How Deceit and Risk Corrupted the Financial Markets
by Frank Partnoy
New York: Times Books, 2003.
If you want to understand the murky world of derivatives trading or how Enron and the other corporate meltdowns of recent years relate to previous high-profile disasters (e.g. Barings Bank, Orange County and Long-Term Capital Management) this is the book to get. It will likely convince you that our financial system is still perilously susceptible to a giant meltdown, and that Sarbanes-Oxley did virtually nothing to prevent that inevitability.
Frank Partnoy, a law professor and former derivatives salesman, has written a convincing account of how the financial markets have created new levels of financial risk and complexity that have infected otherwise solid, industrial corporations, and burned ordinary investors.
In many ways, this is the most useful of Enron postmortems. It is certainly the most convincing explanation of how the recent corporate scandals relate to the labyrinthine developments of high finance over the past decade.
Building on his previous book, F.I.A.S.C.O., which was a personal account of his stint as a Wall Street derivatives salesman, Partnoy looks closely at the historical trajectory of derivatives trading, explaining how the recklessness and lack of regulation could threaten to bring down the entire financial system.
He begins by focusing on the traders who pioneered the wild West of Wall Street derivatives trading, including Bankers Trust’s Andy Krieger and other traders who introduced new financial instruments in the late 1980s. These traders were a new breed -- more MIT geek than the macho floor traders who dominated the trading floors in the late 1980s. They created impenetrable trading strategies that even a team of mathematicians and criminal psychologists – let alone other traders and federal prosecutors – could not decipher.
Derivatives are complex instruments (e.g. futures, options, swaps) whose value is derived from some underlying security. Most derivatives are traded “over the counter” – i.e. not on any regulated exchange. Although originally sold as a way to increase market “efficiencies,” the biggest attraction provided by derivatives is that they allow institutional investors and rogue traders to skirt restrictions on making large, risky investments. Thus, just as stock options twisted the culture of top corporate management by creating an incentive to cook the books so that they could cash out their options, derivatives allowed traders and lower-level employees driven by the prospect of huge year-end bonuses to take huge trading risks. In both cases there was little downside risk for the individuals involved: executives with options were not punished when the stock tanked (and many cashed out long before then), and traders are risking other people’s money.
The “infection” comes when the risk is spread around, to hundreds of industrial corporations and investment funds. The financial subsidiaries of major corporations, under pressure to deliver their own profit, became increasingly important as a profit center when they delivered. But top management often didn’t understand how those profits were made until it was too late. Meanwhile most directors didn’t even have a clue that their company was even trading derivatives, until someone had to explain why they were taking such a big hit. (As was the case at Proctor and Gamble in the early 1990s).
And because the risks were huge, the day of reckoning could come suddenly. Barings Bank, the oldest and one of the most prestigious banks in England, was brought down by huge trading losses created by an obscure back-office trader working out of their Indonesia office.
Joseph Jett, a trader at GE’s investment banking subsidiary Kidder Peabody, lost $350 million. As Jack Welch commented later, when Enron filed for bankruptcy, “We were lucky it was small enough. We sold it [Kidder Peabody] and got out. And got out alive. But it could have eaten us up if it were a bigger thing. This thing at Enron got bigger than the core business and it ate them up.” [Partnoy actually argues that Enron was different than GE and the others. The company’s derivatives trading operation made lots of money, even at the end, when it tried to use those profits to hide other losses on tech stocks and other unprofitable businesses. In fact, Enron offered retention bonuses to its derivatives traders when the company collapsed, and was able to sell its trading operation. Instead he blames the credit rating agencies and the rapid withdrawl of money by spooked investors for the company’s collapse, a theory that is in alignment with Skillings explanation.] Other companies like Freddie Mac have run into trouble by trying to spread their earnings from derivatives over a longer period of time (as a kind of insurance against downturns, and probably to hide the risk they were taking).
It doesn’t seem like anyone has learned anything from the early scandals, or (given the lack of interest in regulating derivatives now) after Enron. After fiascos at Long-Term Capital Management and Orange County created a brief setback in over-the-counter (unregulated) derivatives trading, it came back in force. It's safe to say that derivatives are probably very popular today.
Partnoy lays much of the blame for the potential fallout upon regulators, especially the SEC. Probably most controversial are his criticisms of Arthur Levitt, who has been lauded for supporting specific reforms while at the SEC, including the FASB’s effort to expense options.
Levitt supported “tort reform” rollbacks that created a daisy chain of irresponsibility among those who are supposed to monitor all this risky behavior -- accountants, bankers and lawyers. Unfortunately, Partnoy does not explore the political details of how the Private Securities Litigation Reform Act came about, but he does criticize Levitt for supporting this law (which, interestingly, was the only one that passed over Clinton’s veto during his entire presidency) with speeches about how abusive litigation was imposing tremendous costs on issuers of securities.
Levitt also supported legislation such as the Commodity Futures Modernization Act in 2000, which exempted over-the-counter derivatives from regulation. (The act included a specific exception for energy derivatives, a provision strongly supported by Senator Phil Gramm, whose wife Wendy moved on to serve on Enron’s board of directors just weeks after she was successful in deregulating swaps while at the Commodity Futures Trading Commission. Phil Gramm left the Senate to join UBS, the Swiss bank that bought Enron’s derivatives trading operation.) Levitt somehow managed to skip over these episodes in his own mea ex-culpa, Take on the Street.
Partnoy also criticizes the SEC for going after simple accounting fraud cases (Waste Management, Cendant, Sunbeam), while failing to prosecute complex cases that involved the use of derivatives. Of course the overworked SEC enforcement division could not afford the years of effort and dozens of lawyers and staff (with its high turnover) that would be required to successfully mount a complex case against a major corporation. But Partnoy is right that by focusing on simple cases, the SEC sent a message that major corporations engaging in complex fraud are likely to avoid punishment.
It’s frightening when you realize that derivatives continue to grow in importance. “Regulatory arbitrage” – the increased use of derivatives to take advantage of the difference in legal rules among different jurisdictions – has also created the prospect of global market meltdowns as the transnational use of derivatives had tightened the connections among various markets.
Partnoy offers a number of suggestions to prevent that inevitability. But if he’s right, they will probably not be taken seriously until after the next major corporate financial crisis hits.
If you want to know more about derivatives, I also highly recommend the web site of the Derivatives Study Center.