Infectious Greed

by Frank Partnoy

  During the previous Mexico crisis, in the early 1980s, U.S. regulators had known precisely what troubles faced the Mexican government and its banks, because they could look at a record of assets and liabilities, and immediately grasp the risks. Now, the world was much more complicated, and these institutions were using so many new financial instruments that regulators could not understand the scope and nature of their risks, or even how the different institutions and markets were connected. 31 They believed the losses would be in the tens of billions of dollars, but they couldn’t be sure about much more than that.

  Wall Street lobbied the U.S. government to bail out the Mexican government with loans, and the Clinton administration—especially Robert Rubin—supported the idea. President Clinton sought approval from Congress for loans to Mexico, but when Congress did not indicate any interest, Clinton acted on his own. On January 31, 1995, he determined that the economic crisis in Mexico posed “unique and emergency circumstances” that justified the use of the obscure Exchange Stabilization Fund to provide loans to the government of Mexico.32 A handful of congressional leaders issued a joint statement agreeing with the president’s determination.

  The Exchange Stabilization Fund had been created in 1934, as part of the New Deal, for the U.S. Treasury to use in protecting the value of the dollar in foreign currency markets. But President Clinton obviously wasn’t using the fund to prop up the dollar, which had just gone up relative to the peso. Instead, he wanted to lend money to the Mexican government, to help it avoid a default on its debt, much of which was held by U.S. investors.

  Some members of Congress weren’t happy with President Clinton secretly disbursing money without their approval, and they accused members of the Clinton administration—including Treasury official Lawrence Summers, an economist from Harvard—of concealing information about problems in Mexico before the peso devaluation.33 They also tried to prevent Clinton from using the Exchange Stabilization Fund, arguing that the president did not have the constitutional authority to lend money to Mexico without the approval of Congress. They had a good argument.34 The U.S. Constitution gave Congress the “power of the purse,” and the law establishing the Exchange Stabilization Fund arguably did not permit a multibillion-dollar bailout.

  Nevertheless, on February 21, 1995, Mexico and the United States signed financial agreements for loans of up to $20 billion, to be structured as swaps between the two countries, in which the United States would give Mexico money up front and Mexico would agree to make payments over time. Mexico agreed to open its economy to foreign investment, and the United States began cutting checks. The amount owed on the swaps varied over time, but was in the range of $13 billion.

  The most surprising aspect of these swaps was the low interest rate Mexico would pay. The U.S. Treasury only charged Mexico rates that were “designed to cover the cost of funds to the Treasury and thus are set at the inception of the swap based on the Treasury Bill rate.”35 For example, Mexico borrowed $3 billion, on March 14, 1995, at an interest rate of 7.4 percent. Even before the crisis, dollar-denominated interest rates in Mexico had been higher than that; dollar-denominated rates shot up to 40 percent after the crisis. In other words, the Clinton administration had given Mexico an incredible sweetheart deal, like a credit-card company offering a temporarily low rate to a high-risk borrower. The economic cost of the loan, in foregone interest, was several billion dollars.

  Mexico ultimately repaid the swaps in 1997, three years ahead of schedule, and President Clinton declared the policy a victory. By this time Robert Rubin was secretary of the Treasury and Lawrence Summers was his deputy. The administration claimed the United States had made $580 million on the loans, even though this “profit” represented a below-market interest rate. When many journalists seemed to accept this argument, the Treasury officials were in good spirits. Summers joked with Rubin that he would settle for just one percent of the Treasury’s interest, and Rubin responded, “Larry, anything you can negotiate, I’m happy to split with you.”36

  The Clinton administration glossed over the key problem with the bailout: the message it sent to investors who had foolishly pumped money into Mexico without much thought. The bailout defined “moral hazard”—if investors could count on the government to provide insurance, by stepping in if the market crashed, they undoubtedly would increase their bets. Imagine what gamblers at a roulette wheel would do if they believed the government would cover their losses. Not surprisingly, the Mexico bailout would lead investors throughout the world to take on unwarranted risks, in the same way federal deposit insurance had led U.S. savings and loans to gamble during the 1980s.

  Many economists were highly critical of the Mexico bailout. They argued that moral hazard distorted markets and should be avoided whenever possible. Economist Paul Krugman questioned whether future bailouts would go as smoothly. The fact that Mexico had repaid its loans on time didn’t mean every borrower would be able to do so. Krugman claimed the Clinton administration “got very lucky” in resolving the Mexico crisis, and warned that “it was a mistake on everybody’s part to assume they would always be so lucky in the future.”37 The British regulators would be tested next.

  Nicholas William Leeson was an unlikely rogue derivatives trader. He failed A-level mathematics in high school in Watford, a cheerless suburb of London.38 He did not attend college or business school. Friends described him as “just a normal bloke who likes all the ordinary things like football.”39 With his mediocre record, he was fortunate to find a job as a low-level financial clerk. After a few years, Barings hired him. It was 1989, just before Allen Wheat joined First Boston and set up his derivatives firm, CSFP, in London.

  Barings was a prestigious bank, the oldest in England, and it served clients ranging from the queen to prominent British industrial companies. Leeson began at the bottom, processing trade records, and his early career in London was undistinguished. Barings shipped him to Singapore to help with the back-office settlement of the firm’s derivatives trades there. The Singapore office was lightly staffed, and Leeson also took over a routine, low-margin trading operation, designed to profit from small price differences between Nikkei 225 futures contracts (recall that these are financial instruments based on the value of the Japanese stock-market index), which were traded in both Singapore and Osaka, Japan. If the prices in Singapore were lower, Leeson would buy there and sell in Osaka (and vice versa). This arbitrage trading was not very risky, or very sophisticated. Salomon Brothers had done the trades years earlier, and now First Boston, and other banks, already had begun selling much riskier trades based on the Nikkei 225 index. It didn’t seem necessary to supervise Leeson very closely, and Barings did not.

  When one of Leeson’s clerks made a small error on twenty futures contracts (selling futures—when he had instructed her to buy), he tried gambling in the futures markets to make up the $30,000 loss.40 It worked. When no one at Barings questioned why he had made these trades, he began speculating more often. Unfortunately, he was not a very good trader, and the more he strayed from the low-risk arbitrage strategy, the more money he lost. Over time, Leeson became more aggressive, trading “in size,” and even selling options, betting that Japanese markets would remain within a narrow range. He lost these bets, too. By the end of 1994, he was $285 million in the hole.

  Leeson hid his losses by entering losing trades into an error account, labeled #88888, which was not connected to the rest of the Barings computer network. As with those of Joseph Jett at Kidder Peabody, Nick Leeson’s losses were hidden for a time because of a flawed accounting system. It also helped that Leeson’s supervisors permitted him to act both as trader and as back-office manager, so that he could control both the execution of trades and the processing of trade records.

  The senior managers at Barings didn’t see the $285 million of losses. Instead, their accounting reports showed that the back-office boy in the Singapore office had somehow made $30 million in 1994, nearly 20 percent of the bank’s total profit
.41 Leeson’s trading had grown from a handful of futures contracts to tens of thousands of contracts, representing billions of dollars of bets, almost half of the trading in Nikkei 225 futures in Singapore. The managers didn’t know precisely how Leeson was making so much money, but they liked it, and they were planning to reward him: Leeson’s bonus for 1994 was to be $680,000, more than triple his pay from the previous year.42 He was 28 years old.

  Ron Baker, the head of financial products at Barings, was proud of Leeson. Several hundred managers from offices of Barings around the world were gathering for a year-end conference, and Baker asked Leeson to give a speech summarizing his trading strategies, much as Joseph Jett had done at Kidder Peabody. On December 9, 1994, Baker introduced Leeson to his fellow managers, saying, “Nick Leeson, whom most of you know and all of you have heard of, runs our operation in Singapore, which I want all of you to emulate. You’ll hear later from Nick about how he does it, but I just want to drive home to you guys that if you could all think about Nick and perhaps come up with ideas to follow his footsteps, Barings will become one of the most successful operations in the derivatives business.”43

  It wouldn’t be long before they would be hearing all about how Nick had done it. At the time of the conference, Leeson had sold tens of thousands of call and put options on Japanese stocks, betting billions of dollars that the Japanese stock market would not move much. If the markets remained calm, Leeson would keep the option premiums, and this profit would help him crawl out of his hole. Selling “naked” options was a very risky strategy (so risky Andy Krieger of Bankers Trust had refused to do it).

  On January 17, 1995, a serious earthquake hit near Kobe, Japan, and Japanese stocks crashed. As Leeson’s options positions plummeted in value, he increased his bets, desperately doubling down to try to get back to even. He began buying Nikkei 225 index futures, betting that the Japanese stock market would go up after the earthquake. When other traders questioned the huge increase in Leeson’s trading, he reportedly claimed to be acting on behalf of financier George Soros; in truth, Soros had bet, against Leeson, that the Japanese stock market would fall, and made $320 million.44

  In early February, the Japanese stock market briefly recovered, and Leeson climbed to within a few hundred million dollars of even. At this point, his positions essentially consisted of a $7 billion bet that Japanese stocks would go up and a $22 billion bet that Japanese bonds would go down. If the bets would only move a little more in his favor, he would be out of the hole.

  When Japanese stocks plunged again, and bonds went up, Leeson’s game was up. Given the size of his bets, it would be surprising if he only lost a billion dollars. He and his wife flew to the island of Borneo and hid in a hotel room in a Malaysian resort called Kota Kinabalu. They watched the news about the collapse of Barings on television.

  Needless to say, the senior executives at Barings were surprised to discover, on February 23, that their back-office boy in Singapore had lost $1.4 billion, more than the bank’s capital. Just two days earlier, they had received a Value At Risk report for Leeson’s trading. Value At Risk, or VAR, was a statistical technique designed to show the maximum probable loss for a particular portfolio of investments. The report listed the VAR for Leeson’s portfolio as “ZERO.”45 All of Leeson’s long positions appeared to be matched by short positions, as one would expect in a low-risk arbitrage strategy. In other words, the firm’s accounting system had totally failed to pick up Leeson’s speculative bets. The managers might have learned about the bets if they had asked some hard questions about how, exactly, Leeson had suddenly made $30 million. But they had not. A few months later, Leeson would tell interviewer David Frost, “A couple of the people who were in the core places within Barings that should have been administering a high level of control had what I would describe as almost no understanding of the fundamentals of the business.”46 Ironically, a few months earlier, the penny-wise bank had decided not to buy a $50,000 computer-software system that continually tracked traders’ positions, because it was too expensive.47

  Bank of England officials learned of the losses at Barings and met with a group of senior bankers, but the British regulators—having just watched the U.S. bailout of Mexico—wisely decided to let Barings slip into receivership on February 26, 1995. International Nederlanden Groep (ING) bought the venerable bank for the princely sum of one British pound.

  Leeson flew to Frankfurt, Germany, where police detained him until the Singapore authorities faxed a national arrest warrant. He was extradited to Singapore and sentenced to serve six-and-a-half years in a Singapore prison.48 The lesson: you could commit financial fraud in the United States, but don’t you dare do it in Singapore. In prison, Leeson wrote a book about his experience, which Miramax made into a 1999 movie entitled Rogue Trader. He had come a long way from Watford.

  After the television program 60 Minutes aired a segment on Barings and derivatives on March 5, 1995, Mark Brickell, the pit-bull Wall Street lobbyist, and Arthur Levitt, the SEC chair, were suspiciously defensive in response. Brickell appeared on Charlie Rose’s television program on PBS and insisted that the collapse of Barings had little to do with derivatives. 49 Arthur Levitt phoned reporters from South Africa, saying, “The Barings issue, again, is not a derivatives issue—they could have been trading in cabbages.”50 These comments were odd, given that Barings obviously had lost the money on various types of options and futures.

  Brickell and Levitt were trying to reframe the collapse of Barings to deemphasize these new financial instruments and to persuade the media and regulators not to fan the derivatives flames in the United States with new scandals abroad. Their argument was that the various financial fiascos abroad were caused more by the unique lack of controls at foreign banks than by the instruments themselves. In other words, deceit mattered more than risk.

  But this argument ignored the fact that deceit and risk were feeding off of each other: simply put, it was easier to commit financial misdeeds with derivatives. It was no coincidence that many of the control problems at non-U.S. banks during the mid-1990s involved new financial instruments. Barings was far from alone. Britain’s National Westminster Bank lost more than $80 million on options trades that senior managers were unable to evaluate in an incident that was eerily similar to earlier valuation difficulties at Bankers Trust and Salomon Brothers.51 Deutsche Bank, Germany’s largest bank, also suffered from lax controls, and fired a rogue trader in March 1995, although its losses were only about $15 million.52 Union Bank of Switzerland’s “crown jewel”—its sophisticated equity-derivatives group—lost $240 million on long-dated stock options.53

  During this time, Sumitomo Corporation and Daiwa Bank—two Japanese firms—also experienced billion-dollar-plus scandals involving complex trading strategies. In each case, a rogue trader placed large bets, allegedly without the knowledge of supervisors. Several major Wall Street dealers were involved.

  Sumitomo reported the largest derivatives loss to date: $2.6 billion, in unauthorized trading of copper futures by the firm’s chief trader, Yasuo Hamanaka. The Sumitomo debacle was unfathomably complicated and provoked a Dickensian legal battle, ranging from a prosecution by the CFTC, alleging manipulation, to numerous lawsuits against Sumitomo to a dispute between Sumitomo and J. P. Morgan over alleged loans. J. P. Morgan reportedly paid $125 million to settle a suit by Sumitomo alleging that Morgan had given Hamanaka an off-balance-sheet loan so that he could continue his trading (J. P. Morgan later would make similar loans to Enron, before Enron collapsed). Sumitomo blamed Hamanaka for doing 2,000 unauthorized deals a year for ten years, and for forging records and signatures needed to give him the authority to trade. Hamanaka was charged with forgery and manipulating copper prices, and was sentenced to an eight-year prison sentence in Tokyo. Merrill Lynch was charged with contributing to the manipulation, and agreed to pay a $15 million fine.

  At Daiwa, Toshihide Iguchi’s story was similar to Nick Leeson’s, but it lasted four times longer. In 1984, Iguc
hi lost about $200,000 while trading U.S. Treasury bonds at Daiwa’s New York branch. During the next eleven years, Iguchi made about 30,000 unauthorized trades in an attempt to dig out of the loss. He was quite possibly the worst trader in history. From 1984 until 1995, he lost an average of almost half a million dollars a day, $1.1 billion in all.54 He covered up the losses simply by not booking the sales of securities he sold at a loss. No one knew the bonds had been sold, because Iguchi—like Leeson—was involved in the back-office booking of trades. The bonds were held on Daiwa’s behalf by Bankers Trust, and Iguchi had obtained some Bankers Trust letterhead, and printed forged financial statements on that, just as Leeson had forged his own position reports.55

  During this time, U.S. banking regulators had examined Daiwa ten times and had never spotted the losses, even though the trading involved simple financial instruments issued by the U.S. government. The banking regulators ignored various “red flags,” including the fact that Daiwa lied to the Federal Reserve in 1993.56 One can only imagine what might have happened if complex derivatives had been involved.

  Iguchi was an unlikely rogue trader, and he lacked formal training in finance. He had moved to the United States from Kobe, Japan, to attend college at Southwest Missouri State University, in Springfield, Missouri, a school known more for its proximity to Lake of the Ozarks than for any programs in finance. Iguchi studied psychology and art, and was a cheerleader.57 After graduating in 1975, he worked at a car dealer before joining Daiwa’s back office, the same first job as Nick Leeson.

  Yet Iguchi wasn’t even an unusual hire for Daiwa, which also hired Mohamad Sotoudeh, a trader whose experiences demonstrated the close connections among various financial scandals. Managers at J. P. Morgan, where Sotoudeh worked before Daiwa, reportedly had asked him to resign when they discovered a $50 million discrepancy in the monthly mark-to-market values of his trades in mortgage derivatives, the same risky instruments that had destroyed Askin Capital Management and Worth Bruntjen.58 When Daiwa hired Sotoudeh in 1992 to be its first mortgage-derivatives trader, Andrew Stone, head of Daiwa’s mortgage group, remarked, “We have a lot of people with unusual backgrounds and work histories. He won’t stand out much.”59 Compared to Toshihide Iguchi, it was true.