Playing Hot Potato With Risk-Scary Stories From the Markets

Infectious Greed: How Deceit and Risk Corrupted the Financial Markets , by Frank Partnoy. Times Books, 412 pages, $27.50

“[A]ny appearance of control in today’s financial markets is only an illusion …. The truth is that the markets have been, and are, spinning out of control.” These alarming words come from Frank Partnoy, a former Morgan Stanley derivatives salesman turned law professor, introducing his second book on the U.S. financial markets. Over the next 400 pages, Mr. Partnoy deftly traces the deterioration of market efficiency and safety in dozens of stories of bad behavior from the 1980′s to the present. Along the way, he provides finely crafted, ideologically neutral tutorials on nearly every subject in finance the general reader needs to understand.

Bracingly untrendy, Mr. Partnoy has kind words for the financial markets of the much-maligned 1980′s. No enemy of junk bonds, which he correctly points out are no riskier than equities, he notes that the defenses developed in the 90′s against hostile takeovers insure that today’s greedy or corrupt C.E.O. is in no danger of being ousted by a raider.

Mr. Partnoy devotes most of his attention to dozens of scandals and near-scandals involving derivatives, some as familiar as Enron and Barings, the venerable British bank that fell to rogue trader Nick Leeson (shortly after the bank decided that a $50,000 software system for tracking traders’ positions was too expensive). Some of the villains have begun to fade from memory: Bankers Trust currency trader Alan Krieger, who in the late 80′s shorted nearly the whole money supply of New Zealand; and Robert Citron, treasurer of Orange County, Calif., who drove his county into bankruptcy in the mid-90′s after a loss of $1.7 billion. (A 70-year-old high-school graduate, Mr. Citron asked psychics for advice on interest-rate fluctuations after he borrowed $13 billion to bet on “inverse floaters,” complex structured notes whose coupons varied inversely with interest rates.)

The common thread in nearly all these tales is that even highly sophisticated, mathematically astute investors-not to mention bozos like Mr. Citron-tend to trade their opinions and biases, while their less quantitatively assured supervisors have little idea of how much risk they are assuming and how volatile some of these new markets are. Another is just how difficult it is to value the newer derivatives. Mr. Partnoy distinguishes “good” derivatives, like options and futures traded on regulated exchanges and used as a means to the end of reducing risk, from customized over-the-counter derivatives aimed at avoiding specific securities regulations.

Here’s where Mr. Partnoy thinks the financial markets have gotten themselves into trouble. These new securities, designed not to appear on balance sheets, have created an overhang of risk that taints many seemingly unspeculative investments. The apparently conservative stock you own may belong to a company that operates more like a casino than a conglomerate. Even the Fed is unable to guess the effect of changes in monetary policy on the sea of over-the-counter financings. In short, the stock market is no longer efficient, and classical economics no longer explains investor behavior.

The “irrational exuberance” of the mid-90′s, Mr. Partnoy suggests, is explained by the theory of the downward-sloping demand curve for stocks, in which some individuals will pay more for a stock because they have “heterogeneous expectations” about its performance, or are too lazy to find out what it’s really worth. According to classical theory, such anomalies should be eliminated by arbitrageurs. But classical theory hadn’t considered the possibility of undetected accounting fraud over long periods of time-a dangerous lag during which arbitrageurs might go broke betting against overvalued stock.

Some of the inefficiencies of the 90′s bubble were due to fraud, plain and simple. Consider the phenomenon of I.P.O.’s worth four or seven or 70 times their issue price by the end of the first day of trading. “By 1999 this ‘I.P.O. discount’ had increased from a few percent to an average of 70 percent …. Companies were agreeing to give up proceeds in return for rewarding the bank’s clients.” The investment banks were also giving up millions in fees-the standard fee for taking a company public being 7 percent of the proceeds raised by selling stock. Or so it seemed.

The S.E.C. soon noticed that the clients were simultaneously doing massive trades in unrelated securities at up to 50 times the normal commission rate. Clients had been told to kick back between 50 and 65 percent of their I.P.O. profits or be cut out of future stock allocations. The losers were individual investors who bought the I.P.O. in the aftermarket. In another industry, the executives involved would have gone to jail. But as Mr. Partnoy points out again and again, federal regulators have been loathe to prosecute cases involving complex financial fraud.

Another factor behind the loss of market efficiency-and one Mr. Partnoy doesn’t emphasize enough-is weighting executive compensation toward stock options. Mr. Partnoy notes that managers who own stock are in the same boat as shareholders, but managers who own options aren’t; their downside is limited, making them more willing to gamble. He also suggests that the reduction in dividends paid by public companies in the 90′s is attributable to the proliferation of executive stock options, which do not receive dividends. Most importantly, options tend to have long maturities, which makes them hard to value. When companies have obligations that are hard to value unrecorded as expenses, it’s a time bomb waiting to blast future earnings and stock prices.

The predictable result of combining difficult-to-understand off-balance-sheet financial instruments, executives paid with stock options and lax enforcement? Record corporate losses, daily financial restatements and a stunning 1998 Business Week survey of chief financial officers in which 67 percent admitted that they either misrepresented their financials or were asked to do so by their C.E.O.’s.

Mr. Partnoy has well-argued recommendations for reform, most aimed at allowing the markets to police themselves. As he points out repeatedly, the ratings agencies had been falling down on the job long before Enron, catching on to massive losses months too late. Mr. Partnoy suggests lowering the barriers to entry to bring in fresh talent, and de-privileging credit ratings as a way of deciding which bonds can be bought by institutional investors. Removing barriers to short-selling would help to end the upward bias in stock prices, as would allowing insiders to provide tips about negative-but not positive-information. Mr. Partnoy also urges regulators to “treat derivatives like other financial instruments …. As long as ‘securities’ were regulated, but similar ‘derivatives’ were not, derivatives would be the dark place where regulated parties did their dirty deeds.” He argues for replacing narrow rules which are easily avoided with standards encouraging “a culture of honesty.” Perhaps most importantly, Mr. Partnoy asks that the government aggressively prosecute complex financial frauds. As it is, the more complex the scheme, the less likelihood of any punishment whatsoever.

At the end of this timely and important book, Mr. Partnoy suggests that unless emergency action is taken, the worst is yet to come. Banks have reduced their risk by using credit derivatives, but they have simultaneously passed that risk along to insurance companies and the rest of the financial industry, which is far less regulated and often far less sophisticated about financial risk. “If investors ever come to understand the hidden risks within these non-bank firms,” he argues, “they might very well panic.”

Ann Marlowe, author of How to Stop Time: Heroin from A to Z (Anchor), has a rarely used M.B.A. in finance.