Infectious Greed

Table of Contents

 

 

 

 

 

More praise for
Infectious Greed

“Partnoy has written an important book that provides a well-reasoned blueprint for fighting corporate corruption and restoring the integrity of America's financial markets. Unfortunately, it appears that the cops on Wall Street and the regulators in Congress are not ready to heed his advice.”

—Robert Bryce,
The Washington Post Book World

“Imbued with a deep understanding of finance.”

—Roger Lowenstein,
The Wall Street Journal

“Ambitious . . . A useful book, bringing together details of half-forgotten scandals from the past fifteen years.”

—Floyd Norris,
The New York Times Book Review

“Readers are unlikely to find a more readable explanation of how the financial system has changed since the 1980s and who came unstuck.”

—
Financial Times

“Partnoy makes it appallingly clear that as these hedges against debt have evolved and become increasingly convoluted, the number of takers who will never understand them, much less profit from them, has continued to swell. . . . Riveting.”

—
Kirkus Reviews

“Original, reversing the popular perception by claiming Enron was a profitable company that should have survived, while WorldCom and Global Crossing had no economic substance.”—
Publishers Weekly

“Partnoy expains just about every significant financial blowout of the past fifteen years, from Gibson Greetings to Global Crossing, via Joseph Jett, Nick Leeson, Orange County, Long-Term Capital Management, Enron and many others.”

—
Investors Chronicle

“A breathtaking chronicle of greed and stupidity on an operatic scale . . . A compelling portrait of corruption on the scale of the last days of Rome.”

—
Management Today

“A robust case . . . for the exceptional circumstances of the past fifteen years. Partnoy's protagonists are . . . a parade of macho or geeky grotesques with overdeveloped quantitative skills. . . . The pursuit of self-interest and maximum pay-off trickled down from traders to CEOs to equity analysts.”

—
The Guardian

Also by Frank Partnoy

 

For Fletch

“An infectious greed seemed to grip much of our business community. . . . It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed have grown so enormously.”

—Alan Greenspan, testimony before the Senate Banking Committee, July 16, 2002

“In principle, the losses will be spread across a broader range of investors than in past debt crunches, suggesting risks have been well diversified and the financial system is secure. In practice, financial market and corporate innovation during the 1990s has meant it is impossible to be sure, a source of concern to financial regulators.”

—Stephen Fidler and Vincent Boland,
Financial Times,
May 31, 2002

M
any people know the story of the 2008-2009 financial crisis, but few remember what happened just before that. This book is a financial history, a story of the dramatic changes in markets during the two decades before the subprime mortgage boom and bust. It brings together the most important characters and events of this period, connects the dots among them, and explains what happened—and why. It shows how the levels of deceit and risk grew so dramatically, so quickly, and offers suggestions about how to avoid another round.

The recent happenings in financial markets are mysterious to many investors. The names alone evoke vague memories of scandal, but few common denominators. Think not only of Lehman Brothers and Merrill Lynch, but back to WorldCom, Global Crossing, Enron, and the dotcom bubble, the panic surrounding the collapse of Long-Term Capital Management, the fall of the venerable Barings Bank, the bankruptcy of Orange County, the financial crises in Mexico and Asia, and so on. Most investors recall some of these events, but few people understand how they interconnect.

Each story is remarkable, but the headlines can seem isolated, like distinct cells within different bodies. Even when scandals pique the attention of investors, the details are evanescent, and any links to events of the recent past slip away. Investors become outraged, and the media
seize on indignities, but over time everyone seems to lose the ability to relate back—especially as markets begin going up again.

This was especially true during the 1990s, a decade of persistently rising markets—ten solid years of economic expansion, with investors pouring record amounts into stocks and pocketing double-digit returns year after year. That stock-price boom was the longest-lived bull market since World War II. Some stocks or sectors suffered periodically, but almost anyone who remained invested throughout the decade made money.

During this time, individuals came to believe in financial markets, almost as a matter of religious faith. Stocks became a part of daily conversation, and investors viewed the rapid change and creative destruction among companies as investment opportunities, not reasons for worry. In 1990, the ten largest U.S. firms—including companies such as Exxon and General Motors—were in industrial businesses or natural resources. By 2000, six of the largest ten firms were in technology, and the top two—Cisco and Microsoft—had not existed a generation before. These stocks almost always went up. Microsoft met analysts' expectations in 39 of 40 quarters, and for 51 straight quarters the earnings of General Electric—a leading industrial firm that was also heavily involved in financial markets—were higher than those of the previous year.

The decade was peppered with financial debacles, but these faded quickly from memory even as they increased in size and complexity. The billion-dollar-plus scandals included some colorful characters (Robert Citron of Orange County, Nick Leeson of Barings, and John Meriwether of Long-Term Capital Management), but even as each new scandal outdid the others in previously unimaginable ways, the markets merely hiccoughed and then started going up again. It didn't seem that anything serious was wrong, and their ability to shake off a scandal made markets seem even more under control.

When Enron collapsed in late 2001, it shattered some investors' beliefs and took a few other stocks down with it. But after a few months, many investors began yawning at Enron stories, confident that the markets had survived yet another blow. Few considered whether the problems at Enron were endemic, or whether it was possible that Enron was only the tip of the iceberg. Instead, investors shrugged off the losses, and went back to watching CNBC, checking on their other stocks.

Then, Global Crossing and WorldCom declared bankruptcy, and
dozens of corporate scandals materialized as the major stock indices lost a quarter of their value. Congress expressed outrage and mollified some investors with relatively minor accounting reforms. But most investors were perplexed. Should they wait patiently for another upward run, confident that Adam Smith's “invisible hand” would discipline the bad companies and reward the good? Or should they rush for the exits?

The conventional wisdom was that markets would remain under control, that the few bad apples would be punished, and that the financial system was not under any serious overall threat.

The recent financial crisis seems unrelated to prior scandals, and the revised, new conventional wisdom is that the collapse of 2008 was unique, a financial lightening strike. If only government can repair the damage to banks, the markets will recover and return to their prior well-functioning days.

The argument in this book is that the conventional wisdom is wrong. Instead, any appearance of control in financial markets is only an illusion, not a grounded reality. Markets came to the brink of collapse several times during the past decade, with the meltdowns related to Enron and Long-Term Capital Management being prominent examples. Today, the risk of system-wide collapse remains greater than ever before. The truth is that the markets are still spinning out of control.

The relatively simple markets that financial economists had praised during the 1980s as efficient and self-correcting are gone. Now the closing bell of the New York Stock Exchange is barely relevant, as securities trade 24 hours a day, around the world. The largest markets are private and don't touch regulated exchanges at all. Financial derivatives are as prevalent as stocks and bonds, and nearly as many assets and liabilities are off balance sheet as on. Companies' reported earnings are a fiction, and financial reports are chock-full of disclosures that would shock the average investor if she ever even glanced at them, not that anyone—including financial journalists and analysts—ever does. Trading volatilities remain sky high, with historically unrelated markets moving in lockstep, increasing the risk of systemic collapse.

During recent years, regulators have lost what limited control they had over market intermediaries, market intermediaries have lost what limited control they had over corporate managers, and corporate managers have lost what limited control they had over employees. This loss-of-control daisy chain has led to exponential risk-taking at many companies, largely
hidden from public view. Simply put, any appearance of control in financial markets has been a fiction.

If investors believe in the fiction of control, and ignore the facts, the markets will rise again. But if investors continue to question their faith, as they have more recently, the downturn will be long and hard. As investment guru James Grant recently put it, “People are not intrinsically greedy. They are only cyclically greedy.”
¹
The most recent cycle of greed appears to have ended, but at some point, inevitably, the next one will begin.

This book traces three major changes in financial markets during the fifteen years before the recent crisis. First, financial instruments became increasingly complex and were pushed underground, as more parties used financial engineering to manipulate earnings and to avoid regulation. Second, control and ownership of companies moved greater distances apart, as even sophisticated investors could not monitor senior managers, and even diligent senior managers could not monitor increasingly aggressive employees. Third, markets were deregulated, and prosecutors rarely punished financial malfeasance.