I’ve just finished reading a very interesting book by Frank Partnoy – “Infectious Greed”. I actually remember seeing it in a library back in 2005, however at that time I chose not to invest the effort into reading it, a decision which I regret today. Nonetheless, better late than never, as they say. The book is devoted to a number of related, as far as the author is concerned, crises in financial markets that happened in late 90-s and early 2000-s. He starts with comparatively minor losses in Bankers Trust, today part of Deutscher Bank, and some industrial companies, i.e. Proctor and Gamble, followed by collapse of some institutions, Orange County in California among others, touches the collapse of some foreign currencies (Mexican peso, Thai bhat) and finishes with the Enron and WoldCom disasters. Losses in all the crises amount to absolutely mind-blowing figures of hundreds of billions of dollars. He makes a few points, which in his view are the main reasons behind the failures on the modern financial world, and he demonstrates them with specific examples. I will highlight some of them below. I think it is quite important to understand, that all these causes are interrelated and in many ways feed one another.
During the 80-th and especially 90-th a lot of new financial products were invented, mainly in the derivatives markets. A derivative is a financial instrument, which behaviour depends on another instrument or a number of instruments. A classic example is an option, which price depends on the underlying stock and, usually, on some other economic parameters, such as interest rates. The innovation resulted in appearance of many new instruments. They were complex, hard to understand and hard to value. They were very often traded directly between the parties – “over the counter” – OTC, and not via an established exchange. The volumes of trading in these new instruments grew exponentially and were measured in trillions. Those market players, who understood them better, made fortunes. The reasons new derivative products appeared were often plausible. Such instruments as interest rate swaps and credit default swaps allowed, potentially, their users to manage their risks better and to limit their exposure to various unpredictable movements in the markets. However they quickly became misused, because of misunderstanding or for other reasons.
In addition to new financial products, new accounting tricks allowed big companies and institutions to do amazing things in their financial reports, inflating earnings and revenues and hiding losses and liabilities. The term SPE (Special Purpose Entity), nowadays considered almost a curse in the investment world, was introduced much earlier, but taken to new heights of accounting abuse by extraordinary deals, done by Enron, Global Crossing and others. Also, during that time the US regulators imposed a limit on the salaries of the top executives in public companies. This was a very popular move and done with good intentions, but it had unforeseen consequences.
Inadequate risk assessment
One of the main problems with new products was the lack of understanding of the risks – both in principle and in quantitative estimate. Even modern valuation models for many advanced derivatives are far from perfect and require some assumptions, not necessarily present in real life. 10-15 years ago the situation was much worse. As a result, the banks, which usually sold such products, were mispricing them (and ripping off the clients) and the clients were seriously underestimating their exposure. On the other hand regulatory rules did not require disclosure of many derivative trades in companies’ public reports. This meant that a company could do some derivative trades, which would appear to increase its earnings or reduce costs, while in fact greatly increasing either its direct debt or its risks. However only the “positive” consequences would be clearly flagged, actually trumpeted, in a report, while the details of the OTC deal would be only hinted at in a cryptic footnote. In effect this allowed the companies to abuse current regulations and prevented investors in public companies from assessing their risks correctly. Probably the most notorious example of a derivative instrument used for misleading the investors and authorities were the so called prepaid swaps. In this type of deal a bank would give a company an amount of money upfront, and the company would repay the amount plus extra to the bank over time. If it sounds like a loan, do not be surprised – it is. However, since the deal was declared a swap and not a loan, it was not reported in the same way and the company appeared to have less debt than it had in reality.
Lack of supervision
One aspect of derivatives trading is the potential of very big leverage. For example, a deal could cost $1,000,000 to enter, but could result in win or loss of $20,000,000 or more. Also, as mentioned earlier, the products were complicated and often misunderstood. Even sophisticated banks could have problems valuating their current risks and exposures. As a result, a rouge employee could cause a company to lose huge sums of money even easier, than a star trader could earn a fortune for it. The world famous example of Barings’ Nick Leeson was made into a movie. Mr Leeson lost money while trading futures for the bank and simply hid the losses, using holes in the internal accounting system. Eventually the uncontrolled trading caused the bank to collapse. One would assume, that the surviving banks would learn a lesson, but as late as 2008 a Société Générale trader lost about €5 billion in a strikingly similar incident.
An example was given earlier, demonstrating, how some companies use derivatives to affect their reports. There could be other reasons for a company to use derivatives. For example, some companies are prevented by law from trading in foreign markets or trading certain types of instruments. With derivatives they can very effectives work around these limitations. Therefore by using derivatives, market participants could exploit the so called legal arbitrage opportunities. Unfortunately, they often did not understand the risks involved thoroughly and often lost substantial amounts of money.
One of the main reasons of the crises, described by Mr Partnoy and of the most recent one as well is the fact, that the officially authorised credit rating agencies, namely Moody’s, Standard & Poor and Fitch, are not doing their job. There are simply too many examples of the agencies giving high ratings to companies on the verge of bankruptcy. The author hints at the fact that the brightest and most able employees, capable of proper evaluation of businesses, end up in banks and other well-paying institutions, while the rating agencies pick up the rest. This doesn’t lead to any serious reduction in their profits, unfortunately, since the market for rating agencies is closed for new competition, and the existing agencies are free to charge hefty fees for their services.
It is often assumed by investors, that any wrong-doing by management of their company or financial institutions will inevitably be uncovered and promptly punished. However this seems not to be true in many cases. Enron and Madoff are more of an exception than common practice. The book implies, that the complexity of many cases, lack of trained staff and very uncertain prospects of actual prosecution prevent justice discharge in many instances. In some cases the wrong-doers admit to minor charges and are fined small amounts, without any other serious consequences. And in a number of cases even their reputation magically survives the misfortune.
To sum up, the author presents an interesting and thought-provoking view at the past financial crises, which we should consider carefully in order to avoid new ones in the future.