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From NPR… listen to Frank Partnoy on derivatives (MP3 file)….  excellent discussion of derivative products, how they are sold, Congressional efforts to regulate them and the instability they add to the financial system… (running time ~ 40 minutes)

March 25, 2009 · Years before the current economic crisis, law professor and former Wall Street trader Frank Partnoy was warning about the dangers of risky financial practices.

In his 1997 book FIASCO: Blood in the Water on Wall Street, Partnoy detailed how derivatives — financial instruments whose value is determined by another security — were being used and abused by big financial firms. Partnoy used his experiences as a derivatives trader at Morgan Stanley to give the book an insider’s perspective. In the preface to FIASCO, Partnoy wrote about the growing influence of derivatives:

“Derivatives have become the largest market in the world. The size of the derivatives market, estimated at $55 trillion in 1996, is double the value of all U.S. stocks and more than 10 times the entire U.S. national debt. Meanwhile, derivatives losses continue to multiply.”

Partnoy is a professor at the University of San Diego law school. In addition to FIASCO, he’s the author of Infectious Greed: How Deceit and Risk Corrupted the Financial Markets.

Partnoy joins Fresh Air to explain derivatives, credit default swaps and how they led to the current financial crisis.

Excerpt: ‘FIASCO: Blood In The Water On Wall Street’

by Frank Partnoy

F.I.A.S.C.O.: Blood in the Water on Wall Street
By Frank Partnoy
Paperback (Reprint) 272 pages
W. W. & Norton Co.
List price: $16.95

Afterword

This book is the story of my journey through the gluttony and dysfunctionality of 1990s Wall Street. But it also is a story about the roots of the 2008 market crisis. Today, when I am asked if anyone saw this crisis coming, I think back to the people I worked with in the derivatives groups at Morgan Stanley and First Boston, and my answer is yes. We invented the products that ultimately blew up the banks. We created the instruments at the center of the subprime mortgage meltdown. We fostered a culture of epic greed, which nearly destroyed the financial system.

Yes, we saw it coming. How could we not?

The final months of 2008 marked the end of an unprecedented saga of excess. The mania, panic, and crash had many causes. But if you are looking for a single word to use in laying blame for the recent financial catastrophe, there is only one choice. Derivatives.

Without derivatives, leveraged bets on subprime mortgage loans could not have spread so far or so fast. Without derivatives, the complex risks that destroyed Bear Stearns, Lehman Brothers, and Merrill Lynch, and decimated dozens of banks and insurance companies, including AIG, could not have been hidden from view. Without derivatives, a handful of financial wizards could not have gunned down major mutual funds and pension funds, and then pulled the trigger on their own institutions. Derivatives were the key; they enabled Wall Street to maintain its destructive run until it was too late.

In what follows, I will connect the dots from the mid-1990s through the end of 2008. I will describe how investors and regulators ignored repeated warnings about the hidden dangers of derivatives. I will show you how derivatives were at the heart of the collapse.

After quitting Morgan Stanley, I moved to Washington, D.C., where I practiced law for two years. Lawyering was considerably different from selling derivatives. I can honestly say that I would not have switched to shoveling manure, as my colleagues might have done for lesser jobs, unless a substantial raise were involved.

During the summer of 1996, Scarecrow tracked me down. He said he had a new job with Morgan Stanley’s asset-management group. It had been difficult for him to get the job, and he had been forced to compete against numerous candidates outside the firm. The key question in his interviews had been, “What are the most important qualities a salesman can have?” The interviewer told Scarecrow the firm had recently conducted a survey about such qualities and asked him to pick his favorite among: product knowledge, intelligence, relationship ability, and integrity. Scarecrow said he had answered, “Without a doubt, integrity. This is a trust business, and we are selling our trust.” That answer had clinched the job.

Later that summer, one of my ex-DPG colleagues was married, and the wedding reception served as a derivatives reunion. We traded stories about our various fiascos and the investors who had lost billions and billions of dollars on derivatives. Everyone looked on the two-year period as a once-in-a-lifetime experience, never to be relived, always to be savored. Most seemed to have mellowed. The Queen was there, but wasn’t yelling at anyone. Late in the evening she began apologizing to the ex-members of her RAVs team for her periodic tantrums. We forgave her. Everyone kissed and reconciled. The scene was almost a last derivatives supper, except that not one of us would be punished, jailed, fined, or even sued.

I don’t know how or when Morgan Stanley got a prepublication copy of this book. But someone at the firm discovered it, and by early October 1997, my old bosses were scrutinizing every word.

I had expected the following reactions to my book: from Morgan Stanley, a curt “no comment”; from my former colleagues, cries of betrayal; from derivatives outsiders, mild nausea and, perhaps, a little greater care in investing. I didn’t have a stellar track record on expectations, though. I had been expecting the markets to crash for nearly a decade. I had been expecting the University of Kansas basketball team to win a national championship every year since the last time they won in 1988.

As for my book, my expectations were wrong, yet again.

Within a few weeks, Morgan Stanley started a press war. My former colleagues cried betrayal—not about my exposing their business as a fraud—but about my omitting the juiciest stories (as one early caller put it, I had “barely scratched the surface”). And derivatives outsiders howled they were sick, sick, sick— not about the excesses of the derivatives markets— but about not joining up sooner. During a particularly depressing period, several Irish business school students e-mailed me for job-hunting advice, and one derivatives wannabe wrote that F.I.A.S.C.O. was “actually the best book I have ever read.” I felt I had created a monster.

These people might never have heard of the book if it weren’t for a single propitious decision by Morgan Stanley’s management. It was this decision that ignited the press war, the battle Hal Lux, senior editor of Institutional Investor, would later call Morgan Stanley’s “public relations nightmare.”

The nightmare began when the firm released the following statement, dated Monday, October 6, 1997:

The book is clearly a combination of inaccuracies and sensationalism. Our business is based on consistent and professional service to our clients and customers. We do not engage in conduct that would violate the trust that they place in us. We stand on our record.

I don’t know whose idea it was to issue this statement. It certainly came as a surprise to me. I was teaching a few dozen law students at the University of San Diego, settling into the gentle purr of academia, sharpening my golf game, and preparing for several decades of comfortable, easy living tucked away in a sunny, seventy-degree where-ishe- now file. My days were quiet and contemplative. Receiving more than one call in a day was jarring.

During the next two days my phone rang several hundred times.

Peter Truell, a financial reporter at The New York Times, was among the first to call. Top financial journalists like Truell have thankless jobs. They understand markets better than most bankers, are better educated than most bankers, are more entertaining, erudite, and so forth, yet journalists’ salaries are a pittance compared to the fat bonuses of Wall Street salesmen. Nevertheless, on a rare occasion, the journalist gets a priceless perquisite: the chance to saddle up his or her moral high horse and skewer a white-shoe firm such as Morgan Stanley. Truell seemed to savor the opportunity.

He didn’t pull his punches, either. His article cited a less-than-spirited defense by Jean Marie McFadden, a spokeswoman at Morgan Stanley, that “I’m not saying it’s a nunnery, but this is not the culture of the firm,” and noted a lukewarm comment by Monroe R. Sonnenborn, chief lawyer at Morgan Stanley, that firm president John Mack had never said—as I claimed he did—”There’s blood in the water. Let’s go kill someone.” (Another source later claimed Mack had indeed said those words but had been misinterpreted.) “Monty” Sonnenborn also asserted the economic defense that Morgan Stanley would lose clients if it fleeced them in the way the book described. That defense seemed odd, and I’ve often wondered since why Morgan Stanley doesn’t lose more clients.

Other reporters soon joined the fray. Patrick McGeehan and Anita Raghavan of the Wall Street Journal described Morgan Stanley’s efforts to “stamp out a brush fire” sparked by the book. Kimberly Seals McDonald, in vintage New York Post style, focused on the blow jobs and strippers and sexual escapades, in a full-paged piece entitled “Indecent Exposure.” Amanda Grove of CNBC broadcast an interview, complete with footage of me writing “MARKET FAILURE” in large letters on the board while teaching my Latin American Financial Markets class.

Within a few days, word spread to trading floors in New York, London, and Tokyo, and the book sold out. Second and third printings were ordered. On October 8, 1997, F.I.A.S.C.O. was the third-best selling book on Amazon.com, in part because books were sitting in a warehouse somewhere in North Carolina, and the only way to get a copy fast was to order it online. October 8 was well before the planned publication date, and my publisher and I were still rubbing our eyes.

So much for the gentle purr of academia. I took advantage of the media attention to warn anyone who would listen about the hidden dangers in financial markets. I gave speeches to industry groups and regulators. I wrote op-eds for major newspapers. People liked hearing about the face ripping and skeet shooting, but they weren’t as interested in the details about AAA-rated wolves in sheep’s clothing or hidden risks in mortgage derivatives. No one wanted to hear about the possibility of a systemwide collapse.

When the U.S. stock market fell 7 percent on Monday, October 27, 1997, I began preaching that the end was near. Market crashes always seem to happen in October, and it had been almost exactly ten years since the 1987 market crash, dubbed “Black Monday.” A 7 percent drop alone wasn’t much, but because of derivatives it sent shock waves through the markets.

One of the first victims was Victor Niederhoffer, a celebrated and often barefooted squash champion, financial maestro, and hedge fund manager extraordinaire. I thought his fall was a harbinger of doom. I wanted to be sure everyone knew and understood his story, so they wouldn’t repeat it on a grander scale.

I met Niederhoffer shortly after the October decline, at the St. Regis Hotel in New York. We were there for the second annual Derivatives Hall of Fame, sponsored by Derivatives Strategy magazine, one of about a million new industry publications about derivatives, but the only one with a comic strip.

The conference included most of the biggest names in the derivatives business, including Robert Merton and Myron Scholes, two finance professors who had just won the Nobel Prize in Economics for their research on options. I had been invited to lead a discussion about dealer abuses in the market. Apparently, I was the only abuser willing to talk.

I was thrilled to meet Merton and Scholes, who were making their fortunes at a then-obscure multi-billion-dollar hedge fund called Long- Term Capital Management. But I was most interested in talking to Niederhoffer, who was the lunch speaker. I wanted to hear about the dangerous put option selling strategy that had destroyed his fund.

Just a few months earlier, Niederhoffer had been on top of the world. His excellent autobiography, The Education of a Speculator, was selling well, and he was managing more than $100 million of investments, including much of his own considerable wealth. He was both popular and respected, and had an incredible track record: returns of 30 percent per year for fifteen years, with a 1996 return of 35 percent.

Unfortunately, Niederhoffer also had made a big derivatives bet on Thailand. Remember the mouth-watering Thai baht structured notes I had watched First Boston’s salesmen hawk when I was a derivatives naif? Those notes, and similar investments linked to the Asian “tiger” currencies, were issued by highly rated corporations and government sponsored enterprises, such as General Electric Credit Corporation and the Federal Home Loan Banks. The notes looked safe and paid a deliciously high coupon if the baht stayed strong. That was the bet Niederhoffer had made.

On July 2, 1997, Thailand announced it no longer would peg the baht to a basket of foreign currencies. The baht plunged more than 17 percent against the U.S. dollar, just as the Mexican peso had collapsed on December 20, 1994. The effects were cataclysmic.

The rest of East Asia quickly devalued their currencies, too, and followed Thailand into the dumpster. Asian banks had been feasting, like the fat Mexican banks of the early 1990s, making leveraged bets on their own markets and currencies using swaps, options, forwards, and more complex derivatives. Now, they faced annihilation. Within months, the foreign currency value of investments in East Asia dropped by 50 percent or more.

Derivatives ensured that the ripple effects of the baht devaluation reached well beyond the Asian markets. If a butterfly flapping its wings in Thailand could affect weather in the U.S., imagine what a currency devaluation might do. Investors throughout the world were reeling.

Most of the derivatives causing the pain were traded “over-the-counter” rather than on any exchange. That meant, for example, that Asian banks doing swaps had a counterparty, typically a U.S. or European bank, who expected repayment, just as I would expect repayment if you and I had made a private bet. The Asian banks and companies hadn’t lost money on any centralized exchange; they had lost money to other companies, primarily Western banks. The bottom line was that if the Asian banks went bust, their counterparties might lose the entire amounts the Asian banks owed.

The over-the-counter nature of these derivatives trades created enormous potential for loss. For example, U.S. banks had more than $20 billion of exposure to Korea. One Korean investment firm, SK Securities Company, had bet with J.P. Morgan that the Thai baht would rise relative to the Japanese yen, and when the baht collapsed, SK owed J.P. Morgan about $350 million. Other banks—including Citicorp, Chase Manhattan, and Bankers Trust—each disclosed more than a billion dollars of exposure to Asia. This exposure to a counterparty’s inability or unwillingness to repay was called “credit risk.” Credit risk is a banal nonissue irrelevant to a counterparty until a so-called credit event actually occurs; then, credit risk becomes the central issue mattering all too much. Credit risk was why major banks with Asian counterparties were so worried about the currency declines, even if they hadn’t made bad currency bets. And credit risk was one reason why I thought Niederhoffer’s predicament was an omen.

When the Thai butterfly flapped its wings, the currency crash triggered losses for Niederhoffer of about $50 million, almost half of his fund. Derivatives traders who lose $50 million, or more, seem to follow a pattern. I used to fall into that pattern playing blackjack in Las Vegas. Perhaps you’ve had a similar experience. You play a hand of blackjack for $25, thinking it wouldn’t kill you to lose that much money. You lose the hand. Then, you play another hand, thinking it wouldn’t be a big deal to lose $50. Besides, maybe you’ll win the hand and get back to even. You lose that hand, too. Then, you lose another hand, and another hand, and another. Pretty soon, you’re down $500, an amount of money you really would prefer not to lose. What do you do? Do you quit? Of course not. You do the opposite. You increase your wagers and start betting to get even. That’s the pattern. You look up to the eye-in-the-sky, and a little voice in your head trembles, If only I could win that money back, I would stop gambling. Forever.

To imagine Niederhoffer’s plight, add five zeros to that $500. Now what does the voice sound like? It might sound awfully depressing if the $50 million were your money. But what if the money were, in the words of Justice Louis Brandeis, “other people’s money”? Suddenly betting to get even doesn’t seem foolish at all. Wouldn’t you double- down, at least once, for $50 million of someone else’s money? Why not? If you win, you’re even and no one will ever care about your temporary loss. And if you lose, do you really think it matters much if you lose another $50 million? After the first $50 million, you’ve pretty much guaranteed that special someone else won’t be inviting you to his holiday party.

So Niederhoffer, like others before him— Nick Leeson of Barings, Joseph Jett of Kidder, Peabody; Yasuo Hamanaka of Sumitomo; Toshihide Iguchi of Daiwa— began betting to get even, taking on additional risk in the hope that he could make back enough money to overcome his losses on the baht. Academics would refer to Niederhoffer, at this point, as a rogue trader.

By September, he had recovered a bit of the Thai loss, but was still down about 35 percent for the year. Going into October, he began doubling down by selling put options on S&P 500 futures contracts.

Remember that a put option is the right to sell some underlying financial instrument at a specified time and price. In the trader’s parlance, or Corvette lingo, if you bought a put option, you might pay $1,000 today for the right to sell a Corvette for $40,000 some time during the next month. You would make money if the price of Corvettes dropped. If the price of a Corvette dropped to $30,000, you would make $10,000—the $40,000 you could sell a Corvette for, using the put option, minus the $30,000 you could buy a Corvette for in the market (less the $1,000 premium you had paid). Whereas the buyer of a put option wants the price to go down, the seller of a put option wants the price to stay the same or go up—but definitely, please, don’t go down. The more the price goes down, the more the seller of the put option has to pay the buyer. In our example, if the price of Corvettes had dropped to $30,000, and we had sold put options on 100 Corvettes, we would have lost $900,000 ($1 million less the $100,000 premium we had received). The strategy of selling put options does not carry the one benefit Morgan Stanley touted for some of the riskier products it sold: “downside limited to size of initial investment.” In this case, you could lose more than everything. A put seller’s downside is limited only by the size of his or her imagination (and the fact that prices usually don’t drop below zero).

Niederhoffer was looking okay through the weekend of October 25–26. October had not been an especially eventful month, the publication of my book notwithstanding. Niederhoffer was waiting, hoping the options would expire worthless so he could keep the premium and get back closer to even. Remember, he wanted the market to stay the same or go up—but definitely, please, don’t go down.

For Niederhoffer, the seven percent stock market decline on Monday was a death blow. By noon, he was broke. By Wednesday, his funds had been liquidated. The $100-million-plus of his investors’ money was gone. One of his biggest investors was in my new hometown, the $3.3 billion San Diego public-employee pension fund. Well done, San Diego!

At the conference, Niederhoffer gave a dazzling speech, weaving his philosophical and financial expertise into an absorbing narrative. Merton and Scholes, and the other derivatives Hall-of-Famers, delicately side-stepped Niederhoffer’s recent collapse. After lunch, I approached him, and we talked about his put options imbroglio. He told me some of the details of his losses, and I wished him the best in defending any lawsuits. He signed my copy of his book, which I had brought to the conference, writing somewhat cryptically, “To Frank Partnoy, How Close Fate Has Carried Me To Your Drift. Best, Victor Niederhoffer.” He already had read F.I.A.S.C.O.

For me, Niederhoffer’s story illustrated how derivatives could bring down the financial system. If enough people made enough losing side bets, and then kept doubling down, they could cause major institutions to collapse. Selling options was especially dangerous. Because the downside was potentially unlimited, employees who sold options could put an entire institution at risk. If the losing trades were in the over-thecounter market, not on an exchange, the collapse of one institution would expose others to credit risk. One defaulting bank could become a falling domino that would topple many others.

Indeed, the market declines that destroyed Niederhoffer brought down dozens of institutions that had bet secretly on currencies. However, the Asian crisis was not widespread enough to cause a systemwide collapse. The markets ultimately shrugged off the losses and by spring 1998 the derivatives markets were whirring again.

Regulators, especially Alan Greenspan, the Federal Reserve chairman, were elated that the derivatives markets seemed so resilient in the face of crisis. They agreed with bankers and their lobbyists that no rules were needed; the free markets worked fine on their own. When Brooksley Born, head of the Commodity Futures Trading Commission, suggested the government should at least study whether some regulation of derivatives might make sense, her colleagues, including Greenspan and Treasury Secretary Robert Rubin, admonished her to keep quiet. Arthur Levitt, the longest-serving chair in the history of the Securities and Exchange Commission, dutifully followed Greenspan’s lead.

I thought Greenspan’s laissez-faire zealotry clouded his judgment, and I said so publicly (not that he cared, or even heard). He saw no reason for any legal rules to govern the markets. Greenspan even boasted that there was no need for rules prohibiting fraud, because the markets inevitably would discover it. According to Greenspan, market competition alone, without any regulation, was sufficient, because no one would do business with someone who had a reputation for engaging in fraud. To me, Greenspan sounded a lot like Morgan Stanley’s public relations department.

During fall 1998, Greenspan and other regulators learned that Long- Term Capital Management, or LTCM, the hedge fund that boasted the intellectual firepower of Merton and Scholes, was suddenly near bankruptcy. LTCM’s mathematical models had seriously understated the firm’s risks, as well as the degree of correlation among seemingly unrelated assets. LTCM had stacked a hundred billion dollars of debt and more than a trillion dollars of derivatives on top of a relatively thin sliver of a few billion dollars of equity from investors.

Like Niederhoffer, LTCM had sold massive amounts of options. It ultimately lost $1.3 billion from that strategy. It lost most of its remaining capital on “convergence” trades, bets that diverging prices of various financial assets would return to their historical relationships. LTCM’s derivatives positions were so large that even a relatively small marketwide decline was enough to wipe out its capital. Yet LTCM’s models had suggested such a decline was virtually impossible, and would occur perhaps once during the lifetime of several billion universes.

Regulators claimed they were shocked— shocked!— by these losses. Greenspan called the financial crisis surrounding LTCM the worst he had ever experienced. Rubin remarked that “the world is experiencing its worst financial crisis in half a century.” Merton and Scholes, the options gurus, were disgraced, and considerably poorer. I thought it was inevitable that, in response to LTCM, regulators finally would implement some rules.

Again, my expectations were dashed. The Federal Reserve engineered a private bailout of LTCM, but Greenspan resisted derivatives regulation. The derivatives lobby, led by Senator Phil Gramm and his wife Wendy, who initially had deregulated swaps in 1993 and had been a director of Enron since then, waited out the storm of criticism. Then, in late 2000, as the country rubbernecked at the Bush v. Gore election results, they and Greenspan persuaded President Clinton to perform his last official act, signing the Commodity Futures Modernization Act of 2000. Greenspan, Rubin, and Levitt all supported this sweeping deregulation of derivatives. It was one the greatest mistakes in the history of financial markets.

It didn’t take long for another derivatives firm to hit the fan. When Enron collapsed into bankruptcy in 2001, I once again thought that, surely, this must be the end. The United States Senate invited me to testify as an expert at its first formal hearings on Enron, and I seethed about how the company had become an unregulated derivatives trading firm. I thought I was making some progress when Senator Fred Thompson reacted to questions I had raised about footnote 16 of Enron’s annual report, which contained cryptic disclosures of some of the company’s most opaque and horrific derivatives deals.

Thompson interrupted my rant to remark that he was familiar with footnote 16. But when I became uncontrollably excited about our apparent parallel understanding of the Enron fiasco, he interrupted me again and said, in his classic TV-drawl, that he was only joking. Since this was such a dramatic moment for me, and since most people don’t believe this story when I tell them, here is the full, unedited official transcript:

MR. PARTNOY: I would draw your attention to footnote 16 of Enron’s 2000 Annual Report.

SEN. THOMPSON: I’m very familiar with it.

MR. PARTNOY: If you can tell me what’s going on—

SEN. THOMPSON: Just kidding.

When the dust settled after several more hearings, Congress decided to respond to the collapse of Enron, not, as a reasonable citizen might have expected, with rules that actually related to the collapse of Enron, but instead with a law called the Sarbanes-Oxley Act of 2002. SOX, as the law became known, was sweeping and highly controversial. It imposed costly governance