Infectious Greed (10 page)

These swaps were incredibly profitable for Bankers Trust. From late 1991 to early 1994, the more Gibson lost the more it traded, and the more Bankers Trust made. In all, Bankers Trust made about $13 million from the swaps with Gibson,
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all of which supposedly began as an effort to find a low-cost hedge for a simple fixed-rate debt.

How did Charlie Sanford react to all of this aggressive behavior by his salesmen? Substantial bonuses, of course. In late September 1993, Sanford proudly announced in a memorandum that he was promoting Gary Missner—the senior salesman covering Gibson—to the position of managing director.
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G
ibson Greetings was not alone. Numerous Bankers Trust clients were actively buying and selling similar swaps: Air Products and Chemicals, Equity Group Holdings, Federal Paper Board, Jefferson Smurfit, Sandoz, Sequa, and others, including two Indonesian companies—PT Adimitra Rayapratama and PT Dharmala Sakti Sejahtera—that made some of the biggest trades of all. Bankers Trust was everywhere. As David Urbani, assistant treasurer at Air Products and Chemicals, put it, “If I mention to another company that we were thinking about doing some weird derivative, they'll say you must have been talking to Bankers Trust.”
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The most publicized losses on swaps with Bankers Trust were on those done by Procter & Gamble. An investor in P&G stock—like an investor
in Gibson Greetings—had no clue the firm was gambling on derivatives. Shareholders thought they were buying a soap company. The company's 1993 Form 10-K filing with the Securities and Exchange Commission reinforced this notion, describing its derivatives activity as minimal and low risk.

Kevin Hudson, another smooth-talking Bankers Trust salesman, covered P&G. In the early 1990s, Bankers Trust and P&G had done little business together. Other than an early 1993 deal—linked to the Mexican peso—Bankers Trust had made few inroads with P&G's treasurer, Raymond Mains.
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In October 1993, Hudson began talking to Dane Parker, a junior treasury analyst who reported to Mains. P&G had been borrowing money in the short-term
commercial-paper
market to fund its consumer products business. In that market, there is a floating-rate index, like LIBOR, called the Commercial Paper index, or
CP
for short.

A well-respected company such as P&G could borrow at roughly the Commercial Paper index rate. But P&G's goal was to use swaps to borrow at less than the Commercial Paper index, hopefully by as much as 40 hundredths of a percent, or 40 basis points. In the industry parlance, Parker might call Hudson and say, “I want CP minus 40 basis points.”

In the commercial-paper world, every basis point was precious. If P&G's treasury could outperform its peers by 40 of them, Mains and Parker would be supermen. To do it, they would need to take on some risk, of course, and Bankers Trust had just the recipe: a complex trade resembling Gibson's Treasury-Linked Swap.

It seemed incredible that a big, sophisticated company like P&G would pay Gibson-like fees to gamble on interest rates. But early on, Parker demonstrated that he was potentially just as much of a sitting duck as Johnsen had been. Soon, Hudson was regaling his colleagues with stories about how “smooth” he had been during his visits with P&G. In one taped conversation, Hudson described the deal he had proposed to Parker to a friend, and bragged, “You're looking at an $8 million trade.” In other words, he had estimated that Bankers Trust's profit from this one deal would be $8 million. The friend was impressed and responded, “It's like our greatest fantasy.” Hudson couldn't help but agree. “I know. It is. It is. This is a wet dream.”
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Charlie Sanford's pressures were having their intended effect. His nerds were aggressively pursuing deals, and—because their customers couldn't
evaluate complex swaps properly—Bankers Trust was making unheard-of profits. During this time, a fee of one percent, called a “point,” was substantial. But Bankers Trust was earning multiple points on deals of unprecedented size. The companies were no longer clients of Bankers Trust; they were pigeons.

As one former managing director put it, “Guys started making jokes on the trading floor about how they were hammering the customers. They were giving each other high fives. A junior person would turn to his senior guy and say, ‘I can get [this customer] for all these points.' The senior guys would say, ‘Yeah, ream him.'”
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During this period, Bankers Trust developed a training video for new employees. In one segment of the video—which Bankers Trust officials have maintained was in jest—a bank employee described a hypothetical derivative transaction among Sony, IBM, and Bankers Trust: “What Bankers Trust can do for Sony and IBM is get in the middle and rip them off—take a little money.” The employee then nervously added, “Let me take that back. I just realized that I'm being filmed.”
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Belita Ong, a former managing director and senior derivatives saleswoman at Bankers Trust, believed that Bankers Trust had developed “an amoral culture.” She said, “You saw practices that you knew were not good for clients being encouraged by senior managers because they made a lot of money for the bank.”
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One salesman noted, “Funny business, you know. Lure people into that calm and then just totally fuck 'em.”
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Ong was the managing director who had called the Bankers Trust nerds “mostly guys without girlfriends.” But sweet-talking Kevin Hudson, the salesman covering P&G, had a girlfriend—a fiancée even—another salesperson at Bankers Trust named Alison Bernhard. And he was telling her all of the details about how Bankers Trust was milking P&G, on taped telephone conversations at the bank.

When Hudson finally persuaded P&G to do a swap with Bankers Trust, he immediately called Bernhard to tell her about it. “I just took the biggest trade of the year,” he told his fiancée.
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In the swap, P&G would pay the CP rate minus 75 basis points on $200 million, giving it a cushion so it could lose a bit and still lock in the goal of “CP minus 40.” In addition, P&G would effectively sell some put options to Bankers Trust, giving the bank the right to profit if interest rates increased. If interest rates increased, P&G would pay the following spread:
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Don't stop reading; you don't need to understand precisely how to value this spread to understand what it did. There were two variables in the formula: the 5-year Treasury Yield (the interest rate on 5-year government bonds) and the 30-year Treasury Price (the price of 30-year government bonds). Yields and prices moved in opposite directions: in simple terms, the more cheaply you could buy a Treasury bond, the more yield you would earn over time. The spread formula consisted of a multiple of the 5-year Treasury Yield
minus
the 30-year Treasury Price, but it just as easily could have
added
a multiple of the 30-year Treasury Yield.

Why use the 30-year Treasury Price instead of the 30-year Treasury Yield? And why multiply the 5-year Treasury Yield by 98.5 and then divide—first by 5.78%, and then, at the end, by 100? As in the Gibson Greetings swaps, these terms were there for what traders called optics: they made the spread look more attractive than it really was. For example, 98.5 and 5.78 were roughly the price and yield, respectively, of a 5-year Treasury bond. They focused P&G on the current market values of the bond instead of on the risks of the trade. In reality, these numbers were meaningless: a savvy investor would simply do the math and notice that 98.5 divided by 5.78% divided by 100 was about 17.04, meaning that the spread actually was magnified—or
leveraged
—about 17 times. The same was true of the use of the 30-year Treasury Price instead of the 30-year Treasury Yield. A savvy investor would convert the price to a yield, so as to compare apples to apples within the spread formula. Because the price was much higher than the yield, the 30-year Treasury variable also was leveraged, by a similar amount.

In other words, P&G's $200 million swap with Bankers Trust really was a $3.4
billion
bet that 5-year and 30-year interest rates would remain low. If 5-year rates stayed at around 5.78 percent and the 30-year price remained at its current level, the spread would be close to zero. But if interest rates increased, watch out.

It is unclear whether anyone at P&G did this math. Former P&G chairman Edwin Artzt called his underlings who bought the swap “farm boys at a country carnival” and derided their inability to seek the advice necessary to understand the deal. In discussing two of these employees, Carol Loomis, a veteran reporter for
Fortune,
concluded that “plainly, neither understood the derivatives they bought from Hudson.”
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P&G certainly didn't seem sophisticated to anyone at Bankers Trust. When the profits were tallied, Kevin Hudson and Bankers Trust had made $7.6 million from this one trade. When Hudson told his boss, Jack Lavin, about the trade, Lavin reportedly said, “I think my dick just fell off.”
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His fiancée had a different reaction, in a taped phone call:

In late January 1994, P&G did another swap with Bankers Trust, with a similarly complex formula, this time betting that German interest rates would remain low. This trade was
only
leveraged ten times. In one year, Kevin Hudson had done deals with more than $25 million in fees. His fiancée was beginning to worry.

The leverage factors in these trades were so large that the size of the bets was a significant percentage of the entire amount of money the U.S. and German governments borrowed. If P&G elected to close out the trade early—as Gibson had—its actions would rock the world's government-bond markets.

 

 

A
s it turned out, Dane Parker at P&G wasn't the only person unable to figure out the value of these complex swaps. Smooth-talking Kevin Hudson couldn't do it either, and he admitted as much to Parker, saying he didn't build the computer models that valued the options in P&G's
trades—a trader had done that.
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As a result, Hudson was taken to the cleaners, too. Incredibly, a Bankers Trust trader squeezed profits from Hudson on the first P&G swap, just as Hudson had squeezed them from P&G.

Guillaume Henri André Fonkenell began his career as a junior swap trader at Bankers Trust in June 1990.
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He was very successful, and by November 1993 had been promoted to a senior trader in New York.

During October 1993, Kevin Hudson had been working on the P&G trade with Kassy Kabede, one of Fonkenell's junior traders. When Kabede left the country on November 1—the day before the first P&G trade—Fonkenell took over. After the swap was done, there was the key question: how much money did Bankers Trust make on the trade? Just as Andy Krieger had needed to come up with a valuation of his trades, Fonkenell needed to determine the value of the complicated put options embedded in the P&G swap.

When a salesman booked a trade, he obtained a price from the trader. Commissions went to the salesman; trading profits went to the trader. If the trader valued a trade at $90, gave the salesman a value of $95, and the salesman sold it for $100, Bankers Trust would make $10 and the trader and salesman each would make $5.

But if the trader gave the salesman a higher value (say, $97), then the trader would declare more profit ($7), leaving less for the salesman ($3). Bankers Trust made the same amount of money on the trade either way, but the salesman received less credit for it in the second example. Wall Street is a dog-eat-dog world where, it is said, salesmen wear Milkbone underwear. Traders are the alpha dogs, and they frequently lie to salesmen about trade values, especially on complex deals, when they know the salesmen won't be able to figure out the valuation themselves. One of a bank manager's challenges is to keep the traders honest, and to keep the salesmen from killing the traders.

As with Krieger's trades, the valuation of the first P&G swap depended on volatility. At the time, volatility was not quoted in the markets. Instead, a trader would select an appropriate volatility measure based on historical data or on the range of prices for options similar to those embedded in the swap. By plugging those prices into an options model, such as Black-Scholes, the trader would get a range of numbers called
implied volatilities.
Then, the trader would input those volatility numbers into a spreadsheet or computer program to calculate the swap's value.

To improve controls at Bankers Trust, Charlie Sanford required that
the back-office employees mark to market the bank's trades every day. That meant someone in the back office would need to report a daily value for the P&G swap. These values were the basis for a ten-page bank-wide risk assessment Sanford received every day. The Krieger incident had made it especially important that those numbers be accurate, and Bankers Trust supposedly had been improving its control systems during the five-and-a-half years since then.