As the global financial crisis unfolds people everywhere are seeking to understand how markets devolved to this perilous, volatile state. In this dazzling and meticulously researched work of financial history, first published in 2003, and now thoroughly revised and updated, law professor and financial expert Frank Partnoy tells the story of how “classical” Wall Street securities like stocks and bonds were quietly eclipsed by ever more “quantum” products like derivatives. He documents how, starting in the mid-1980s, each new level of financial risk and complexity obscured the sickness of corporate America, and how Wall Street's evlving paradigm moved farther and farther beyond the understandingand regulationof ordinary investors and government overseers, leading inevitably to disaster.
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About the Author
Frank Partnoy is the author of The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals, and F.I.A.S.C.O.: Blood in the Water on Wall Street. A graduate of Yale Law School, he is currently the George E. Barrett professor of law and finance at the University of San Diego.
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How Deceit and Risk Corrupted the Financial Markets
By Frank Partnoy
Henry Holt and CompanyCopyright © 2003 Frank Partnoy
All rights reserved.
Andy Krieger was one of those kids who, it seemed, could do everything. He was an excellent high school student, and was admitted to the University of Pennsylvania, where he was elected to Phi Beta Kappa. He was a competitive athlete and briefly played professional tennis on the European circuit. He was an advocate for the poor, and was especially interested in the plight of lepers in India. As a graduate student during the late 1970s, he studied South Asian philosophy, translated obscure Sanskrit texts, and planned for a career in academia. He was a vegetarian.
One day, Krieger's dissertation adviser told him that although his work had been first-rate, he would not be able to land an academic job until one of a handful of people working in his area died. Krieger wanted to help the poor, not become one of them, so he decided to trade careers. After six years of graduate study, he enrolled in business school.
Almost immediately, his life was transformed. Krieger studied finance at the Wharton School of Business, whose graduates included the infamous financiers Michael Milken and Donald Trump, men who had thrived in the relatively simple 1980s world of junk bonds and corporate takeovers. Krieger took a course in international finance, and was captivated by a new, more esoteric phenomenon: trading in foreign-currency options, the rights to buy and sell currencies at specified times and prices.
The curriculum at Wharton — which by 2002 would include more than twenty specialized courses in finance — barely touched currency options when Krieger was there.But J. Orlin Grabbe, a young finance professor at Wharton and a pioneer in the area, became Krieger's mentor and taught him just enough to whet his appetite. Krieger sought to reinvent himself as a currency options specialist; in 1984, he wrote a computer program to assess the value of currency options, and when he learned that Salomon Brothers, the New York investment bank, would be interviewing Wharton students for a position trading currency options, he submitted his résumé.
At Wharton, Krieger had learned how foreign currencies whose value had been linked to gold or to the U.S. dollar were now floating freely. Instead of requiring that their currencies be exchanged for a fixed amount of gold or dollars, various central banks — including the Federal Reserve — were permitting the value of their currencies to fluctuate in the market. Trading in these currencies was increasing exponentially, and companies had moved beyond simply exchanging U.S. dollars for Japanese yen, or German marks for British pounds, to betting on dozens of currencies in all sorts of new and fantastic ways.
During school, Krieger did a stint at O'Connor & Associates, an options trading firm in Chicago. He found that in currency trading, "you're pitted against some of the sharpest minds in the world." The currency markets were intensely competitive, with hundreds of billions of dollars changing hands every day. Firms that traded the more exotic instruments — including currency options — were cleaning up. When Krieger discovered that some of these traders were making millions in bonuses, he quickly found "an inner drive to see how good I could be." So much for Sanskrit.
Krieger gave up his tennis career and put his academic interests to the side. He persuaded the interviewers from Salomon that his brief experience as a trader, plus his detailed understanding of currency options, plus his knowledge of foreign languages and cultures, made him the ideal hire. Salomon agreed, and Krieger began his career there after graduation.
Four years later, during early 1988, Krieger briefly was as well-known as some of the men who had come before him at Wharton. The publicity didn't last long, and few people remember Krieger today. But Krieger's story from that time is an object lesson in the risks associated with financial innovation.
* * *
It was 1984, and few bankers knew much about currency options. The Chicago Mercantile Exchange had just introduced them, and they had been trading for less than two years on the Philadelphia Stock Exchange, where Andy Krieger had traded a bit during business school.
Few bankers knew about the theory of options pricing, either. A decade earlier, three economists — Fischer Black, Myron Scholes, and Robert Merton — had published formulas for evaluating options, coincidentally at the same time the Chicago Board Options Exchange opened for business. Within six months, Texas Instruments was advertising that traders could calculate options values by plugging the formulas — known generally as the Black-Scholes model (Merton, unfortunately, lost out on credit) — into a calculator. Within twenty years, virtually every company would use the Black-Scholes model to evaluate options, and the formulas would be taught in introductory finance courses in business school.
But bankers are slow, and it took more than a decade for options theory to migrate from the trading pits of Chicago to the banks of Wall Street. At Citibank in the early 1980s, only one trader on the trading floor even had a computer, a clunky Radio Shack TRS-80, which was primitive even for its time. At J. P. Morgan, one customer persuaded a treasurer named Dennis Weatherstone (who later became the bank's chairman) to do a currency option, but the bank's traders had no idea how to price the option and ended up losing money.Options were a mystery to most bankers, who were wary of these new markets.
In fact, the state of knowledge on Wall Street in 1984 was such that if you read the next five paragraphs, you will know just as much as a typical investment banker knew at the time.
In simple terms, an option is the right to buy or sell something in the future. The right to buy is a call option; the right to sell is a put option. Options on all kinds of commodities were traded on exchanges during the 1980s, mostly in Chicago but also in Philadelphia. These options were straightforward and standardized, and currency options were no exception. They were simply options to buy and sell amounts of various currencies at a specified time and exchange rate.
To understand how currency options work, suppose you are planning to take a vacation in Mexico a month from now. If the Mexican peso weakens during the next month, you can plan to eat some fancier dinners during your trip, because you will be able to buy more of the weakened pesos when you arrive. But if the peso strengthens, you might be eating at taco stands.
To hedge this risk, you might pay someone money today for the right to buy pesos at a set price a month from today. For example, if one dollar is worth ten pesos today, you might want to lock in that rate. You could pay a foreign-exchange broker a fee (called a premium) in exchange for the right to buy pesos at the ten-for-one rate in one month. If you did so, you'd be buying a peso call option.
The peso call option would act as an insurance policy. A month from now, if the peso had weakened, so that a dollar bought eleven pesos, you wouldn't exercise your right. As a purchaser of an option, you aren't required to buy; it is your option. Instead, you would buy pesos at the eleven-for-one rate in the market, and let your right expire. In other words, you wouldn't need the insurance policy. On the other hand, if the peso had strengthened, so that a dollar bought only nine pesos, you would exercise your right to buy at the more attractive ten-for-one rate. In other words, the insurance would protect your downside.
Options transactions typically are too costly for individuals taking vacations, because foreign-exchange brokers charge very high premiums. Instead, currency options are designed for big banks and corporations, which trade in much higher volumes. The value of these options is based on several variables, but the most important variable is volatility — how much the underlying currency has been moving up and down. The more volatile the currency, the more valuable the option.
Krieger understood options better than a typical banker. He knew the Black-Scholes formula and, more important, its limitations. The computer program Krieger had written at Wharton did a better job of assessing currency options than the models other traders were using, because it didn't rely on the same assumption as Black-Scholes. In particular, Krieger understood that traders should not look to history alone in calculating the volatilities of currencies, which were prone to periods of calm followed by abrupt twists and turns. Krieger easily completed the highly quantitative training program at Salomon, and he entered the new world of currency options trading at the perfect time.
* * *
Krieger was at Salomon during its heyday, the period described so memorably by Michael Lewis in his book Liar's Poker. Salomon's trading desk was legendary, but small. Krieger sat two seats down from John Meriwether, the top trader at the firm. Next to Meriwether was Tom Strauss, the firm's vice chairman, and John Gutfreund, the chairman. To Krieger's immediate left was Lawrence Hilibrand, an aggressive trader who would earn a $23 million bonus in 1990. Next to Hilibrand was Eric Rosenfeld, a former Harvard business-school professor and options expert. A few steps away was Victor Haghani, a researcher who worked for Krieger. Across the room was Paul Mozer, a bond trader who was about to become embroiled in a scandal that would nearly sink Salomon (more on that in Chapter 4).
By the late 1990s, Meriwether, Hilibrand, Rosenfeld, and Haghani would become well-known as the key players in the rise and fall of Long-Term Capital Management (more on that in Chapter 8). During the mid-1980s, these men were simply the most profitable group of traders in the world. And Krieger was sitting right in the middle of this group, at the center of the financial universe.
Krieger thrived in the hard-driving, aggressive environment, where — it was said — you needed to begin the day ready to "bite the ass off a bear," and where traders began their mornings with rounds of onion cheeseburgers from the Trinity Deli. Given the gluttony, it seemed silly to have scruples about harming animals. Krieger began eating meat again.
Salomon was the ideal training ground for Krieger, and he was successful from the start. He traded all day long, from the early morning when the London markets opened until the early evening, when the New York markets closed. Then he went home, and traded the Tokyo markets by phone. He made $30 million for Salomon during the year, but the firm paid him a first-year bonus of just $170,000 — more than any other beginning trader, but still only a fraction of the commissions he arguably was due.
Given the vicious competition among Wall Street traders, it might seem surprising that Krieger — a relative novice — was able to make as much money trading as he did. The consensus among economists during the 1970s and early 1980s was that financial markets were efficient — that is, market values generally reflected available information. Economists loved to tell the story of the finance professor who refused to pick up a $20 bill lying on the ground, arguing that it couldn't actually be there because if it was, someone would have picked it up already. Picking up "free" $20 bills was a good business, while it lasted. But it never lasted long, especially on Wall Street, where even compassionate traders used the phrase "sell your mother for a nickel."
As Nobel laureate economist Paul Samuelson put it, "It is not easy to get rich in Las Vegas, at Churchill Downs, or at the local Merrill Lynch office." Samuelson had plenty of followers. Economist Eugene Fama presented extensive evidence of market efficiency at the American Finance Association meeting in 1967, and the presumption among economists since then had been that trading strategies based on available information did not outperform the market.
That presumption made sense. It was difficult to outperform the market. Even in new markets — such as the market for currency options — Wall Street traders were very quick to exploit any mispricings, and therefore mispricings didn't last long. If a particular stock, bond, or currency were too cheap, traders would buy it, and continue to buy it — just as people buy gasoline from the station with the lowest price — until the asset was fairly valued.
Yet there were some examples of market inefficiencies, and traders — including some of those at Salomon — were very good at finding and milking them. John Meriwether's group — which was shrouded in secrecy, even at Salomon — was especially skilled at exploiting these inefficiencies. Meriwether's ability to make money, year after year, was puzzling to efficient-market believers, and was a sign of cracks in their scholarly foundation. By the mid-1980s, a few financial economists (branded heretics at the time) had begun questioning whether financial markets actually were efficient.
But if any markets could be efficient, surely currency markets would be. Currency markets were the largest in the world; the amount of trading dwarfed that of the stock exchanges. And even though currency options were new, they were based on the currency markets themselves. Most traders agreed that they could not outguess or even affect currency markets in the long run.
Then how did Andy Krieger make so much money? One possible answer was luck: Krieger made one-way directional bets on the values of various currencies, occasionally without much more than a hunch to support his directional position. After studying the historical charts of various currencies, he became a believer in trends, making bets based on where he thought currencies were headed. On a net basis, Krieger always bought options, because of what he described as a "personal abhorrence to selling options." He won many of these bets, although to an outsider he didn't seem to have any particular strategy that would generate sustained trading profits over time. Charts were available to any trader, and any bank could trade based on trends. A 1980s financial economist assessing Krieger's early profits — on their face — might have claimed they were due mostly to dumb luck.
Yet there was more to Krieger's strategy than he let on. Yes, he was using options to bet on currencies, but only when his research and computer models told him volatility was so low — and therefore the options were so cheap — that the bets were good ones. Krieger became a master of volatility, combining the art of assessing patterns in foreign-currency markets with the science of using options models to determine the best way to make currency bets. In Krieger's view, the markets were not efficient, because traders — and their computer models — often underestimated the volatility of a currency, and therefore undervalued the related currency options. When markets did so, Krieger swooped in and bought the options, like a gambler at the racing track who had discovered a way to buy two betting tickets for the price of one.
Moreover, because the cost of an option was only a fraction of the value of the currency it was based on, Krieger could use options to make much larger bets than competing traders who did not use options. A $30 million options position might control a billion dollars worth of currency. Given that Krieger was using more sophisticated models than his competitors, and then using options to place much larger bets, he had an edge. According to Krieger, the other traders were still "using conventional artillery in what had become a nuclear world."
Although Krieger sat next to the members of John Meriwether's group, he was not formally a member of Meriwether's inner circle, known as the Arbitrage Group, which included the highest-paid people at Salomon. Other banks quickly learned of Krieger's prowess and began recruiting him. Although Krieger was successful at Salomon, it soon became apparent that he could make more money elsewhere.
In 1986, Bankers Trust, then the eighth largest commercial bank in the United States, hired Krieger to set up a currency-options trading business to compete with Salomon. Bankers Trust was becoming more sophisticated, but the bank's managers had little expertise in currency options. Krieger accepted the offer, with a guaranteed minimum bonus of $450,000, and an oral promise of a five percent commission on his trading profits. He was 29 years old.
* * *
At Bankers Trust, Krieger faced some daunting challenges. By 1986, it already was becoming difficult to make money trading currency options on the various exchanges. Like most exchange-based trading, currency options were a ruthlessly competitive business; within a year the markets were crowded and profit margins were slim. And Bankers Trust was late to the game.
Worse still, there were limits to the amount and types of trading Bankers Trust could do on the exchanges where options were traded. Exchanges in Chicago and Philadelphia offered only a limited menu of standardized options. Traders who wanted to place other bets couldn't do it with the exchanges, and neither could a bank's customers. In particular, the exchanges fixed two of the key variables in currency-options contracts: the exercise price and the expiration date.
Excerpted from Infectious Greed by Frank Partnoy. Copyright © 2003 Frank Partnoy. Excerpted by permission of Henry Holt and Company.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents
Stage One: Infection,
1. Patient Zero,
2. Monkeys on Their Backs,
3. Wheat First Securities,
4. Unreconciled Balances,
5. A New Breed of Speculator,
Stage Two: Incubation,
6. Morals of the Marketplace,
7. Messages Received,
Stage Three: Epidemic,
8. The Domino Effect,
9. The Last One to the Party,
10. The World's Greatest Company,
11. Hot Potato,
Also by Frank Partnoy,
About the Author,