Fortune ranking, by some financial measures Sanford had earned his pay. From 1990 to 1993, Bankers Trust was the most profitable major bank in the United States. During this time, about a third of its profits were from derivatives, including swaps; another third was from trading. The bank’s return on shareholders’ equity was above 20 percent every year, almost double the return for a typical bank.72

  However, the bank’s stock price was in a rut, which was why many argued Sanford was overpaid. Securities analysts—burned once by the Krieger incident—no longer trusted the bank. To some sophisticated investors, the bank’s glowing financial statements only spelled more trouble. As a result, Bankers Trust’s price/earnings ratio—its stock price divided by its earnings per share—was a measly 8, whereas other banks had ratios almost twice as high.73 Sanford frequently said that the single most important measure of a CEO was his company’s stock price; but, by that measure, he was a failure.

  In just a few years, Chairman Sanford had radically transformed Bankers Trust, as he had promised. But the transformation had its price. Shareholders didn’t do nearly as well as employees. And within a few months, this short-term, product-oriented focus would nearly destroy the bank.

  Bankers Trust had proved that technology and financial innovation could generate substantial profit for banks, just as they enabled companies to take on new risks in fantastic ways. From the equity-derivative deal that went European-investor-to-Canadian-bank-to-Bankers-Trust-to-Japanese-insurer, to Gibson’s squared swap, to P&G’s complex three-billion-dollar bet, the possibilities using derivatives seemed endless.

  Brian Walsh, head of derivatives at Bankers Trust, would later admit that Bankers Trust had inappropriately emphasized complex, high-margin products over the needs of its customers: “What happened that I’m not happy about is that we fell in love with a product instead of trying to understand the client.”74 But this emphasis seemed inevitable, given Charlie Sanford’s relentless questioning about “what’s next?”

  Bankers Trust also learned that a relentless focus on short-term profit can turn employees into rogues. Charlie Sanford couldn’t control Gary Missner, Mitchell Vazquez, or Kevin Hudson any better than his clients could keep tabs on Jim Jo
hnsen of Gibson Greetings or Dane Parker of P&G. Nor was Bankers Trust’s back office able to evaluate complex options, even though Sanford supposedly had improved controls years earlier, after the Krieger incident.

  Meanwhile, regulators were gone from the scene entirely, lobbied away by the newly powerful International Swap Dealers Assocation. Shareholders, too, were largely unaware of these dealings. The only effective police force was the securities analysts, who at least tried to keep Bankers Trust honest by punishing its stock price.

  From 1988 to 1994, the culture of Bankers Trust had changed in ways that benefited employees, but perhaps not shareholders or clients. In 1994, the world would learn about the swaps Bankers Trust sold to Gibson Greetings and Procter & Gamble. But first, the question remained whether these changes—increasing complexity, loss of control, and deregulation—were affecting other institutions. Put another way, if the Bankers Trust culture were set loose in another bank, what would happen?

  This question wasn’t merely hypothetical. Allen Wheat, Bankers Trust’s derivatives guru, had left the bank in 1990 to join First Boston, where he was breeding the aggressive culture of Bankers Trust with First Boston’s dying and dysfunctional investment-banking practice. Months after Wheat arrived at First Boston, a group of even more fantastic products was being born.

  3

  WHEAT FIRST SECURITIES

  Before Allen Wheat joined First Boston, in February 1990, the investment bank was in a death spiral. In 1986, it lost $100 million trading government bonds. In 1987, it lost $60 million trading stocks. In 1988, it lost Bruce Wasserstein and Joseph Perella, the co-heads of its lucrative mergers-and-acquisitions group. In 1989, it lost $1 billion on loans to companies involved in takeovers.1 In one late 1980s deal, First Boston had foolishly loaned $450 million—40 percent of its equity—to just one firm, Ohio Mattress, in a deal later dubbed “the burning bed.”2

  Finally, in 1990, Credit Suisse, the huge Swiss commercial bank, bailed out First Boston with $300 million of its own capital in exchange for a 45 percent stake3—the most it could own under Glass-Steagall, the law that separated investment and commercial banking. Ultimately, First Boston got a new name, too: CS First Boston (the CS stood for Credit Suisse).

  Not surprisingly, several awful years had turned First Boston into a nasty place, with low morale and vicious infighting. So many people were leaving that some called the firm “Second Boston.” Still, First Boston had potential. From the 1940s through 1985, First Boston and Morgan Stanley had been alone at the top of the investment-banking elite. The Swiss bankers were hoping to resuscitate the once-profitable First Boston of yore.

  They would need some new talent, especially in derivatives, where First Boston had virtually no presence. And the obvious place to look for talent was Bankers Trust, then regarded as the top firm in that area. The swaps Bankers Trust had sold were part of a broader class of derivatives—financial instruments based on the value of some other instrument or index—which was growing at a breakneck pace.

  Allen Wheat was not a rocket scientist, although his father—a nuclear physicist—was: “He was always blowing things up. There would be a huge hole and we would have to move. I was always the kid introduced halfway through term.”4 But what he lacked in mathematical training, Wheat made up for with a quick wit and a good nose for profitable business opportunities.

  Wheat had attended Wharton—like Andy Krieger and Charlie Sanford—although he received his M.B.A. from New York University. He had worked as an assistant treasurer at Chemical Bank, but left after a few years because “I was underpaid, and oddly at that time industry was paying more than banking.” Wheat spent the next eight years in the treasury department at General Foods, where he set up a finance company and dealt extensively with bankers.5 When banking began paying more than industry, Wheat left General Foods for Bankers Trust.

  Wheat focused on one thing: money. As one colleague described him, “He is one of the most openly self-centered individuals that I have ever come into contact with. His only focus in life is making money for here, now, and the hereafter. He only wants to be rich.”6 This was meant as a compliment. On 1980s Wall Street, the money-obsessed were saints, not sinners.

  Wheat led Bankers Trust’s swaps efforts in the early 1980s, took over options and private placements in 1984, and ran the bank’s Asian operations from Tokyo beginning in 1986. Wheat’s focus on money worked, and everything he touched was profitable. Wheat was a popular and approachable leader. He told jokes and even played dice with lower-level employees in Singapore when he visited that office. His one weakness was that he neglected client relationships.7 But who at Bankers Trust didn’t neglect clients?

  Nevertheless, when Charlie Sanford needed to staff his six-man management committee, he excluded Wheat in favor of Eugene Shanks, one of Wheat’s contemporaries. The Economist conjectured that Wheat was “too much of a quip-tongued outsider.”8 Whatever the reason, Wheat didn’t take the snub very well.

  On Friday, February 9, 1990, when Wheat left his office in London, he told colleagues at Bankers Trust that he might go skiing for a few days. The next Monday, at two P.M. London time, he called Charlie Sanford and abruptly quit. First Boston sent out press releases within two hours.9 Wheat had worked at Bankers Trust for nine years. Now he was out to prove Charlie Sanford had been wrong for not backing him.

  When Helen Dunne of the Daily Telegraph in London asked Wheat about his favorite pastimes, he joked that “I don’t do anything that is constructive. I mean I don’t do pottery or anything like that.”10 A sardonic 41-year-old, with no hobbies and no interests other than banking, was the perfect hire for First Boston. The 1980s had ended, and the image of the handsome, slicked-back trader in the movie Wall Street was fading. It was appropriate, then, that First Boston’s diminutive new superstar—with his disarming humor and self-deprecating style—was more like Woody Allen than Gordon Gekko.

  Allen Wheat was given two immediate tasks: stop the losses in the Tokyo office and set up a new derivatives business. He would spend the next three years jetting back and forth between London and Tokyo. Fortunately, he had no problem sleeping on planes.

  The two tasks were related. Much of Bankers Trust’s derivatives profits had been from Asia, including fees from equity derivatives sold to Japanese insurers who weren’t supposed to be betting on the stock market. Like Sanford, Wheat understood the benefits of combining commercial banking with investment banking, so he began by creating a new bank—called Credit Suisse Financial Products—a joint venture between the Swiss commercial bank and the U.S. investment bank. CSFP, as it would become known, would handle all the swaps and derivatives activities of both firms, although Credit Suisse would have control.11

  CSFP was located in London, so it wouldn’t have to comply with U.S. banking laws. This would be a huge advantage, because many of First Boston’s clients were governed by regulations that made it much cheaper for them to deal with London banks than U.S. securities firms.12

  Moreover, CSFP would have a AAA credit rating, the same as Credit Suisse, and the highest possible rating—several notches higher than most Wall Street banks, especially investment banks, which typically were rated only single-A. That high rating was important for the same reason as the London location: it would make it easier for CSFP’s regulated clients to enter into deals with the bank. Allen Wheat was not trained as a lawyer but, like Charlie Sanford, he knew his way around a legal rule or two.

  Wheat persuaded his bosses to give CSFP $150 million of capital, and he hired about 100 employees, many from Bankers Trust.13 CSFP’s risk-taking and pricing functions would be in London, also for regulatory purposes, but the bank would do its marketing in New York, where most of First Boston’s salespeople worked. Wheat was obviously excited; he told a reporter, “It should be pretty big. Our objective is to be the best in this market.”14

  On July 16, 1990, the Bank of England sent CSFP its letter of authorization, and Allen Wheat completed his first four transa
ctions that day. It had taken him just five months to build the business from scratch.

  That month, CSFP employees learned that Hammersmith & Fulham, a London local government authority, was refusing to pay hundreds of millions of dollars it owed to several banks on seventy-two interest-rate swaps, claiming it had not been authorized to do them.15 Essentially, the borough claimed that the swaps had been done for a trading purpose that was outside its authority, and that therefore the swaps were null and void. It was a valuable lesson for CSFP to learn at the start; it would be more careful than other dealers—especially those in the United States—to ensure that clients were authorized to do complex derivatives.

  A few months later, CSFP obtained the approval of New York State banking regulators, so it could officially do business in New York. CSFP did four deals on its first day in New York, too, all of them clearly authorized.16

  In the United States, the bank’s AAA rating was especially important and was the first item CSFP mentioned in the press release it sent out when it opened in New York.17 With this top credit rating, Allen Wheat could modify Bankers Trust’s clever practices to generate even greater profits. The financial-market innovations that began in 1987 were about to take a few more twists and turns.

  Credit ratings were central to the changes, although few financial-market participants understood why at the time. A decade later, credit ratings would be even more important, and would play a central role in the collapse of several companies, including Enron. A few years after, credit rating agencies would be at the center of a global financial meltdown.