Infectious Greed (70 page)

In 2003, President Bush needed to nominate a candidate to lead OFHEO, the regulator of Freddie Mac and Fannie Mae, another mortgage bank embroiled in a derivatives dispute. Given the questions surrounding the mortgage market, and the recent brouhaha over corporate scandals, their regulator needed to be able to assert credibly that he or she could confront these crises.

Incredibly, Bush selected Mark Brickell, the pit bull lobbyist for JP Morgan and ISDA, who had blocked regulation of derivatives markets for more than a decade. The media seized on Brickell's nomination, and numerous commentators questioned whether he was an appropriate choice, given his background as an unusually aggressive industry lobbyist. At his confirmation hearing, several senators questioned him about conflicts of interest, and requested that he answer some additional questions in writing (including some he had not satisfactorily answered at the hearing). Senator Paul Sarbanes, coauthor of the corporate reform legislation
of 2002, likened Brickell's nomination to putting a fox in charge of the henhouse.

The collapses of Global Crossing and WorldCom had involved simple men, and simple schemes. But financial markets no longer allowed for simplicity, and the risks associated with those firms and others had been swapped and reconfigured in incomprehensible ways, transferring risks, through credit derivatives and financial institutions, on to individuals who did not even know they were exposed. Investors had been shocked by recent bankruptcies, but the real horror was that the losses went much deeper than the money individuals had lost on stocks. It would be a long time before anyone discovered where the losses from credit derivatives lay. By that time, the financial markets would be on to the next game.

T
he original edition of this book, published in 2003, closed the body of the story with these two sentences:

In fact, it took about five years, an eternity in finance. When the banks finally began disclosing massive losses from subprime-related derivatives, many investors were shocked. Regulators labeled the crisis a perfect storm and claimed that no one could have predicted the declines. But anyone who closely followed the derivatives markets had a decent sense of where and when the collapse would occur, and some investors became billionaires by betting on it in advance.

Before the markets could move to the next game, the financial crisis demonstrated that the hands-off approach to the regulation of derivatives had been a mistake. For years, regulators had believed banks used derivatives primarily to reduce and manage their risks. Alan Greenspan and his compatriots had been overjoyed by growth of the $60 trillion market for credit derivatives. They thought banks were using collaterized debt obligations and credit default swaps to toss risk off their balance sheets. But Greenspan and his compatriots were wrong.

In reality, the banks had used credit derivatives to load up on more than a trillion dollars of hidden side bets based on risky subprime mortgages. The banks initially might have tossed risk away, but they later took back even greater risks, in highly concentrated, complicated, and secret form. The losses were so large that many of the banks were technically insolvent; the government stepped in to rescue most of them.

The scale of the recent collapse might have been unprecedented, but the risk-shifting story wasn't new and the role of complex financial instruments and deregulation shouldn't have been surprising. The financial crisis was the inevitable result of the transformations that began at Bankers Trust during the 1980s and continued through the collapse of dozens of major financial institutions during the following two decades. It was simply the biggest of the many dots connected in this book.

 

 

T
he key issues behind the recent financial crisis are the complex instruments used to skirt legal rules; the rogue employees whom managers and shareholders cannot monitor; and the incentives for managers to engage in financial malfeasance, given the deregulated markets. The antiquated system of financial regulation, developed in the 1930s and designed to prevent another market crash after 1929, no longer fits modern markets. Efforts to deregulate pockets of the markets, at the urging of financial lobbyists, have created an admixture of strict rules governing some dealings and no rules governing others. As a result, the markets are now like Swiss cheese, with the holes—the unregulated places—getting bigger every year, as parties transacting around legal rules eat away at the regulatory system from within.

The information and sophistication gap between average investors and the companies whose shares they buy is now bigger than ever, thanks to the changes in markets, law, and culture since the late 1980s. Accountants, bankers, and lawyers continue to use derivatives to avoid regulation. Corporate executives, securities analysts, and investors continue to focus more on meeting quarterly estimates of accounting earnings than on the economic reality of their businesses.

Media coverage of the stock market is as intense as ever, and though investors are bombarded by information, increasingly they cannot filter it or find anyone who will tell the truth about a particular company. In the past, when investors followed the hype about technology companies,
markets soared in response, in part because of limits on betting against stocks. More recently, investor fear helped slice the market's value in half. Whether the stock markets are going up or down, they are not nearly as efficient as a generation of economists had taught corporate and government leaders they would be.

Sometimes, markets respond quickly to new information. During the first sixty seconds after the first plane hit the World Trade Center, the German stock market fell five percent. In recent years, the values of many stocks were quartered within one day of the announcement of bad news. But often, the markets respond sluggishly, seemingly unsure of whether corporate news is credible. Just as it took securities analysts months to digest Enron's publicly filed documents during 2001, it took investors most of 2002 to abandon their practice of buying stocks on the basis of a whim, myth, or rumor. The financial market crisis of 2007-2008 took place in slow motion, one company at a time, as investors learned it was virtually impossible for them to understand many of the companies whose stock they had been buying.

Until recently, the markets withstood losses at Bankers Trust, Procter & Gamble, Orange County, Barings, Long-Term Capital Management, Enron, and others, largely because these collapses did not create widespread panic among investors. Regulators, too, remained composed, in part because they believed that banks, which used credit derivatives to reduce their risks, had virtually eliminated the threat of a systemwide banking collapse, the primary concern of regulators in the United States.

However, regulators were wrong about where the risk went. Although many banks appeared to toss credit exposure off their balance sheets, that risk secretly swung back to them, like a financial boomerang, through complex credit derivatives. By the time regulators understood that a sharp housing price decline would destroy the major banks, it was too late.

Regulators also misunderstood the dangers of shifting risks to insurance companies, particularly American International Group (AIG). In addition to being the world's largest insurance company, AIG was also the counterparty to half a trillion dollars of swaps with major banks throughout the world. Yet incredibly, AIG slipped through the cracks. It had quietly and cryptically disclosed its credit-derivatives exposure, in financial statement footnotes that resembled Enron's. No one noticed.

Unfortunately, when banks pass credit risks along to insurance firms
and industrial companies like AIG, these other companies become de facto banks, and the rules and oversight that have kept banks safe for decades do not cover these firms. As investors began to understand credit derivatives and the hidden risks within these nonbank firms, they panicked. When the government allowed Lehman Brothers to collapse in September 2008, investors rushed for the exits. The credit markets seized with fear. Regulators tried to rescue AIG and hurriedly helped crippled banks merge into larger, supposedly healthier ones. Federal accounting regulators tweaked their rules so banks could avoid recognizing losses. That bought some time. Yet soon it became apparent that even behemoths such as Citigroup were probably insolvent, and the markets crashed.

In November 2008, Bernard L. Madoff was arrested in New York and confessed to a $50 billion-plus pyramid investment scheme. For more than a decade, Madoff had sent his clients written statements indicating that year after year, they had earned double-digit returns from money they had invested with him. In reality, Madoff hadn't been making any money. In fact, for thirteen years, he hadn't even bought or sold any securities.

Madoff's fraud was outrageous, but at its core, his scheme was not so different from what the banks had done. Both Madoff and the banks operated in the shadow of the law. Both made bad bets on complex financial instruments. Both used dubious means to hide losses from investors. As news spread about problems at the banks, the apparent gap between these institutions and Madoff narrowed, and the faith of investors, which had sustained the modern financial system, evaporated.

 

 

R
egulators and investors need to rethink their approach, or the financial markets will find a new derivatives game and repeat the cycle of mania, panic, and crisis. The six recommendations that follow are drawn from the major lessons of the intertwined financial fiascos of the past twenty years. Ultimately, the health of financial markets will depend on whether credible intermediaries and new regulatory approaches can bridge the gap between investors and corporate executives, reducing the costs of the separation of ownership and control of companies, instead of providing tools and incentives for some executives to bilk their shareholders. Without a change in view and a shift of priorities, the financial
markets will continue to teeter on the edge. The end of the most recent crisis will be merely the end of the beginning.

During the past two decades, regulators have treated derivatives differently from other financial instruments, even if they were economically similar. Different rules led parties to engage in “regulatory arbitrage,” using derivatives instead of securities simply for the purpose of avoiding the law.
¹
There were numerous instances of the differential treatment of derivatives and equivalent financial instruments: stock options were accounted for differently from other compensation expenses, prepaid swaps and other off-balance-sheet deals were recorded differently from loans, over-the-counter derivatives were exempt from securities rules applicable to economically similar deals, swaps were regulated differently from equivalent securities, and credit default swaps were treated differently from insurance. The result was a split between perceived costs (the numbers reported on corporate financial statements) and economic reality (the numbers reported in incomplete or misleading footnotes, or not reported at all).

Derivatives and financial innovation generate great benefits, enabling parties to reduce risks and costs. In theory, some derivatives markets might appropriately be left unregulated. But you can't forget that some derivatives are economically equivalent to other financial instruments. Andy Krieger made money trading options, in part because other traders thought he had sold when he really had bought in a different market. Bankers Trust sold swaps that were really complex trades based on interest-rate indices. CSFP's structured notes were really currency bets. Salomon's Arbitrage Group and Long-Term Capital Management bought cheap options embedded in bonds and then sold equivalent options in a different market. Nick Leeson of Barings bought and sold futures indices on the same Japanese stocks in both Osaka and Singapore.

The problem is that when similar financial instruments are regulated differently, parties are encouraged to use the less-regulated version to hide risks or to manipulate financial disclosures.
²
As long as “securities” are regulated, but similar “derivatives” are not, derivatives will be the dark place where regulated parties do their dirty deeds. The only way to
reverse the trend is for regulators to apply various rules—prohibitions on fraud, disclosure requirements, banking regulations, and so forth—on the basis of the economic characteristics of the financial instrument, not on whether the instrument is called a derivative.

Moreover, it is foolish to deregulate markets simply because large institutions, instead of individuals, are involved.
³
Ultimately, individuals are at risk, as the owners of institutions, and the relevant question should not be the size or wealth of an institutional investor, but rather its sophistication relative to the firm selling the derivatives it was buying. As Gibson Greetings and Procter & Gamble have shown, large companies can be babes in the woods compared with Wall Street bankers. A well-established economic principle is that markets with large gaps in sophistication and information—such as the market for used “lemon” cars—do not function very well. It isn't that Procter & Gamble was defenseless when approached by Bankers Trust's nerdy sales force; it is that the costs of an unregulated market were too great, given the sophistication and information gaps between Procter & Gamble and Wall Street bankers. “Suitability” rules are designed to cover trades with institutions as well as individuals.
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Bankers often deny this intent, however, and courts sometimes believe them.
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