May 10, 2003     Home  l  Broadcast  l  Expert Archive  l  About Us  l  Contact Us

Frank Partnoy
Professor and Author
F.I.A.S.C.O.: Blood in the Water on Wall Street

Editor's Note:  We have edited the interview in this transcription for clarity and readability.
The original real audio interview may be heard on our Ask The Expert page.

JIM PUPLAVA: Welcome everyone. It’s time to introduce my guest this week. Joining me on the program is Frank Partnoy. He is currently a professor at The University of San Diego School of Law. He has worked as an investment banker on Wall Street as derivatives broker and a criminal defense and securities attorney. He also consults on regulation of the markets and white-collar crime and has provided expert testimony before the Senate committee, investigating the Enron collapse. Partnoy is also the author of F.I.A.S.C.O.: Blood in the Water on Wall Street. His new book is called Infectious Greed: How Deceit and Risk Corrupted the Financial Markets. Professor, in 1984, a gentleman by the name of Andy Krieger, a Sanskrit scholar, and a young Wharton graduate, began a career trading currencies. He invented a new way of making money on Wall Street. What was this new method of making big dollars? In fact, I think you mentioned he made $30 million his first year. How did Andy Krieger make so much money?

FRANK PARTNOY: Andy Krieger, who is a very interesting guy, sort of a renaissance guy, was a very early participant in over the counter of foreign currency options and he switched from studying Sanskrit at the University of Pennsylvania to the Wharton School, where he began studying currency options; and he developed a computer *model while he was there, that was able to evaluate these options in a more sophisticated way than other parties were then evaluating them. This is a decade after the Black-Scholes* Merton model had made clear a closed form way of valuing options, but still Black-Scholes *Merton wasn’t the end of the debate about how currency options were valued and so after he graduated, went to work, at first at Salomon Brothers where he sat right next to a number of quite infamous traders, John Meriwether, who later founded Long-Term Capital Management and John Goodfriend the chairman of Salomon Brothers, were just right on the desk, right next to Andy and he started making money almost immediately. He was really a star there and made a considerable amount of money and in the story that I tell, in Infectious Greed, it’s a story of a virus spreading through the market and I pinpoint his move to bankers trust, this is Andy Krieger’s move to Bankers Trust and what happened to his trading there, not necessarily because of him but because of how Bankers Trust and it’s accountants dealt with that trading as the patient zero in the story is where the virus first starts to spread, and so the problem that Andy Krieger ended up or the people dealing with him and his trading, that they ended up confronting was that people just didn’t understand how to evaluate options appropriately. The models are quite complex. Krieger is a brilliant guy. He is still managing money, actually, has a hedge fund and works in, it’s quite successful in the financial arena still. But back in the late 1980’s people, didn’t understand how an animal like Krieger worked and they didn’t understand how to assess his profits and so he had an unbelievable year trading for Bankers Trust after he left Salomon Brothers, this is in 1987 and he basically saved the bank from a losing year. He made in the range of $250 - $300 million of profits just on his own that year. The problem was that Bankers Trust was unable to figure out exactly how much those options positions were worth at the end of 1987 and ended up miss stating it’s financials for that year. So he’s the first person in this story and what I try to do in the book is connect the dots from that story at Bankers Trust in 1987 to today.

JIM PUPLAVA: Why is it important in looking at Andy Krieger’s story for understanding the, let’s say, the trajectory of the financial markets which would take place in the ensuing 15 years?

MR. PARTNOY: Well, it’s really an example of a bunch of different themes. One is the increase in financial innovation. How much more complicated the acts of individuals got over this period of time. Another is the separation between management and employees – how far away the CEO of Bankers Trust was from the activities of one of its traders, even a trader who, being like Andy Krieger, had $700 million dollars worth of the banks capital to play with, and then finally the deregulatory focus of the markets and the increasing reluctance of prosecutors to bring complex criminal cases. The Bankers Trust example from 1987, is a good example of all three and with respect to prosecution, what ended up happening is that Bankers Trust when it added up all of Krieger’s trading profits, found that it’s numbers fell $80 million short of what it already had reported in a press release and so Bankers Trust went to it’s accountant then, Arthur Young, which is now Earnsten Young and the managers of Bankers Trust together, with the accountants at Arthur Young came up with a scheme that basically hid that $80 million of profit from investors for a period of time and that sounds a lot like Enron. It sounds a lot like what’s happening in a number of companies in the economy today. They were able to re-trigger these numbers in part and be confident in doing that, in part because they knew or suspected that they wouldn’t be punished and in fact Bankers Trust ultimately was forced to restate its numbers to admit that it had made this $80 million mistake in its financials and no one was punished for it. Not a single person did a day of jail time and so that marks the transition point. In the late ‘80’s there were a lot of criminal prosecutions but many of them were for very simple insider trading cases in the heyday of the ‘80’s, those were cases prosecutors liked to bring they were relatively easy to prove. This is the time when Michael Milken of *Drexel was prosecuted but the Bankers Trust case was too hard it was complicated and so prosecutors and the SEC let it go and I think that the fact that you let a case like that go creates repercussions, and then if you reinforce it by over the next decade, not punishing people and this happened over and over again over the course of the next decade that individuals were not punished when they engaged in financial fraud that that sends a signal to the markets that you can get away with this and as the markets became more complex and as individuals separated from their managers, you got a phenomenon where people, it became economically rational for people to take on massive risks, that their employers to inflate profits to hide liabilities and it just increased exponentially over time as the signal made its way in the same way a virus spreads through its population the, signal made it’s way further and further and deeper and deeper within companies.

JIM PUPLAVA: After the Krieger fiasco, he left Bankers Trust, however that didn’t stop things from developing exponentially because banks began to push the envelopes even further in the ‘90’s. How did they do this? What instruments did they use to, let’s say, push the envelope even further?

MR. PARTNOY: Well they started inventing new kinds of sophisticated financial instruments. In the late ‘80’s people started using *swaps, which are financial contracts between two players, where one agrees to make a payment based on an index and receive a payment based on either a fixed rate or some other index. For example the simplest form would be an interest rate swap where, I would agree to pay you a floating rate based on a certain notional value and you would pay me a fixed rate and those swaps became increasingly complex during this period, and institutions began adding all sorts of variables to swaps. To the point where one of the most infamous cases was when Bankers Trust, the same bank that Krieger had generated these profits for, went to a small greeting card company, in Cincinnati Ohio and sold it a range of swaps, but one of which was linked to *LIBOR, the London InterBank Offered Rate, an interest rate, multiplied by itself and people always snicker and point to that as one of the most incredible contracts that, why would anyone bet on a payment that’s based on LIBOR squared, you may as well go to bet on the ponies if you’re going to bet on something like LIBOR squared and I’ve always heard and I’ve seen terms used for transactions that were based LIBOR cubed, LIBOR multiplied by itself three times although I’ve never heard or seen evidence directly of somebody who actually bought one of these things. But in fact the LIBOR squared swap, was actually not the most complicated instrument that was sold during this period and there were all sorts of new risks that banks discovered that parties were willing to take on, very complicated correlations between markets, the people were willing to bet on and moreover, there were ways that banks figured out, ways to structure these bets to make them permissible for a new range of investors. So that for example, Orange County, California, which had an investment, set up investment restrictions that required it to buy only highly rated short term bonds, that it could play in these markets too because the banks, the investment banks and commercial banks would structure things called structured notes, which are financial instruments that look a lot like bonds or notes, but whose payments are linked to something else. So, it might be LIBOR squared or more typically it would be something like 15 minus 3 times some interest rate index and the beauty of these kinds of instruments from the perspective of an investor like Orange County, is that they would look like they were highly rated in short term and in fact they would be. They would be rated AAA or AA by the credit rating agencies. They’d be issued by highly credit worthy counter-parties like banks or some of the government sponsored entities and they would be short term and so technically they would fit within the investment restrictions that govern these investors and they weren’t just being * but they were a wide range of investors from companies to mutual funds to insurance companies and they would enable all sorts of new types of risk taking and so that was, the banks developed all sorts, there’s a wide range of products. These markets, which were relatively small in the late 1980’s are now, no one really knows how large they are, but the estimates that are out there are all north of $100 trillion, trillion with a T, in notional values, so these markets have grown exponentially, but the late ‘80’s and early ‘90’s were among the most creative period for bankers who were designing new gizmos and new products based on different variables and creating these instruments that would enable people to get around their own investment restrictions or somehow otherwise avoid relevant rules that would enable them to take on new risks.

JIM PUPLAVA: In your book you also talk about these five dramatic changes in the financial markets. Everything seemed to be concentrated, the leadership is focused in the top 10 companies remain the same from the ‘80’s all the way through the ‘90’s. Does this concentration concern you?

MR. PARTNOY: It does. The finance industry is so unlike every other industry we can think of, except perhaps accounting, in how little it’s changed. How little the players have changed over the last decade. You think about any other part of the economy, in industry, in technology, the landscape changes dramatically. You don’t have the same players involved. You have much more competition and we really don’t have, even though the markets, the financial markets are the most competitive place you can possibly imagine. The competitors themselves, the parties, the largest banks, are almost always in the same position and in any other industry we would worry a lot. We’d have anti trust concerns. We saw some very strong evidence of cartel like behavior. You have trade organizations that get together and lobby for particular types of financial regulations. It’s a problem for that reason. It’s also a problem because if you worry about the systemic risks, if you worry about the possibility of some sort of market collapse or market breakdown you want to have risks dispersed as widely as possible and if you have a relatively small number of people who are just contracting with each other, then the risk that one of them, if one of them goes under then it will spread to the others, is increased and so there are all sorts of concerns and it’s curious that you have this very odd situation where you have perhaps the most competitive part of the economy, that is the financial markets with the least competitive group of participants. These are participants who are paid much higher than any other industry, more than lawyers, more than accountants, more than doctors, more than any other professional you can find and yet the entities themselves are, it’s always the same names at the top and so it’s certainly a very unusual situation. We don’t have any other part of the economy that functions that way and I think it should create concerns both for the anti trust and systemic reasons.

JIM PUPLAVA: I want to talk about systemic risk for a moment because there is a lot of hedging that goes on in the marketplace today. Let’s say that I want to hold long positions in my stock, but I want to hedge it with, let’s say a short position. So, I take a derivative contract and/or it could be a currency, it could be interest rates and so I have this position that I’m exposed to a certain degree of risk, however, I think that I have hedged that risk by taking out these contracts. My risk hedging is only as good as the counter party to that contract that I take out honoring that contract in the event of loss. In this case it would be equivalent to let’s say an insurance company paying on a policy. Isn’t this another risk when you have so much of this activity concentrated in so few hands?

MR. PARTNOY: Sure. What you’ve just pointed to is the problem of concentrating credit risk. Interestingly a lot of companies, including companies in the energy and telecommunication sectors didn’t understand, you’re absolutely right with your point and they didn’t understand your point at all, and they would enter into contacts where they would take on these risks, these credit risks and not hedge them. So that they would have a suspicion within the company that they had no longer exposed themselves to interest rate or currency risk and yet what they’d done was take these risks and simply shifted them to another area, and that is credit risk and the more, it’s a paradoxical situation because the more hedging they did, the more of their interest rate and foreign currency hedging that they did, the more credit risk they created. So, there are two sides to the story. Of course risk is a hot potato, it gets passed around and somebody ends up bearing the risk, but credit risk can be passed around as well, and so the last few year’s people have gotten much more sophisticated about credit risk, and the banks in particular have started getting rid of their credit risk. So that the problems that you point to with entities not necessarily understand that, oh, I’ve gotten rid of my interest rate risk, that’s great and not knowing about their credit risk. Actually what’s happened more recently, is that banks have gotten rid of their credit risk as well, so banks made loans to companies like Enron and WorldCom and then used credit derivatives to push those risks off their balance sheet onto others, in particular insurance firms and reinsurance firms and then that’s a whole other set, that creates a whole other set of problems from the economy’s perspective. But credit risk, I think you’re absolutely right in pointing to credit risk as being one of the key variables and of course a lot of this stuff starts to sound very complicated. Derivatives markets are very complicated, credit derivatives are complicated, but really all we’re talking about it just the extension of credit. It’s the basic function of the market economy and it’s been there forever and we’re just talking about allocating loans and borrowings among parties and trying to figure out how or when if at all, we need to regulate those kinds of relationships but it was astonishing to me that at companies, and I’ll just mention one which is Williams in Tulsa, which had created enormous risks through interest rate and commodity, both speculation and hedging, and yet didn’t really focus as much as it should have on the fact that every time it entered into one of these contracts it wasn’t with an exchange, it’s not like you’re trading on an exchange in Chicago or New York. You’re trading with someone else and whenever you enter into a contract with someone else there’s a chance you might not get repaid and companies were not very sophisticated about thinking through those risks.

JIM PUPLAVA: Tell us about John Meriwether and Long Term Capital Management. Because certainly that marks a very important chapter in the history of the development of these instruments and also points to the dangers that lurk out there when let’s say someone like Meriwether or LTCM is allowed to take these positions.

MR. PARTNOY: Well John Meriwether is a very smart guy and in fact had some overlap in terms of his background with Andy Krieger. I talk in the book about how in some ways they were very similar. Meriwether had spent his entire career virtually at Salomon Brothers before he was pushed out in the aftermath of the Paul *Moser treasury scandal. Paul Moser had been involved in purchasing US Government bonds at auction and had bid for more, not only more than the 35 percent that the US Treasury limited dealers to, but had bid for even more than the entire auction. He actually bid for several 100 percent of certain auctions and was alleged to have illegally cornered that market and actually was convicted and ended up serving four months in a minimum-security prison, virtually the only time anyone did jail time during the 1990’s for financial fraud. Meriwether and his other senior colleagues, who were supervising Paul Moser were forced out and were given relatively small, sort of slap on the wrist fines, and Meriwether immediately started out this new firm Long Term Capital Management and he hired many people from Salomon Brothers, some of the smartest people who had been in his group, called the *Arbitrage Group at Salomon and also hired some very well known political figures and financial economists. Including those who had been at the forefront of creating options theory during the 1970’s. So he got this group of people together and they went out and raised money in a very secretive way and it was almost like they were the Wall Street equivalent of movie stars out there creating money and anyone who was anyone wanted to be invested with them and so people literally threw billions of dollars at the fund on very favorable terms to Long Term Capital Management and the fund was unbelievably successful. It made big money from the start and it generated astronomically high returns. The ratios as they’re used to measure fund performance, were incredible for Long Term Capital they were off the charts and it was an unbelievably successful place. Unfortunately by 1998, many people had picked up on some of the tactics that Long Term Capital was using so successfully in the markets, and the firm had become much more aggressive. It was taking outright speculative positions, it was playing in markets that were far beyond the kinds of arbitrage trades that they had started with and as they got more aggressive, the potential for loss increased. At one point, the bets that were out there, that were like what one economist described as Long Term Capital as a vacuum cleaner sucking up all the nickels that were available in the financial markets. Well the nickels started going away and at one point they gave a large chunk of their investors money back and then a little bit later, decided that they wanted to reduce the risk of the funds. Well, when they went to reduce the risk of the fund, *to unload positions, the strangest thing happened, all of the risk measures went up after they reduced their positions trying to unload this risk and their mathematical models were going haywire, they had gotten it wrong. They had forgotten about some important variables that should have been in their models and they had made all of these bets that were very different from their original strategy, so that they were exposed and the bond market started getting in trouble in 1998.  There were problems in Russia , but also people point to that as being the major problem with Long Term Capital but it really wasn’t. There were a whole series of other bets that the firm lost and toward the end the Federal Reserve started to get quite nervous about Long Term Capital Management because it, mostly because of the over the counter derivatives that the firm had. It had over a trillion dollars worth of these instruments and the Feds prior experience in 1994, had been that when it raised interest rates the interest rate height reverberated throughout the economy in ways they had never anticipated. The Fed really didn’t have a good understanding of how much the over the counter derivatives markets had changed how people took on risk and how they leveraged themselves. So the Fed was very worried about Long Term Capital Management. Alan Greenspan was very worried and the other banks that participated in the same markets were very worried. In part because they had loaned a lot of money to Long Term Capital Management and so the Federal Reserve knew that it didn’t want to bail out the firm because it had in the past bailed out investors in a wide variety of situations, including the Mexico bail out and it didn’t want to create a moral hazard encouraging people to take on risk in the presence of insurance, this perceived insurance from the Fed so they very politely invited all the bankers to come to the New York Feds office and they served up some cookies and locked people away for a day with the very subtle persuasion that you can imagine was in the air, and the banks agreed to a private bail out of Long Term Capital and the great worry at the time was that there was this house of cards that had been built up, there were so many counter party contracts and so much leverage that if we allowed Long Term Capital Management to go under it might cause the entire financial system to collapse and Alan Greenspan and Bob *Regan the treasury secretary later described this incident as coming close to the brink. The people really didn’t know what would happen and were as scared as financial regulators can get.

JIM PUPLAVA: I want to talk about as a result of this; we saw a new kind of speculator come into the market in the ‘90’s. Who were these people and I guess a follow up question, what made them different from speculators in the past?

MR. PARTNOY: Well they were a lot less sophisticated we saw some quite colorful characters come in. Whereas the previous speculators had been very smart hedge fund managers, people with training in finance. The new speculators were people like the treasurer of Orange County, Robert *Citron an elderly fund manager who kept records on index cards, who essentially never went to New York or met with bankers outside of his offices, who was not especially sophisticated about the markets. People like *Worth Brungen, who ran a very large portfolio at Piper, a mutual fund manager who also did not have the same kind of training in finance that you might expect from a very sophisticated market participant and they were just a couple of examples, *municipalities of state governments began speculating on interest rates and currency rates in the same way that individuals got caught up in the fever of day trading stocks, fund managers at all levels, including those who quite frankly didn’t know what they were doing, got caught up in the idea that they could bet on interest rates or that they could somehow figure out the better mouse trap that they could buy into collateralized mortgage obligations in a particular way and make money and in fact a lot of those people did make money, up until the Fed raised rates in early 1994 they were very successful. The most amazing thing is how little time it took from when the carnage spread through the markets in 1994 until the time when again relatively unsophisticated players were back gobbling up risk again, just a few years later, and just a few years after that you have the appetite for risk shifting to all sorts of new parties. Where today now you have credit risk being borne by people you never imagine would bear it. Insurance companies and reinsurance firms and where we don’t really know where a lot of risk is going, so you have a market shift from very sophisticated people at very sophisticated firms taking on this residual risk to much less sophisticated people at the kinds of firms that never took on these risks before, so that’s not the shifting of risk and this passing along of the hot potato farther and farther down the line should not be especially comforting to people, certainly to people who have their money invested with the less sophisticated people.

JIM PUPLAVA: Now in the early ‘90’s there was a shift in terms of regulation. There was an attempt, I believe by Arthur Levitt to clean things up. The Clinton Administration appointed Levitt and his appointment was somewhat controversial because he was obviously coming from the brokerage side. What did Levitt try to do and in many ways what did he fail to do?

MR. PARTNOY: Well I think, in my opinion, Arthur Levitt is one of the great, great failures of this story and perhaps is the worst chairman of the SEC we’ve ever had. If you think about his reputation now, he has, I think quite favorable reputation among most investors, he has had very good public relations and he’s been out lately on the lecture circuit telling people why things went wrong, but he was on the job for 7 ½ years, longer than any other chair of the SEC and more bad things happened on his watch than happened to any other chair of the SEC and the seeds of all of the corporate scandals that have occurred since he left, were planted during that time. So, I think that when we have a chance to look back in a sober way on the 1990’s that Arthur Levitt will not be treated very favorably. I think history is not on his side. In some ways it’s not surprising. Arthur Levitt was not a typical SEC chair. He didn’t want the job; he was a very political animal. His father was a quite famous and well respected New York political figure and never quite measured up to his father, but he certainly tried. He was very active and raised a lot of money for a number of political candidates and especially Bill Clinton when he was running the first time around. But, I think was almost certainly disappointed when he didn’t get a cabinet level appointment and so he was put into this position the SEC chair, which is typically a position that a lawyer holds or at least someone with exposure to the regulatory structure and legal training would hold and almost immediately he was doing precisely the opposite of what you would expect for a SEC chair to do. For example, when there was a push to require that companies include the cost of stock options on their income statements, something that became quite a scandal today, in that many companies are starting to do finally and that accounting rules may require. Arthur Levitt opposed it; he was on the side of the people who said that stock options didn’t need to be expensed. This is while he was SEC chair. He also lobbied in favor of the limitations on private lawsuits, during the debates about the Litigation Reform Act in 1995. He talked about he, when he was industry had been the victim of this kind of litigation and about how it was a bad thing. Now of course, he’s singing a very different tune. He looks back and he says, well, I made mistakes and I’m sorry about that and now he’s changed his positions. But never the less that was what our SEC chair was doing at the time. Now to be fair to Arthur Levitt, toward the end of his term he did start to understand how important the aggressive accounting that many companies had been following was and he gave a speech in which he really *castigated these players for their aggressive practices. The problem was that the train had already left the station. These practices were already being followed and no one had been prosecuted for any sort of complex financial scheme during the prior period. The other problem is a problem that’s really not Arthur Levitt’s fault, but was something he wasn’t in a position to be able to help and that’s that the SEC, the Securities and Exchange Commission doesn’t have the power to bring a criminal case against anyone. They can’t throw someone in jail. They have to go to the Department of Justice to lobby and so it’s very important for the SEC to have political strength to be able to go and persuade the Department of Justice to bring criminal cases. Well, the vast majority of the important cases that were brought for accounting fraud were civil cases, they were SEC cases they could result in a fine, but no one went to jail for any of these financial schemes during the 1990’s. So you had, we had talked a little bit before about the problem associated with not having the cops come in and how people will behave badly when they know there aren’t very many risks. The same thing happened under Arthur Levitt’s watch. You had this wave of scandal and he, both because he originally didn’t have the appetite to do so and later because he didn’t have the power to do so, oversaw in SEC that he did not have the ability to prosecute those cases. I think when we look back, we’ll simply shake our heads at Arthur Levitt’s 7 ½ years at the SEC and wonder what might have happened if we had someone else in that position.

JIM PUPLAVA: What about some of the regulatory changes, I’m thinking, in your book in 1994 there was regulation passed that sent three messages, basically to corporate CEO’s. What were they and I guess as a follow up how did they lead to the corporate scandals and malfeasance which was so much part of our headlines in the last year?

MR. PARTNOY: There were a number of regulatory changes. One of which I just referred to which was the TSLRA, The Securities Litigation Reform Act; and that act made it more difficult for the plaintiffs law firms which were increasingly unpopular during the early 1990’s and may still not be very popular right now. Lawyers have never been popular, but they certainly weren’t popular during the mid ‘90’s and so there was this legislation passed. There also was a very prominent Supreme Court case called the Central Bank Decision, that was decided around the same time that limited lawsuits for aiding and abetting securities fraud and what that decision did, was basically take away from plaintiffs the ability to sue accounting firms and investment banks and in some cases law firms, for secondary liability for securities fraud. There also were a number of decisions on the other side to deregulate, to eliminate from the regulatory structure, different contracts. In 1993, at the very end of her term, Wendy Graham, the outgoing Chair of the Commodity Futures Trading Commission, submitted an exemption for *swaps, the contracts that we talked about before, the over the counter derivatives contracts that would take them outside of the regulatory structure. She by the way, ended up on Enron’s board and we could talk about that if you’re interested. There were a number of deregulatory moves along those lines. Energy trading, energy derivatives were very substantially deregulated during this period and the legislation to require more disclosure * derivatives generally was squashed in 1995. So, this period you pointed to the exact period that I think is the key in thinking about regulatory changes. 1994 and 1995 were when there were a number of initiatives to peel back the rules that were in place and there were a number of deregulatory initiatives as well.

JIM PUPLAVA: I wonder if we can move on and talk about how this financial innovation has moved on and has spread into, in fact in your book you call it an epidemic, is global. We see it in London, we’ve seen it in Japan, I think what is at the world wide estimate of notional value derivatives is what somewhat in the neighborhood of 130 trillion, which is a large figure, and I guess what I’m concerned about, Professor, is we’ve seen so many times, whether it’s Long Term Capital Management, or Orange County, derivatives have a way of blowing up. It doesn’t seem to be a happy medium. You’re either making a lot of money or you’re broke.

MR. PARTNOY: Right and so you’re asking about the spread outside of the United States or the nature of these instruments?

JIM PUPLAVA: Correct.

MR. PARTNOY:  It’s not necessarily a bad thing to have speculation. We like gambling, or at least many people do, we just learned recently that Bill Bennett, one of the great lecturers on moral virtue, is an avid gambler. Gambling is good for the market. Speculation leads to a more transparent pricing and more accurate pricing in general. One of the problems with it, with the derivatives market is that people can be speculating and you’d never know about it because these markets are so much in the dark. There isn’t good disclosure. We really don’t know and this is perhaps most true outside of the United States. London is certainly a very active place and of course Tokyo and Hong Kong . But there are many other places as well and when companies start up businesses elsewhere they often find that they very quickly have some *rogue there who is betting the farm and probably the most prominent example of this was when Berings Bank had a young trader called, Nick *Leason, who went to the Singapore Branch and was trading what originally appeared to be a very, very low risk strategy of just betting on the same contracts in two different markets in Asia and just basically buying low and selling high. When oranges are a $1.00 on one side of the street and $2.00 on the other side of the street, you buy an orange for $1.00 and you sell it for $2.00 and that’s a pretty low risk trading strategy. Well, Nick *Leason, as part of the strategy early on, lost a little bit of money. I think it was in the range of $30,000.00 and ended up trading to try to cover up those losses, trying to make back those losses and ended up trading a variety of very complicated instruments in size, as they say. That’s the term that traders use when they want to describe very large trading strategies in size, meaning billions and billions of dollars of these trades and many of them were being booked in accounts that the executives didn’t see. There’s a risk measure that people, managers like to look at in the financial markets, called value at risk, and that’s called VAR or V.A.R. and Berings executives received VAR reports from Nick Leason’s trading operations and interestingly, even though he had these billions and billions of dollars worth of positions, which created huge losses, when there was an earthquake in Japan, during this period, the list reports that they received, the VAR reports showed a VAR of zero. So, you have to wonder whether it’s even possible for executives to get accurate information when someone decides that he or she wants to engage in some sort of a *rogue trading operation. Of course, that story ends very sadly with the collapse of the bank, where this one 28 year old derivatives trader so far away in Singapore, loses so much money that the *vulnerable bank of the Queen of England collapses, but that’s how far these instruments have spread. They really are everywhere now. The central banks of many Asian countries were trading in these instruments before the Asia crisis in 1997 and as you say, they’re instruments where you can win a lot and you can lose a lot and there’s not necessarily anything bad about that, but as long as you know. As long as, for example, as long as Barings knew what it’s traders were doing, that would be fine. If it wanted to have a speculative enterprise that would be fine and as long as the shareholders of Barings and the regulators of Barings knew that what’s going on, then it would be okay too. The shareholders would say, well we’re going to punish you, we’re going to knock the stock price down because we don’t like this, or maybe they’d say, hey you’re actually a pretty good gambler, we’ll bump the stock price up, the regulators also might say, well now that we know this, we’re going to tighten things up or maybe you’ve shown us that you’re safe, but the problem is compounded when you have people trading in the dark and so it’s really a combination of the nature of the instruments in the fact that they’re not disclosed, it’s led to these spectacular losses. But it certainly isn’t just in the U.S. It’s spread everywhere. You can trade derivatives at just about any spot on the earth now, and companies that have businesses throughout the world can either speculate or hedge risks based on variables, ranging from currencies to commodities just about anywhere in the world.

JIM PUPLAVA: I guess another concern I have is where you see so many of these derivatives are not exchanged traded, they’re not very liquid. In other words, a lot of the price of these derivatives is theoretically valued based on some kind of formula or pricing mechanism and in the case of Long Term Capital Management you don’t know really what their real value is, until such time as you really have to put them to the market and try to liquidate them. Doesn’t that create a concern?

MR. PARTNOY: It does. It does create a concern. It created a problem at Long Term Capital. This is one reason why their risk models were so out of whack in 1998, because when they went to recalculate their VAR, their Value At Risk, it doubled, precisely for this reason. There have been a range of funds that have done what some people call *mark to model, where they use a computer model to figure out what their securities are worth. *Aspen Capital Management is probably the most infamous of those and if you’re very highly leveraged as Aspen was, if your model is wrong, your whole investment can just go poof. If you’ve borrowed money to fund those investments. Warren Buffett recently wrote a *screed against derivates in his annual letter to Berkshire Hathaway shareholders and he referred to this practice, using a term that I love. He called it Mark to Myth. The idea being that these prices, these valuations are a myth. Now there’s been some pressure to move away from mark to model to try to have independent third party verification of these values, but you can’t be incredibly confident in those valuations and as you say, it’s not like having an exchange. On an exchange you can take out the paper, you can open up the financial pages of the paper and you can say look, even for pretty exotic stuff, here’s where June hogs are trading, right, you can see the number right there, but if you want to find the number for these counter party contracts, these over the counter derivatives, you’re not going to be able to find it from any of these contracts. They just don’t exist and so when people are valuing their portfolios at the end of the quarter or the end of the year, they’re often just putting their finger in the wind and trying to get somewhat of a sense and that creates all sorts of problems for aggressive behavior. If you’re at the end of the year and your bonus depends on how valuable this portfolio is, it’s not surprising that you would pick the most inflated value that you could find. That you would be as aggressive as you could and of course that creates a problem later down the line because you’ve made the prospects of the firms portfolio look rosier than they really should be.

JIM PUPLAVA: Let’s talk about Enron for a moment because it seems like in your book Enron encapsulizes so many of the things that we’ve been talking about throughout this interview.

MR. PARTNOY: Well my view of Enron is a little bit different than the standard view. I think that people seem to think of Enron as being a place that was full of crooks. It was an energy company; it was an oil company down in Houston with a bunch of aggressive cowboys who were violating the law. I don’t think the story is that simple; I think that Enron started out as an energy firm, but by the end, and during it’s last few years it really, really the way to think about Enron is that it was a trading firm. It was a derivatives trading firm and this is how the company made its money and ultimately it’s why the company lost its money. They traded, by the end all sorts of derivatives. They started primarily trading energy derivatives, natural gas and power and made a lot of money; some of it, in perfectly legitimate ways, because they were the largest player in that market. They dominated the market. Some of it in less legitimate ways because they took advantage of rules in California , selling out of state and back into state to avoid legal rules and sometimes took advantage of their customers. Either front running them, getting in front of them before a customer wanted to buy or wanted to sell or just gouging their customers. But in any event, they ran huge trading books and especially in 2000, they were making enormous profits from their speculative activities. They were betting the ranch on the prices of natural gas and electricity and when they bet right, they made hundreds and hundreds of millions of dollars. When they bet wrong, they lost hundreds and hundreds of millions of dollars but the swings on particular days would be that large and that’s remarkable I think, for a company to have swings that were that large. So, I started looking at Enron in 2001, just trying to get a sense of what the company, as carefully as I could, as what the company was up to and looking at their financial statements, which I don’t think people looked very carefully at. There are lots of clues that this is really what the company was, you can pull out, if you look carefully enough at the financials, you can pull out some details that tell you, you know this really is a trading firm. The interesting question for me is why the markets performed and what we call the gatekeepers of the markets performed so abysmally in tracking down that data. The credit rating agencies, Moody’s and Standard and Poor’s rated Enron investment grade up until the very end, just a few days before the company’s bankruptcy. They had all this information available to them. Securities analysts, I think 16 or 17 of them, who covered Enron, rated the company up high. They had all this information available to them, so what were these folks doing? It’s remarkable to me. There was a conference call during the summer, just before Enron collapsed during which rumors spread that Andy *Fastow, the CSO of Enron was receiving compensation linked to the performance of one of the special purpose entities, one of these partnerships that later became so well known and was flayed in the media. That relationship, that compensation and Fastows name had already been disclosed in the company’s proxy statement for that year. Their regulatory filings had already disclosed this and apparently the securities analysts hadn’t even bothered to look at it because his name was right there in black and white and the fact that he was receiving * compensation was also there in black and white. So, Enron to me is the culmination of these changes in financial markets over the last decade or so. It’s a company that used these very complex financial instruments that traded in derivatives in ways people didn’t understand. It’s a company where the distance between the CEO and the traders who are actually making the money, was so vast that I think that Ken *Lay really even to this day perhaps doesn’t understand what was happening in the bowels of his company and I think that’s part of the reason why prosecutors have had such a hard time bringing a case against him and then finally it shows what happens when you have substantially deregulated market where prosecutors send signals to market participants by not bringing these cases. I think that Enron was playing in the dark. It was playing in an unregulated market and there wasn’t good disclosure about what Enron was doing. But having said that, the great paradox of Enron is that there was some information that the company put in it’s financials and one of the great, I think lessons to be learned from Enron is that a whole school of maybe a generation of people who were schooled in the idea that markets are efficient will now have to go back to basics. That Enron really shows that information does not efficiently flow from companies through their financial statements to investors. There was a lot of information about this company that was available that should have keyed investors to sell and Enron’s price should have been dropping much earlier and it didn’t and yet at the end Enron probably shouldn’t have gone into bankruptcy. It was a company that had a viable business. It wasn’t a business that justified a share price of $80 or $90 a share, but it was a business that justified a share price that was well worth maybe $5 or $10 a share and yet the company got whipsawed for this combination of an inefficient market and then the failure of the gatekeepers and ultimately the demise of the company occurred when the credit rating agencies finally downgraded Enron below investment grade and it’s sources of capital dried up. It could no longer borrow money to finance this trading operation and having tried to pitch itself to investors as being a technology company, an energy company and not a trading firm. When the truth got out, no one wanted to give Enron money to finance those sorts of ventures and so I think that’s why it was forced into bankruptcy, so that’s my basic take on Enron. It’s a very complicated story. It’s a whole chapter of this book and I think it’s a story that the media, that financial journalists got largely wrong. I think it’s really a story, there were a few people who were covering the story and in particular David *Barboza of the New York Times, who I think covered it very closely and got it right, but what people reported on and what people wanted to read about Enron was much more about the colorful characters and some of the imaginations of these colorfully named vehicles, like Jedi and the Chewbacca related to Star Wars, special purposed entities. But the story really is more complicated than that, so what I try to do in Infectious Greed is to connect, is to explain, basically the book is the first three quarters of the book is how we got to Enron and then to try to frame Enron in context, so that even people who followed the Enron story closely doesn’t necessarily understand how it fits contextually in the last decade or so. That’s what I try to do, is explain how these various themes, this viral transmission of the last decade or so led to Enron. Sorry, I know that’s a very long-winded answer to your question, but it’s a very complicated question.

JIM PUPLAVA: Let’s fast forward to the future. We now have a situation where the markets are rolling again, we’ve got widespread speculation, we’ve got attempts at preventing the Accounting Standards Board from requiring companies to report stocks options as an expense, we’ve got pro forma accounting which I guess is one of my pet peeves when I hear that a company beat estimates, and you find out their pro forma estimates. In your book you talk about how there is a larger information gap today, is larger despite the fact that we have the internet, where is this leading us? To me, it seems like we’re heading into a storm here.

MR. PARTNOY: Well, I agree. I’m not especially optimistic. One of the, I guess to paint the most optimistic picture, pro forma accounting and the detailed nature of accounting rules have been an absolute disaster and the shift, the one optimistic thing that I see happening is that people are starting to talk about a shift away from these highly specific rules to more general standards. The International Accounting Standards Board, the entity outside of the U.S. has been proposing a range of more general standards that would govern how companies disclose information. But, we’ve gotten ourselves into a bind. The problem is that companies in the U.S. are really addicted to getting very specific guidance about what they can and can’t disclose and at the same time, they want to disclose the most optimistic numbers that they can and this is one reason why we’ve gotten to pro forma accounting and all sorts of protection for forward looking statements because companies, they want to have their cake and eat it too. Managers want to disclose the highest earnings per share numbers that they can possibly justify, but they also want to have somewhere in writing, preferably in an opinion from counsel, some justification for the disclosures that they’re making, so I think it’s very difficult now for any investor to look at a company and understand what it’s doing and why it’s worth what it’s worth. I think that accounting has gotten so garbled and financial statements have gotten so complicated that if you don’t believe me, just take a look, if you own stock, if you own shares in any sort of financial services company, my two favorite 10K’s for the last year are JP Morgan and AIG and if you have any sort of diversified portfolio, if you own an index fund, or any sort of mutual fund, you own shares in those two companies likely. You look at their financial statements and there is no way that any human being can understand what those companies are doing and what they’re worth based on those financial statements. They are so complicated and I talk to analysts who cover the financial services sector and they tell me and occasionally they say publicly, I quote one of them in the book as saying, in a public setting, that paradoxically there isn’t enough information in these financial statements to be able to understand the company. So, this is what happens when you live in such a complicated world. How can you tell a company you’re not telling me enough, when their 10K, their annual report with footnotes, is 150 to 200 or in some cases 300 pages. They’ll scream, they’ll say what more can I do? What more information do you want? And yet the information that we get is not the key information. There isn’t enough information about the risks the companies are taking. There isn’t enough information about what they do intra-quarter. We know what they do at the end of the year, but what are they doing after and before they’ve dressed up their financial statements. Sort of like these videos of what dogs do when their owners come home or when they leave, they’re perfectly well behaved, but when the owner is gone, the dogs are all up on the sofa. Right. Well, the companies are up on the sofa for a quarter and there’s no information about what exactly it is that they are doing. So, pro forma accounting is one of the problems, but in general financial reporting is even though, it’s so much more complicated is increasingly useless to sophisticated investors who want to try to figure out what companies are worth. So, I think, my general view of where the markets are headed is not a very optimistic one. I mean, I think that it takes awhile for these kinds of things to sink in. Even after the 1929 crash, it took several years for investors to realize how things had gotten in the markets were in the doldrums for years and I think we’re entering into a period like that now, where the more that investors learn about what happened, the more pessimistic they’ll get, the more reluctant they’ll be to be invested in the market. The problem, and we’ll come out of this eventually. It will take some time. The problem is, what are the alternatives? Over the long haul you want to be invested in the U.S. You want to be invested in U.S. stocks in some way. It’s just that you have to weather the storm. Anybody who’s going to be invested in the market in the next few years is going to be subject to a lot of risk and there isn’t a lot of upside. But, in the long run and people are going to find that there is value in U.S. companies and hopefully companies will reform and will learn more about them in the same way that when we finally turned out of the 1930’s, that companies were much more forthright with investors and we learned about them then. The markets move in cycles and so we’ve just been through a cycle of greed and now we’ll go through a down cycle. Jim Grant, the famous bond analyst and commentator, says that people are cyclically greedy and many of us, people listening to this right now, we were caught up in this as well and so we have to go through a period now paying the price for the surge and the bubble that we experienced a few years ago.

JIM PUPLAVA: What role do you think the central banks play in this? Because I know throughout the ‘90’s Greenspan was against any kind of regulation of these markets and what happens when the Fed creates a climate of easy money, where we have the capital or what happens when the Fed goes in and bails out somebody like a Long Term Capital Management? It seems to me that they sort of feed these frenzies periodically, going back to the ‘20’s where there was a period similar to what we saw in the ‘90’s, this tremendous credit expansion and kind of high risk gambling type behavior.

MR. PARTNOY: Yes, this is the moral hazard problem again. I think there are two issues. One is the moral hazard issue and the Fed, although it has talked a good game, really when you look at what the Fed has done, it has engineered a number of bail outs that have led market participants to think, there was this thing people called the Greenspan Put, The Greenspan Put Option, that he’ll always come in and the Fed will always come in and help you, always bail you out and that some institutions like, ranging from Fanny Mae and Freddie Mac to perhaps JP Morgan and Long Term Capital Management are too big to fail in the same way the banks generally, large banks generally have been regarded as too big to fail and with that sort of mentality is going to lead to that kind of frenzies that you described. So we do, on the one hand we have this moral hazard problem. On the other hand we have a problem with how central banks look at inflation. I think the way central banks have thought about inflation is much too narrow minded and Alan Greenspan has admitted this over time, although it’s unclear that monetary policy has changed that much, but the focus in terms of inflation has been on things like the consumer price index or these measures traditional measures of price increases in the economy, but hasn’t been really focused more generally on how money supply and money demand are changing overtime and one of the problems is that the growth in money supply, which is inflationary can be reflected, not only in increases in the price of cheese or cars or consumer items, but also can be reflected in the price of financial assets and so Greenspan has hinted that the Fed cares more about this now, but I think that we’ve actually through a period recently of pretty high inflation. It’s just that the inflation that we saw was not measured by CPI, Consumer Price Index, so what has picked up there, was picked up in housing markets, it was picked up in the markets for stocks and financial assets and so we really have had an inflationary environment and the Fed and central banks around the world haven’t responded as they might have if inflation had been reflected in one of the more traditional measures. The central banks are also involved as players in these markets so, they do supposedly have their finger on the poll, so what’s happening in the bond market, mortgage market they’re trading these markets everyday. So they may very well know more than we do looking from the outside as commentators but it seems to me that you’ve pointed out this moral hazard problem certainly one of the issues and potentially inflation, the misperception of inflation is another one.

JIM PUPLAVA: So, if you were to sum up, if there was one thing you would want, let’s say a reader of your book to learn, what would that be?

MR. PARTNOY: The one thing I want people to learn is that the various scandals of the last 15 years are connected. That there are these reasons the growth and increase in the use of sophisticated financial instruments, the separation of ownership and control and in particular management employee distance of increase within companies and this deregulatory theme that substantially deregulates markets at the same time we haven’t prosecuted, complex financial fraud and so that really what’s happening now, if you take the broader historical view, shouldn’t be that much of a surprise, that it isn’t just that there are a few bad apples out there, it’s really that over the last 15 years the entire tree got rotten and so what I try to do in the book, is to give enough information about these various stories and about some of the participants, the characters of these narratives that have driven the story over the last 15 years, going back to the late 1980’s and I try to connect them, so that a reader will have in one place the dots connected so that you can understand how we got to Enron and hopefully learn something from the last decade or so, so that it doesn’t happen again.

JIM PUPLAVA: And I think you’ve done a very good job of doing that, Professor and I think a lot of that comes from not only, your own in-depth experience, but I might point out just for our listeners, that you actually worked on Wall Street in the derivatives department.

MR. PARTNOY: Thank you. That’s very kind of you and I hope that that gives me some perspective. I worked for just a couple of years on derivatives desk and I worked as a white-collar criminal defense attorney as well, for a bit and, I’m at the University Of San Diego School Of Law. I’ve been a law professor here for six years, so I now have the luxury of sitting back and trying to get a sense of the big picture. So, I appreciate those comments very much.

JIM PUPLAVA: You did a great job. The name of the book is called, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets by Frank Partnoy. Professor, thank you so much for joining us on the Financial Sense Newshour.

MR. PARTNOY: Thank you very much for inviting me, Jim

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