Infectious Greed

by Frank Partnoy

  Finally, on December 1, 1994—long after it was clear Orange County had lost more than a billion dollars—Standard & Poor’s finally said it might lower Orange County’s credit rating.10 The agencies finally downgraded Orange County during the second week of December 1994, as the county was preparing to file for bankruptcy. The downgrades were much too late. Robert Froelich, director of bond research at Van Kampen Merritt, said, “If rating agencies can’t keep track of one of the largest counties in the U.S., what is the value of their ratings on other counties?”11 Or, he might have said, other companies?

  As Orange County fell into bankruptcy, the major derivatives dealers swooped down to feed on its carcass. First, they made sure their loans would be repaid. In early December, First Boston sold $2.6 billion of collateral the county had posted for its loans.12 Chapter 11, the relevant section of the bankruptcy laws for companies and individuals, would have prohibited such a sale, but First Boston’s lawyers argued it was permitted under Chapter 9, the little-known and little-used section for municipalities. Other banks liked this argument, and sold collateral after the filing, something most experts agreed was prohibited.

  Freed from the loans they had made to Orange County, the banks began feasting on the county’s structured notes. In 1994, dealers bought back about $20 billion of structured notes, roughly one-fifth of the total outstanding in the entire market.13 They repackaged the notes and sold off their risks, using swaps and securitizations, the recent innovations by First Boston and other Wall Street firms. They commonly earned fees of about a half percent from these deals, which meant profits of another $100 million.

  Notably absent from these dealings was Salomon Brothers. By this time, its Arbitrage Group had disbanded, and the firm was slow to enter the Orange County fray.14Now under the control of Warren Buffett, Salomon was taking fewer risks and having a terrible year; it was well on its way to losing $400 million in 1994.

  Given the spread of financial innovation, the collapse of Orange County seemed, with hindsight, to have been entirely predictable. It was dangerous to have someone like Robert Citron managing billions of dollars, especially when Wall Street firms were inventing new financial instruments to help fund managers place aggressive bets without regard for investment restrictions. Moreover, many of these new instruments were largely unregulated, so there were no ground rules to prevent fund managers—even municipal treasurers—from putting other people’s money at risk. There weren’t even disclosure requirements related to the new instruments. Given these circumstances, Orange County’s collapse was not only understandable, it was practically unavoidable.

  Orange County emerged from bankruptcy intact, but it wasn’t the only municipality to buy complex derivatives. Municipal officials throughout the country had wanted to gamble on interest rates during the early 1990s, and because they couldn’t evaluate derivatives properly, they paid high fees, just like Orange County and Gibson Greetings. The same factors that led Michael Stamenson to pitch structured notes to Robert Citron also led other Wall Street salesmen to pitch complex derivatives deals to various city and county treasurers throughout the United States. As one example, brokers called Joseph Flowers, the controller of Escambia County—in Florida’s panhandle—four or five times a day, until he finally put 15 percent of Escambia’s $45 million portfolio into structured derivatives.15

  Some municipal treasurers said no. Charles Cox, finance director of the city of Farmers Branch, Texas, reasoned, “If I don’t understand it and I don’t know how it works, I’m not going to invest in it.” David Bronner, head of the Alabama state pension fund, added a Southern sensibility: “Why should I invest in something I can’t even spell?”16 (In 1992, Orange County officials had bragged to Bronner about their returns and called him “antiquated.”)

  But many more said yes, and there were dozens of Orange County debacles, writ small. Every municipality imaginable—from San Diego County to the Municipal Electric Authority of Georgia, from Auburn, Maine, to Lewis & Clark County, Montana—was invested in structured notes and Collateralized Mortgage Obligations. In 1994, the House Banking Committee heard testimony by officials from Odessa College in Texas, Charles County in Maryland, and the Eastern Shoshone Tribe in Wyoming about why they had invested public funds in mortgage derivatives. Dozens of schools and townships across the country were gambling in derivatives. Eighteen Ohio municipalities lost $14 million; the Louisiana state pension fund lost $50 million; City Colleges of Chicago lost $96 million, almost its entire investment portfolio.17Even the Sarasota-Manatee Airport Authority lost money on inverse floaters. Derivatives had come a long way, baby.

  Of course, public officials weren’t the only ones betting on interest rates. As individual investors were about to learn—much to their horror—for every municipality gambling in derivatives, there was a mutual fund doing precisely the same thing. Dozens of mutual funds, including supposedly safe money-market funds, had been speculating in even riskier instruments than Orange County had bought. One mutual-fund manager in particular had put hundreds of millions of dollars, invested in a purportedly conservative fund, into the riskiest mortgage derivatives Wall Street had been able to imagine. His story was even more disturbing than Robert Citron’s.

  Of all the mutual fund managers gambling on interest rates through February 1994, Worth Bruntjen of Piper Jaffray led the pack. Bruntjen’s arrival at Piper’s headquarters in Minneapolis in 1988 was like a tornado touching down.18 He appeared at sales meetings dressed as General Patton. He demanded that other managers move their desks to make more space for him and his subordinates. He created his own fiefdom, even reconstructing Piper’s floor plan to seal him and his staff into private quarters, behind a frosted-glass door. This special work area was known as “the vortex.”

  Bruntjen managed Piper’s flagship mutual fund, the Piper Jaffray Institutional Government Income Portfolio. When Piper first introduced the fund in 1988, it was extremely low risk, and invested almost exclusively in U.S. Treasury bonds and plain-vanilla government-agency mortgage securities. Piper had been a well-respected fund manager since 1913, and it advertised Bruntjen’s fund as more of the same: safe and secure.

  Beginning in 1991, when new rules made it for difficult for banks and thrifts to buy risky mortgage derivatives, Bruntjen decided to step in to fill the void. He began planning to invest in various types of mortgage derivatives—in particular, Collateralized Mortgage Obligations, the mortgage derivatives Salomon had pioneered—in an effort to boost Piper’s returns. CMOs were highly rated mortgage bonds backed by the U.S. government, so they technically fit Bruntjen’s investment mandate. On a paper list, all CMOs looked basically the same as government bonds: the name of a government agency, a rating of AAA, and a few numbers and letters designating the code for the particular security. However, CMOs ranged widely, from very conservative—safer even than plain-vanilla mortgages—to unbelievably volatile. Some were much riskier than anything Bruntjen’s fund previously had purchased.

  During the summer of 1991, Piper held a conference in Sun Valley, Idaho, for its top salespeople. Bruntjen’s low-tech presentation at the conference—just a few slides on an overhead projector—was difficult to follow. In explaining his plan to invest in mortgage derivatives, Bruntjen used so many unusual words and acronyms that some of the salesmen felt he was “speaking another language.” It seemed clear that Bruntjen was expanding from plain-vanilla mortgages to more exotic investments, but the salespeople didn’t get all the details about inverse IOs (more on them later). There were repeated whispers of “Did you understand that?” and when Piper’s top-performing salesman was asked about Bruntjen’s new strategy, he said it seemed “like magic.”

  And it was. From 1991 through early 1994, Bruntjen’s fund was the top-rated short-term government-bond fund in the United States. Bruntjen generated annual returns of more than 13 percent—double the average of other short-term government-bond funds—with little volatility. During this period, Bruntjen simply blew awa
y Piper’s competition.

  How did Bruntjen do it, given that the fund’s stated investment objective—conservatively seeking high income while preserving principal investment—never changed? Was he exploiting some market inefficiency, like Meriwether’s traders at Salomon? Or was he just placing big bets, like Andy Krieger at Bankers Trust?

  The answer was: a bit of both. Bruntjen bought the complex mortgage derivatives that First Boston and Salomon Brothers had invented in the 1980s, and that other banks such as Kidder Peabody and Bear Stearns had begun selling by the billions of dollars. Many of these investments—known on Wall Street as nuclear waste—involved risks that required advanced mathematical training to understand. Because of these complexities, these instruments occasionally would be undervalued, or at least Bruntjen hoped they might be. But whereas the Arbitrage Group at Salomon had captured that value by buying cheap mortgage derivatives and hedging the risks in other markets, Bruntjen just bought the mortgage derivatives outright, without such hedges.

  Essentially, Bruntjen’s investment strategy was a huge bet that interest rates would remain low, although it also carried other risks. For example, Bruntjen bought a special kind of mortgage derivative, called an inverse IO. An IO, on its own, was the right to receive the interest-only portion of payments on home mortgages. An inverse IO was an IO with a twist: instead of paying a coupon that corresponded to the interest payments homeowners actually paid, an inverse IO paid a coupon that moved in the opposite direction of interest rates.

  The inverse IO had a formula just like a structured note. For example, the coupon might be 25 percent, minus four times the short-term interest rate. So if the short-term rate were three percent, the inverse IO would pay 25 percent minus 12 percent, or 13 percent (the amount Bruntjen was earning in his fund). If short-term rates went up, the coupon, based on the formula, went down.

  This formula made the inverse IO doubly hard to assess. On one hand, the inverse IO seemed to become less valuable when interest rates declined, because individuals prepaid their mortgages and the inverse IO lost some of its payments. On the other hand, the inverse IO seemed to become more valuable when interest rates declined, because the coupon formula—which moved in the opposite direction of rates—actually went up.

  In other words, an inverse IO was a whipsaw. There were two risks—maturity and coupon—that went in opposite directions. It paid a higher coupon when interest rates dropped, but it also shortened in maturity because of mortgage prepayments; it paid a lower coupon when interest rates rose, but it also lengthened in maturity because of few prepayments. Thus, the inverse IO had two faces, neither of which was very attractive. It was a short-fused explosive when interest rates were low, and a long-fused dud when rates were high. This was why inverse IOs were known on Wall Street—quite appropriately—as nuclear waste. It was unclear whether any mutual-fund managers really understood all of this.

  All things considered, an interest-rate hike would be especially damaging to an owner of inverse IOs. Although few homeowners would refinance their mortgages if rates were higher, the owner of inverse IOs wouldn’t benefit from the additional payments of interest in the future, because as rates went up the coupon on the inverse IOs would go down. In fact, a significant rate increase would send the coupon plummeting to zero, leaving the owner stuck with a 30-year investment that did not pay anything at all.

  As Bruntjen loaded up his fund with inverse IOs, he was moving far, far away from the fund’s original strategy. Although investors did not realize it, by March 1993, more than 93 percent of the fund’s net assets were invested in CMO derivatives.19

  Although the securities in the fund were complex, the pitch to investors was simple: put your money with Worth Bruntjen and get a better return. Bruntjen didn’t directly solicit investors, but he gave numerous presentations regarding his investment strategy. For important clients, salespeople were told to “bring ’em in to talk to Worth.” Brokers hinted to corporate clients that if they invested a substantial amount in the fund, they might improve their investment-banking relationship with Piper, and perhaps even persuade one of Piper’s respected stock analysts to begin following their companies. (Such hints would become a reality when Internet-securities offerings heated up several years later.) Bruntjen was poised and articulate during these presentations, and clients left feeling swept away in the whirlwind of his enthusiasm and expertise.

  Less sophisticated investors didn’t need to visit Piper’s offices or hear Bruntjen talk about the fund. They knew enough just by looking at the fund’s advertisements: THIRTEEN PERCENT RETURNS! Even better, Bruntjen’s fund had top ratings from Morningstar and Value Line, the two rating systems for mutual funds (although this wasn’t surprising, given that those ratings were simply based on the fund’s historical returns).

  It wasn’t hard for Piper’s brokers to sell 13+ percent returns with a top Morningstar rating. A good broker could bring in over a million dollars per month of new investments into the fund. Individual investors were greedy, just like the managers at Gibson Greetings and Procter & Gamble, and with double the returns of any other comparable investment, the fund basically sold itself.

  The small companies and individual investors who bought the fund didn’t ask many probing questions about the 20 percent of the fund invested in inverse floaters, or even about the 33 percent invested in principal-only strips and Z-bonds (essentially, these were CMOs with a very long maturity, well beyond the fund’s stated limit of three-to-five years). Even if investors had read the prospectus carefully, they had no reason to ask about the fund’s CMOs, which on paper looked just like any other AAA-rated U.S. government-backed obligation—the details weren’t disclosed, but even if investors had asked, they wouldn’t have gotten any answers. The top brokers at Piper didn’t understand what Worth Bruntjen was buying, either.

  To expand Piper’s investor base, Piper’s lobbyists drafted legislation—known as the Piper amendment—that permitted Minnesota towns and counties to invest in Piper funds. With this amendment, the tiny Orange County wannabes throughout the Midwest could enter Piper’s casino, too. About sixty government bodies did so, including cities such as Eden Prairie, Moorhead, Maple Grove, and Mound. Even the Metropolitan Sports Facilities Commission—which operates the Metrodome stadium, where the state’s beloved football team, the Minnesota Vikings, plays—put millions into Bruntjen’s fund.20

  The fund’s performance attracted $500 million of new investment during 1992 and 1993. As money flowed into the fund, investors from all over the world spoke with awe of Piper’s investment acumen. Bruntjen became a media celebrity, and was called the “Wizard of Mortgages.” Tad Piper, an heir to the Piper family of funds, was overjoyed that Bruntjen had given the Minneapolis firm a national profile. He rewarded Bruntjen by taking him on a ski vacation.

  In retrospect, Tad Piper and his sales force might have been more skeptical about how Bruntjen was generating such stellar returns. When Bruntjen bragged in a December 6, 1993, cover story in Business Week that “We buy government-agency paper that has a higher interest rate than the 30-year bond but has an average life of only three to five years,” it sounded too good to be true. Bruntjen was buying highly rated government bonds, and beating all of his peers, year after year. But instead of being subject to scrutiny, or punished for taking excessive risks, he was promoted to senior vice president at Piper, and was personally charged with managing almost a third of Piper’s $12 billion in assets.

  Worth Bruntjen’s fate was intimately tied to that of David J. Askin, a soft-spoken and scholarly fund manager, with an ego as big as his oversized spectacles.21 Askin had been a successful banker at Drexel Burnham Lambert, but as Drexel was failing, in 1990, Askin looked to start his own firm. When Edwin Whitehead, a wealthy investor who ran Whitehead/Sterling Advisors, died that year, Askin found his opportunity. He bought one of Whitehead’s funds, whose investors included various charities related to Whitehead, along with Whitehead’s estate.

&nb
sp; In January 1993, Askin renamed Whitehead’s fund Askin Capital Management. Like Piper, Askin told investors his fund would purchase only the “highest credit quality” securities. Askin also said the fund would employ a “market neutral investment strategy to hedge against market volatility.” Unlike Bruntjen, Askin wasn’t planning to make outright bets. Instead, the fund’s investments would be “hedged so as to maintain a relatively constant portfolio value, even through large interest rate swings.”22

  Askin’s strategy sounded just like that of Salomon’s Arbitrage Group. Askin told investors the fund had “proprietary analytic models” that identified mispricings among complex mortgage securities, such as Collateralized Mortgage Obligations. The fund then bought the cheap CMOs and sold the expensive ones, just like Greg Hawkins of Salomon Brothers.

  The funds within Askin Capital Management had rock-solid names, such as Granite Partners and Quartz, and solid returns, too, which attracted hundreds of millions of dollars of investment. New investors ranged from Nicholas J. Nicholas Jr., former CEO of Time Warner, to the 3M Employee Retirement Income Plan.23 General Electric and its chairman, Jack Welch, also were involved in Askin through Kidder Peabody.