Infectious Greed

by Frank Partnoy

  Under the “gentle pressure” of the Federal Reserve, which was concerned that LTCM’s failure might trigger a sequence of global defaults that would cause the entire banking system to unravel, LTCM’s lenders met in the offices of the New York Federal Reserve Bank. Fed chief Alan Greenspan already had remarked that the financial crisis surrounding LTCM was the worst he had ever experienced; Treasury Secretary Robert Rubin said in September that “the world is experiencing its worst financial crisis in half a century.” U.S. government officials didn’t want to bail out LTCM, so they bullied the banks to do so instead.

  On September 23, 1998, after a potential buyout, involving billionaire Warren Buffett, fell through, fourteen major banks—including the banks that had given LTCM sweetheart terms on its loans—agreed to contribute $3.6 billion in return for a 90 percent stake in LTCM.101 With the regulators watching, and the alternative of a widespread international crisis, the bankers didn’t have much of a choice. It was incredible, but no one had seen it coming.

  Many commentators criticized U.S. regulators for assisting with another bailout, but the more troubling issue was the fact that the Fed had seemed powerless to do much more than offer cookies and a meeting room, as Alan Greenspan later admitted. The minutes of the Federal Open Market Committee, from September 29, 1998, stated, “The Committee discussed the limited role of the Federal Reserve Bank of New York in facilitating a private-sector resolution of the severe financial problems encountered in the portfolio managed by Long-Term Capital Management L.P. The size and nature of the positions of this fund were such that their sudden liquidation in already unsettled financial markets could well have induced further financial dislocations around the world that could have impaired the economies of many nations, including that of the United States. Against this background, the Federal Reserve Bank of New York had brought together key interested parties with the aim of increasing the probability of an orderly private-sector solution to the hedge fund’s difficulties.”

  To their credit, the regulators had learned at least a partial lesson about the moral hazard created by earlier bailouts. This time, they were involved only indirectly, and no government funds went to support either the Wall Street banks or John Meriwether’s traders.

  Meriwether and his crew kept their jobs, but lost most of their personal stakes in LTCM. In all, the fund had lost more than 90 percent of its value during 1998: less than 10 percent of the losses were from emerging markets; $1.3 billion was from selling options, and $1.6 billion was from the convergence strategies that had generated 87 percent of the profits at Salomon Brothers just a few years earlier.102

  From Mexico to Barings to East Asia to LTCM, the international financial crises of the mid-to-late 1990s had become progressively more complex and far-reaching. By 1998, it was obvious that global markets were linked more closely than anyone had anticipated, so that a problem in Russia could lead to the collapse of a hedge fund in the United States. Now investors had plenty to talk about at Super Bowl parties, regardless of who was hosting. The open question was: where could they possibly put their money?

  No one doubted that new financial instruments had created great benefits by enabling investors and corporations to manage risks more efficiently. But the instruments also had increased the frequency and potential severity of market crises, in part because they were so hidden from view. Commentators argued about whether the changes were for better or worse, but the argument was moot: the changes were permanent, and investors and regulators would need to deal with the new risks, or else.

  Even the strongest supporters of deregulation recognized that market participants were not adequately monitoring their risks. The President’s Working Group on Financial Markets blamed Wall Street for these risk-management failures, although it stopped short of recommending new rules. The Working Group’s report on LTCM rebuked major U.S. banks for being complacent during good times, and warned them not to let the lessons of LTCM recede from memory. As a Sword of Damocles, the Working Group listed “Direct regulation of derivatives dealers unaffiliated with a federally regulated entity” as a “potential additional step.”103 Meanwhile, the derivatives activities of the top investment banks remained outside the scope of U.S. law.

  These unregulated financial institutions were LTCMs-in-waiting. In many ways, the top investment banks looked just like LTCM. They had an average debt-to-equity ratio of 27-to-1—exactly the same as LTCM’s (and that did not include off-balance-sheet debt associated with derivatives—recall that swaps were not recorded as assets or liabilities—or additional borrowing that occurred within a quarter, before financial reports were due).104 They did many of the same trades, and used the same risk models. Now that LTCM was laying off employees, some investment banks would even hire the same traders.

  The various international crises highlighted the fact that market participants were no longer able to assess their own risks. Investment funds didn’t have a good understanding of the risks in Mexico or Thailand. Executives at Barings had no clue about Nick Leeson’s trading. And, worst of all, the traders at LTCM had used computer models that simply did not work. When the President’s Working Group on Financial Markets surveyed financial firms to see how they were managing risks, it reached the following chilling conclusion, buried in an appendix to its report on LTCM: “Most models do not incorporate all products traded by the firm. Firms initially included products they believed presented the highest risks to them, with the intent of including other credit sensitive products at some future date. Some firms do not have an ability to calculate and monitor aggregate exposure limits across all product lines in a VAR-based environment. For instance, some firms only include derivative and foreign exchange transactions, and not repurchase agreements, mortgage backed securities and forwards. A firm’s inability to evaluate exposures across all product lines could considerably underestimate credit exposures during periods of extreme market volatility.”105

  In other words, even firms that used Value At Risk—which calculated the maximum daily loss with a 95 percent confidence interval, based on historical data—were not able to track their own risks. In truth, VAR was dangerous. It gave firms a false sense of complacency, because it ignored certain risks and relied heavily on past price movements. In some markets, VAR actually increased risk, because every trader assessed risk in the same flawed way. In other markets, traders calculated VAR measures that varied “by 14 times or more.”106

  Risk management was more art than science, and risk could not be boiled down to a single VAR number. LTCM’s VAR models had predicted that the fund’s maximum daily loss would be in the tens of millions of dollars, and that it would not have collapsed in the lifetime of several billion universes. Askin Capital Management’s VAR had been only about $15 million just before it collapsed.107 Barings’s VAR models said its risk was zero.

  Yet even after LTCM collapsed, more than 80 percent of financial firms said they used VAR with a 95 percent confidence interval.108 This was true even though, in 1998, almost anyone could buy much more sophisticated computer models—which would have required an army of Ph.D.s in 1994—for just a few thousand dollars, as a plug-in to a computer spreadsheet such as Microsoft Excel. But instead of using more sophisticated models, most firms used a simple VAR model. Companies paid Bankers Trust a million dollars each for access to the firm’s VAR model, called RAROC 2020, based on the risk-adjusted rate of return Charlie Sanford had introduced at Bankers Trust many years earlier. In 1997, the credit-rating agencies—always slow to the game—finally adopted J. P. Morgan’s benchmark model, called CreditMetrics, which relied on historical data and V AR.109 The names were fancy—VAR, RAROC 2020, CreditMetrics—but all these models really did was compare historical measures of risk and return. They were the models the President’s Working Group on Financial Markets had said were seriously flawed.

  Why were so many firms using such faulty models? Once again, the primary explanation involved legal rules. Although some firms stuck with VAR b
ecause they didn’t know any better, the major reason firms used VAR—and even disclosed VAR measures in financial statements—was that regulators required them to do so. Just as regulators had inadvertently led CEOs to become mercenaries by tinkering with the rules for executive compensation and stock options, they were now inadvertently encouraging firms to misstate their own risks.

  On January 28, 1997, the SEC had adopted a rule110 requiring companies to disclose more information about derivatives, and gave them three options, the easiest of which was to disclose a VAR measure with a 95 percent confidence interval. Likewise, the Bank for International Settlements also recommended the use of VAR, as did many international-banking regulators, including the Federal Reserve. Not surprisingly, companies used VAR.

  Fed Chairman Alan Greenspan opposed any additional regulation. Although Greenspan publicly mouthed support for laws prohibiting financial fraud, in private he was willing to disclose his true opinion—that he believed there was no need for anti-fraud rules, either. In one lunch meeting in his private dining room at the Fed, he told a senior regulator, “We will never agree on the issue of fraud, because I don’t think there is a need for laws against fraud.” Greenspan said his experience trading commodities early in his career had persuaded him that anti-fraud rules were unnecessary, because participants in the markets inevitably would discover fraud. Market competition alone—without any regulation—was sufficient, because no one would do business with someone who had a reputation for engaging in fraud.

  Given Greenspan’s power and strong opinions, any new financial regulations were going to be market-based. Regulators began allowing financial institutions to use their own versions of models to assess whether they were complying with rules that required them to reserve a sufficient cushion of capital based on the risks they took. In simple terms, banks had been required to keep eight cents in reserve for every $1 of loans they made. That requirement was easy to administer when all banks did was make loans. But banks were now engaged in more complex businesses, and they weren’t the only financial institutions with capital requirements. How much capital should a securities firm reserve against an inverse IO? What about an insurance company that owned a slice of a Collateralized Bond Obligation? How should a bank treat a complex swap with a hedge fund such as LTCM?

  These were more difficult questions, and regulators knew that if they created specific rules for particular instruments, they would be drawing lines in the sand, where financial innovators would quickly find economically equivalent instruments that fell on the other side. So, instead, regulators abdicated to the market and permitted companies to use their own models—flawed or not—to determine whether they were in compliance with minimum capital requirements. In reality, there wasn’t much they could do. As one regulator put it, “For $112,000 a year, we can’t hire someone who can check the models of kids making ten times that.”111

  All of these issues were much too complicated for average investors. Even if they scoured financial statements to assess a company’s leverage and derivatives, and examine its VAR measures, they still wouldn’t have an accurate picture. If Wall Street banks couldn’t even get an accurate sense of their investments, or gauge their own risks, and if a sophisticated hedge fund such as LTCM could collapse because it had been using bad computer models, what hope did individuals have of accurately assessing the risks of their investments? In 1994, it hadn’t made much sense to read lengthy corporate annual reports. Now, it didn’t even seem worth bothering to look at anything other than the company’s name, or perhaps its website.

  In such a hopelessly complex environment, with all the various international crises, companies involved in speculative ventures related to the Internet and other new technologies seemed like reasonable investments. If the alternatives were established companies that either were lying about their accounting data or were unable to manage their own risks, just about any new investment looked attractive. When technology companies began issuing shares to the public in Initial Public Offerings that shot up by hundreds of percent during the first day of trading, and then continued going up, these stocks looked like sure things.

  9

  THE LAST ONE TO THE PARTY

  Frank “Frankie” Quattrone grew up in a small, two-story row house in a working class neighborhood in south Philadelphia, where the movie Rocky was filmed.1 As Rocky Balboa was running past Quattrone’s home, and up the seventy-two steps of the Philadelphia Museum of Art, on his way to winning the heavyweight boxing championship, the bookish Quattrone was acing his high school exams and standardized tests, on his way to winning a scholarship to Wharton—the same school Michael Milken, Charlie Sanford, Allen Wheat, and Andy Krieger had attended. After Wharton, Quattrone worked for two years as an investment banker at Morgan Stanley in New York,2 moved to Palo Alto, California—where he graduated from Stanford’s business school—and then returned to Morgan Stanley, this time in the firm’s California office, not far from Stanford. It was 1983.

  At the time, a group of technology “nerds” in the Silicon Valley area—many from Stanford—were starting up companies with strange and unfamiliar names, such as Cisco and Netscape. Quattrone fit right in, befriending and advising hundreds of these young entrepreneurs. They loved the fact that a Wall Street banker would wear ugly sweaters instead of expensive suits, and entertain clients at karaoke bars by singing “Rocky Raccoon.”3 Quattrone was smart and offbeat, and his thick, black, center-parted hair and bushy mustache were about as far as it got from a Wall Street look. As Will Clemens, CEO of Respond.com, put it: “He looks like a guy who could be towing your car.”4

  Many start-ups in Silicon Valley hired Quattrone, and Morgan Stanley promoted him to managing director in 1990, the year the investment bank did Cisco’s IPO—the Initial Public Offering in which the privately owned technology firm first sold shares to the general public. In 1995, Quattrone did the IPO for Netscape—the software company that created Netscape Navigator, which enabled individuals to access the Internet—and this deal marked the beginning of the Internet boom. By that time, Morgan Stanley was involved in the lion’s share of technology deals, and Quattrone reportedly was making $10 million a year.5

  After a few control-related disputes with Morgan Stanley’s president, John Mack, and a run-in with a Morgan Stanley technology research analyst who had rated one of Quattrone’s clients a “hold” instead of a “buy,”6 Quattrone quit in 1996 to join Deutsche Bank’s investment banking division (called Deutsche Morgan Grenfell). Deutsche gave Quattrone everything he wanted, including more staff, a greater share of profits, and control of research analysts.

  Quattrone’s success and offbeat approach continued at Deutsche. His “pitch book” for the IPO of Amazon.com, an Internet bookseller, looked like a real hardcover book; Deutsche won that deal—and many others. But like Rocky Balboa, Quattrone was a restless superstar. Notwithstanding the fact that he had doubled his annual pay to a reported $20 million, he considered moving to another firm.7 When rumors spread in 1998 that he might leave Deutsche, he wrote a letter to clients assuring them, “We are here to stay. Please trust us.”8 Then he promptly quit to join CS First Boston—Allen Wheat’s firm—taking along the best bankers from his group, capturing even greater control and an even more lucrative pay package.

  At CS First Boston, Quattrone dominated the market for technology IPOs, and CS First Boston made $718 million in fees for IPOs of technology companies alone, much more than any other bank.9 (Incredibly, as it would turn out, that amount included just the firm’s disclosed fees, which were only a fraction of the money it really made from those IPOs.) In two years, Quattrone took CS First Boston from the 19th-ranked technology investment bank to number one.10

  Quattrone also continued his antics. When Peter Jackson, the CEO of Intraware, complained that soliciting investors during his company’s IPO was going to make him “feel like a mule,” CS First Boston actually delivered a live mule to Intraware’s lobby the next morning, complete with a
sign urging the company to hire CS First Boston. Intraware hired Quattrone, and Jackson later admitted that the mule “may have made the difference.”11 Quattrone bristled when others attempted to grab the limelight. When Katrina Garnett, the 38-year-old Australian founder and CEO of CrossWorlds Software—whose board Quattrone served on—tried a marketing gimmick of her own—appearing in advertisements in Vanity Fair and The New Yorker magazines wearing a black size-4 cocktail dress and a seductive pose, as part of a million-dollar advertising campaign—Quattrone resigned in a huff, protesting that he had not been informed of the campaign.12

  During the late 1990s, Quattrone was the highest-paid person on Wall Street, at a reported $100 million a year. Other bankers weren’t far behind. Wall Street firms made tens of billions of dollars in the late 1990s, and paid roughly half of their revenues to employees. Hedge-fund managers who bought shares in technology IPOs could make even more money, as share prices increased by hundreds of percent. Looking back, Andy Krieger’s $3 million bonus in 1988 seemed like peanuts. In response to a claim that $6 million was an impressive bonus in the late 1990s, one industry veteran said, “What he thinks of as a lot of money isn’t a lot of money. He thinks that people who are worth $50 million are rich guys. In this world, lots of people have that kind of money. Nobody’s impressed when they hear you have guys in the firm making $6 million.”13

  Investors didn’t do nearly as well. Unfortunately, the mania in technology stocks ended badly: by 2002, 99 percent of all IPOs of Internet companies were trading below their first-day closing price, and more than half of such companies were worth less than $1 per share.14 In addition to the hundreds of billions of dollars lost on Internet companies, roughly a trillion dollars of money invested in telecommunications companies was squandered during the late 1990s, and nearly half a million people working in the telecommunications industry lost their jobs.