Infectious Greed

by Frank Partnoy

  A second example of a FASB proposal failing in the face of well-funded lobbying involved the question of whether derivatives contracts should be marked to market, so that companies would record changes in value over time. With such a requirement, corporate financial results would be more volatile, but investors would receive more accurate and timely information. For example, investors would have known more about the losses stemming from the Fed’s rate hike. In October 1994—after forty-five months of work in the face of intense lobbying—FASB still couldn’t agree on rules, and it adopted only a watered-down “interim” proposal, which gave companies great discretion in deciding which instruments to mark to market.54

  Banking regulators, including Alan Greenspan, consistently opposed these changes, saying they would introduce too much volatility. Commentator Martin Mayer was skeptical of the regulators’ motives, and said, “The Fed has no interest in honest mark-to-market accounting and never has. Their interest is that they, and they alone, should value the banks’ portfolio. They don’t want the market to do it.”55 Senator Lauch Faircloth from North Carolina—home state to First Union, Bank of America, and Wachovia—played the role of Senator Lieberman in this debate, introducing a bill to prevent FASB’s new rules from taking effect. FASB’s mark-to-market proposal died, just as its options proposal had.

  FASB later resurrected both proposals. In the aftermath of Enron’s collapse, Congress and FASB again began debating the issue of accounting for stock options, and some change appeared likely in early 2003. The mark-to-market proposal actually passed, in a grossly mutated form, as part of an 800-page set of rules (called Financial Accounting Standard 133) so watered down and complex as to be incomprehensible. FAS 133 now requires companies to add several more garbled pages to their annual reports, but few analysts pay attention to those disclosures, because they do not accurately portray a company’s derivatives risks. If you think you really understand a company whose stock you own, a perusal of the section of its annual report discussing FAS 133 probably will change your mind.

  The SEC, to its credit, proposed some regulatory changes to improve disclosure of derivatives risks,56 and many of these changes were adopted in 1997.57 After surveying the annual reports of 500 public companies, the SEC staff found that companies accounted for derivatives with similar economic characteristics in different ways. They also focused on the section of companies’ reports entitled “Management’s Discussion and Analysis of Results and Operations,” known as MD&A. With some prodding by the SEC, companies began telling investors a bit more about their accounting procedures related to derivatives, but not enough for investors to know with certainty how much of a particular company’s profit was from volatile financial businesses.58

  Moreover, the SEC’s new MD&A rules didn’t exactly flush out information. Companies were only required to disclose material information, and “materiality” was a very loose term. The SEC tried to clarify the definition by requiring that companies examine future earnings, fair values, and cash flows from “reasonably possible” near-term changes in market rates or prices. But that term wasn’t any clearer, so the SEC advised in a footnote that “reasonably possible” meant that “the chance of a future transaction or event occurring is more than remote but less than likely.”59 These definitions weren’t encouraging anyone to make useful disclosures.

  The difficulties posed in these regulatory debates centered around the problem that new legal rules would simply encourage private parties to figure out ways around them, or even move offshore. The first four chapters of this book described numerous instances of such “regulatory arbitrage.” Those practices didn’t change during the mid-1990s. For example, in 1995, when FASB adopted new rules requiring companies to account for certain foreign-exchange hedging, Bankers Trust quickly developed a way around the rules, by creating a financial contract with an unlikely contingency related to a company’s offshore activities.60 Accounting for derivatives continued to be open to novel interpretations because, although accounting is based on the notions of assets and liabilities, derivatives are not really either.61 In other words, many accounting concepts were too crude to be useful in modern finance.

  Some academics—most notably Professors Henry T. C. Hu and Lynn A. Stout—argued that, because unregulated derivatives markets had flaws, legal rules might improve market imperfections, but these scholars were in the minority.62 In 1995, Alan Greenspan testified: “It would be a serious mistake to respond to these developments by singling out derivative instruments for special regulatory treatment. Such a response would create artificial incentives to structure transactions on the basis of regulatory rules rather than of the economic characteristic of the transactions themselves.” Joseph A. Grundfest—a former SEC commissioner—described “an escalating cycle in which regulatory initiatives inspire financial innovations that trigger further regulations that in turn give rise to additional rounds of innovation. At the end of this cycle, the rule books are thicker, but the capital markets often restructure themselves to block the regulatory regimes’ goals.”63

  The stealth nature of derivatives also made government economic policy difficult. Although the Federal Reserve Board—which sets monetary policy in the United States by controlling short-term interest rates—employs numerous top economists and devotes a great deal of time to discussing derivatives at its meetings (at least according to meeting minutes), 64 Fed officials said that derivatives made it impossible to predict how its short-term rate changes would affect markets.

  Although the Fed controlled short-term interest rates directly, long-term rates were the key factor affecting the economy and long-term economic planning. Before 1994, Fed economists thought they understood the relationship between short-term and long-term rates. But when the Fed raised short-term rates in 1994, long-term rates increased by almost triple the amount Fed economists had predicted.65 One reason for the widespread losses at mutual funds and corporations in 1994 was that the Fed had slammed on the brakes too hard, not realizing how slippery the road had become. As the markets skidded along, even Alan Greenspan was realizing how little power he wielded when compared to modern financial markets.

  Without new legal rules, the only way for regulators to punish the financial malfeasance of the previous years was to bring cases under existing law. Unfortunately, by this time, many of the best and the brightest prosecutors had left for the private sector. For example, the two key securities-enforcement officials from the Drexel Burnham/Michael Milken era of prosecutions left for jobs at prestigious private law firms. Gary Lynch, formerly director of enforcement at the Securities and Exchange Commission, left for the New York law firm of Davis Polk & Wardwell, and Bruce Baird, formerly chief of the securities fraud unit of the U.S. Attorney’s Office in Manhattan, left for the Washington, D.C., law firm of Covington & Burling. (During the following years, both would ably represent defendants in several high-profile derivatives disputes.)

  Many securities prosecutors remained, but they found it difficult to obtain support for criminal cases against major banks and corporations, especially after the bombing of the World Trade Center in 1993. Prosecutors were much more interested in high-profile terrorism trials, or cases against the Mafia or drug dealers, which were easier to prove than financial fraud. The SEC instituted about 500 formal enforcement actions each year, many of which involved straightforward cases of fraud or insider trading. Arthur Levitt indicated a preference for high-profile cases that were “signature” in some way, and he made it clear that only those investigations “we believe are most relevant” or present a “broad public danger” would receive support.66 But without the support of the Department of Justice, the SEC could not bring criminal charges, which would result in jail time. This was another major change since the late 1980s, when prosecutors from the Department of Justice had policed the markets by bringing high-profile cases against Michael Milken and numerous insider traders. On its own, the most the SEC could do was impose a fine and a cease-and-desist
order—a slap-on-the-wrist enforcement remedy Richard Breeden, the previous SEC chairman, had requested in 1990 to “permit the Commission to resolve cases without protracted negotiation or litigation . . . [and to] provide the Commission with an alternative remedy against persons who commit isolated infractions and present a lesser threat to investors.”67 The derivatives losses of 1994 hardly fit this definition; they weren’t isolated and they already had proven a threat. Yet on its own, the SEC could do no more.

  The SEC devoted much of its resources to the highest-profile cases—such as Bankers Trust—leaving other cases to the discipline of private, civil lawsuits. This approach would work only if the high-profile cases persuaded other bankers that they, too, were at risk of prosecution if they broke the law. But it turned out that neither was true: prosecutors lost many of the high-profile cases, and other bankers—quite rationally—perceived the probability of going to jail for financial fraud as virtually zero. Here is an assessment of these cases, beginning with Bankers Trust. The regulators’ inability to prosecute these misdeeds provided great comfort to anyone considering committing financial fraud.

  When federal regulators began investigating Bankers Trust, they uncovered a mountain of damning evidence. In taped conversations, Bankers Trust employees admitted giving Gibson Greetings false valuations; one employee said, “We told him $8.1 million when the real number was $14 million.”68 Then there was the infamous quote from another Bankers Trust employee, describing the derivatives business: “Funny business, you know? Lure people into that calm and then just totally fuck ’em.” These statements were ideal fodder for a criminal jury trial. Yet not a single person from Bankers Trust did any jail time, the principal actors were not charged with crimes, and most of the people involved in the cases continued to work on Wall Street. Even the fines were minimal.

  Kevin Hudson—the Bankers Trust salesman who had made millions selling complex swaps to Procter & Gamble—was not punished at all. In fact, Hudson’s last appearance in the news was on November 5, 1994, when, in the midst of the Bankers Trust prosecutions, he and Allison Bernhard—the saleswoman he had regaled with stories about his exploits—were married in Greenwich, Connecticut. The next day, the New York Times took a break from its coverage of the various derivatives fiascos to run a society-desk article about the wedding, complete with a photograph from UV Studios. The happy couple moved to London, where they continued to work for Bankers Trust.

  Gary Missner—the Bankers Trust salesman who had covered Gibson Greetings—agreed to settle SEC charges by paying a fine of $100,000 and agreeing not to work in the securities industry for five years.69 Mitchell A. Vazquez, the other salesman covering Gibson, paid $50,000 and was barred for four years.70 The SEC charges in those cases were harsh, alleging that “Missner knowingly provided Gibson with values that significantly understated the magnitude of Gibson’s losses, and that as a result, Gibson remained unaware of the actual extent of its losses from derivatives transactions and continued to purchase derivatives from BT Securities,”71 and that Vazquez “participated in providing Gibson with valuations which materially understated Gibson’s losses from derivatives transactions.”72

  But because they settled their cases out of court, neither Missner nor Vazquez even admitted guilt. In fact, Missner disputed the charges, in a letter to Fortune magazine that was hardly contrite: “Whatever you wish to conclude from the regulatory consent decrees entered into by Bankers Trust, I never lied to Gibson Greetings at any time about anything, including the extent of Gibson’s losses on derivatives contracts entered into with Bankers Trust. Bankers Trust stood ready to transact with Gibson at the tear-up prices [that is, prices for terminating swaps] quoted to Gibson from 1991 to 1994, without exception. The fact that the quoted tear-up prices did not always agree to a theoretical model price is not only not unusual but reflects a practice that, at least until recently, has been common among derivatives dealers.”73

  Vazquez remained quiet, and in 1999—before his four-year SEC ban had expired—reentered the finance business, as president of an investment fund called Global Capital Investment LLC .74 Vazquez and GCI sold over-the-counter currency options—the same contracts Andy Krieger had traded at Bankers Trust more than a decade earlier. But instead of dealing with other Wall Street traders, Vazquez offered these financial contracts to the public, in “mini accounts” of as little as $250, with leverage of up to 200 times the original investment (in other words, $250 could control $50,000 of currencies). Vazquez and GCI transacted almost $2 billion per month through an Internet website.

  Vazquez’s case demonstrated the limitations of existing federal regulation. First, although the SEC had brought Vazquez’s case in the Bankers Trust matter, the CFTC—which regulated futures instead of securities—pursued Vazquez the second time. The SEC case had related to violations of securities law, whereas the CFTC case involved rules related to the illegal sale of futures. The CFTC investigators didn’t seem to notice that Vazquez had violated the SEC’s four-year ban; but, even if they had, Vazquez could have argued that the SEC couldn’t bar him from a business regulated by the CFTC.

  Second, there was some question whether Vazquez’s actions had been subject to any regulation at all. Years earlier, Wendy Gramm, the previous CFTC chair, had exempted many derivatives from regulation, and there were nagging questions about the CFTC’s jurisdiction, given the turf battle with the SEC. It was all very complicated; but, ultimately, Vazquez abandoned the issue and submitted to the CFTC’s jurisdiction.

  The SEC and CFTC were like Keystone Kops. The CFTC fined Vazquez $100,000 and barred him from CFTC-regulated businesses for five years; but, by this time, his SEC ban had lapsed, so he was permitted to sell securities again. In theory, he could even approach Gibson Greetings with more structured swaps if he wanted.

  Brooksley Born, the former head of the CFTC, said in 2002 that she favored merging the SEC and CFTC in order to ensure federal regulators would have the power and sophistication to oversee the OTC derivatives markets and to maintain the necessary independence from the industry, although she recognized that the split in congressional jurisdiction over the agencies might make a merger politically impossible, and she expressed concern that the able staff of the CFTC would suffer a loss of autonomy and power in a merged agency. Meanwhile, the new leaders of the CFTC were gutting the agency from within, relinquishing authority and deregulating markets, even claiming that the collapse of Enron did not involve derivatives. After a few more years of such “leadership,” a merger wouldn’t matter—the CFTC would be an empty shell.

  Guillaume Fonkenell—the Bankers Trust trader who had made last-minute changes in the values of P&G’s first swap—was charged with falsifying the bank’s books and records, but ultimately was cleared of the charges, eight years later. Fonkenell’s case was a huge embarrassment for banking regulators, who almost never lose cases brought before administrative-law judges. Yet administrative-law judge Walter J. Alprin of the Office of Financial Institution Adjudication, which handles Federal Reserve cases, found that “Fonkenell has not been proven to have violated any law, rule or regulation or to have engaged in any unsafe or unsound banking practice.”75

  This dismissal gave a green light to managers and traders looking to use volatility to manipulate their financial results. Even though an expert had testified in the Fonkenell case that financial institutions other than Bankers Trust tried to use some objective measure of volatility—such as the “mid-market” point, between where traders were buying and selling options—the Fed declined to require any objective practice. Instead, traders would be permitted to use any volatility within a “reasonable” range. The judgment concluded that marking to market involved a “number of judgment calls,” and closed by instructing: “Management’s assessment of risk may well take into account the variation in value that can result from choosing one volatility rather than another equally defensible one.” This judgment was a road map for Enron employees to follow when they later ma
nipulated their trading results, and it provided a solid defense for bankers who manipulated the values of their options positions.

  Jack Lavin—the derivatives boss who allegedly had responded to Kevin Hudson’s news about Bankers Trust’s trade with P&G by saying, “I think my dick just fell off”—aggressively defended his case, which was tied up for years in a dispute about whether the SEC could use tapes of conversations between Lavin and his wife. The dispute was the subject of lengthy opinions in the District of Columbia federal courts in 1996 and 1997.76 Lavin’s case remained unresolved years later, and federal investigators would not comment on its status. Meanwhile, Lavin joined Arrow Financial Services, his father’s credit card collection agency, where he was chief executive until Sallie Mae, the student loan firm, bought Arrow in 2004. Lavin rose through Sallie Mae’s management, becoming executive vice president and head of the asset performance group in 2008.

  Securities regulators settled a case against Bankers Trust itself, although the SEC was arguably outside its jurisdiction in charging Bankers Trust with violating the securities laws in its trades with Gibson Greetings. The swaps arguably were not securities, and the instruments on which the swaps were based—currencies and interest rates—clearly were not securities. However, Bankers Trust decided it was in no position to raise this jurisdictional issue, and the firm agreed to pay a $10 million fine and reform some of its practices.77 The SEC also pursued Gibson Greetings, which agreed to cease and desist from violating the law, but did not pay any fine.78 Treasurer Jim Johnsen was subject to a cease-and-desist order, but no fine or criminal charge.