Infectious Greed

by Frank Partnoy

  In fact, the details of the episode remained a secret for more than three years, until Fortune magazine—in an article entitled “How Bankers Trust Lied About $80 Million”—unearthed the discrepancy. The article was ruthless, calling the events “mind-boggling,” and asking whether the regulators’ decision not to bring a case implied “that it is okay for companies to falsify line items?”52 Again, there was no response from the government. In 2002, when the memories of most of the participants had faded, one former federal official involved in the decision not to bring a case, who wished to remain anonymous, still clung to the notion that the accounting judgments had been reasonable under the circumstances.

  Andy Krieger is an important first case in understanding the trajectory of financial markets during the past two decades. His trading of currency options was an early example of how financial instruments were becoming more complex, and how traders were quick to exploit new trading strategies. Krieger’s experience also showed how easily an employer could lose control of its employees dealing in these instruments: Krieger was permitted to take substantial risks with options, and no one at Bankers Trust was able to evaluate his profits from complex trades. In addition, the government, by not prosecuting anyone involved in the Bankers Trust accounting scandal, signaled to the financial community that it would not closely scrutinize the largely unregulated over-the-counter markets.

  These three changes—increasing complexity, loss of control, and lack of regulation—would become the most important issues in financial markets. Financial instruments would become more complex and, increasingly, would be used to avoid legal rules; control and ownership of companies would move further apart, leaving individual managers unable to monitor increasingly aggressive employees; and markets would become deregulated, as prosecutors continued to avoid complex financial cases, and accounting firms and banks were insulated from private lawsuits. These developments began with Andy Krieger, but soon would spread throughout Bankers Trust, then to CS First Boston and Salomon Brothers, and then to numerous other financial institutions and their clients.

  For many bankers, the news about Krieger’s trading was a wake-up call. It was time for them to go back to school, to learn to use computers and spreadsheets, and to delve into the details of options pricing and finance theory. Notwithstanding its problems in 1988, Bankers Trust was well positioned in the over-the-counter derivatives markets, which would soon become the largest markets in the world, far surpassing the New York Stock Exchange in overall size.

  With these new instruments, a rogue employee could inflate trading profits, or even put much of a company’s capital at risk, all in a matter of seconds. Bankers could easily dodge regulators, who were overwhelmed. Lawmakers, if lobbied effectively, were unlikely to subject these markets to much scrutiny. In this new world, shareholders—and even boards of directors—would quickly become lost, struggling to decipher their company’s financial statements. If a financial officer’s direct supervisors couldn’t monitor or accurately evaluate his trades, how could shareholders or directors be expected to do more?

  The major financial fiascos of recent years would have been unimaginable during the time Andy Krieger was at Bankers Trust. The financial markets were still relatively simple in 1988. But Bankers Trust’s approach to evaluating Krieger’s trading was a foreboding precedent, and as the seeds sown in this saga began to take root, the previously inconceivable would soon become commonplace. Bit by bit, the markets were losing control. And several Bankers Trust employees who had followed in Andy Krieger’s footsteps were about to take a different and more troubling path.

  2

  MONKEYS ON THEIR BACKS

  When Andy Krieger left Bankers Trust in early 1988, the markets were in decline. Charles S. Sanford Jr., the newly appointed chairman and CEO of Bankers Trust, had put out the fire surrounding Krieger’s currency-options trading. But now, in only his second year at the helm, Sanford confronted a much bigger problem. The future of Bankers Trust—and the future of banking generally—was in question.

  The go-go period of the mid-1980s was ending, and Wall Street was hurting. Merger-and-acquisitions work was stagnant, and investors were pulling money out of stocks. Many banks were posting losses. Although Bankers Trust had reported a slim profit for 1987, in truth—without Andy Krieger’s $80 million of phantom earnings—the bank had lost money. Sanford couldn’t count on another last-minute bonanza from one of his traders, and no one at Bankers Trust wanted to depend on another Krieger. To avoid another losing year, Sanford needed to find a new and reliable source of profits, fast.

  Sanford was a Wharton graduate, like Krieger, but he had twenty more years of experience. Sanford was a Savannah, Georgia, native, and had majored in history and philosophy at the University of Georgia, where the football stadium was named after his grandfather, the university’s chancellor. After graduation, Sanford tried teaching, but he lasted only a year, deciding—as he put it in his Southern drawl—that “I didn’t want to spend my life in a profession where I couldn’t be measured.”1 He left Georgia for Wharton, and joined Bankers Trust—which, at the time, was still hiring history and philosophy majors—right after business school.2

  From the start, Sanford refused to believe Bankers Trust was merely another commercial bank. He began working as a loan officer in the bank’s Southern division in 1961, but he acted more like a trader than a staid commercial banker. He was quickly promoted to head of the bank’s bond-trading operations,3 and he pressed his employees to emulate traders at Wall Street investment banks. He persuaded his bosses to lift a cap on bonuses so top performers could be paid as much as their investment-banking counterparts.

  Sanford’s greatest strength was his intuition about risk. For example, as an executive vice president of Bankers Trust in 1975, Sanford ignored political pressures and pulled out of an underwriting syndicate for a New York bond deal; he felt that New York was simply too risky (as the city flirted with bankruptcy, he was proved correct).4 He was the key voice persuading his bosses to sell the bank’s eighty New York branches in 1978, thereby moving away from the traditional commercial banking business of taking deposits.

  During this time, Sanford—ever the trader—began using much of the bank’s capital to place bets on whether interest rates would go up or down; not surprisingly, he won more than he lost.5 The bank’s top management viewed him as a “golden boy,” a nitty-gritty, roll-up-the-sleeves guy; he was Bankers Trust’s obvious heir-apparent.6 Employees described Sanford as having a “constitutional inability to be second-best at anything.” 7 Sanford’s boss, Alfred Brittain III, told him at the time, “Charlie, you’ll turn this bank into a Wall Street trading house.”8

  When Sanford was promoted to president of the bank in 1983, he began his quest to do precisely what Brittain had predicted, focusing on three issues: financial technology, incentives for employees, and deregulation. He developed sophisticated risk-measurement systems; applied intense pressure to his traders and salespeople, who increasingly had math and science backgrounds; and took full advantage of existing deregulation (and lobbied for more).

  Sanford was named chairman and CEO, as expected, in 1987. As he celebrated his 50th birthday, finally in charge, he shifted into high gear. Bankers Trust was the most technologically sophisticated bank in the world. Within a few years, it would be the most profitable one, too.

  Sanford hired people other banks wouldn’t touch, most notably “quants” and “rocket scientists” who didn’t have the pedigree or connections necessary to land a job at, say, Morgan Stanley. Sanford wasn’t the first one to realize that new employees didn’t really need to know anything about banking; white-shoe investment banks had been hiring employees with family connections and little industry knowledge for decades. But Sanford was the first one to understand that, in the financial markets of the next decade, mathematical smarts would matter more than a low golf-handicap index.

  By the late 1980s, it was no longer as easy for history and phi
losophy majors to get jobs at Bankers Trust. Instead, the bank hired chess masters and physics Ph.D.s with no knowledge of banking, and trained them in finance. Interviewers more frequently asked questions such as, “What do the numbers 1 through 500 add up to?” than “What are a bank’s assets and liabilities?” The nerds found banking a breeze compared to chess openings or general relativity theory. The Bankers Trust training program was so complete that, after a few months, new employees had become smooth-talking salesmen, eager to out-pitch their peers elsewhere.

  One observer described Bankers Trust during this era as a “techno-loony bin of crazed nerds.”9 According to a former managing director of the bank, “They were really nice kids, basically smart nerds, mostly guys without girlfriends. They would hang out in the office and work all night.”10 Sanford crammed several hundred of these nerds into a noisy room stacked with computer terminals on the 33rd floor of the bank. According to one former employee, “The ceilings were very low, very poor air circulation. You barely had any room.”11 But they all loved it, and Sanford had persuaded them that Bankers Trust would soon become the greatest financial institution of all time.

  With his new intellectual horsepower, Sanford could move quickly into new businesses, exiting when the competition arrived and profit margins dwindled. The bank’s recent moves had been frenetic. In 1986, Bankers Trust was focused on plain-vanilla swaps—contracts between the bank and another party to exchange cash flows, based on various indices, including interest rates. At $30 billion total, Bankers Trust was the second biggest swap dealer at the time, just behind Citicorp.12 But as the margins for interest-rate swaps began a nearly twenty-fold decline,13 Bankers Trust looked elsewhere.

  During 1987, Bankers Trust had turned to currency trading, and Andy Krieger. But now Krieger was gone, and the currency markets were becoming saturated, with profit margins dwindling.14

  In 1988, Sanford did another quick pivot, and moved three of his nerds into a new business: long-term stock-index options. These stock options were different from those already traded on the various options exchanges. They had maturities of a year or more, and were based on stock-exchange indices, rather than on individual stocks. In other words, they resembled Andy Krieger’s over-the-counter options, except that they were based on stock indices instead of currencies.

  Bankers Trust executives expected the long-dated stock-index-options business to generate modest returns of perhaps $5 million during 1988. Instead, the business exploded—particularly in Japan—and became the focus of Bankers Trust’s derivatives operations, with dozens of employees. Here is how, and why, these options worked.

  A typical stock option gives the buyer the right to buy or sell stock at a specified time and price. For example, a June 100 IBM call is the right to buy IBM stock for $100 in June. In contrast, a stock-index call option is the right to buy all of the stocks in a particular stock index. For example, you might purchase the right to buy the stocks that made up the Nikkei 225 index—the major Japanese stock market index of the top 225 stocks—for 10,000 yen during the next year. This right would cost you, say, 500 yen.

  If the Nikkei 225 went up to 12,000, you could exercise your right, and buy all the stocks in the index for 10,000. If the Nikkei 225 index were worth 12,000 yen, the stocks also should be worth that much—the index is just the sum of the stocks’ values—so you could sell the stocks for a 2,000-yen profit. Deduct the cost of the option and you made 1,500 yen. If the Nikkei 225 went down, the most you could lose was 500 yen, your initial investment.

  If the individual stocks in the Nikkei 225 weren’t worth the same, in aggregate, as the index itself, Wall Street traders—including those at Bankers Trust—would swoop in, buying the undervalued stocks and selling the index, or vice versa. Such trading—buying low and selling high at the same time—was called arbitrage, and the traders who engaged in arbitrage were called arbitrageurs. Arbitrage was a key force ensuring that markets would be efficient, because if prices did not reflect available information, traders could profit from buying and selling with little or no risk. Not surprisingly, true arbitrage opportunities—like the $20 bill on the ground—were difficult to find. It was easy for traders to “arb” the Nikkei 225 index, buying low and selling high, and profit opportunities from such arbitrage disappeared quickly. Charlie Sanford planned to find some other way to profit from this new business.

  Bankers Trust employees knew Japanese investors were bullish about their own stock market. Japanese insurance executives, who especially thought stocks were going up, were frustrated by legal rules that prohibited insurance companies from investing in stocks. As Japanese stocks skyrocketed, and everyone else was making money in the markets, the insurance executives were stuck with their lackluster bond portfolios.

  Other banks had concluded there was nothing they could do to satisfy the Japanese insurers. But Bankers Trust came up with an ingenious solution, a kind of cross-continental ménage à trois, which gave the Japanese insurance companies exactly what they wanted, while addressing the needs of two other clients: Canadian banks and European investors.

  What did Japanese insurers, Canadian banks, and European investors have in common? And how could Bankers Trust be their yenta? The answer was complicated, and revolutionary.

  First, Bankers Trust went to the Canadian banks and pitched a special kind of loan: the Canadians would borrow Japanese yen, instead of Canadian dollars, and instead of agreeing to pay interest, they would give the lender an option on the Nikkei 225 stock index. The desperate Japanese insurance executives jumped at the chance to make these loans. Although they weren’t permitted to play in the stock market directly, they were permitted to lend money. If the loan also involved a bet on the Nikkei 225, well . . . the Japanese regulators didn’t need to know about that.

  Second, to persuade the Canadian banks that their borrowings did not depend on the yen, or on selling bets related to the Japanese stock market—risks they were horrified by—Bankers Trust agreed to exchange the yen for Canadian dollars, and to sell the Canadians an option that exactly mirrored the one the Japanese had bought. If the Nikkei 225 went up, Bankers Trust would pay the Canadians exactly the amount they owed to the Japanese. The Canadians were perfectly hedged. Their incentive to do this deal was that, in exchange for the hedge from Bankers Trust, they would pay Bankers Trust a lower rate than any they could get borrowing elsewhere.

  Third, Bankers Trust needed to find someone to take on its bet against Japanese stocks. If the Nikkei 225 went up, Bankers Trust had to pay the Canadians, who would pay the Japanese. But who would pay Bankers Trust? Now enter the European investors, who were eager to bet against Japanese stocks, especially if Bankers Trust could offer a longer-term bet than those available on the exchanges. The Nikkei 225 options were of the same maturity as the Canadian bank’s loan; typically, three or four years. These longer-term options were over-the-counter and unregulated, just like Andy Krieger’s. The European investors gobbled them up.

  Effectively, a Nikkei 225 gamble was being passed from European investors to Bankers Trust to Canadian banks to Japanese insurance companies. It was one of the first examples of how complex financial techniques, including derivatives, could turn risk into a hot potato. All of the participants in this adventure were happy with the result, especially Bankers Trust, which pocketed substantial fees on the various deals. The Japanese regulators and citizens would not be as happy in a year when the Nikkei 225 crashed, and they learned that—over the course of a decade—their insurance companies had been loading up on stock-market bets they should not have been making. But for now, the Japanese markets were rising, and there was bliss.

  Bankers Trust offered several versions of this matchmaking exercise, all collectively under the rubric of equity derivatives. A small group that had been expected to make just $5 million in a year could easily make more than that in a week. In 1989 the group made $200 million, one-third of Bankers Trust’s profits that year.15

  As was typical, other
bankers quickly learned of Bankers Trust’s deals, and they entered this market immediately. In early 1990, four investment banks—Bear Stearns, Goldman Sachs, Salomon Brothers, and Morgan Stanley—sold hundreds of millions of dollars of long-term Nikkei options in various structures.16 Like Bankers Trust, the other banks set up free-standing new businesses to do these deals, which they also called equity derivatives.

  As the outside competition increased, tensions mounted between Charlie Sanford and Allen Wheat, the fiery New Mexican who was in charge of equity derivatives at Bankers Trust. Wheat was smart and enormously popular. He had led the international capital-markets group, and many saw him as the eventual heir to Sanford. Some even thought he was gunning for Sanford’s job already. But Charlie Sanford—now in just his fourth year as CEO—was not planning to leave anytime soon. Moreover, Sanford would not say that he would back Wheat as the next CEO, when Sanford eventually stepped down.

  Capitalizing on these tensions—and on Allen Wheat’s ambitions—another investment bank, First Boston, entered the market for equity derivatives in a big way, hiring Wheat away from Bankers Trust. Wheat brought along eighteen key employees and all of their expertise in over-the-counter derivatives. With them, Bankers Trust’s expertise and culture would be spreading to another bank. The defection reportedly sent “shock waves” through Bankers Trust; The Economist reported that “Bankers Trust’s 40-strong equity-derivatives group is now ruined.”17

  It was time for Sanford to regroup yet again. But this was nothing unusual for him or his employees, most of whom remained. If equity derivatives wouldn’t be a huge source of profits anymore, Sanford would find another. Sanford described Bankers Trust as “250 smart guys who all have monkeys on their backs that force them to come in every day and say, ‘Never mind what I did yesterday. What’s next?’”18 In 1990, he continued to walk the trading floor, constantly quizzing, “What’s next?” and encouraging his 250 smart guys to find new and creative deals.