Infectious Greed

by Frank Partnoy

  In July 1995, Iguchi wrote a 30-page confessional letter to his bosses, saying, “After 11 years of fruitless efforts to recover my losses, my life is filled with guilt, fear and deception.” His bosses responded by immediately trying to cover up the losses, too. When officials at the Japanese Ministry of Finance discovered the losses, they, in turn, also tried to cover up the losses, this time from U.S. regulators. A few months later, when U.S. regulators finally learned of the scandal, they returned the favor, prosecuting Daiwa and Iguchi with a vengeance. Iguchi was sentenced to four years in prison, where—like Leeson—he wrote a book about his experiences. In The Confession, Iguchi alleged that other traders at Daiwa also had engaged in unauthorized trading, and claimed that his bosses in the United States had promised to protect him so long as he agreed to hide his losses from the firm’s Japanese managers.60 Daiwa ultimately resolved its sordid case by paying a $340 million penalty, the largest fine for financial fraud in U.S. history.

  It was embarrassing for Europe and Japan that Barings, National Westminster, Deutsche Bank, Sumitomo, and Daiwa were their elite financial institutions. But even Barings and Daiwa ran tight ships compared to companies and governments in East Asia during the 1990s. Managers of companies in Indonesia, Malaysia, the Philippines, and Thailand borrowed billions of dollars, which they invested in largely frivolous new projects, especially in real estate.

  Governments encouraged the borrowing by propping up their currencies, in the same way Mexico had supported the peso. For example, the government of Thailand committed to maintain the value of its currency, called the baht, at an overvalued level based on a basket of several other currencies. Recall that it was this basket that formed the basis of the Thai baht-linked structured notes sold by CSFP, Allen Wheat’s firm, during the early to mid-1990s.

  Individual investors were drawn to the apparently high returns in these “Asian Tiger” economies until 1997, when some traders finally questioned the dubious nature of corporate investments in East Asia, and predicted that governments would not be able to sustain overvalued currencies for much longer. These traders used over-the-counter derivatives to bet tens of billions of dollars against those currencies until July 2, 1997, when Thailand—in a repeat of Mexico a few years earlier—finally gave up trying to maintain the value of its currency. The baht devalued by 15 percent in one day, just as the Mexican peso had fewer than three years earlier. Other countries soon followed.

  Investors in East Asian companies hadn’t paid much attention to the fact that they were not entitled to the protections available to shareholders in the United States and England.61 They generally could not file private suits, and securities regulators were much less effective. Boards of directors did little to monitor managers, and the threat of a corporate takeover was minimal.62 In international rankings of the rule of law, countries in East Asia consistently received the lowest ratings.63

  One reason was the concentrated family ownership of East Asian companies. Buying a million dollars of stock in an Indonesian conglomerate was like buying a single share of a small family business in the United States or England: you might make money, but your investment really depended on how much the family decided you should receive. Outside shareholders, even in aggregate, had little influence on family-controlled corporations, even in countries with strong legal protections.

  In Indonesia, the Philippines, and Thailand, ten families controlled half of the corporate sector.64 The Suharto family in Indonesia controlled 417 listed and unlisted firms through business groups led by children, other relatives, and business partners.65 The Marcos family controlled almost one-fifth of the value of all stocks in the Philippines. Although commentators complained about Japan’s “keiretsu,” which bound together firms with cross-ownership, ownership of Japanese companies was highly diversified compared to ownership in East Asia, where a handful of mostly corrupt families controlled many of the largest companies in the region.

  Not surprisingly, managers at these firms didn’t always tell investors the truth about their investments. For years, companies hid bad loans and failed real-estate projects, while borrowing more money, often in surprisingly unsophisticated ways (the “commercial paper” markets in Indonesia and Thailand included postdated checks and notes scribbled on the backs of envelopes).66 As more foreign investment arrived, the value of shares increased, but the value of the projects underlying those shares declined.67

  It was an ugly picture, and yet money continued to flow in. Why? The simple explanation was that investors were irrationally optimistic, swept up into the first stage of a cycle of manias, panics, and crashes economic historian Charles P. Kindleberger had argued applied generally to financial crises.68 Mutual funds investing in East Asia generated double-digit returns in the mid-1990s, and those returns attracted new money, driving up the value of stocks. The markets weren’t efficient, in part because it was too difficult, expensive, and risky for sophisticated investors to bet against stocks. Shorting stocks was even more difficult in East Asia than it was in the United States, and even an outside investor betting against an obviously overvalued company might lose money, temporarily, if wealthy and powerful families—or even the government—provided temporary support. As a result, manic investors, instead of sophisticated ones, drove prices, and stocks were temporarily overvalued.

  But that explanation was only part of the story, because sophisticated investors, including major hedge funds and investment banks, also were putting money into these countries, not betting against them. Why would sophisticated investors believe they could make money by providing loans to East Asian companies and governments, even if those institutions were in poor shape? This is where the central banks enter the picture.

  If interest rates in Thailand were 15 percent, an investor from the United States could borrow at, say, 5 percent, lend money in Thailand, and keep a profit margin of 10 percent, so long as Thailand’s currency did not devalue. Even if some of the borrowers defaulted, a U.S. lender would still make money, so long as the Bank of Thailand (the central bank) continued to support the baht. This strategy—borrowing in U.S. dollars and lending the money in another country’s currency—was called a carry trade, and it resembled the strategy many investors followed within the United States during the early 1990s, borrowing at low short-term rates and investing at higher long-term rates, hoping to earn the difference. Foreign carry trades began in Malaysia in 1991, and followed in Thailand and Indonesia in 1993.69

  The increase in these carry trades might not have been problematic if they had been disclosed and monitored by investors and regulators. But because of restrictions on borrowing and lending in East Asia, much of the trading was done in the over-the-counter derivatives markets, where there was no centralized information and no requirement that trades be reported on companies’ financial statements.70 As a result, no one knew how much money particular East Asian companies or countries had borrowed. It was difficult to predict when a company had borrowed so much that it would be unlikely to repay, or when a government spent so much of its reserves that it would no longer be able to defend its currency.

  In fact, the derivatives used in East Asia during this time were even more hidden from view than they had been a few years earlier, because banks were selling structured derivatives transactions with a new twist: the Special Purpose Entity, a company or trust created specially for a particular transaction. Like derivatives, SPEs could be used for good or ill. An SPE could be a necessary component of a deal to build a new power plant in Indonesia, or to distribute interests in leases to new investors; or it could be an otherwise useless add-on that enabled a company to create false profits, hide losses and liabilities, and remove the details of various risks from its financial statements.

  During the early 1990s, banks had enabled institutional investors to bet on various currency rates by purchasing structured notes or entering into currency swaps. (Remember, a structured note was simply a debt, issued by a highly rated company, with payments
that were linked to financial variables, such as the value of a foreign currency; a swap was an agreement between two parties to exchange payments linked to such variables.) These were the instruments Bankers Trust had sold to various investors, including many in East Asia.

  But structured notes and swaps had drawbacks for banks, including the risk of being liable for “unsuitable” sales, as the losses of 1994 had shown. Federal regulators in the United States had sued Bankers Trust for selling complex swaps to unwitting customers, even though the extent to which U.S. law covered them was unclear. In private legal disputes regarding structured notes and swaps, purchasers had argued that the selling bank was responsible for their losses, either on suitability grounds or because the bank had breached some agreement or duty. Buyers had obtained favorable settlements in these disputes in the United States, and had even won in court in England.

  By using a Special Purpose Entity, a bank could ostensibly avoid these problems, and—depending on the type of SPE—create a deal that wasn’t taxable or that avoided disclosure requirements. The SPE could be domiciled in a tax and regulatory haven—Cayman, Jersey, Labuan, and so forth—countries whose financial regulations had been shaped by years of transactions in illegal narcotics and money laundering. In simple terms, a bank could put an SPE between itself and an investor, and thereby keep the details of a transaction hidden from view, while avoiding the problems that had arisen in earlier derivatives deals.

  During the mid-1990s, banks began offering elaborate webs of transactions so complicated that it was difficult even to explain the roles of various parties. Economically, the bank was still the seller, but the diagrams and documents for the deals described the bank’s role in minimal terms. The buyers dealt directly only with the SPE, not with the bank and, as a result, the bank disclaimed any responsibility. In simple terms, the buyer entered into a swap with the SPE, who entered into a swap with another entity, who entered into a swap with the bank. If the deal went bad and the buyer sued, the bank now had defenses to the arguments that had been raised in earlier cases: the bank didn’t breach any contract or duty because there was no relationship between the buyer and the bank. Economically, the bank was the seller, but on paper it was merely a swap counterparty to an SPE, who was a swap counterparty to the buyer.71 And all of these details remained hidden from anyone except the parties to a particular transaction.

  In early 1997, as rumors spread that many borrowers in Thailand were in or near default, sophisticated investors reversed their positions in Thailand, betting that the baht would collapse.72 But U.S. banks continued to sell investors derivatives linked to the Thai baht, using SPEs. In May 1997, several large Thai corporations began selling baht and buying U.S. dollars, to ensure they would have currency on hand to satisfy their debts. With all this downward pressure on the baht, the Bank of Thailand itself began entering into over-the-counter derivatives transactions to support its currency. On May 8 and 9, the Bank of Thailand sold $6 billion of forward contracts on the baht, roughly one-fifth of its net foreign-currency reserves. After a few weeks of selling forward contracts, the Bank of Thailand was obligated to deliver $26 billion—all of its U.S. dollar reserves. At that point, it should have been obvious that the Bank of Thailand would not have any money left to support the baht, and that therefore a collapse of both the currency and stock prices was inevitable. (Stock prices would decline following a devaluation of the Thai baht, because Thai companies would need to repay their obligations using less valuable currency.) Investors who knew all of this could have sold off their investments in May 1997. However, neither Thai companies nor the Bank of Thailand disclosed their derivatives positions, and investors in Thailand did not learn the details until it was too late. Even now, investors do not know the details of derivatives structured using SPEs during this time.

  The rating agencies—which had performed so abysmally in the United States, downgrading Orange County only after it was obviously bankrupt—did not warn investors about the various financial problems in East Asia. In fact, both Moody’s and S&P continued to give a single-A rating to the bonds of the government of Thailand for several months after the devaluation.73 Standard & Poor’s did not even put Thailand on its “credit watch” until August, and did not downgrade Thailand’s credit rating until late October 1997.

  After the Bank of Thailand abandoned its defense of the baht on July 2, investors began worrying about similar problems throughout East Asia. Indonesia, the Philippines, and Malaysia faced similar predicaments and abandoned their currencies a few weeks later. The Malaysian central bank, known as Bank Negara, blamed foreign investors speculating in derivatives. It certainly had reason to know: it had made and lost billions of dollars speculating in currencies, and allegedly had even played a role in Andy Krieger’s trading years earlier. In fact, the Malaysian complaints were a near-perfect replay of the supposed battle between Andy Krieger and New Zealand’s central bank, the only change being an increase in the size of the bets from billions to tens of billions of dollars.

  The International Monetary Fund—led by the United States—engineered a $17 billion bailout for Thailand and a $42 billion one for Indonesia,74 thereby compounding the moral-hazard problems of the Mexico bailout. The economies of Indonesia, Malaysia, the Philippines, and Thailand all soon recovered, as Mexico’s had, and investors quickly returned, confident that they would be rescued if another crisis hit.

  John Meriwether’s firm, Long-Term Capital Management (known as LTCM), was the “Rolls-Royce” of hedge funds, and its expenses justified the name.75 LTCM charged a two percent annual fee (double the going average), plus 25 percent of any profits, and the fund required a minimum investment of $10 million. Moreover, investors would not be able to withdraw their money for three years, hence the name “Long-Term.” The idea was that LTCM—unlike other investment funds with a time horizon of, perhaps, a few days—could weather a financial storm, keeping bets it believed in even if they turned bad for months.

  LTCM employed many of the top minds in finance: John Meriwether; Robert C. Merton and Myron Scholes, two of Meriwether’s finance professors (who later would win the 1997 Alfred Nobel Memorial Prize in Economic Sciences for their work in options theory); David Mullins, a former vice chairman of the Federal Reserve and Merton’s first research assistant; a former senior Italian treasury official;76 and a cadre of traders from Meriwether’s Arbitrage Group at Salomon. With this staff, investors approached Meriwether more than he approached them. As Roy Smith, a professor at New York University and the author of several important finance books, put it, “Investing in this thing was done on the basis of networking, wanting to do the cool thing and trusting the superstars.”77

  The men from LTCM knew they were superstars, too. During one early meeting, Andrew Chow, the head of derivatives at Conseco, an insurance company, questioned whether LTCM really could be very profitable, given how competitive the financial markets had become. When Chow told Myron Scholes he didn’t think there were enough “pure anomalies” for LTCM to succeed, Scholes snapped back, “As long as there continue to be people like you, we’ll make money.”78 Conseco didn’t invest, but plenty of others did. By early 1994, Meriwether had raised $1.5 billion.

  In addition, several major Wall Street banks agreed to lend billions of dollars to LTCM, often through zero-margin loans, in which LTCM would not even post collateral to assure banks that it would repay the loans. Individual investors had to post collateral of at least 50 percent, and even other hedge funds posted a few percent, but Wall Street was starstruck, too, and gave LTCM special deals. James Cayne, the CEO of Bear Stearns, a second-tier securities firm, was so taken by LTCM that he not only agreed that Bear Stearns would serve as the clearing agent for most of LTCM’s trades—transferring money and various securities to the parties who were owed them—but he also invested $13 million of his personal funds, even though he had never even met John Meriwether.

  LTCM began trading on February 24, 1994, just after the Fed’s rate
hike. Its prospectus permitted the fund to do just about anything, and warned investors about the volatility of its strategies. The prospectus described relative-value and convergence trades—essentially, buying a temporarily cheap asset, selling a roughly equivalent, temporarily expensive asset, and waiting for the two to converge in price—and cited a few examples of such trades from Salomon’s Arbitrage Group, noting that new strategies were expected and could not be specified in advance. It also mentioned that the firm was permitted to make directional bets (“Directional trades will tend to occur opportunistically and at times may involve positions of significant size”), although the fund didn’t plan to engage in much outright speculation.

  In a rare statement, David Mullins explained: “We’re not directional investors. We don’t take highly leveraged bets in the direction of markets. This is a long-term activity which could last a year or two, although we fine tune the hedging during this period. It’s very intensively research oriented, with state of the art valuation models which relate various securities to each other. Normally, we only pursue 10 of these plays a year, so it’s not frenetic trading.”79 The prospectus also noted that LTCM intended to form “strategic relationships” with important organizations throughout the world. Mullins would be the point man in these dealings.

  LTCM lost money during its first month of trading, but in April 1994 it began an incredible four-year run of profits. It made money during the market chaos of 1994, buying mortgage derivatives that Askin Capital Management and Worth Bruntjen were dumping, and betting that temporarily cheap bonds would move back to their historical levels. In ten months of trading in 1994—a terrible year on Wall Street—LTCM made 28 percent.80