Infectious Greed (24 page)

The losses at mutual funds affected millions of investors. Moreover, now that commercial banks were increasingly engaging in the securities business, it was difficult for investors to separate a risky investment in derivatives from a simple deposit at their local bank. Consider NationsBank, for example. In 1993, NationsBank received permission to begin operating a securities firm, called NationsSecurities, which immediately began selling
Term Trusts
to NationsBank clients.
⁴¹
Term Trusts were 10-year-maturity bond funds that paid an extra one percent or more above the 10-year U.S. Treasury Yield. To a bank customer with money in a checking account or a certificate of deposit, this was a huge increase in yield.

Of course, the increase didn't come without risk. Unlike a bank deposit, return of principal was very much at risk. The Term Trusts achieved a high yield by investing up to 40 percent of their assets in inverse floaters, which—as Orange County made clear—were not without risk.

NationsSecurities made the Term Trusts its first focus product, creating monetary incentives for its representatives to sell them. In the first months of the program, through February 1994, NationsSecurities sold more than $300 million of the Term Trusts, generating more than $16 million in fees. Sales representatives pitched the Term Trusts to investors in traditional Certificates of Deposit, telling NationsBank customers who never had invested in anything other than CDs that Term Trusts were as safe as CDs, but better because they paid more. NationsSecurities paid NationsBank employees referral fees for sending these customers.

The sales representatives were given detailed prospectuses with fine print describing the various risks associated with Term Trusts, but apparently they either ignored them or did not read them very carefully. Instead, the sales representatives told clients, as they had been told during presentations, that the Term Trusts were backed by the U.S. government and would not lose principal. On several occasions, a sales manager held up a picture of a Term Trust brochure with a picture of the U.S. Capitol Building on the cover, and said, “If the Capitol is standing in 10 years, these people will get their money back.” The representatives fed these pitches to their customers during “call nights,” when they emphasized the Term Trusts' safety, predictability, and return. Some Texas representatives told customers that “until now you had to be Texas A&M or have the wealth of Ross Perot, to get access to this quality of management.” Some representatives even told customers that because the Term Trusts would
return
all
of the principal payment in 10 years, there was no fee (in reality, the sales commission was a whopping 5.5 percent). These representatives didn't discuss the details about all the inverse floaters the Term Trusts held.

NationsSecurities blurred the line it was supposed to maintain between itself and NationsBank. Even the names were almost interchangeable. NationsSecurities sent a mass mailing about the Term Trusts to more than a million NationsBank customers, in envelopes bearing the NationsBank logo and colors. Representatives were taught to call the Term Trusts “accounts at the bank”—rather than securities—and to say they were calling “from the bank.”

Not surprisingly, the Term Trusts did not perform very well. Recall that inverse floaters decline in value when short-term interest rates rise. After the Fed's rate hike, the Term Trusts declined in value by more than a third. So much for protection of principal. (NationsSecurities later was censured by the SEC and fined $4 million.)
⁴²

The spread of financial innovation to more traditional and conservative financial intermediaries—particularly, money-market funds and commercial banks—created new dangers. How could individual investors discern the risks of these new menus of investment possibilities? The Securities and Exchange Commission had taken the position that stock and bond mutual funds should be able to invest in whatever they wanted, so long as they disclosed the risks. But what constituted adequate disclosure? And even with adequate disclosure, should an elderly banking client who had never bought anything other than a CD really be purchasing inverse floaters under any circumstances? The questions were not merely theoretical. NationsBank was one of several large banks entering the securities business to sell new financial products to millions of individual banking customers.

In addition, paying bonuses based on performance skewed the incentives of fund managers and bank salespeople. If they performed well, they made a lot of money for themselves. If they performed poorly, they lost someone else's money. Federal law generally barred investment advisers from receiving incentive compensation for sales to small clients (people with less than $1 million of net worth or $500,000 in investments). But there was an exception for mutual funds, and financial institutions had shown, in recent years, a great ability to drive trucks through even small exceptions. Mutual funds had to compete with Wall Street for
talent, and if they couldn't pay big bonuses, they wouldn't be able to attract the best managers. The more Wall Street traders made, the higher the fund managers' compensation would have to be.

Still another problem was the lack of sophistication among fund managers. The data showed that most active managers underperformed market indexes. The Arbitrage Group at Salomon Brothers had been able to spot inefficiencies and outperform their peers, year after year. But not many fund managers were like John Meriwether's traders. Certainly Robert Citron and Worth Bruntjen didn't measure up. And the greatest damage had come from the smartest manager, David Askin.

Fund managers all seemed to be buying the same financial instruments, like gamblers all betting on red at a roulette wheel.
Fortune
magazine conducted a detailed survey and found only four money managers who had outperformed the major bond-market indices in 1994.
⁴³
It was remarkable, but nearly every professional money manager during the early 1990s had been speculating that interest rates would remain low.

The Federal Reserve had fueled this speculation by committing to keep interest rates low. In 1989, short-term rates had been higher than long-term rates, which were around eight percent. By 1992, short-term rates were three percent, while long-term rates were still near eight percent. As long as this interest-rate environment held, it was easy to make money, with just a little bit of (relatively painless) math.

Suppose you use $1,000 of savings to buy long-term bonds. If long-term rates are eight percent, you make $80 in a year, if rates don't change. Not bad.

Now suppose that you also borrow $10,000 and invest the entire $11,000 amount in long-term bonds. You still make $80 on your $1,000 of savings. But now you also make $800 on your $10,000 of borrowings—$880 in all. If short-term rates were only three percent, you would only have to repay $300 of interest on a 1-year loan, so you would keep $580—a return of more than 50 percent on your money. And, in that example, your leverage—the ratio of your borrowings to your savings—was only 11-to-1. Financial institutions typically had leverage in the range of 25-to-1. Throughout the early 1990s, financial institutions could do this simple
carry
trade—borrowing short-term and investing long-term—and make a fortune. (“Carry” refers to the difference between short-term and long-term rates.)

The incredible thing about the carry trade was that
everyone
did it—not only mutual funds, but also hedge funds, the unregulated investment
funds that often did everything but hedge.
Hedge fund
was a generic term that referred to any unregulated investment fund;
mutual fund
referred to a regulated U.S. fund. (Hedge funds could avoid U.S. regulation if they had 100 or fewer U.S. investors.) Managers of the biggest hedge funds had them borrow money to place huge bets on various currencies, interest rates, and other securities. George Soros was a prime example. So was David Askin.

During the early 1990s, nearly every hedge fund bet on the carry trade. As Stan Jonas, a well-regarded trader at Societe Generale/FIMAT, described it, looking back on 1994, “If a Martian came to the U.S. and looked at the universe of hedge fund managers, he'd see the same person. Many of these managers are interrelated by blood, by hobbies, by education. They're all competing, checking what the other one's doing.”
⁴⁴
And they all made the same bets.

Unfortunately, the Federal Reserve didn't understand hedge funds very well, and didn't realize how much financial institutions had borrowed to bet on interest rates using unregulated derivatives. The spread of this leverage was the reason the Fed's rate hike had had such far-reaching, unanticipated effects.

By early May 1994, the Fed had raised rates another half a percent, and the carnage was more visible. Three of the biggest hedge-fund managers—Leon Cooperman of Omega Partners, Julian Robertson of Tiger Management, Michael Steinhardt of Steinhardt Partners—lost billions of dollars. Banks and securities firms also were hit hard, with Bankers Trust finally experiencing its first loss, and Salomon Brothers reporting a pretax loss of $371 million for the first half of 1994, most of it from bond losses. The life insurance industry lost about $50 billion on bonds in 1994; property and casualty insurers lost $20 billion, more than they paid in claims for Hurricane Andrew.
⁴⁵
(These losses didn't show up in financial statements, either, because insurance companies recorded their bond investments at their historical cost.)

A few prescient firms abandoned their bets just before February 4, 1994. For example, AIG Financial Products made more than $1 billion on derivatives between 1988 and 1992, but AIG's chairman, Maurice “Ace” Greenberg, decided in 1993 that his firm was taking too many risks, and the head of AIG Financial Products, Howard Sosin, left the firm, along with a reported $200 million in compensation. Sosin had joined AIG from Drexel Lambert in 1987, and he avoided the frenzy of Wall Street's trading culture by operating out of an office in Westport,
Connecticut, with a fifty-foot saltwater fish tank. Long-Term Capital Management—which was just opening its doors as the Fed was raising rates, in a similarly relaxed setting in Greenwich, Connecticut—took advantage of the collapse of various investment funds by hiring several dozen employees with strong quantitative backgrounds.

Joseph Erickson, a partner at Peat Marwick and a consultant on derivatives, derided fund managers who didn't understand the derivatives they bought, saying: “If you don't understand, you might as well place it all on red at Atlantic City or Las Vegas, because at least there you get free drinks.”
⁴⁶
Erickson was missing the point. Sophisticated or unsophisticated, understanding or not, drinks or no drinks, everyone had bet on red.

 

 

I
n 1995, Brandon Becker and Jennifer Yoon, of the Securities and Exchange Commission, compiled a list of institutions that had lost money in the various new financial instruments during the previous year. The list included virtually every kind of institution, from every sector of the economy. To get a sense of how far these new instruments had spread by then, take a glance at this paragraph, which includes a selected “top 100” from the list. (You might even recognize a few that lost some of your money.)

ABN AMRO; Air Products and Chemicals; Allied-Lyons; American International Group; AmSouth Bancorp; Askin Capital Management; Atlantic Richfield; Auburn, Maine; Banc One; Bank of Montreal Harris Trust & Savings; Baptist Missionary Association of America; Barings; Barnett Banks; Benjamin Franklin Federal Savings and Loan; Berjaya Industrial; CS First Boston Investment Management; Capital Corporate Federal Credit Union; Cargill Investor Services; Caterpillar Financial Services; Chemical Bank; China International Trust and Investment; City Colleges of Chicago; Codelco; Collier County, Florida; Colonia Asset Management; Common Fund; Community Bankers Fund; Connecticut State Pension Fund; Constitution State Corporate Credit Union; Corporate One Credit Union; Credit Lyonnais; Cuyahoga County, Ohio; Dell Computer; Eastman Kodak; Escambia County, Florida; Federal Farm Credit System; Federal Paper Board; Fidelity; First Boston; Fleet Financial; Florida operating fund; Franklin Savings; Fundamental Family of Funds; Gibson Greetings; Glaxo; Gothaer Life Insurance; Hammersmith & Fulham; Independence Bancorp; Indiana Corporate
Federal Credit Union; Investors Equity Life, Hawaii; J. P. Morgan; Japan Airlines; Joplin City, Missouri; Kanzaki Paper Manufacturing; Kashima Oil; KeyCorp Bank; Kidder Peabody; Mead; Mellon Bank; Meritor Savings Bank; Merrill Lynch; Metallgesellschaft; Mutual Benefit Life Insurance; National Fisheries, South Korea; New England Investment; Northern Trust; Norwest; Odessa College; Ontario Province, Canada; Orange County; Paine Webber; Piper Jaffray; Pittsburgh National Bank; Postipankki Bank, Finland; Procter & Gamble; Robert W. Baird; Salomon Brothers; Sandusky County, Ohio; Seamen's Bank for Savings; Sears Roebuck; Shanghai International Securities; Showa Shell Sekiyu; Silver-ado Banking Savings and Loan; Sinar Mas; Soros Fund Management; Southwestern Federal Credit Union; Southwestern Life; St. Lucie County, Florida; St. Petersburg, Florida; Tokyo Securities; Union Bank; UNIPEC; Virginia state pension fund; West Virginia Consolidated Fund; Western Corporate Federal Credit Union; Wilmington Trust; Wimpey Group; Wisconsin State Pension Fund; Yamaichi Securities.

The list was impossible to ignore. The stories of investors losing money on derivatives were not isolated incidents; they evidenced an epidemic. Just a few years earlier, structured notes did not exist, and complex CMOs were merely the wacky idea of a few traders. But by 1994, the financial innovations of Bankers Trust, First Boston, and Salomon Brothers had spread so far that it was hard to find someone who
didn't
own these instruments. The news was bewildering and overwhelming for average investors, who barely had time to follow the media coverage of the losses, and certainly did not have the resources to understand all the details. In this new world, how could a person keep tabs on his or her investments?