Infectious Greed

by Frank Partnoy

  February 1994 was an eventful month. Bankers Trust was preparing to close another complex swap with Procter & Gamble. First Boston was preparing to fire hundreds of employees. Long-Term Capital was preparing to begin trading in a few weeks. Paul Mozer—now permanently excluded from Meriwether’s inner circle—was preparing to spend several months in a Florida prison. But few people were prepared for what Alan Greenspan, chairman of the Federal Reserve, was planning. Greenspan was about to turn over a rock, revealing just how much the markets had changed during the years since Andy Krieger.

  5

  A NEW BREED OF SPECULATOR

  On February 4, 1994, Alan Greenspan and the Federal Reserve raised overnight interest rates from 3 percent to 3.25 percent. To most investors, the change seemed insubstantial. Greenspan’s reasoning appeared sound: the economy was growing very quickly, and although slightly higher interest rates would hurt investments, they also would help contain inflation. The markets fell in response, but the move was not unusual. Stock prices declined about two percent; bond prices dropped half a percent.

  But behind the scenes, it was pure panic.

  Most individual investors did not yet know of the swaps Bankers Trust had done with Gibson Greetings and Procter & Gamble, or of the complex financial strategies First Boston and Salomon Brothers had engineered. And no one realized how far and quickly those strategies had spread beyond those firms.

  By early 1994, hundreds of money managers and treasurers—from Robert Citron, the 70-year-old treasurer of Orange County, California, to Worth Bruntjen, the aggressive mutual-fund manager at Piper Jaffray in Minneapolis—had secretly bet hundreds of billions of dollars using strategies and instruments that were near copies of those described in the previous chapters. Although the trades were complex, most of them—at their core—were bets that interest rates would stay low. Collectively, these managers had placed the largest secret wager in the history of financial markets. When the Fed raised rates on February 4, they lost.

  Imagine a casino full of gamblers betting on a roulette wheel. Spin after spin, the ball lands on a red-colored number. The gamblers bet on red numbers and win, doubling and feverishly redoubling their bets. As the cheers grow louder, they begin ignoring the fact that the wheel has just as many black numbers as red. They believe they have entered an incredible new world where the roulette ball only lands on red numbers. They bet everything on the next spin of the wheel.

  Substitute “low interest rates” for “red numbers” and you have a description of the early-1990s financial markets. Fund managers had been placing huge bets on a financial-market roulette wheel, where the ball kept landing on low interest rates. They insisted interest rates would remain low and increased their bets, frequently borrowing huge sums to do so. Egged on by the Fed’s commitment to keep interest rates down in order to boost the economy, they imagined a new world where short-term interest rates were always three percent. Inevitably, on February 4, the ball landed on black.

  Why didn’t investors learn about the losses that day? One reason was that the bets involved largely unregulated and undisclosed financial instruments, such as structured notes, swaps, and other derivatives. Another was that many fund managers simply hid the losses, not only from investors, but from their bosses as well. After February 4, those managers were scurrying like a colony of ants whose cover had just been kicked over. Given the complexity of the instruments and the lack of regulation, they would be able to hide for quite a while. The public would discover the losses only in dribs and drabs during the year.

  In contrast to investors, Wall Street bankers immediately knew the damage caused by the rate hike, for two reasons: first, they had created the various fund-managers’ bets, so they knew the hidden details; second, Wall Street traders had hedged the bets by taking “mirror” positions in the market. Traders closely monitored these hedges, and—with a few glaring exceptions, such as Bankers Trust and Salomon Brothers—bank managers generally knew their traders’ positions. Various sources estimated the total damage to the bond market at around $1.5 trillion. That made the rate hike more costly than any other market debacle since the 1929 stock-market crash. The New York Times took note of the panic among financial specialists on February 5, the day after the rate hike, saying the Fed’s action sent “an Arctic blast through Wall Street.”1

  During the next few months, the fund managers—one by one—would admit their losses. David Askin was first. His fund, Askin Capital Management, was one of the largest and most sophisticated investors in mortgage securities. Askin was a respected trader—formerly of Drexel Burnham Lambert, Michael Milken’s firm—and he was among the most active traders of complex mortgage derivatives. Often, Askin was the market. Yet Askin’s $600 million fund evaporated within weeks after the rate hike, and Askin filed for bankruptcy on April 7 (more on the details later).

  Five days later, Gibson Greetings and Procter & Gamble admitted to losses on their previously hidden bets with Bankers Trust, and rumors swirled about similar losses at other companies. Air Products and Chemicals lost $113 million, Dell Computer lost $35 million, Mead Corporation lost $12 million, and so on.

  Various congressional committees immediately held hearings, with much fanfare (just as they would after the collapses of Long-Term Capital Management, Enron, and then nearly every major financial institution in 2008). On April 13, the House Banking Committee called on George Soros, the billionaire investment guru who briefly had employed Andy Krieger. Soros warned that many fund managers were using financial alchemy to make otherwise-prohibited bets. Regarding new financial instruments such as derivatives, he said, “There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated investors.”

  To average investors, the public discussion of these new instruments was impossibly complicated. Professor Jonathan Macey of Cornell Law School suggested that for the ordinary citizen contemplating these new instruments, “it is rational to remain ignorant.”2 The costs of learning about financial innovation were simply too great, relative to the potential benefits. But as the floodgates opened, and investors learned of billions of dollars of losses at brand-name companies, mutual funds, pension funds, government treasuries, and other organizations, the costs of remaining ignorant began to rise. Even investors who didn’t understand any of these new instruments still had to put their money somewhere.

  As news spread, it appeared that many of the biggest losers were no more sophisticated than the average investor. The most surprising losses were in the treasurer’s office of Orange County, California, and at Piper Jaffray, the Minneapolis mutual fund. Orange County and Piper were well-respected, supposedly conservative, institutions. Yet the individuals who were blamed for the losses—Robert Citron of Orange County and Worth Bruntjen of Piper—were surprisingly inexperienced and unsophisticated. Citron and Bruntjen didn’t have college degrees, much less Ph.D.s, and they lacked the financial training necessary to understand the details of structured notes and mortgage derivatives.

  Nevertheless, they had bought billions of dollars of these instruments, feeding the Wall Street firms that created them, and—for many years—generating positive investment returns for their constituents. Citizens of Orange County counted on Citron as a reliable and trustworthy steward of public funds. For investors in Minneapolis, Bruntjen was practically a hero. Citron was the top-performing municipal treasurer in the United States; Bruntjen was the top-performing U.S. government-bond fund manager. In February 1994, citizens of Orange County and investors in Piper had no idea how far their men had fallen.

  The story of Orange County, California, was well publicized during late 1994 and early 1995. Everyone read newspaper stories describing the record losses of $1.7 billion; assessing the antics of eccentric Robert Citron, the 70-year-old treasurer whose investment strategy had led to the county’s bankruptcy; and speculating about the uncertain future of the wealthiest county in the United States. />
  But even after all the media coverage, most investors remained baffled by the Orange County story, and few people could explain exactly what had happened, or even answer basic questions about what went wrong with the county’s investment strategy. How could an elected official have been secretly gambling with so much public money for so long? And how could he have lost so much money, given that he technically was operating within the county’s conservative investment guidelines?

  The reason the Orange County debacle made no sense was that few people understood its context. Orange County’s losses were the inevitable result of the recent spread of new financial instruments and strategies from Wall Street to much less sophisticated venues. To understand Orange County’s collapse, you had to understand the recent wave of financial innovation at Bankers Trust, First Boston, Salomon Brothers, and other Wall Street firms. With that perspective in hand, Orange County’s story was a reasonably simple one.

  Robert Citron was about as far from the high-tech Arbitrage Group at Salomon as a person could get. He was a University of Southern California dropout who had been to New York only four times in his life. He kept investment records on index cards and a wall calendar, and used his wristwatch calculator more than any financial software. Instead of developing computer pricing models, he consulted psychics and astrologers for advice about interest rates.

  Citron had spent his entire career in Orange County’s treasury department. After several decades, he held the elected position of treasurer—with no term limits. Throughout the 1980s and early 1990s, Citron had outperformed every other county investment manager, sometimes by several percentage points. While some counties were earning just two or three percent, Citron was earning almost 10 percent. The voters loved Citron and reelected him, over and over.

  By the early 1990s, Citron was one of the largest investors in the country, managing $7.4 billion of Orange County taxpayers’ money. But instead of investing the money in plain-vanilla Treasury bonds, he bought structured notes—the same instruments with embedded formulas that Allen Wheat and First Boston had sold by the billions. Citron bought a few of these notes from First Boston, but most of his purchases were from other banks, especially Merrill Lynch. By this time, structured notes had spread to every major investment bank, including Merrill.

  Merrill’s structured notes looked just like First Boston’s: they ranged in maturities from 3 to 5 years (as Orange County’s guidelines—which Citron had helped to write—required), and were issued by highly rated entities, such as the Federal Home Loan Bank (as Orange County’s guidelines required). On paper, they looked like very safe, AAA-rated investments.

  But the structured notes contained formulas that essentially were a big bet on interest rates remaining low. For example, one $100 million note paid a coupon of 10 percent minus LIBOR, the short-term interest-rate index. So if LIBOR were 3 percent, Orange County would receive a 7 percent coupon. As interest rates rose, Orange County’s coupon went down, and vice versa. By buying these inverse floaters, Citron effectively was borrowing at short-term rates and investing at longer-term rates. Most of the notes were based on U.S. rates, but Citron also bet that European rates would remain low; he even purchased $1.8 billion of structured notes tied to Swiss LIBOR.3

  Citron quickly came to believe that $7.4 billion was not a big-enough bet, so he borrowed as much as he could—about $13 billion—from various banks, including Merrill Lynch. He invested that money in structured notes, too. In all, by early 1994, Citron had made a $20 billion bet on low short-term rates.

  In many ways, Robert Citron was simply a big, public version of Jim Johnsen of Gibson Greetings, the company that had unknowingly paid more than $10 million in fees for the interest-rate bets it bought from Bankers Trust. Like Johnsen, Citron wanted to gamble on interest rates, but was constrained by investment guidelines that permitted only highly rated, short-maturity bonds. Like Johnsen, Citron did not understand how to evaluate the derivatives embedded in structured notes, and he paid more for them than he should have, especially because he frequently didn’t bother to shop around. That made Citron an extremely valuable client to Merrill Lynch. From 1990 to 1993, Merrill Lynch earned profits of $3.1 billion, more than it had earned during its 18-year history as a public company, and a big chunk of the profits—about $100 million—came from Orange County.4 Merrill earned $62.4 million from Orange County in 1993 and 1994 alone.

  Thus placed in its proper context, the story of Orange County’s losses was simple, and all too familiar. Citron used structured derivatives to bet on low interest rates, just as Gibson Greetings had, and he lost his bets when the Federal Reserve raised rates on February 4. The only difference between Orange County and Gibson Greetings was the size of the bet: millions of dollars for Jim Johnsen, billions for Citron.

  Who was to blame for the losses? Obviously, Citron was at the top of the list. He made all the decisions and hid all the risks. On January 17, 1995, he told a special committee of the California State Senate, “I was an inexperienced investor. In retrospect, it is clear that I followed the wrong course. I will carry that burden the rest of my life.”

  Many public accounts also blamed Merrill Lynch. Michael Stamenson, the top salesman in Merrill’s San Francisco office, didn’t help Merrill’s media relations when he publicly praised Citron’s investment acumen. No one thought Stamenson genuinely believed, as he testified, that “Mr. Citron is a highly sophisticated, experienced, and knowledgeable investor. I learned a lot from him.”

  But while Stamenson may have engineered Citron’s gambling, the structured notes Merrill sold to Orange County were no different from tens of billions of dollars of similar instruments sold by numerous banks to numerous investors. To the extent there were problems with structured notes, they weren’t specific to Merrill; they were endemic to the financial system. If Merrill was to blame for Orange County, then all of Wall Street was to blame for billions of dollars of losses in 1994.

  In fact, Merrill seemed less culpable than other banks, especially Bankers Trust. Merrill had warned Citron on at least eight occasions, from 1992 to 1994, to reconsider his risky interest-rate bets. But Citron ignored all warnings, including those from prestigious Goldman Sachs, which disapproved of Citron’s risks and refused to sell him any structured notes. When Goldman criticized Citron, he responded with an angry letter, saying, “You don’t understand the type of investment strategies that we are using. I would suggest that you not seek doing business with Orange County.”

  The central problem for Merrill and other banks was not necessarily selling structured notes (as troubling as it might seem for Merrill to be selling securities with complex embedded formulas to an antediluvian client like Citron). Instead, the problem was that Merrill had played a dual role of derivatives salesman and bond underwriter. In this second role, Merrill and other banks had arranged new Orange County bond issues and sold them to the public. Unfortunately for Merrill, the public disclosures related to those bond issues did not mention Citron’s risky interest-rate bets. That meant that even if Merrill had dealt properly with Citron in selling structured notes, it arguably had violated the securities laws by failing to disclose risks associated with Orange County’s bonds.

  The other blameworthy parties were the credit-rating agencies. Just as Standard & Poor’s and Moody’s had been critical to the development of new financial instruments at First Boston and Salomon Brothers, the agencies had played a central role in the collapse of Orange County.

  First, they had given AAA ratings to the structured notes Orange County bought, even though the market risks of those notes were much greater than those of more typical AAA-rated investments. That enabled Robert Citron to fit his large interest-rate bets within the technical boundaries of Orange County’s investment guidelines, even though the structured notes he bought were riskier than any highly rated bond in existence when the guidelines were written.

  Second, both Standard and Poor’s and Moody’s gave Orange County itself the
ir highest ratings through December 1994, when the county filed for bankruptcy. These high ratings gave confidence not only to Orange County residents, but also to investors in the county’s bonds. Investors in many conservative bond mutual funds—including those at Franklin Advisors, Putnam Management, Alliance Capital, Dean Witter, and many others—had purchased Orange County’s bonds, precisely because of the high credit ratings.5

  The rating agencies collected substantial fees for rating Orange County’s bonds (S&P made more than $100,000 from Orange County in 1994 alone).6 They collected even greater fees for rating structured notes. These fees raised questions about whether the agencies had been objective in assessing Orange County’s risks. More than six months before Orange County’s bankruptcy, the agencies had learned about Citron’s losses on structured notes, but they kept this information secret, and didn’t adjust their ratings in response.

  For example, according to notes taken by a rating-agency analyst, on a telephone conference call with the rating agencies on May 9, 1994—seven months before the agencies downgraded Orange County’s debt—Matthew Raabe, Citron’s assistant treasurer, candidly discussed the county’s risks, noting “DISASTER” and “danger!” and concluding that if interest rates rose one percent, Orange County’s collateral would be “gone.”7 At another meeting, officials from the rating agencies learned about large numbers of “inverse floaters.”8 In addition, Raabe explained that Orange County was not “marking to market” its portfolio, meaning that it wasn’t recording changes in value over time, even as interest rates increased.9 In other words, if Orange County had paid $20 billion for structured notes in 1993, they were still recorded as being worth $20 billion in 1994, even though the Fed’s rate hike had decimated their value.

  Even if the agencies hadn’t been privy to this information, they knew of numerous public warning signs about Citron, including Citron’s own remarks from the previous year. In July 1993, when Citron was asked how he knew that interest rates would not rise, he replied, “I am one of the largest investors in America. I know these things.” In a September 1993 report to the County Board of Supervisors, Citron wrote, “Certainly there is nothing on the horizon that would indicate that we will have rising interest rates for a minimum of three years.” These statements were red flags showing how important the level of interest rates was to Citron’s investment strategy, and how naïve Citron was. In spring 1994, John Moorlach, an accountant from Costa Mesa, California, launched an aggressive campaign to unseat Citron. Moorlach warned voters that the county was taking on huge risks and predicted a billion-dollar loss. But Citron won reelection, the losses remained hidden, and the rating agencies stayed mum.