Infectious Greed

by Frank Partnoy

  The bad reputation and blame are undeserved. In fact, legal rules already make short selling difficult and expensive, and these restrictions have contributed to an “irrational” upward bias of stock prices. To short a stock, you need to borrow shares, which often are in limited supply, and you can’t trade many stocks unless the previous trade in the market has occurred while the price of the stock was rising, because of the so-called uptick rule. Some savvy investors figure out ways to avoid these legal rules, using put options—the right to sell stock—which effectively are bets against the stock. For example, some hedge funds buy a stock along with a put option and then sell the very same stock. The effect is to buy the stock once and sell it twice, because the terms of the put option—the right to sell the stock—can be set so that the holder almost always would sell the stock when the option expired. By using these trades, called bullets, traders don’t need to borrow stock and can avoid the uptick rule because, technically, these trades are not short sales, even though they are economically equivalent.

  However, the bullet rigmarole is complex and expensive, and many traders remember the pain from betting against stocks when prices soared during the late 1990s. As the Internet boom demonstrated, it is dangerous to get in front of an investing herd. The result—as research in behavioral finance confirms—is that stock prices frequently reflect the trading of optimistic investors more than pessimists, at least until optimists finally learn that the value of a company is lower than they believed, at which point they all sell and prices crash.17

  One way to make stock prices more accurate is to do the opposite of what some regulators have suggested: make short selling easier. In fact, Congress had attempted to do just this in December 2000, when it passed a law legalizing the trading of single-stock futures, derivatives that essentially are bets on how stocks will perform at future dates.18 The restrictions on short selling don’t apply to single-stock futures, so investors could more easily use these instruments to bet against stocks. Investors can also use swaps and other derivatives to bet against stocks. This is an area where harnessing the power of derivatives could make markets fairer and more efficient.

  Another way to encourage betting against stocks would be to permit insiders to tip others as to negative information about their companies. Negative information tends to remain bottled up within companies, in part because of a Supreme Court case that spelled out when it was illegal for insiders to tip others about problems at their companies. In that case, Raymond Dirks, a securities analyst during the 1970s, had been prosecuted for giving his clients negative, but true, information he had learned about Equity Funding, a company involved in a massive financial scam; his clients then profited from trading on the basis of this information. The Supreme Court exonerated Dirks, and a decade later, he was still betting against stocks and advising others to do the same.19 But the Dirks case cast a shadow over anyone who traded on an insider’s negative tip about a company, and most market participants cautiously avoided such trading.

  In the Dirks case, the Supreme Court unintentionally had ensured that stock prices would be less accurate by discouraging individuals who know negative information about a company from telling outsiders those facts. If Cynthia Cooper of Global Crossing, Roy Olofson of WorldCom, or Sherron Watkins of Enron, or various employees of AIG had been permitted to tip outsiders—including traders—about their companies’ troubles, those stocks would have fallen to a lower, more accurate price right away. Many investors still would have lost money, but market prices would have been more accurate, and investors would have avoided the uncertainty and panic during the months when they speculated about worst-case scenarios. Historically, investor panic has proven to be one of the most dangerous elements in financial markets, perhaps even more dangerous than the possibility that insiders will abuse negative information in trading their firm’s securities.

  However, securities regulators have been obsessed with making the investment playing field at least appear to be level, and so instead of permitting insiders to tip others as to negative information, the SEC has done the opposite. The SEC has prosecuted tipping cases, and in 2000, with Arthur Levitt’s urging, the commission passed Reg FD, the fair-disclosure rule, which bars insiders from selectively disclosing any material information to particular individuals, unless that information is also broadcast simultaneously to the entire market, typically in a public-television broadcast or on a conference call. Not surprisingly, under Reg FD, companies do not hold press conferences to tell investors bad news about their stocks, and as a result, an even greater amount of negative information is penned up within companies.

  Regulators should reverse this course. Short sellers should be encouraged to bet against stocks, and company insiders who have negative information and who are willing to tip outsiders about it should be allowed to do so, at least under circumstances when the insider is not profiting directly from tipping. It is easy to distinguish negative from positive information, and regulators should not treat them the same.

  6. Encourage investors to control and monitor their own investments.

  Until recently, investors had rushed to participate in financial markets, primarily through various types of investment funds, including mutual funds. Fifty years ago, 97 percent of individual investors held shares directly; now, most people hold shares indirectly, through mutual funds.20 But many people follow investment strategies—whether through mutual funds or direct ownership of stocks—without doing the research necessary to understand the companies whose securities they hold.

  The insights of modern finance suggest that investors are better off with a passive approach. Trading too much hurts returns; trying to pick stocks hurts returns. Economic theory suggests that, instead, investors should invest in a low-cost index fund that simply buys and holds a diversified portfolio of all the securities in the market.

  Unfortunately, mutual funds have proven disastrous for investors. Most investors have sought out the best-performing funds, whose managers trade too much and try to pick stocks, both of which hurt returns over time. Many funds advertised as “index” funds or “enhanced index” funds are really just actively managed mutual funds in disguise, and the vast majority of actively traded mutual funds have underperformed market indexes, because of their high costs and relatively low comparative advantage.

  As the debacles of the past two decades have shown, mutual-fund managers don’t do much better than individual investors at researching and understanding the nature of the companies whose stock they buy. Most mutual-fund managers have neither inside information nor the sophistication to spot fleeting arbitrage opportunities, and past performance is never a promise of future results (in fact, many studies show that the worst-performing mutual funds are a better bet in the long run than the best-performing ones). Moreover, actively managed mutual funds give fund managers incentives to take excessive risks. Investors who buy funds on the basis of past performance are taking on more risk than they think—in many cases, those funds have performed well historically because they invested in companies that had hidden risks or were involved in fraudulent accounting schemes.

  It is still a reasonably good strategy to buy a low-cost, diversified, buy-and-hold index fund or an exchange-traded fund—such as the SPDR Trust, known as Spiders, which trade on the American Stock Exchange and represent a share of the S&P 500 stocks. But there is an alternative, which, if investors follow it, might generate better returns and create incentives for intermediaries to monitor corporate managers more effectively. This strategy is simple: instead of buying mutual funds, buy two dozen or so different stocks directly, and hold them. A few dozen different stocks generate almost as much diversification benefit as an index fund, and given the low commissions of Internet brokers, the strategy is comparable in terms of cost.

  The do-it-yourself strategy has one major advantage: investors can avoid stocks they believe are most likely to be involved in shady dealings. For example, if you buy an index fund, you are
forced to own General Electric stock, even if you are nervous about General Electric’s financial statements. By choosing your own stocks, you can avoid General Electric, if you want. If individuals follow this strategy, avoiding particular stocks, the stocks that investors perceive as problematic will suffer, and their prices will be lower. These perceptions will not be reflected in market prices if individuals passively invest in the entire market.

  Moreover, if investors take the time to do proper research in directly selecting portfolios of stocks, instead of passively investing through mutual funds, they will create incentives for companies to be more forthcoming about their businesses. Intermediaries will begin advising investors about which stocks to avoid—soon there will be lists of the top several dozen stocks to include in a diversified portfolio, like Consumer Reports ratings. Excluded companies will need to persuade investors and intermediaries that the lists are wrong and that the companies actually have viable businesses and transparent finances. Companies might even band together to list their securities collectively on an exchange, monitoring each other to see that they live up to the standards of the group. Instead of buying mutual funds, people could buy “packages” of a few dozen stocks. There are good companies out there with honest CEOs and good businesses, and if investors engage in serious research in making their investment decisions, they will reward those good companies and punish the bad ones.

  If markets were truly efficient and someone were betting against companies involved in fraudulent schemes, then buying the entire market through an index fund might make sense—the suspect companies would have lower stock prices. But if the limits on short selling and the inability and unwillingness of gatekeepers to do real due diligence prevent negative information from influencing market prices, then investors will be better off avoiding the entire market, with its hidden pitfalls. They will be better off being a little bit less diversified, with a portfolio of a few dozen companies that are the most forthcoming in their financial statements.

  As one example, consider Enron and Alliance Capital Management, the gigantic mutual fund. Alliance permitted Alfred Harrison, a 64-year-old portfolio manager, to make a huge bet on Enron, buying shares at prices ranging from $9 to $80. By 2001, Alliance was Enron’s largest shareholder, with 43 million shares, worth several billion dollars at the peak. Yet top managers at Alliance admitted that the fund’s managers did not dig into Enron’s footnotes and did not uncover key details or even ask key questions. Alliance sold its Enron shares on November 30, 2001, two days before Enron’s bankruptcy filing, for $0.28 per share. The massive losses decimated the investors in Alliance’s mutual funds, but hardly mattered at all to Alfred Harrison, from a financial perspective: Alliance paid him $2 million in compensation in 2001; his bonus the previous year had been more than $4 million.21 As James Grant, the well-regarded investment guru, put it, “If a 43-million share investment wasn’t enough to command the attention of our leading fiduciaries, what would have been?”22 And Alliance was one of the best-run mutual funds at the time.

  Likewise, in the recent crisis, investors who owned diversified mutual funds could not avoid losses from the meltdown at the banks and AIG, for one simple reason: those funds owned large stakes of the banks and AIG. The funds had loaded up on shares of financial services companies years earlier and continued to hold those shares as the markets collapsed. Investors in mutual funds watched helplessly during the crisis as their retirements and college savings were sliced in half. And they paid substantial fees to the funds for the privilege of sustaining such massive losses.

  Many investors who are afraid to invest directly in companies buy actively managed mutual funds, such as Alliance, instead. But that strategy will work only if a particular mutual-fund manager is doing his or her job, and if—by some miracle—that mutual fund is one of the few that outperforms a market index. For an individual considering an investment in stocks today, there really are only three defensible choices: buy a low-turnover index fund; avoid investing in stocks altogether; or do your own thorough research and buy a few dozen stocks in different industries. Of these choices, the only one that ultimately will put pressure on companies to become more honest is the last.

  Two decades have passed since Andy Krieger’s record year of trading at Bankers Trust, and that bank’s efforts to manipulate its financial statements as a result. During those years, a financial virus has worked its way deep into the markets, leading to unprecedented levels of risk coupled with new forms of deceit. These practices first infected Wall Street bankers and accountants, and then—after a brief incubation—spread to corporate executives and investors. Then, spectacularly, the virus returned home to wipe out the banks.

  Many warning signs of the resulting epidemic have been lurking in the footnotes of corporate annual reports—Related Party transactions, options compensation, and off-balance-sheet derivatives, to name a few. An astute investor who actually read these reports could have spotted many of the recent financial collapses before they happened. And if corporate managers had believed that investors were scrutinizing their filings, the managers would have been much more careful in their dealings.

  Modern financial markets might be impossibly complex, but the business of investing need not be impossible. Ultimately, investors own a share of the earnings of real companies. The financial filings of every public company are available on the Internet for free, and anyone who uses a computer to check e-mail, weather, sports scores, or news can just as easily download these filings. The Securities and Exchange Commission encourages investors to access this information by making it easily accessible on its website. If a company cannot explain its financial dealings in plain language in these filings, it is not worth risking any money on it.

  Today, there are an astonishing number of individuals buying and selling stocks. Maybe you are one of them. Maybe you have contributed to the volatile and risky nature of these new markets. As you reflect on the story of the last twenty years of risk and deceit, ask yourself: Did I carefully read the annual reports of the companies whose stocks I bought? Did I really understand what those companies were doing, who their customers were, and how they made money? Did I know how much they were involved in complex financial instruments? Did I resist the recommendations of friends, colleagues, and talking heads on television about the latest hot stock?

  If you answered no, then you have one more person to blame, in addition to the accountants, bankers, lawyers, credit raters, corporate executives, directors, and regulators who failed to spot the various financial schemes of recent years. You.

  NOTES

  Introduction

  1 James Grant, “Pecora’s Ghost,” Forbes, March 18, 2002, p. 200.

  2 Bryan Burrough and John Helyar, Barbarians at the Gate: The Fall of RJR Nabisco (HarperCollins 1991).

  3 Kevin G. Salwen, “Year-End Review of Markets and Finance: Follies, Foibles, and Fumbles,” Wall Street Journal, January 3, 1989, p. 1.

  4 Salwen, p. 1.

  Chapter 1: Patient Zero

  1 The facts in this chapter are based on a series of interviews and correspondence with Andrew Krieger during 2002. Much of Andrew Krieger’s background is covered in his autobiographical book, The Money Bazaar (Times Books 1992). Gregory J. Millman interviewed Krieger and reported some additional facts in The Vandals’ Crown: How Rebel Currency Traders Overthrew the World’s Central Banks (The Free Press 1995). In addition, Charles W. Stevens of the Wall Street Journal wrote several articles about Krieger, including a front-page story, “Change of Heart: Andrew Krieger Made $3 Million Last Year; Why Isn’t He Happy?,” Wall Street Journal, March 24, 1988, p. A1.

  2 Krieger, p. 5.

  3 Krieger, p. 6.

  4 Krieger, p. 27.

  5 J. Orlin Grabbe, “The Pricing of Put and Call Options on Foreign Exchange,” Journal of International Money and Finance, December 1983. Another early academic paper on foreign currency options was Mark B. Garman and Stephen W. Kohlhagen, “Foreign Currency Optio
ns Values,” Journal of International Money and Finance, Volume 2 (1983), p. 231. There were numerous other papers published during the time when Krieger was trading at Salomon and Bankers Trust.

  6 Krieger, p. 27.

  7 Stevens, p. A1.

  8 Stevens, p. A1.

  9 Krieger, p. 6.

  10 Krieger, p. 6.

  11 The theory of options pricing was developed in two key articles published in 1973, one coauthored by Fischer Black and Myron Scholes, the other by Robert Merton. Fischer Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy, Volume 81, May-June 1973, p. 637; Robert C. Merton, “Theory of Rational Option Pricing,” Bell Journal of Economics and Management Science, Volume 4, Spring 1973, p. 141.

  12 Peter L. Bernstein, Capital Ideas: The Impossible Origins of Modern Wall Street (The Free Press 1992), p. 227.

  13 Millman, p. 19.

  14 Millman, p. 13.

  15 Michael Lewis, Liar’s Poker (Penguin 1990).

  16 Lewis, p. 119.

  17 Stevens, p. A1.

  18 Bernstein, p. 17.

  19 This research ultimately was published in 1970. Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance, Volume 25 (1970), p. 383.

  20 A good review of this literature is Stephen F. LeRoy, “Efficient Capital Markets and Martingales,” Journal of Economic Literature, Volume 27 (1989), p. 1,583.

  21 Krieger, pp. 33, 38.

  22 James B. Stewart, Den of Thieves (Simon & Schuster 1991), p. 14.

  23 Krieger, p. 38.

  24 Krieger, p. 96.

  25 Krieger, p. 104.