Infectious Greed (40 page)

T
he Société Générale Super Bowl parties were a reminder to financial market participants in the United States that they were not alone. Beginning in 1992, traders from the French bank—one of the biggest options dealers in the world, with $80 billion in currency options alone
¹
—gathered on Super Bowl Sunday with hundreds of their clients in a custom-built derivatives trading pit at the Equitable Building in Manhattan. The floors were covered with AstroTurf and white yard lines. Several big-screen television sets showed the pregame festivities.

A 27-page rule book explained the various ways participants could trade derivatives, pegged to which team won and by how much. Traders could buy options that the Washington Redskins would win by 10 points, or futures on the Buffalo Bills leading at a particular time. French employees wearing striped referee shirts explained the rules; options traders wore red, white, and blue smocks; and futures traders wore pink. Hall of Fame football players—including Howie Long, Roger Staubach, and Walter Payton—advised the traders, who made more than 100,000 trades during the game.

The bank's head of options sales, a Frenchman, turned up his nose when asked whether the betting was legal: “A triple-A rated French bank would never do anything that has any possibility of being related to gambling.”
²
Société Générale also planned derivatives trading events
in Europe based on international rugby matches, and in Japan based on sumo wrestling.
³

The Super Bowl parties were a microcosm of the financial markets: global in scope, frenzied in pace, and steeped in risk taking. It was fitting that a non-U.S. bank was sponsoring them. Participants came from throughout the world. Every year, when they weren't trading, they could discuss a new international financial crisis, each one more severe than the last. On December 20, 1994, just before the 1995 Super Bowl party, corporate treasurers, who finally had recovered from the Fed's interest-rate hike, were stunned by the crash of the Mexican peso. The next year, Barings—the 233-year-old British bank—collapsed after Nick Leeson, one of the bank's derivatives traders, lost more than a billion dollars. In 1997, the Central Bank of Thailand abandoned its support for the Thai currency, called the baht, and numerous currencies in Asia plunged. In 1998, financial problems in Russia and Brazil led to an international crisis in which the markets briefly froze, and then moved downward in lockstep. Incredibly, during this last crisis, Long-Term Capital Management, the much-admired hedge fund managed by John Meriwether and his rocket-scientist traders from Salomon Brothers, lost nearly all of its investors' money in a period of weeks.

Financial innovation and derivatives were at the center of these crises, and the proliferation of unregulated financial instruments both contributed to the problems and exacerbated their effects. The Mexican and Asian currency crises led to unexpected losses at various corporations and investment funds that had secretly bet on currencies, much as the Fed's rate hike in the United States had flushed out interest-rate speculators. Nick Leeson's trading involved offshore derivatives in Singapore and Japan; Long-Term Capital Management held more than one
trillion
dollars of derivatives.

There were three key lessons from the various international crises. First, governments had created incentives for investors to take on excessive risks by bailing out investors or companies in times of crisis. The Mexico and East Asia bailouts, and the indirect role the Federal Reserve Bank of New York played in the private bailout of Long-Term Capital, led investors to take on additional risks under the assumption that governments would help rescue them. These bailouts created
moral hazard
among investors—the taking of excessive risks in the presence of insurance.
⁴

Second, it became increasingly difficult to measure and monitor
cross-border risks. Barings and Long-Term Capital collapsed primarily because their owners improperly assessed their risks. Even the sophisticated models at Long-Term Capital did not work as predicted. Moreover, many investors did not realize the extent of their exposure to particular risks, such as the risk of currency devaluation in Latin America and East Asia.

Third, financial derivatives were now everywhere—and largely unregulated. Increasingly, parties were using financial engineering to take advantage of the differences in legal rules among jurisdictions, or to take new risks in new markets. In 1994,
The Economist
magazine noted, “Some financial innovation is driven by wealthy firms and individuals seeking ways of escaping from the regulatory machinery that governs established financial markets.”
⁵
With such innovation, the regulators' grip on financial markets loosened during the mid-to-late 1990s. Central banks could not defend themselves against speculators who could access over-the-counter currency options and futures markets. Legislators could not restrict investment, because if they did it would simply move elsewhere. Regulators found it impossible to predict how a crisis in one market would spread to another. And when one financial regulator—Brooksley Born, chair of the Commodity Futures Trading Commission—suggested that government should at least study whether some regulation might make sense, a stampede of lobbyists, members of Congress, and other regulators—including Alan Greenspan and Robert Rubin—ran her over, admonishing her to keep quiet.

Derivatives tightened the connections among various markets, creating enormous financial benefits and making global transacting less costly—no one denied that. But they also raised the prospect of a system-wide breakdown. With each crisis, a few more dominos fell, and regulators and market participants increasingly expressed concerns about
systemic risk
—a term that described a financial-market epidemic. After Long-Term Capital collapsed, even Alan Greenspan admitted that financial markets had been close to the brink.

 

 

F
inancial innovation was not limited to the United States. London was a hub of derivatives activity, and a close second to New York in terms of profits. The London markets benefited from a more efficient regulatory system than the one in the United States. British regulators merged into a single financial-market regulator (after deciding that “there are too
many cooks in the regulatory kitchen”),
⁶
and British judges seemed to understand when to take a “hands-off” approach, and when a proper whipping was in order. The London market had survived a scare in 1990, when a British court found that the Council of the London Borough of Hammersmith & Fulham (a municipality like Orange County) had entered into seventy-two interest-rate swaps “for the purpose of trading and not for the purpose of interest rate risk management.”
⁷
The court found that this trading purpose was unauthorized and outside the powers of the Council, and declared the swaps null and void. The banks that were owed hundreds of millions of dollars on these swaps were understandably upset about the decision. But it clarified important legal boundaries in the market; and, in response, banks took careful measures to establish whether a client was authorized to purchase particular instruments.

Similarly, although regulators in the United Kingdom generally were more permissive than U.S. regulators regarding derivatives trading, they took a much harder line in questioning the “suitability” of complex derivatives, such as structured notes. Laws in both the United States and the United Kingdom required that a seller of financial instruments take into account the sophistication of the buyer, and not sell “unsuitable” financial instruments. For example, Morgan Stanley lost a high-profile case in which a well-respected British judge ruled that the currency-linked structured notes it had sold to an Italian client were not suitable. Morgan Stanley was forced to swallow the losses on the instruments and pay a fine.
⁸
The case was especially notable because the instruments at issue—called PERLS, for Principal Exchange Rate Linked Securities—were relatively straightforward instruments compared to the derivatives at issue in cases in the United States. Whereas U.S. regulators took a one-size-fits-all deregulatory approach, British regulators distinguished between markets that were limited to the major derivatives dealers and markets that involved less sophisticated participants.

But like their U.S. counterparts, British prosecutors had largely abandoned criminal prosecutions. England's equivalent of Drexel and Michael Milken—the “Guinness Case,” probably the most prominent criminal securities trial to occur outside the United States—had been in 1990, the same year Milken was sentenced. Four prominent British businessmen, including Ernest Saunders, were found guilty of a conspiracy to prop up the price of Guinness shares so that its bid (in shares) for Distillers Co. would be more attractive.
⁹
Although the facts in that case were relatively
simple, at least compared to the new financial transactions in London, the trial lasted 113 days. There were odd parallels between Milken and Saunders, both of whom were flayed by the media and sentenced to lengthy prison terms. Both also left prison early, became gravely ill, and miraculously recovered. (Milken overcame cancer; Saunders was diagnosed with Alzheimer's, which he incredibly conquered after he was released early from prison—apparently, the proper diagnosis had been curable pseudo-dementia; or, as many British newspapers argued, prevarication.) There had been few criminal prosecutions for financial fraud in either the United States or England since those two cases in 1990.

International regulators, often based in Europe, followed the British practice of distinguishing between segments of the financial markets, although their focus was on major banks and derivatives dealers. The Basel Committee of the Bank for International Settlements published reports on the derivatives positions of major banks. In July 1993, the Global Derivatives Study Group of the Group of Thirty—called the G-30, for the thirty countries who were members—issued a report on derivatives practices and made a set of recommendations, although they related primarily to specific questions for major dealers, such as whether a swap contract would be enforceable, rather than any broader concerns related to investors or markets more generally.

In contrast, Japan's regulators were both fragmented and largely dysfunctional. The powerful Ministry of Finance and the Bank of Japan, the central bank, split jurisdiction, but the Ministry of Finance—called the MOF—was dominant. Any firm planning to deal in a new type of derivative needed to obtain prior approval from the MOF, although firms often would obtain approval for a generic transaction, and then add bells and whistles without the MOF's knowledge.

Because the MOF tightly restricted Japanese companies, but barely even winked at foreign ones, non-Japanese banks operating under the regulators' radar dominated the Japanese markets, selling derivatives to Japanese institutions that were willing to pay high fees to skirt the MOF's often-nonsensical legal rules. Allen Wheat's salesmen at Bankers Trust and First Boston had pioneered deals designed to enable Japanese institutional investors to avoid legal requirements or to create false profits. By 1994, many other banks—especially Salomon Brothers and Morgan Stanley—were doing the same. Even as Jack Welch was preparing to sell off Kidder Peabody, Kidder's salesmen were pitching a deal in Japan with two pieces, one of which was virtually guaranteed to make 20 percent,
the other of which was virtually guaranteed to lose 20 percent. The Japanese company buying the deal would recognize the 20 percent gain, but hide the 20 percent loss—a blatant accounting scam.
¹⁰
Other banks did similar deals.

Not surprisingly, Japan had its share of derivatives victims in the early 1990s. In 1992, Yukihusa Fujita lost $1.1 billion trading currencies for a Japanese subsidiary of Royal Dutch/Shell.
¹¹
Kashima Oil, a Japanese firm, lost $1.5 billion on currency derivatives. Tokyo Securities lost one-third of its value trading currency options—about $325 million—in November 1994.
¹²

When the Fed raised rates in 1994, the losses spread well beyond investors in the United States, especially to Asia. In Indonesia alone, dozens of major companies lost millions of dollars on derivatives linked to interest rates, including major conglomerates such as Indah Kiat, Indocement Tunggal Prakasa, Tjiwi Kimia, and the Dharmala group.
¹³
Two Indonesian companies—PT Adimitra Rayapratama and PT Dharmala Sakti Sejahtera—lost more than $100 million combined. Berjaya Group, a Malaysian property developer, insurer, and bicycle manufacturer, lost $14 million on a complex swap with CSFP, the derivatives subsidiary of First Boston that Allen Wheat had created.
¹⁴
Berjaya disputed the losses, and the case resembled the Gibson Greetings-Bankers Trust dispute; First Boston settled the case by writing off half the losses.
¹⁵
Several Chinese trading firms lost over $100 million on swaps, and then refused to pay Lehman Brothers and Merrill Lynch.
¹⁶
Taiwan's Overseas Chinese Bank lost $20 million on five Quanto swaps (the complex trade pioneered by CSFP) it bought from Union Bank of Switzerland.
¹⁷

Of course, there were plenty of losers in Europe, too. Major European banks lost millions, and were involved in disputes with their own clients over structured notes and mortgage derivatives. Glaxo Holdings, the British drug maker, lost more than $100 million on complex derivatives, including structured notes and Collateralized Mortgage Obligations.
¹⁸
Carlton Communications, a British media company, lost money on structured notes it bought from Bankers Trust.
¹⁹
Balsam, a German floor manufacturer, borrowed nearly a billion dollars from various German banks, and then lost most of it trading in interest-rate derivatives and selling currency options.
²⁰
And this was all
before
the various international crises began in late 1994.