The derivatives lobby occasionally was as inaccurate as it was aggressive. For example, Warren Heller, director of a research firm called Veribanc Inc., quickly became popular among derivatives dealers when he published a study in the fall of 1994 saying that banks were not at risk from their derivatives activities. It turned out that Heller had made a glaring error, counting only the contracts on which banks had a net gain, not those on which the banks had a net loss.27 But few investors had the resources to find the error, and point it out.
Jim Leach was one of the few members of Congress who consistently stood up to the lobbyists at ISDA (others included Democratic Representatives Henry Gonzales and Edward Markey). In 1994, he introduced derivatives legislation, based on his staff’s 900-page study of the market. Mark Brickell battled Leach, making arguments—to various members of Congress and the media—that included serious misstatements of fact. For example, Brickell said that Leach’s bill would impose a suitability standard on derivatives “that is not applied to any other area of finance”; in fact, the standard was no different from the applicable standard in other areas, such as the rules for banks and savings and loans. Brickell also complained about the Leach bill’s supposed capital standards for swaps, when in fact the bill contained no such provisions.
At a July 12, 1994, hearing on the bill, Representative Leach finally lost his patience with Brickell. Congressional hearings are typically scripted, calm affairs, but this time Leach blasted Brickell, accusing him of lying about provisions of the derivatives bill Leach had proposed.28 Leach said, “You are quoted yesterday in the American Banker that banks could become liable for every derivatives contract that loses money. Well, I would like to know where in my bill it says that. That is a very powerful statement and one that is false. What section of the bill is this in? I mean, I and my staff wrote the bill. I don’t recall putting it in.” Leach said his bill’s provision on suitability was the same as the standards already imposed by the Office of the Comptroller, and he noted that capital standards for swaps were not even in the bill. He admonished Brickell, “If you’re going to be a constructive engager in making recommendations to this Congress that carry weight, I would recommend that you state valid objections.”29 When Brickell attempted to defend himself by noting that Leach’s bill treated derivatives differently than other securities, Leach lashed out again, telling him that “derivatives are new, they are off balance sheet, they are a totally different dimension, and your bank has been in the lead in suggesting that.”30
Brickell said he didn’t take the attacks personally, but he gave up trying to persuade Leach. Instead, Brickell shifted his focus to other legislators. Brickell had alienated a few staff members of the Senate banking committee, who refused to meet with J. P. Morgan officials until they were assured Brickell was out of town (they were worried Brickell “might cause a scene in the halls”).31 But he persuaded many other members of Congress that Leach’s bill was premature and would be counterproductive. He argued that regulation of derivatives, including swaps, was unnecessary, and focused on how derivatives were used to hedge, ignoring their speculative uses. He said, “Swaps guys may be clever characters, but we haven’t been able to invent new kinds of risk. What swaps have allowed us to do is tear apart different sorts of risk, isolate them, and manage them independently.”32
Brickell had plenty of help from Arthur Levitt, who suggested, in August 1994, that it would be better for the top derivatives dealers to regulate themselves. Levitt urged the dealers to form a self-regulatory “Derivatives Policy Group,” and said legislation should wait until that group had decided on a plan.
Brickell also received help from several former and soon-to-be-former regulators. Gerald Corrigan, who had issued so many warnings about derivatives as head of the New York Fed, had just left for a much-higher-paid position at Goldman Sachs, and he was named co-chairman of the Derivatives Policy Group, which was lobbying for self-regulation. Wendy Gramm, the former CFTC chair and board member of Enron, praised Brickell and said that he and ISDA “could have been even tougher in terms of their position.”33 Gramm wrote an opinion piece in the Wall Street Journal entitled “The Good Derivatives Do,” in which she argued, “If another major default or market shock occurs, we must all resist the urge to find scapegoats, or to over-regulate what we just do not understand.” Frank N. Newman, the Treasury undersecretary for domestic finance, lobbied Congress in a September 16, 1994, letter, to “indefinitely postpone” derivatives legislation in light of the progress being made in the private sector. (Newman’s comments were a job interview of sorts; he would soon leave to become the head of Bankers Trust, where he would be paid more money than former chairman Charlie Sanford had ever dreamed of making.)
With this assistance, Brickell and ISDA stopped the derivatives legislation. Brickell was obviously pleased and confident, calling the opposition to derivatives regulation a “consensus.”34 He belittled members of Congress who had continued to support new laws during the 1994 hearings on the legislation, and who failed to draw a distinction between structured notes and swaps, saying, “I don’t know how they even realized it during the hearings, but none of the investors were talking about the use of swaps.”35 Just before the 1994 elections, Brickell predicted a Republican victory, saying, “I suspect that after Nov. 8, we’ll be dealing with a very different Congress.”36
Many prominent regulators were surprised that more members of Congress hadn’t supported some new legislation, given the magnitude of the losses and the widespread, unseemly behavior of many Wall Street bankers. As David Mullins Jr., former vice chairman of the New York Fed and later a partner of Long-Term Capital Management, put it, “Given the steady stream of reported losses and all the publicity, there’s been surprisingly little steam for legislation.” Institutional Investor magazine, a prominent Wall Street publication, gave the credit to ISDA.37
In 1995, the prospects for new derivatives legislation declined even more. President Clinton appointed Robert Rubin—the ex-chairman of Goldman Sachs—to replace Lloyd Bentsen as Treasury secretary, and Rubin joined the band of regulators opposing new laws.
Four bills were proposed during the 1995 Congress. Jim Leach introduced a new version of his 1994 bill, proposing a “Federal Derivatives Commission” to regulate the markets.38 Henry Gonzales introduced a bill requiring companies to disclose their derivatives investments, and coordinating federal regulation of derivatives.39 Democratic Senator Byron L. Dorgan, of North Dakota, introduced a bill to prevent federally insured banks from speculating using derivatives.40And Democratic Senator Edward Markey, of Massachusetts, introduced a bill to bring derivatives dealers into a regulatory framework similar to that for securities generally.41
All the bills died. Brickell’s prediction about Congress becoming more sympathetic had come true. By 1995, the losses from the Fed’s rate hike were a distant memory. There had been no obvious financial crisis. The markets hadn’t crashed. And derivatives reform was not part of the “Contract with America,” the agreement among Republicans who now controlled Congress. Perhaps most important, the private sector had responded to Arthur Levitt’s request for self-regulatory reforms. On March 9, 1995, the Derivatives Policy Group—the six top Wall Street firms in the over-the-counter derivatives markets—agreed to a “Framework for Voluntary Oversight,” a document in which the dealers pledged to improve internal controls and risk management, and to report more quantitative data privately to federal regulators.
Although Congress supported self-regulation by derivatives dealers, it sharply questioned efforts by a private self-regulatory accounting group to create new disclosure requirements for some financial instruments. Many of the questionable accounting practices that would plague the financial markets during the late 1990s and early 2000s grew out of these failed efforts.
Since 1973, the Financial Accounting Standards Board had set accounting policy for U.S. companies, telling them what information they needed to disclose to their investors. In th
e alphabet soup of accounting, FASB established GAAP (Generally Accepted Accounting Principles), the basic rules of accounting practice, which were a key factor in persuading investors that the stock prices of companies traded in U.S. markets were fair and accurate.
For their first two decades, FASB and GAAP worked reasonably well. But by the early 1990s, accounting rules had fallen well behind financial innovation. Many experts said that if you asked all of the Big Five accounting firms a question about a complex accounting issue involving new financial instruments, you would get five different answers.
Anyone who had looked at a corporate annual report understood the problem. According to a survey by Ernst & Young, the length of an average annual report had increased from thirty-five pages, when FASB first began setting accounting rules, to sixty-four pages in the early 1990s. The number of footnotes was up from four to seventeen. Ray J. Groves, the chairman of Ernst & Young, warned that “we can expect to see even fatter and more unreadable annual reports in the future. Readers will decide to ignore them, as many people already do.”42
Even as the amount of disclosure increased, the reports became less useful, especially as to complex financial products. In response to a question raised at an ISDA conference, Ethan M. Heisler, a vice president at Salomon Brothers, expressed skepticism that even sophisticated securities analysts could draw anything of value out of financial disclosures about derivatives: “Show me an equity analyst who has taken the disclosures that you currently have on derivatives and made any kind of meaningful use out of those disclosures. I would challenge you to find it. I have never seen it.”43
Nevertheless, when FASB proposed new rules for derivatives, in an attempt to make financial statements more accurate, the financial lobby and many members of Congress opposed—and killed—them. There were two notable examples of proposed rules during the mid-1990s: accounting treatment of options and mark-to-market requirements for derivatives more generally.
The regulatory treatment of stock options became a hot issue in the new Clinton administration. The issue arose out of President Clinton’s campaign promise to do something about allegedly excessive corporate-executive pay. In reality, CEO compensation was not excessive, based on historical measures, and was trivial compared to other corporate expenses, at roughly one-sixteenth of one percent of an average shareholder’s annual returns in 1992.44 But voters had been moved by various television programs on CEO pay, as well as Graef Crystal’s exposé, In Search of Excess.45 Following up on his promise, Clinton pushed Congress to limit the tax deduction for the salaries of top corporate executives to $1 million.46 Never mind that only forty-nine CEOs had base salaries of more than $1 million.47 The law had popular appeal and easily passed.
However, the tax deduction contained a loophole large enough to fly a private jet through. The $1 million cap didn’t apply to “performance-based compensation,” which Internal Revenue Service regulations said required “objective performance goals.”48 The stated purpose of the regulations was to remove discretion from the corporate directors who determined the pay of top executives. Instead of trusting directors to make judgments based on qualitative factors, the rules required directors to follow quantitative ones, based on metrics easily measured by the market. The prime example of performance-based compensation was a stock-option plan.49 The value of a stock option was based, at least in part, on a simple objective factor: the price of the company’s stock. In response to the new regulations, companies began shifting executive compensation from salary to stock options, in part to preserve the rather small tax deduction but, more important, to assure shareholders and commentators that they were following the letter of the new law.
This relatively minor legal change would have unanticipated, insidious effects. As companies shifted to stock options and other forms of market-based compensation, executives began to focus almost exclusively on those quantitative factors. The more a CEO could increase the company’s stock price (or its earnings per share, or some other objective measure), the more money he would make, regardless of how the board thought he had performed. As the board’s power was reduced, a mercenary culture developed among corporate executives. Corporate executives began managing their company’s earnings, buying potentially higher-growth companies, and in too many cases even committing accounting fraud, all of which resulted in higher compensation. Much of the crisis of confidence in the financial markets in recent years can be traced back to the cultural change that began in 1993, with new tax rules encouraging performance-based executive compensation.
This tax change was reinforced by the FASB accounting rule for stock options, which did not require companies to include options as an expense. This rule—established in October 1972—said the cost of an option to a company was the difference between the market price and the exercise price at the time the option is granted.50 In other words, if a stock is trading at $10, a company can give an executive the right to buy stock for $10 with no accounting charge. To an investor looking at a company’s financial statements, such options would appear to be “free.”
Just a few months after this rule was established, economists Fischer Black, Myron Scholes, and Robert Merton had published research showing how options could be valued. The accounting rule was demonstrably wrong, and stock options had an ascertainable value. Yet even as traders began using financial models to track changes in the value of stock options on a minute-by-minute basis, the 1972 rule remained unchanged.
FASB officials knew that the $1 million cap on non-performance-based pay would lead companies to switch to stock options, and they were concerned that investors wouldn’t understand how much those stock options were costing the company. The officials began considering a proposal to require that companies include, as a compensation expense, an estimate of the value of the stock options they awarded to executives. The proposal seemed reasonable enough: the options clearly had a cost, and options models such as Black-Scholes had been churning out options valuations for two decades.
But companies—especially high-technology companies in Silicon Valley—didn’t want to include the options as an expense, because it would limit their ability to match executives’ pay to the performance of their stock. It also would hurt the value of their stocks. In theory, the accounting change shouldn’t have mattered—efficient-market theorists said that as long as the options compensation was disclosed in footnotes or appendices to financial statements, the stock price would reflect that compensation. (Existing disclosure rules for stock options and other compensation required companies to describe all compensation in a footnote, including a summary compensation table and performance graphs, but did not require companies to include the cost of stock options in their financial statements. Theoretically, these rules should have had the same effect as requiring that companies include stock options as an expense in both financial statements and footnotes.)51
Yet the difference mattered. Corporate CEOs—especially those from Silicon Valley—lobbied aggressively against FASB’s proposal. They obviously did not think markets were efficient, or that stock prices reflected the costs of stock-option compensation. They were afraid the proposal would hurt their stock prices, and they told regulators about their concerns. They claimed that, without favorable treatment of options, they wouldn’t be able to attract top executives, because they didn’t have enough cash to pay them. Lobbyists sent out hundreds of comment letters and distributed thousands of “Stop FASB Action Kits.”
Again, individual shareholders were powerless to lobby against such forces. The day before FASB was to issue its new rule for options, Senators Joseph Lieberman, Barbara Boxer, Dianne Feinstein, and Connie Mack introduced a bill to force FASB to drop the proposal.52 Senator Carl Levin was a lonely voice in Congress supporting FASB, although he had plenty of company among accounting and finance experts. Arthur Levitt—who earlier had expressed concern about stock-options accounting during his confirmation hearing—abruptly caved in, and announced his opposition to the
FASB options proposal. In May 1994, the U.S. Senate passed a resolution condemning the proposal, by a vote of 88 to 9. Facing this opposition, FASB backed down. Arthur Levitt would later describe his timid flip-flop on the accounting proposal as his “greatest mistake.”
Senator Lieberman’s position was that, “As a matter of abstract accounting theory, FASB’s approach to stock option accounting may be defensible. But from a public policy, job creation, and competitiveness perspective, it simply is unnecessary and unusually disruptive.”53 Lieberman certainly was correct in arguing that some options—particularly complex, long-term options—were difficult to value, as the losses at Bankers Trust and Salomon Brothers established. But if companies couldn’t figure out what long-term stock options were worth, should they really have been giving those options to their CEOs, instead of simply paying them in stock, which had an obvious value?
The next chapter describes the effect of large stock-option grants on the behavior of corporate executives. It isn’t pretty. For now, it is sufficient to note that the increase in the use of stock options coincided with a massive increase in accounting fraud by corporate executives, who benefited from short-term increases in their stock prices. More than half of the profits from some major high-technology firms were from the accounting treatment for options. The accounting treatment of stock options also was a dangerous precedent in allowing companies to use stock to affect their own income. When Jeffrey Skilling, formerly Enron’s CEO, was challenged at a congressional hearing to name one example of when a company was entitled to use its own stock to affect its income statement, he cited the accounting rules for stock options.
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