Infectious Greed

by Frank Partnoy

  The incredible thing about the carry trade was that everyone did it—not only mutual funds, but also hedge funds, the unregulated investment funds that often did everything but hedge. Hedge fund was a generic term that referred to any unregulated investment fund; mutual fund referred to a regulated U.S. fund. (Hedge funds could avoid U.S. regulation if they had 100 or fewer U.S. investors.) Managers of the biggest hedge funds had them borrow money to place huge bets on various currencies, interest rates, and other securities. George Soros was a prime example. So was David Askin.

  During the early 1990s, nearly every hedge fund bet on the carry trade. As Stan Jonas, a well-regarded trader at Societe Generale/FIMAT, described it, looking back on 1994, “If a Martian came to the U.S. and looked at the universe of hedge fund managers, he’d see the same person. Many of these managers are interrelated by blood, by hobbies, by education. They’re all competing, checking what the other one’s doing.”44 And they all made the same bets.

  Unfortunately, the Federal Reserve didn’t understand hedge funds very well, and didn’t realize how much financial institutions had borrowed to bet on interest rates using unregulated derivatives. The spread of this leverage was the reason the Fed’s rate hike had had such far-reaching, unanticipated effects.

  By early May 1994, the Fed had raised rates another half a percent, and the carnage was more visible. Three of the biggest hedge-fund managers—Leon Cooperman of Omega Partners, Julian Robertson of Tiger Management, Michael Steinhardt of Steinhardt Partners—lost billions of dollars. Banks and securities firms also were hit hard, with Bankers Trust finally experiencing its first loss, and Salomon Brothers reporting a pretax loss of $371 million for the first half of 1994, most of it from bond losses. The life insurance industry lost about $50 billion on bonds in 1994; property and casualty insurers lost $20 billion, more than they paid in claims for Hurricane Andrew.45 (These losses didn’t show up in financial statements, either, because insurance companies recorded their bond investments at their historical cost.)

  A few prescient firms abandoned their bets just before February 4, 1994. For example, AIG Financial Products made more than $1 billion on derivatives between 1988 and 1992, but AIG’s chairman, Maurice “Ace” Greenberg, decided in 1993 that his firm was taking too many risks, and the head of AIG Financial Products, Howard Sosin, left the firm, along with a reported $200 million in compensation. Sosin had joined AIG from Drexel Lambert in 1987, and he avoided the frenzy of Wall Street’s trading culture by operating out of an office in Westport, Connecticut, with a fifty-foot saltwater fish tank. Long-Term Capital Management—which was just opening its doors as the Fed was raising rates, in a similarly relaxed setting in Greenwich, Connecticut—took advantage of the collapse of various investment funds by hiring several dozen employees with strong quantitative backgrounds.

  Joseph Erickson, a partner at Peat Marwick and a consultant on derivatives, derided fund managers who didn’t understand the derivatives they bought, saying: “If you don’t understand, you might as well place it all on red at Atlantic City or Las Vegas, because at least there you get free drinks.”46 Erickson was missing the point. Sophisticated or unsophisticated, understanding or not, drinks or no drinks, everyone had bet on red.

  In 1995, Brandon Becker and Jennifer Yoon, of the Securities and Exchange Commission, compiled a list of institutions that had lost money in the various new financial instruments during the previous year. The list included virtually every kind of institution, from every sector of the economy. To get a sense of how far these new instruments had spread by then, take a glance at this paragraph, which includes a selected “top 100” from the list. (You might even recognize a few that lost some of your money.)

  ABN AMRO; Air Products and Chemicals; Allied-Lyons; American International Group; AmSouth Bancorp; Askin Capital Management; Atlantic Richfield; Auburn, Maine; Banc One; Bank of Montreal Harris Trust & Savings; Baptist Missionary Association of America; Barings; Barnett Banks; Benjamin Franklin Federal Savings and Loan; Berjaya Industrial; CS First Boston Investment Management; Capital Corporate Federal Credit Union; Cargill Investor Services; Caterpillar Financial Services; Chemical Bank; China International Trust and Investment; City Colleges of Chicago; Codelco; Collier County, Florida; Colonia Asset Management; Common Fund; Community Bankers Fund; Connecticut State Pension Fund; Constitution State Corporate Credit Union; Corporate One Credit Union; Credit Lyonnais; Cuyahoga County, Ohio; Dell Computer; Eastman Kodak; Escambia County, Florida; Federal Farm Credit System; Federal Paper Board; Fidelity; First Boston; Fleet Financial; Florida operating fund; Franklin Savings; Fundamental Family of Funds; Gibson Greetings; Glaxo; Gothaer Life Insurance; Hammersmith & Fulham; Independence Bancorp; Indiana Corporate Federal Credit Union; Investors Equity Life, Hawaii; J. P. Morgan; Japan Airlines; Joplin City, Missouri; Kanzaki Paper Manufacturing; Kashima Oil; KeyCorp Bank; Kidder Peabody; Mead; Mellon Bank; Meritor Savings Bank; Merrill Lynch; Metallgesellschaft; Mutual Benefit Life Insurance; National Fisheries, South Korea; New England Investment; Northern Trust; Norwest; Odessa College; Ontario Province, Canada; Orange County; Paine Webber; Piper Jaffray; Pittsburgh National Bank; Postipankki Bank, Finland; Procter & Gamble; Robert W. Baird; Salomon Brothers; Sandusky County, Ohio; Seamen’s Bank for Savings; Sears Roebuck; Shanghai International Securities; Showa Shell Sekiyu; Silver-ado Banking Savings and Loan; Sinar Mas; Soros Fund Management; Southwestern Federal Credit Union; Southwestern Life; St. Lucie County, Florida; St. Petersburg, Florida; Tokyo Securities; Union Bank; UNIPEC; Virginia state pension fund; West Virginia Consolidated Fund; Western Corporate Federal Credit Union; Wilmington Trust; Wimpey Group; Wisconsin State Pension Fund; Yamaichi Securities.

  The list was impossible to ignore. The stories of investors losing money on derivatives were not isolated incidents; they evidenced an epidemic. Just a few years earlier, structured notes did not exist, and complex CMOs were merely the wacky idea of a few traders. But by 1994, the financial innovations of Bankers Trust, First Boston, and Salomon Brothers had spread so far that it was hard to find someone who didn’t own these instruments. The news was bewildering and overwhelming for average investors, who barely had time to follow the media coverage of the losses, and certainly did not have the resources to understand all the details. In this new world, how could a person keep tabs on his or her investments?

  As average investors learned about the losses, they became upset with Wall Street, and bankers briefly became pariahs, as they occasionally do. The number of top business-school graduates seeking finance jobs dropped by half. The media portrayed wealthy bankers as villains. And the inevitable cartoons appeared, one picturing a man in a three-piece suit, holding a briefcase and a cup for begging, next to a sign that said “Dabbled in Derivatives.” Another had a caption, “Hey, there’s always tomorrow. Well, unless you’re in derivatives.” For the 1994 holiday season, Trimedia, a public-relations firm, sent out a card depicting Santa and his reindeer crashing into a building, with the legend, “Don’t worry. He’s got a derivatives contract from Bankers Trust. Happy Holidays!”

  The bankers didn’t seem to care about all the fuss. They knew it would go away soon, as it always did. Instead, they disclaimed any responsibility, and blamed investors for making stupid bets and for failing to supervise their investments. Besides, in December 1994, there was little chance of getting bankers to focus on anything other than the upcoming bonus check.

  After several years of being spoiled by skyrocketing bonuses, bankers threw tantrums when they learned overall pay would be down 20 percent for 1994. Many angrily tore up their bonus checks, took unannounced vacations, quit, or otherwise behaved as one might expect of youngsters losing their million-dollar allowances. A trader from Lehman Brothers sent an impostor to perform his jury service while he skipped out on a trip to Milan.47 (Reportedly, when the judge began routinely questioning the surrogate, he said he wasn’t the trader, asked to visit the men’s room, and never returned.) New York magazine reported on ot
her bankers’ attempts to “get even” by billing expensive consumer items to their firms, including groceries, home furnishings, Brooks Brothers shirts, and even Chanel suits. One banker said, “Given what they put me through, they owe me.” The greatest abuses involved limousine services, which cost firms millions of dollars in waiting time alone. Bankers called for cars at odd times, made drivers wait, and then billed the fees to their firms, or to clients. One Goldman Sachs banker sent a briefcase—just the briefcase—home to Connecticut in a limo.

  As investors learned about these stories, they became angrier, still. This clash between Main Street and Wall Street created the ideal atmosphere for legislators to create new legal rules governing the various new financial instruments and strategies. Investors are typically too diffuse to mount intense lobbying efforts, especially compared to banks, which have well-funded trade organizations and dedicated lobbyists. But in 1994, investors were crying for reforms, and there were signs they were being heard. Congressional staffers began drafting new legislation, judges were hearing lawsuits related to the losses, securities regulators were preparing rules to improve disclosure, and prosecutors were considering bringing criminal cases against various perpetrators. As the year closed, with Orange County filing for bankruptcy, investors found little comfort, except perhaps the hope that governmental officials would punish the wrongdoers and create a new regulatory framework to stop the wave of undisclosed risk-taking of 1994 from spreading even further. Instead, the regulators were about to do precisely the opposite.

  STAGE TWO

  INCUBATION

  6

  MORALS OF THE MARKETPLACE

  The two most prominent people managing the regulatory response to the financial fiascos of 1994 were Arthur Levitt Jr. and Mark C. Brickell. Levitt was the chairman of the Securities and Exchange Commission, the primary regulator of financial instruments in the United States—a federal agency that advertised itself as “the investor’s advocate.” Brickell was a vice president of J. P. Morgan and the top lobbyist for the derivatives trade group, called ISDA, that had persuaded lawmakers to allow the unregulated derivatives markets to grow unchecked since 1985. It was surprising how much the two men were in sync.

  Levitt was an unlikely candidate to be the investor’s advocate. During the 1960s and 1970s, he had been a Wall Street broker, eventually rising to become president of the predecessor firm to Lehman Brothers. To the extent he focused on individual investors, he was persuading them to buy stocks. In 1981, he even wrote a book of investment advice called How to Make Your Money Make Money. (When Levitt testified before Congress on the collapse of Enron in January 2002, one admirer sitting in the second row of a packed room in the Hart Senate Office Building was clutching a tattered copy of Levitt’s book, presumably seeking an autograph.)

  After working as a stockbroker, Levitt spent twelve years as chairman of the American Stock Exchange (the smaller sister of the New York Stock Exchange), where he advocated on behalf of major Wall Street firms and even ran a derivatives-trading business. Levitt had plenty of experience with derivatives, stretching back to as early as 1985, when he chaired a conference on futures and options.1

  Notwithstanding his Wall Street background, Levitt served the longest term of any SEC chair—nearly eight years—acquiring a reputation as an effective regulator (a reputation that this chapter will show is mostly undeserved). In 2002, after Levitt finally stepped down, some members of Congress even apologized for ignoring some of the proposals Levitt advanced late in his term.

  Levitt was a fish in a barrel for Mark Brickell, an aggressive banker who, beginning in 1976, spent more than two decades at J. P. Morgan. J. P. Morgan—like Bankers Trust—was transforming itself from a stodgy commercial bank into a sophisticated risk manager and trader of new financial products. Brickell had studied politics at the University of Chicago and, although he also had attended Harvard Business School and worked in swaps, he only began to thrive at J. P. Morgan when he returned to politics, lobbying on behalf of his bank and other derivatives dealers as chairman of ISDA.

  When Brickell’s colleagues said he was good at “working” Washington, they vastly understated the case. Many legislators and regulators dreaded Brickell. He was both condescending (saying officials couldn’t possibly understand derivatives) and reassuring (saying Wall Street had everything under control). But even Brickell’s enemies admitted that he was a success. Brickell and ISDA had kept lawmakers away since the mid-1980s, and in early 1994 over-the-counter derivatives were largely unregulated.

  After the Fed raised interest rates in February 1994, Brickell became a pit bull, telling legislators that although recent derivatives losses looked bad, regulators couldn’t possibly understand or control the situation any better than market participants. He said new legislation would cause unforeseen damage, potentially imperiling not only Wall Street and the derivatives industry, but—by implication—campaign donations as well. (ISDA’s members were major political contributors.)

  Throughout 1994 and 1995, Brickell and Levitt worked to protect the finance industry from new legislation. In early 1994, lobbyists waited for investors to calm down from the shock of how much money-fund managers and corporate treasurers had lost gambling on interest rates. When legislation was introduced, Brickell fought it and Levitt gave speeches saying the financial industry should police itself. The issues were complicated, and the public—once so angered by the various scandals—ultimately lost interest. Instead of new derivatives regulation, Congress, various federal agencies, and even the Supreme Court created new legal rules that insulated Wall Street from liability and enabled financial firms to regulate themselves. Under the influence of Levitt and Brickell, regulators essentially left the abuses of the 1990s to what Justice Cardozo had called the “morals of the marketplace.”2

  As a result, most of the financial dealings described in previous chapters—even obvious malfeasance—went unpunished. Regulators stretched the existing law to bring a questionable case against Bankers Trust, but the result was a relatively small fine for Bankers Trust and no prison time for any bank employee. No one in the Orange County debacle did prison time for any conviction, either. Piper was much the same: Worth Bruntjen continued to manage money, his only punishment being a regulatory slap on the wrist.

  The best illustration of this new self-regulatory approach was the response to a $350 million loss incurred by Orlando Joseph Jett, a trader at Kidder Peabody—the investment bank owned by General Electric that sold mortgage derivatives to Worth Bruntjen and David Askin. Prosecutors attempted to bring cases against the key parties at Kidder Peabody, but the facts were too complex, and the law was too unfriendly. (The basic pattern of the “Joseph Jett” story would be repeated several times during the next decade, including by Kent Ahrens of the Common Fund, which lost $138 million on stock-index options and futures at about the same time as Jett’s loss,3 and by Nick Leeson of Barings Bank, which lost a billion dollars trading options and futures in Singapore a few months later—more on Leeson in Chapter 8.)

  Where the regulators failed, the markets succeeded in a limited way, by punishing the shareholders of firms that had engaged in questionable schemes. For example, the Joseph Jett scandal destroyed Kidder Peabody and embarrassed Jack Welch, the chairman of General Electric. The message to shareholders was: watch your investments carefully, because without the help of securities regulators—including the supposed “investor’s advocate”—you are on your own.

  After almost thirty years working in finance, Arthur Levitt Jr. wanted to cap off his Wall Street career with a Cabinet-level political appointment in the Clinton administration: secretary of commerce or perhaps even treasury. Levitt was an unlikely nominee for chairman of the Securities and Exchange Commission, a lower-level position requiring substantive knowledge of securities regulation. The typical SEC chairman had been a distinguished lawyer or law professor.

  After majoring in English at Williams College, Levitt had ambled through severa
l low-prestige sales jobs in the 1950s, including life insurance and cattle (ironically enough, he had sold cattle to William Casey, who later became chairman of the SEC),4 until Sandy Weill—the later chairman of Citigroup—gave Levitt a job as a stockbroker. Levitt was moderately successful under Weill’s tutelage and, although he wasn’t always liked or respected, he made a fair amount of money.

  But throughout this time, Levitt was unable to satisfy his political ambitions, which stemmed from his father, a respected senior statesman and long-time New York State comptroller. Levitt took on a few minor political appointments, including chairman of President Carter’s “White House Conference on Small Business,” but nothing compared to what Arthur Levitt Sr. had accomplished.5

  The second Reagan administration considered Levitt for a position, but he still lacked both experience with policy issues and political connections. Besides, he was a Democrat. In 1989, Levitt improved his résumé by taking a quasi-political job as chairman of the American Stock Exchange, where he developed connections with both politicians and Wall Street leaders. He also bought a controlling interest in Roll Call, the newspaper that covered insider scoop on Congress.