Infectious Greed (13 page)

Other structured-note issuers included U.S. government-supported agencies and well-known corporations. (The
issuers
were the institutions that were using the notes to borrow money; the
sellers
were the banks that marketed the notes to their investors.) The Federal Home Loan Bank was the 700-pound gorilla, issuing tens of billions of dollars of structured notes.
²⁵
Two government-sponsored mortgage agencies—known as Fannie Mae and Freddie Mac—were big players, as were quasi-governmental entities, including the World Bank. For example, one of CSFP's very first deals in New York was a $252 million structured note for Sallie Mae, the government-sponsored entity that makes student loans.
²⁶
By issuing structured notes, some of these agencies sometimes borrowed at lower rates than even the U.S. Treasury, which wouldn't soil its name by participating directly in these markets.

The most active corporate issuers of structured notes included new financial subsidiaries of many industrial companies, such as General Electric, IBM, and Toyota. DuPont Co. issued more than $1 billion of structured notes during the early 1990s.
²⁷
By issuing structured notes, these companies could save a half percent or more in interest costs. The companies didn't really care if the note payments were linked to a complex formula involving interest rates or currencies—or some other wild bet—because the investment bank selling the structured notes always agreed to hedge the issuer's risks with swaps, in the same way Bankers Trust had agreed to hedge the Canadian bankers' risks in the Japanese markets. Companies often preferred raising money through structured notes instead of issuing stock or taking loans, both of which were typically more expensive.

Structured notes quickly transformed these issuer companies. Even as early as 1991, 10 percent of GE Capital's borrowing consisted of structured notes. By 1993, almost half of GE Capital's medium-term-note program was in structured notes.
²⁸
GE Capital was especially savvy about credit ratings, adding a ratings
trigger
—stating that if a counterparty's rating fell below a certain level, the swap was automatically unwound and settled—to many of its deals, beginning in April 1992.
²⁹
IBM and Toyota had similar approaches. The big three U.S. car makers also were involved, as were many insurance companies, especially American International Group.

Shareholders of these companies were largely oblivious to these new instruments, because the securities laws did not require disclosure. Moreover, the notes were issued by financial subsidiaries, not by the parent company, and disclosure rules applied primarily to the parent. As a result, many of the details of the financial subsidiaries of major corporations—GE, IBM, and others—were kept secret.

Likewise, the purchasers of structured notes—including many mutual funds, pension funds, and government-treasury departments—did not tell anyone about them. Public filings did not require descriptions, and fund managers certainly weren't talking.

The term
structured note
—ubiquitous in finance today—was not even mentioned in a major newspaper or business magazine during this period. The first listing in the general-news database of Lexis-Nexis, a computerized information service, was on April 27, 1992, in an article by Michael Liebowitz, of the specialty publication
Investment Dealers' Digest,
noting in passing that First Boston had hired Tom Bruch to become the firm's second structured-note trader. There were no substantive discussions of structured notes until well over a year later. The first reference to “structured note” in the
New York Times
was not until June 16, 1994;
BusinessWeek
on May 16, 1994;
Fortune
on November 29, 1993; and the
Wall Street Journal
on August 10, 1993. As a result, even a sophisticated, well-read investor following the markets during the early 1990s would not have heard of structured notes.

 

 

A
lthough structured notes were very profitable for the banks at first, just as complex swaps had been, inevitably the business became more competitive and margins declined. To maintain their profit margins, bankers needed to invent new versions of the notes, new structures that could not easily be copied, with margins that would last.

CSFP liked to describe itself as solving problems for clients. However, a closer analysis reveals that CSFP was not so different from Bankers Trust in its approach to client relationships. Many of the “problems” CSFP was solving involved enabling clients to avoid regulation.

Bankers Trust had demonstrated that regulation-avoiding trades were not only very profitable—they had staying power. And as long as clients couldn't accurately value the trades and were using them to avoid legal rules, they would pay a premium. CSFP was about to take Bankers Trust's approach to a new level of complexity.

One of CSFP's most innovative trades was called a
Quanto,
a turbocharged version of the structured notes the bank already had been marketing. A version of this trade was awarded “derivatives trade of the year” in a 1991 survey by
Institutional Investor
magazine. CSFP was widely credited with inventing the Quanto concept, which it first marketed to Japanese companies, although the concept grew from earlier deals Wheat did at Bankers Trust, and it resembled the swaps sold to Gibson Greetings and P&G.

In a Quanto, the investor received payments based on foreign interest rates, with the unique twist that all payments were in the investor's home currency. In other words, a U.S. investor could bet on European interest rates, but receive payments in U.S. dollars. In one typical deal, the Federal Home Loan Bank of Topeka, Kansas, issued $100 million of notes paying a coupon of twice U.S. LIBOR, minus British LIBOR plus 1.5 percent, all payable in U.S. dollars.
³⁰

This twist—putting all payments in one currency—looked simple enough. But in reality, it was unimaginably complex.

In most trades, the impact of the risk of different economic variables could be analyzed separately. An investor could first consider the effect of changes in interest rates, and then worry about currencies. Interest rates and currencies affected each other—they were correlated—but, in a typical trade, the correlation didn't matter. If the correlation didn't matter, it was safe to analyze the risks separately. For example, it was difficult to value Andy Krieger's currency options or Bankers Trust's structured swaps, but neither posed a correlation problem; the interest rate and currency risks of these trades were separated.

The Quanto's risks could not be separated, because—unlike the payoffs of the other trades—the payoffs of a Quanto depended on the correlation of interest rates and currencies. In simple terms, the amount to be converted at maturity into U.S. dollars (the currency variable) depended on the value of, say, British LIBOR (the interest rate variable). Interest rates and currency rates affected each other, not only in the real world, but also in the Quanto. They could not be separated.

At the time, correlation risk was new, and could not be hedged or traded directly. So banks had to come up with ways of pricing the risk on their own. Bankers Trust developed some techniques; CSFP mastered them. The techniques were sufficiently complex that most clients had no hope of accurately evaluating Quantos. Worse, traditional risk measures understated the amount of risk in correlation-based trades, so that even
a sophisticated client—trained in the state of the art of risk analysis at the time—might underestimate the risk of a Quanto.
³¹

Investors weren't likely to obtain much comfort by phoning other banks, as they might have for other structured trades, because many banks didn't understand correlation risk any better. In 1991, the banks selling Quantos disagreed so much about what the trades were worth that their quoted prices differed by as much as half a percent, a huge amount. By late 1993, the differences had narrowed to one-fifth of that, but still were substantial.
³²
During this period, it took a typical bank an entire weekend to produce a report assessing correlation risk. (Today, relatively inexpensive software programs calculate these risks instantaneously.)

Investors didn't seem bothered by correlation risk, and they bought Quantos in droves. Either they were oblivious to the fact that their investments now depended on correlations of various interest rates and currencies, or they didn't care. CSFP sold over 100 Quanto swaps in 1990 and 1991, more than any other bank.

The Quanto was the perfect trade for Japan. Many companies believed interest rates outside Japan would fall, but wanted their investments denominated in Japanese yen. Similarly, Quantos also fit U.S. investors who sought higher yields, but did not want to receive a currency other than U.S. dollars.

Still, it seemed odd that investors would be so eager to buy Quantos, especially when they were unable to assess correlation risk. If currency rates moved the wrong way, the investor still would lose money; it wouldn't help that the money paid in a Quanto was in U.S. dollars instead of foreign currency. Moreover, investors who wanted to bet on foreign interest rates could easily buy foreign bonds and exchange whatever foreign currency they received at maturity, thereby avoiding correlation risk. Yet they wanted Quantos anyway. Why?

The answer: legal rules, yet again. The true driving force behind Quantos was that they allowed investors who, by law, were not permitted to speculate in a particular currency, to do so indirectly, without being noticed. Many investors—especially U.S. insurance companies, major clients of CSFP—could not buy large amounts of non-U.S. dollar instruments. But they arguably could buy as many Quantos as they wanted, because their payments were denominated in U.S. dollars.

James M. Mahoney, writing in the
Federal Reserve Bank of New York Economic Policy Review,
put the issue clearly:

(“Diff swaps” were based on the difference between two interest rates; P&G's second swap with Bankers Trust—the one based on U.S. and German interest rates—was a typical example.)

Eventually, the Quanto market, too, became competitive. Banks did billions of dollars of such trades. The U.S. government-supported agencies also got involved, as issuers. Pension funds, insurance companies, and other regulated institutional investors bought Quantos, and—as with other structured notes—did not disclose the risks. Investors had no way of knowing whether they owned companies that speculated using Quantos or similar instruments.

A fund manager considering Quantos faced enormous temptation. Consider this deal: in January 1992, the Student Loan Marketing Association sold $150 million of three-year notes with a Quanto-style interest rate. The rate was twice the Swiss franc version of LIBOR minus twice the U.S. version of LIBOR. As was typical of a Quanto, the interest rates were in different currencies, but payments would be only in U.S. dollars.
³⁴

Why would a fund manager be tempted to buy this structured note? The first interest rate was set at 7.6 percent, an incredible teaser, given that U.S. interest rates were very low and European interest rates were falling. The note had a three-year maturity; but, for a fund manager focused on the upcoming year, the first-year return would outperform just about any other fund (perhaps except funds that were buying similar notes). It wasn't clear what would happen in years two and three. But, by then, the fund manager would have a stellar reputation and likely would have opportunities to leave for other firms.

Fund managers loaded up. And when they tired of correlation trades based on European currencies—which were converging as part of the planned move to a single currency—they began doing trades based on more exotic interest rates and currencies, including those of Hungary, Mexico, and Brazil. No computer program could model the correlation risks in those markets.

T
he second major innovation at CSFP—after structured notes such as Quantos—involved structured finance, the repackaging of financial assets to reallocate risks and obtain higher credit ratings. Structured finance generated great benefits for many institutions, enabling banks to repackage and sell off their exposure to home mortgages, credit-card loans, and other assets. Before the mid-1980s, companies had done
factoring
transactions, in which they sold their receivables—rights to payments owed by other parties. Examples included uncollected debts or the rights to various lease payments. Structured finance was simply a modern version of factoring.