Without the tax benefit, PERCS lacked mass appeal. The idea was really not that new, and investors preferred to buy either common shares, which kept all of the upside, or corporate bonds, which were safer. The main advantage was that a company could “borrow” money using PERCS without increasing its debts (at least in the minds of rating agencies officials). In the early 1990s, a few debt-laden companies whose credit ratings were lower than their competitors’ issued PERCS, instead of debt: Citicorp, General Motors, Kmart, RJR Nabisco, Sears, and Tenneco. 63 The credit-rating agencies did not seem to care that these companies’ short-term obligations were increasing, and they did not count these securities as debt in their analyses. The companies protected their credit ratings, and were willing to pay large fees for the deals. Morgan Stanley doubled its income in 1991, due in large part to the sale of about $7 billion of PERCS.
Then, in 1993, Salomon Brothers introduced DECS (for Dividend Enhanced Convertible Stock), which added a twist to PERCS, to give the investor more upside. PERCS had two payout zones: above and below a specified exercise price—below that price, the investor received one common share for each PERC; above that value, the investor received a diluted number of shares, capping the investors’ upside. DECS added a third zone, at a higher stock price, above which the investor received the upside of common stock.
For example, Salomon did a DECS deal for First Data Corp., the data-processing subsidiary of American Express. If you bought 100 DECS, your payout in three years would fall into one of three zones, divided by common stock prices of roughly $37 and $45. If the common stock were below $37 in three years, you would receive 100 common shares. Between $37 and $45, you would receive fewer shares, to maintain a constant value of $37—that meant that if the price went up to $40, you would still only receive $37 worth of shares per DECS; if the price reached $45, you would receive only 82 common shares. However, in the new third zone, when the price increased above $45, you would still receive 82 shares—no more dilution—regardless of how high the price went. This new upside was the only economic difference between PERCS and DECS.
For American Express and First Data, the regulatory benefits of the DECS were enormous. First, because American Express had agreed to pay the first three years of dividends, the credit-rating agencies gave the DECS a high rating, based on American Express, not First Data Corp.64 The rating agencies also treated the DECS as equity in their analyses. Second, Salomon had obtained an opinion that the three years of payments—called “dividends” for PERCS but “interest” for DECS—were tax deductible. 65 In other words, tax lawyers were willing to call DECS “debt” for tax purposes. Third, accountants did not include DECS among the financial statement’s other debts and obligations, even though everyone else was calling them debt. Salomon had created a financial chameleon that could appear to be equity or debt, depending on the regulator. Investment Dealers’ Digest labeled the DECS for American Express “Deal of the Year” in 1993, and Salomon was paid an incredible $26 million, 66 roughly the same fee Salomon would have received from advising Bell Atlantic on its planned $21 billion takeover of Tele-Communications Inc.—the largest announced takeover since the RJR Nabisco deal in 1989—if that deal had not collapsed in 1993.67
In 1994, as the Fed was raising rates and losses were spreading throughout the financial markets, every major investment bank was copying Salomon’s mousetrap. Merrill Lynch had Preferred Redeemable Increased Dividend Equity Securities (PRIDES), Goldman Sachs had Automatically Convertible Enhanced Securities (ACES), Lehman had Yield Enhanced Equity Linked Securities (YEELDS), and Bear Stearns had Common Higher Income Participation Securities (CHIPS).68 For a time, having a facility with acrostics became more important on Wall Street than mathematical training.
For the next two years, Wall Street made substantial fees from these deals; and companies raised billions of dollars while propping up their credit ratings, reducing their taxes, and hiding their debts. A company’s financial statements would not reflect changes in its obligations on these new instruments as the companies’ share prices changed, even though the value of the obligation depended on which of the three zones the company’s stock was in.
Accountants at the SEC began questioning this accounting treatment in 1996, after they examined a Merrill Lynch PRIDES deal for AMBAC Inc. When they told officials at Merrill that AMBAC would need to record an ongoing expense for the PRIDES, the deal collapsed.69 Then Goldman Sachs invented a security called MIPS, for Monthly Income Preferred Securities, which purported to qualify as equity for accounting purposes but debt for tax purposes. Enron was a major issuer of MIPS, and even won a battle with the Internal Revenue Service in 1996 over the tax treatment of such preferred securities.
In 1997, Merrill added the FELINE twist to its PRIDES, thereby inventing a nearly perfect financial mousetrap. Instead of the company itself issuing the PRIDES securities, Merrill would create a special-purpose trust to issue securities resembling the original PRIDES. The trust would give the money it received from investors to the company in exchange for securities that matched the trust’s obligations on the new securities it had issued. In other words, the trust was simply a middleman: cash would flow from investors through the trust to the company, and the obligations would flow from the company through the trust to investors. The economics of the deal were essentially the same as those of the original PRIDES, with a few bells and whistles added to target specific investor profiles, and a maturity that was extended to five years. By March 1997, Merrill had completed its first FELINE PRIDES deal for MCN Energy Group Inc., through a special-purpose entity called MCN Financing III, which was created especially for the purpose of new issue.70 The new hybrid securities would be tax deductible, would be treated as equity for credit-ratings purposes, and would neither be included as a liability nor dilute the common shares on a company’s balance sheet.71
On February 25, 1998, just weeks before Cendant’s massive accounting scam was uncovered, Cendant announced the public offering of 26 million units of FELINE PRIDES, worth about $1 billion in aggregate. Essentially, investors would buy a preferred stock that would pay a dividend of 6.45 percent for five years and then automatically convert into Cendant common stock, according to a specified schedule. The FELINE PRIDES were tax deductible, received an investment-grade credit rating, and were not included as debt or equity on Cendant’s balance sheet. Merrill Lynch—which had represented HFS in the Cendant merger—created the FELINE PRIDES and was one of the lead underwriters for the Cendant deal. This deal was Cendant’s last gasp for breath, an attempt to raise money to fund its money-losing businesses without disclosing any new debt or jeopardizing its credit rating.
The fact that Cendant did a FELINE PRIDES deal just before its collapse is significant for two reasons. First, it shined a bright light on these new financial instruments. There were numerous related lawsuits, and the publicity presented an obvious opportunity for SEC accountants and, perhaps, even experts at the Internal Revenue Service and the credit rating agencies, to reexamine the impact of these new financial techniques, now that—please indulge one jab at the acronym—the cat was out of the bag.
Second, Cendant’s deal made it clear that the investment bankers were facing serious conflicts of interest in their various businesses, conflicts that became more intractable as financial instruments became more complex. Merrill Lynch had advised HFS in the Cendant merger negotiations and, supposedly, had performed due diligence on CUC at that time. It also had created Cendant’s FELINE PRIDES, so it should have performed due diligence at the time of that deal, too. In addition, Merrill Lynch brokers had been involved in selling Cendant stock to investors, and Merrill’s analysts had recommended Cendant stock. Merrill had earned substantial fees from all of these various sources, just as it had pocketed huge fees from its role in the Orange County debacle as derivatives salesman, bond underwriter, and cleanup crew. Was it really any surprise that Merrill had not uncovered the accounting problems at Cendant?
&n
bsp; The scandals in the United States during the mid-1990s raised troubling questions about the conflicted role of accountants and investment bankers, and the inability of regulators to police them. Top accounting firms were involved in approving accounts that later turned out to be fraudulent. Top investment banks were closely advising the firms engaging in these schemes. In 1998, regulators finally began pursuing accounting fraud in a few cases, but they largely ignored the more complicated schemes, sending yet another message that complex financial crime did, indeed, pay. Meanwhile, the financial innovations of the early 1990s, having been nurtured in a warm, comforting, deregulated environment, were about to multiply and spread throughout the markets. Their next stops would be outside the United States, where no one was prepared for the consequences. Soon enough, they would return home.
STAGE THREE
EPIDEMIC
8
THE DOMINO EFFECT
The Société Générale Super Bowl parties were a reminder to financial market participants in the United States that they were not alone. Beginning in 1992, traders from the French bank—one of the biggest options dealers in the world, with $80 billion in currency options alone1—gathered on Super Bowl Sunday with hundreds of their clients in a custom-built derivatives trading pit at the Equitable Building in Manhattan. The floors were covered with AstroTurf and white yard lines. Several big-screen television sets showed the pregame festivities.
A 27-page rule book explained the various ways participants could trade derivatives, pegged to which team won and by how much. Traders could buy options that the Washington Redskins would win by 10 points, or futures on the Buffalo Bills leading at a particular time. French employees wearing striped referee shirts explained the rules; options traders wore red, white, and blue smocks; and futures traders wore pink. Hall of Fame football players—including Howie Long, Roger Staubach, and Walter Payton—advised the traders, who made more than 100,000 trades during the game.
The bank’s head of options sales, a Frenchman, turned up his nose when asked whether the betting was legal: “A triple-A rated French bank would never do anything that has any possibility of being related to gambling.”2 Société Générale also planned derivatives trading events in Europe based on international rugby matches, and in Japan based on sumo wrestling.3
The Super Bowl parties were a microcosm of the financial markets: global in scope, frenzied in pace, and steeped in risk taking. It was fitting that a non-U.S. bank was sponsoring them. Participants came from throughout the world. Every year, when they weren’t trading, they could discuss a new international financial crisis, each one more severe than the last. On December 20, 1994, just before the 1995 Super Bowl party, corporate treasurers, who finally had recovered from the Fed’s interest-rate hike, were stunned by the crash of the Mexican peso. The next year, Barings—the 233-year-old British bank—collapsed after Nick Leeson, one of the bank’s derivatives traders, lost more than a billion dollars. In 1997, the Central Bank of Thailand abandoned its support for the Thai currency, called the baht, and numerous currencies in Asia plunged. In 1998, financial problems in Russia and Brazil led to an international crisis in which the markets briefly froze, and then moved downward in lockstep. Incredibly, during this last crisis, Long-Term Capital Management, the much-admired hedge fund managed by John Meriwether and his rocket-scientist traders from Salomon Brothers, lost nearly all of its investors’ money in a period of weeks.
Financial innovation and derivatives were at the center of these crises, and the proliferation of unregulated financial instruments both contributed to the problems and exacerbated their effects. The Mexican and Asian currency crises led to unexpected losses at various corporations and investment funds that had secretly bet on currencies, much as the Fed’s rate hike in the United States had flushed out interest-rate speculators. Nick Leeson’s trading involved offshore derivatives in Singapore and Japan; Long-Term Capital Management held more than one trillion dollars of derivatives.
There were three key lessons from the various international crises. First, governments had created incentives for investors to take on excessive risks by bailing out investors or companies in times of crisis. The Mexico and East Asia bailouts, and the indirect role the Federal Reserve Bank of New York played in the private bailout of Long-Term Capital, led investors to take on additional risks under the assumption that governments would help rescue them. These bailouts created moral hazard among investors—the taking of excessive risks in the presence of insurance. 4
Second, it became increasingly difficult to measure and monitor cross-border risks. Barings and Long-Term Capital collapsed primarily because their owners improperly assessed their risks. Even the sophisticated models at Long-Term Capital did not work as predicted. Moreover, many investors did not realize the extent of their exposure to particular risks, such as the risk of currency devaluation in Latin America and East Asia.
Third, financial derivatives were now everywhere—and largely unregulated. Increasingly, parties were using financial engineering to take advantage of the differences in legal rules among jurisdictions, or to take new risks in new markets. In 1994, The Economist magazine noted, “Some financial innovation is driven by wealthy firms and individuals seeking ways of escaping from the regulatory machinery that governs established financial markets.”5 With such innovation, the regulators’ grip on financial markets loosened during the mid-to-late 1990s. Central banks could not defend themselves against speculators who could access over-the-counter currency options and futures markets. Legislators could not restrict investment, because if they did it would simply move elsewhere. Regulators found it impossible to predict how a crisis in one market would spread to another. And when one financial regulator—Brooksley Born, chair of the Commodity Futures Trading Commission—suggested that government should at least study whether some regulation might make sense, a stampede of lobbyists, members of Congress, and other regulators—including Alan Greenspan and Robert Rubin—ran her over, admonishing her to keep quiet.
Derivatives tightened the connections among various markets, creating enormous financial benefits and making global transacting less costly—no one denied that. But they also raised the prospect of a system-wide breakdown. With each crisis, a few more dominos fell, and regulators and market participants increasingly expressed concerns about systemic risk—a term that described a financial-market epidemic. After Long-Term Capital collapsed, even Alan Greenspan admitted that financial markets had been close to the brink.
Financial innovation was not limited to the United States. London was a hub of derivatives activity, and a close second to New York in terms of profits. The London markets benefited from a more efficient regulatory system than the one in the United States. British regulators merged into a single financial-market regulator (after deciding that “there are too many cooks in the regulatory kitchen”),6 and British judges seemed to understand when to take a “hands-off” approach, and when a proper whipping was in order. The London market had survived a scare in 1990, when a British court found that the Council of the London Borough of Hammersmith & Fulham (a municipality like Orange County) had entered into seventy-two interest-rate swaps “for the purpose of trading and not for the purpose of interest rate risk management.”7 The court found that this trading purpose was unauthorized and outside the powers of the Council, and declared the swaps null and void. The banks that were owed hundreds of millions of dollars on these swaps were understandably upset about the decision. But it clarified important legal boundaries in the market; and, in response, banks took careful measures to establish whether a client was authorized to purchase particular instruments.
Similarly, although regulators in the United Kingdom generally were more permissive than U.S. regulators regarding derivatives trading, they took a much harder line in questioning the “suitability” of complex derivatives, such as structured notes. Laws in both the United States and the United Kingdom required that a seller of financial instruments take into
account the sophistication of the buyer, and not sell “unsuitable” financial instruments. For example, Morgan Stanley lost a high-profile case in which a well-respected British judge ruled that the currency-linked structured notes it had sold to an Italian client were not suitable. Morgan Stanley was forced to swallow the losses on the instruments and pay a fine.8 The case was especially notable because the instruments at issue—called PERLS, for Principal Exchange Rate Linked Securities—were relatively straightforward instruments compared to the derivatives at issue in cases in the United States. Whereas U.S. regulators took a one-size-fits-all deregulatory approach, British regulators distinguished between markets that were limited to the major derivatives dealers and markets that involved less sophisticated participants.
But like their U.S. counterparts, British prosecutors had largely abandoned criminal prosecutions. England’s equivalent of Drexel and Michael Milken—the “Guinness Case,” probably the most prominent criminal securities trial to occur outside the United States—had been in 1990, the same year Milken was sentenced. Four prominent British businessmen, including Ernest Saunders, were found guilty of a conspiracy to prop up the price of Guinness shares so that its bid (in shares) for Distillers Co. would be more attractive.9 Although the facts in that case were relatively simple, at least compared to the new financial transactions in London, the trial lasted 113 days. There were odd parallels between Milken and Saunders, both of whom were flayed by the media and sentenced to lengthy prison terms. Both also left prison early, became gravely ill, and miraculously recovered. (Milken overcame cancer; Saunders was diagnosed with Alzheimer’s, which he incredibly conquered after he was released early from prison—apparently, the proper diagnosis had been curable pseudo-dementia; or, as many British newspapers argued, prevarication.) There had been few criminal prosecutions for financial fraud in either the United States or England since those two cases in 1990.
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