"F.I.A.S.C.O.:Blood in the Water on Wall Street" is about Frank Partnoy's journey through Wall Street and what happens when derivatives creation gets out of hand. (image courtesy of Frank Partnoy)

A few weeks ago, I flew to San Francisco to cover the annual meeting of the International Swaps and Derivatives Association, a [...]]]>

"F.I.A.S.C.O.:Blood in the Water on Wall Street" is about Frank Partnoy's journey through Wall Street and what happens when derivatives creation gets out of hand. (image courtesy of Frank Partnoy)

A few weeks ago, I flew to San Francisco to cover the annual meeting of the International Swaps and Derivatives Association, a large over-the-counter derivatives lobbying group. For two days I listened to ISDA executives convince journalists that derivatives “regulation” should remain as is. Even renowned Stanford economist and former Treasury Undersecretary John Taylor—of the Taylor Rule—said repeatedly that derivatives were not a cause of the financial crisis.

I’ve read cautionary tales about Wall Street, as told through Michael Lewis’s “Liar’s Poker.” I’ve read the story about how former CFTC Chairwoman Brooksley Born confronted former Treasury Secretary Robert Rubin, former SEC Chairman Arthur Levitt and former Fed Chairman Alan Greenspan about the need to regulate the OTC derivatives industry in the late-1990s.

But no account about the OTC derivatives market has been as convincing or damning as Frank Partnoy’s “F.I.A.S.C.O.: Blood in the Water on Wall Street.”

As the notional value of the derivatives industry swelled to $55 trillion, Partnoy, a law and finance professor at the University of San Diego who spent the early 1990s structuring derivatives products at First Boston and Morgan Stanley, was instrumental in the creation of BIDS and MEXUS derivatives, complex derivatives products based on Brazilian bonds and peso-denominated, inflation-linked bonds. Partnoy was also responsible for FP Trust, derivatives based on the Philippines state-owned electric company, the National Power Corporation (NPC) and bundled with AAA-rated U.S. Treasury bonds in order to secure a safe investment rating.

While Lewis’s book raises a red flag about Wall Street excesses, Partnoy is wildly waving multiple flags while leading a massive marching band down Main Street. Partnoy isn’t just a derivatives expert: he’s a reformed derivatives trader who saw the evils of derivatives and is trying to warn everyone about its destruction throughout the book.

Instead of immediately delving into a “derivatives are bad” diatribe, Partnoy compares the rise of derivatives with the evolution of Morgan Stanley from “first class business in a first class way,” to “first class business in a second class way,“ a reference to the bank’s new aggressive style of business that feasted on the fear and greed of its customers.

Partnoy recalls a rousing speech from the brokerage firm’s former president, John Mack, following a period of massive derivatives losses: “There’s blood in the water. Let’s go kill someone.” (Appropriately enough, F.I.A.S.C.O. is an acronym for Fixed Income Annual Sporting Clays Outing, a recreational gun-shooting event at Morgan Stanley.)

Partnoy interweaves the immoral behaviors and conversations of coworkers with detailed explanations about the derivatives deals that took place, leaving nothing to the reader’s imagination. From beginning to end, you know exactly how the derivatives products were created and how they sold them and what happened to the customers, which were mostly pension funds and retirement systems.

So while Partnoy provides intricate details about the derivatives his group created and sold, he revealed the consequences of ripping off one’s face, like devoting an entire chapter about the Orange County bankruptcy, the largest municipal bankruptcy in U.S. history. Using complex derivatives, some of which were highly rated bonds tied to interest rate changes, the county amassed at least $1.5 billion in derivatives losses.

As Partnoy continues through his Wall Street travails, we might not be able to remember what a Trigger Note does or the exact purpose of PEARLS, but we do sense that derivatives are not right. There’s a reason Warren Buffet referred to derivatives as “financial weapons of mass destruction.”

Partnoy left Wall Street following his stint at Morgan Stanley and began teaching in 1997. While “F.I.A.S.C.O” was published toward the end of that year, there was prescience to his experience. At the end of the original edition, which was published in 1997, Partnoy wrote:

“Given the dearth of regulation and proindustry balance of power, you don’t need a psychic to predict that there will be another Orange County-like fiasco some time soon. The financial services industry will continue to pay tens of millions of dollars to lobbyists and congressional campaigns to fend off regulation. Derivatives will continue to cause billions of dollars in losses by hundreds of derivatives victims, all along the way destroying reputations, twisting lives, and emptying bank books.”

This was a year before the collapse of Long Term Capital Management, three years before President Clinton signed the Commodity Modernization Act, which exempted the OTC derivatives market from regulation, and 10 years before collateralized debt obligations, credit-default swaps and the collapse of Bear Stearns and Lehman Brothers.

In his updated afterword Partnoy said, “F.I.A.S.C.O. is the story of my journey through the gluttony and dysfunctionality of 1990s Wall Street.” It’s also the story of a young Wall Streeter who said, “I told you so.”

John Taylor delivers Friday's keynote address at the ISDA annual general meeting. (Alexandra Harris/MEDILL)

“It’s amazing what facts can show and not rhetoric,” ISDA CEO Conrad “Connie” Voldstad said.

The over-the-counter derivatives market had its day today, contesting what so many politicians and pundits have thought about the crisis.

“Swaps and derivatives [...]]]>

John Taylor delivers Friday's keynote address at the ISDA annual general meeting. (Alexandra Harris/MEDILL)

“It’s amazing what facts can show and not rhetoric,” ISDA CEO Conrad “Connie” Voldstad said.

The over-the-counter derivatives market had its day today, contesting what so many politicians and pundits have thought about the crisis.

“Swaps and derivatives are not at the top of the list of what went wrong,” Stanford Economist John Taylor said during Friday’s keynote address.

So what was a primary cause of the financial crisis? Taylor said the Federal Reserve kept interest rates too low for too long.

Taylor is known for the Taylor Rule, a formula that determines how a central bank like the Federal Reserve should set short-term interest rates as economic conditions change.

Although some have told Taylor that he was using his own rule incorrectly. “The current chairman says, ‘you’re using the wrong Taylor rule, Taylor.’”

Taylor said other problems with the crisis resulted from the high levels of government intervention, including the rollout of the Troubled Asset Relief Program (TARP), which Taylor said exacerbated the crisis, the stimulus packages and the Fed’s $1.25 trillion mortgage-backed securities purchasing program (“They’ve had little effect. The spreads have not moved up.”)

And despite what ISDA participants perceive as over-regulation, Taylor sees some positive benefits to the recently introduced derivatives reform bills. For Sen. Blanche Lincoln’s, D-Ark., version, Taylor likes the emphasis on price transparency and central counterparty clearing (although too many clearinghouses could dramatically increase risk).

So why is Washington pushing regulation on derivatives?

“Derivatives are easy to point at,” Taylor said. “People don’t know what they are and there are so many different kinds, it lends itself to that.”

Panelists discuss the need for regulation during "Systemic Risk: Advances and Challenges in the Wake of the Crisis" at the ISDA General Meeting. (Alexandra Harris/MEDILL)

While President Barack Obama castigated Wall Street from New York City’s Cooper Union, the International Swaps and Derivatives Association’s annual general meeting kicked off in San [...]]]>

Panelists discuss the need for regulation during "Systemic Risk: Advances and Challenges in the Wake of the Crisis" at the ISDA General Meeting. (Alexandra Harris/MEDILL)

While President Barack Obama castigated Wall Street from New York City’s Cooper Union, the International Swaps and Derivatives Association’s annual general meeting kicked off in San Francisco.

And the word buzzing around was regulation.

The consensus in the Bay area is that while regulation is needed, there’s a concern that there could be too much regulation, which could harm more than help.

According to ISDA Executive Vice Chairman Robert Pickel, there’s a flawed notion that exchange trading will create liquidity and better pricing for markets.

And while Obama spoke about the financial reform bill that’s heading to the U.S. Senate floor, Deputy Treasury Secretary Neal Wolin made the case for Washington’s version of financial reform.

This was an exercise in amusement, especially when an audience member told Wolin that he “may make his trip worthwhile.”

“We see that pricing is fair,” said ISDA CEO Conrad “Connie” Voldstad. “None of the end users are squawking.”

“It’s a group of people trying to be protected from something they don’t want to be protected from,” IDSA Chairman Eraj Shirvani added.

After acknowledging the damage derivatives caused during the financial crisis, Voldstad said in prepared remarks that “much of the debate over the causes of the financial crisis has so far been based more upon rhetoric and less on facts. There has been no estimate made as to the economic benefits, or, more appropriately, the economic costs of regulation. There has been misguided belief that exchange trading will bring more liquidity and better pricing to one of the most liquid and efficient markets in the world.”

Even though ISDA executives like the less-is-more approach to derivatives trading, there was some push-back during the session titled “Systemic Risk: Advances and Challenges in the Wake of the Crisis.”

In fact, when moderator and ISDA board member Stephen O’Connor fielded a question regarding ISDA’s “abstract” position on regulation, O’Connor jokingly “asked Connie and Bob [Pickel] to step forward.”

The annual meeting continues Friday with Stanford professor and Hoover Institution Fellow John Taylor—best known for the creation of the Taylor rule, which determines how much a central bank should change interest rates—addresses members.  There will also be a panel, “The Future of Credit Derivatives and Structured Finance,” which, at this point, is just about anyone’s guess.

Photo from C-SPAN

As the global financial markets unraveled, and words like “derivatives”, “credit default swaps” and “collateralized debt obligations” seeped into America’s lexicon, Brooksley Born stayed quiet.

During her tenure as Commodity Futures Trading Commission chairwoman in the Clinton administration, Born recognized and warned her colleagues about the dangers of [...]]]>

Photo from C-SPAN

As the global financial markets unraveled, and words like “derivatives”, “credit default swaps” and “collateralized debt obligations” seeped into America’s lexicon, Brooksley Born stayed quiet.

During her tenure as Commodity Futures Trading Commission chairwoman in the Clinton administration, Born recognized and warned her colleagues about the dangers of an unregulated over-the-counter derivatives market.

But then-Federal Reserve Chairman Alan Greenspan, along with then-Treasury Secretary Robert Rubin and Securities and Exchange Commission Chairman Arthur Levitt scoffed at her proposal that the CFTC regulate the products, and eventually, after a failed push for regulation, Born resigned in 1999 and went quietly into the private sector.

Now, as a member of the Financial Crisis Inquiry Commission, Born spoke forcefully.

And, ironically, her detractors Greenspan and Rubin listened as she castigated the men for their role in the deregulation of OTC derivatives, the same derivatives that caused the near-collapse of American International Group Inc. and the demise of investment banks Lehman Brothers Inc. and Bear Stearns Inc.

“You’ve long championed the growth of the over-the-counter derivatives market because of the risk-shifting opportunities it provides,” Born said to Greenspan. “You’ve also taken the position that the over-the-counter derivatives market should not be regulated. “

“You welcomed the adoption of the Commodity Futures Modernization Act of 2000, which eliminated virtually all Federal government regulation of the OTC derivatives market and also pre-empted certain state laws relating to it,” Born said. “So as a result, OTC derivatives have been trading with virtually no regulation for a decade and the market grew to exceed $680 trillion in notional amount by the summer of 2008.”

Greenspan’s response: “There was no evidence that they [OTC derivatives] didn’t work exactly as they were going to.”

And, at one point during Rubin’s testimony, he said he wasn’t in favor of any derivatives deregulation during his time as Treasury Secretary.

Greenspan and Rubin’s testimonies revealed Wall Street and Washington’s lethargy toward changing its ways, even though the crisis has proven Born to be right.

Andrew Ross Sorkin speaks to Chicago audience Feb. 9. Photo by Chris Guillen

It was Tuesday evening in Chicago, and though you may have watched him co-host CNBC’s Squawk Box from New York that same morning, there was Andrew Ross Sorkin giving a talk about Wall Street and his new book, “Too [...]]]>

Andrew Ross Sorkin speaks to Chicago audience Feb. 9. Photo by Chris Guillen

It was Tuesday evening in Chicago, and though you may have watched him co-host CNBC’s Squawk Box from New York that same morning, there was Andrew Ross Sorkin giving a talk about Wall Street and his new book, “Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves.”

The title and phrase has become ubiquitous (much like Sorkin) in and about Washington and Wall Street when describing the contentious bailouts that resulted from the economic crisis. Sorkin, in his book and in Tuesday’s talk at the Kellogg School of Management’s downtown Chicago campus, gave a behind-the-scenes look at Wall Street during the most tumultuous days of 2008, as well as the government’s involvement in the ultimate bailout – and he explained just why these institutions were indeed too big to fail, and what might be done to avoid that in the future.

Sorkin learned much in his quest to finish the 600-page monster of a book.

“What surprised me was the level of government antics we never knew of,” Sorkin said to the audience comprising mixed professionals and students.

Apparently, astounding deals were being brokered by then Treasury Secretary Henry Paulson, Fed Chairman Ben Bernanke and then New York Fed Chairman Tim Geithner (so many deals in fact the Street started calling Geithner eHarmony) that the public never would come to see: Goldman Sachs Group was encouraged to merge with Citigroup; Wachovia was a candidate to merge with Goldman; Geithner told Morgan Stanly CEO John Mack to sell the company to JPMorgan Chase for $1, according to Sorkin.

Barclays Bank PLC CEO Bob Diamond had already been in talks to purchase Lehman Brothers and Warren Buffett had already been tapped to invest in Lehman months before Sept. 15, 2008, when Lehman declared the chapter 11 bankruptcy that nearly tilted the world off its axis.

In an elegant and succinct example for how connected things were, Sorkin said the dominoes were falling after Lehman Brothers, and two of the later dominoes were Goldman Sachs and Morgan Stanley. After that, the next domino could very well have been General Electric Company, which was massively intertwined with Wall Street banks. And if that happened, all the McDonalds’ franchisees that rely on GE for financing would not have been able to make payroll – and there you have the connection for why the government poured all these taxpayer dollars into the villainous investment firms.

Sorkin’s suggestions for rehabilitation are:

• The government needs resolution authority, which allows it to put any such huge company, investment bank or insurance company into a conservator-ship and wind down the operation, so that they are not too big to fail – like what the FDIC can do for commercial banks. “Why we haven’t, it’s beyond me,” says Sorkin.

• The Federal reserve needs to raise capital requirements and in so doing change the definition of what capital means. For instance buildings and tax rebates shouldn’t necessarily be capital that is used to meet capital requirements. There might be different types of capital requirements for different parts of a company.

• And regulate derivatives, especially credit default swaps, which are the insurance products bought against corporate debt that not only turned into billions of dollars of liabilities, but also incentivized investors to let or help other companies fail.

Addendum: Kellogg has featured the following journalists in the last year, according to Kellogg director of media relations Megan Washburn:

o   Gail Collins, New York Times

o   Jon Meacham, Newsweek

o   James B. Stewart, WSJ

o Sylvia Nasar, has written for The New York Times, Fortune and U.S. News & World Report

www.amazon.com

BY JOSEPH FREEMAN-MEDILL NEWS SERVICE

Monday night University of San Diego professor Frank Partnoy appeared on “The Daily Show” to discuss his new book about Ivar Kreuger, the most effectively damaging ponzi scheme artist to have emerged over the past century, known to most by his honorific, the “match king.”  But before [...]]]>

www.amazon.com

BY JOSEPH FREEMAN-MEDILL NEWS SERVICE

Monday night University of San Diego professor Frank Partnoy appeared on “The Daily Show” to discuss his new book about Ivar Kreuger, the most effectively damaging ponzi scheme artist to have emerged over the past century, known to most by his honorific, the “match king.”  But before you pick it up on Amazon, I suggest starting with Partnoy’s memoir “F.I.A.S.C.O.”

Here’s a brief passage on page 218 of this entertainingly informative tell-all (the title is an acronym for a corporate skeet-shooting excursion), a book about his years in the mid-90′s as a salesman in the Derivatives Products Group at Morgan Stanley.

“Because mortgage payments are so unpredictable, even the most sophisticated investment banks that actively trade mortgages have suffered significant losses; in 1987, Merrill Lynch lost $377 million when a trader made several large losing mortgage trades.”

Did you catch the year?  1987.  F.I.A.S.C.O. is about the rise of derivatives, and like the advances in geometry since Euclid’s time, these derivatives morphed from somewhat easy to grasp financial instruments into complex deals linked to the performance of seemingly incongruent and various volatilities, like the Mexican peso, a Philippines power company, and industry benchmarks like the London Interbank Offered Rate (known as LIBOR to anyone who is not a financial philistine).

While Partnoy does a commendable and humorous job of breaking down the theories behind many of these impenetrable bonds of ill repute and why anyone like a municipal treasurer would invest in them (see Orange County, whose treasurer in 1994 lost over a billion dollars in the bustling derivatives agora), he presents an undeveloped picture.

Derivatives have come under a lot of warranted fire lately, but Partnoy does nothing to dispel the notion that derivatives, in many forms, such as those exchange-traded commodities at The Chicago Board of Trade, have been a boon to the U.S. economy and have helped business owners protect themselves against fraud and volatile price swings.

The problem with the word derivative is that it can mean almost anything.  Saying “derivatives trader” today comes weirdly close to calling someone a “fascist.”  It roughly translates, in the public mind, to a male, chauvinistic and rapacious trickster who most likely works on Wall or LaSalle St. and takes pleasure only in divesting a small business owner or farmer of his life savings.  Though truth be told, Partnoy and his colleagues at Morgan Stanley were guilty of similar scurrilous acts.

But as an early warning, and an instructional primer on the rise of these suicide bond derivatives and tax scams like equity swaps, as well as a piece of farce, the book is invaluable.  My favorite passage is about Partnoy’s foray into so-called “emerging markets” in Latin America.

“It wasn’t clear what ‘emerging’ meant, or how these markets might ‘emerge.’  Still, it sounded awfully good, and it helped cloud the fact that the emerging bond an investor bought actually was a Peruvian loan that hadn’t paid any interest since the 1800s.”

The only problem with the book, and the discourse about derivatives ever since, is that they are always called “sophisticated” and “exotic.”  Nay.  The definition of love in Plato’s “Symposium” is sophisticated, and canoe trips down the Amazon are exotic.  Brady Bonds, RAVS, MEXUS notes, and Pre4 Trust structured vehicles are lurid gimmicks that, for the most part, can only end in a fiasco.

(www.aig.com)

BY JOE FREEMAN — MEDILL NEWS SERVICE

Rene M. Stulz, professor of finance at The Ohio State University’s Fischer College, wrote an op-ed in the Wall Street Journal today entitled: “In Defense of Derivatives and How to Regulate Them.”

Peculiarly, the article had little to do with how to regulate them and almost [...]]]>

(www.aig.com)

BY JOE FREEMAN — MEDILL NEWS SERVICE

Rene M. Stulz, professor of finance at The Ohio State University’s Fischer College, wrote an op-ed in the Wall Street Journal today entitled: “In Defense of Derivatives and How to Regulate Them.”

Peculiarly, the article had little to do with how to regulate them and almost everything to do with the defense of derivatives.

Stulz’s main argument can be summed up in one word: liquidity. Namely, that capital constantly flowing through the system is an undeniable asset to the economy and provides businesses and investors ways and means of hedging risk. Agreed.

But what if this system is abused, as it clearly was? What if liquidity turns into leveraging and weirdly packaged products and this all happens to coincide with a bursting bubble in, shall we say, housing?

Not to fear, says Stulz, all we need is a “systemic risk regulator” that will place participants under “federal regulatory oversight.” It’s strange to read a proposal for federal regulatory oversight of derivatives and not see any mention of the Commodity Futures Trading Commission, the federal regulator of exchange-traded derivatives.

Speaking of regulation, let’s not overextend ourselves, Stulz continues, claiming that we should leave “participants in capital markets free to engage in bilateral contracts for derivatives that fulfill specific needs as well as for new products.” Specific needs? New products? You mean like investors hedging their risk in mortgage-backed securities with credit-default swaps? Oh dear.

Stulz continues by allaying our obviously mounting concerns. “Derivatives are not the culprit,” he asserts near the end of the piece. Sure, liquidity is key, we need strong regulation, and there are many culprits (overreaching homeowners, predatory lenders).

But to free up blame and propose regulations that either already exist or won’t get the job done is futile at best and hurtful at worst. To say credit default swaps aren’t at all responsible for the meltdown, that they are “not the culprit,” is like positing that guns don’t kill people, bullets do.

The opinions expressed are those of the author and do not necessarily represent the views of medillmoneymavens.com, the Medill School of Journalism or Northwestern University.

BY J.H. FREEMAN- MEDILL NEWS SERVICE

In times of crisis, we look for lessons from history, or on the rare occasion, in literature. Published in 1957, Ayn Rand’s “Atlas Shrugged,” a novel about industries and businesses boycotting a fiscally manipulating government, has been seized upon mostly by free market trumpeters as the encapsulation [...]]]>

BY J.H. FREEMAN- MEDILL NEWS SERVICE

In times of crisis, we look for lessons from history, or on the rare occasion, in literature. Published in 1957, Ayn Rand’s “Atlas Shrugged,” a novel about industries and businesses boycotting a fiscally manipulating government, has been seized upon mostly by free market trumpeters as the encapsulation of the crisis and the loss of liberal economic ideals.

In a Wall Street Journal opinion piece published in January, Stephen Moore wrote the following paean to the novel.

Some years ago when I worked at the libertarian Cato Institute, we used to label any new hire who had not yet read ‘Atlas Shrugged’ a ‘virgin.’ Being conversant in Ayn Rand’s classic novel about the economic carnage caused by big government run amok was practically a job requirement. If only ‘Atlas’ were required reading for every member of Congress and political appointee in the Obama administration. I’m confident that we’d get out of the current financial mess a lot faster.

The Guardian books blog posted a review of the novel last week, which began with “If recent reports are to be believed, people have started seeing parallels between our current economic meltdown and the world collapse outlined in the 1200 pages of Ayn Rand’s libertarian classic Atlas Shrugged.”

And today, Don Watkins, a writer for the The Ayn Rand Institute posted a column entitled, you guessed it, “The Resurgence of Central Planning.”

Whether or not it speaks to the lack of literary pedigree in our journalists and commentators of the free market disposition is impossible to know, but ask any expert or graduate student in Russian literature and you will quickly find there is already a more prescient novel about the causes of the economic crisis, and it was written almost 170 years ago in the land of central planning itself.

Nikolai Gogol’s “Dead Souls”, published in post-Napoleanic Russia in 1842, is the first novel in the history of literature that concerns itself almost entirely with derivatives. The protagonist, Chichikov, arrives in a small Russian town and begins buying from landowners the certificates of serfs (“souls”) who have died but remain registered “living” with the government because the census is slow to record the changes. The landowners are forced to pay taxes on serfs that are dead, and Chichikov offers to relieve them of this economic burden.

Chichikov’s end-game is to acquire enough dead souls and put them up as collateral, secure a large loan, and set himself up in the style of a gentleman landowner. This all sounds dreadfully familiar, as Wall Street brokers as well as Main Street homeowners refinanced and leveraged against a mortgage market in which prices were believed to keep rising.

But like the dead souls in Gogol’s novel, the prices didn’t rise and the schemes backfired, leaving those involved, like Chichikov at the end of the book, to leave town in disgrace. It’s not a coincidence that the term “mortgage” derives from an old French phrase meaning “dead pledge,” referring to the reversion of ownership to the lender if the homeowner dies.

If Stephen Moore gets his way and the Obama administration is compelled to read “Atlas Shrugged,” I submit that Stephen Moore and the outfits who peddled the dead souls of credit default swaps should have some required reading of their own.