Risk mismanagement

Complex financial instruments have made Wall Street incomprehensible to the average consumer -- and allowed "experts" to make fortunes. Two new books remind us that swindlers may have always been with us, but that today they are running the show.

By Andrew Leonard

May 1, 2003 | Consider the phrase "risk management." It sounds sensible, prudent, the height of fiduciary responsibility. It means, or should mean, hedging one's bets -- protecting your investments, for example, against the possibility of market crashes, or sudden swings in interest rates, or Third World economies collapsing.

Sure, you've got to risk your money if you want high rates of return -- but you don't need to risk it recklessly. Not when Wall Street's finest investment banks are packed with whip-smart Ph.D.s and MBAs, armed with state-of-the-art software programs based on models devised by Nobel Prize-winning theoreticians, eager to offer you the latest in "risk management products." Interest rate swaps, collateralized mortgage obligations, derivatives of every shape and color -- the variety of these "complex financial instruments" is boggling.

But like so many of the popular buzzwords of high finance, the words "risk management" teeter perilously close to an oxymoronic cliff. Risk management products are usually unregulated, and are often extraordinarily complex. As such, they tend to be, well, risky. And in case after case, as documented by Frank Partnoy in his new book, "Infectious Greed: How Deceit and Risk Corrupted the Financial Markets," they are designed not so much for the purpose of reducing risk as for skirting laws or accounting rules and providing a source of windfall profits to Wall Street's traders and brokers.

And in that respect, "risk management products" aren't at all new, and they probably shouldn't be Nobel Prize-eligible. As elegantly recounted in Malcolm Balen's delightful "The Secret History of the South Sea Bubble: The World's First Great Financial Scandal," financial innovation has at least a 300-year-old tradition of being a cover for outright fraud and swindling. Even as markets have become more sophisticated, human nature doesn't appear to have changed; the main difference between then and now is that it gets harder and harder to figure out exactly what the swindlers are up to.

Frank Partnoy is a former derivatives salesman who is a member of a select breed: He knows an awful lot more than most people about complex financial instruments. In "Infectious Greed," he takes pains to explain their mysteries, which makes him an even rarer beast. Because it is not in the interest of the vast majority of people who do know what, say, a FELINE PRIDE (Flexible Equity-Linked Exchangeable Security Preferred Redeemable Increased Dividend Equity Security) is to divulge their secrets. If shareholders knew what the blue-chip companies they invested in were up to, they might stay away from the market altogether (as indeed many are, after the revelations of the last few years). Complexity is a shield, a defense from regulators, investors and even the very clients that, say, Bankers Trust or Credit Suisse First Boston wants to sell its latest concoction to. Lift up the curtain, and the bond salesmen and CFOs and derivatives traders lose their advantage, their ability to con clients into buying into foolish deals, their opportunities for sweeping losses off the accounting books, their chances to pad their own pockets at the expense of everyone else.

If my rhetoric seems overwrought, that's because it's hard not to seethe after reading Partnoy's fascinating, illuminating and enraging account of the last 15 years of high-finance shenanigans. (Just as it's hard not to slap your head at the spectacle of English investors in 1720 throwing their money at a "trading" company that actually traded no physical goods.) In 480 pages, Partnoy covers a formidable swath of territory, from the growth of derivatives trading at the end of the 1980s at institutions like Bankers Trust and Salomon, through the rise and fall of such entities as the hedge fund Long Term Capital Management, to the dot-com bubble and beyond, finishing off with the squalid splendor that is Enron and WorldCom and Global Crossing. Along the way, he doesn't have a whole lot of nice things to say about Republican or Democratic administrations, regulators, credit rating agencies, analysts, bankers or even ordinary shareholders.

Significant parts of his story have been told elsewhere, but Partnoy sets it all forth in more detail than is usually offered by business journalists who themselves may not understand the intricacies of the innovations they are covering. Partnoy also ups the ante by putting his stories together in the larger context of how financial markets have evolved over the last decade and a half. In Partnoy's world, Enron isn't a bad apple and the dot-com bubble wasn't an abnormal outbreak; they're both part of a larger story of out-of-control speculation that has yet to reach its final chapter.

Likewise, "The Secret History of the South Sea Bubble" is required reading for anyone who might be tempted to dismiss dot-com antics or Enron-scale shenanigans as aberrations. There it all was in the early 1700s -- only instead of lobbying, there was outright bribery of members of Parliament; and instead of stock options for executives, the South Sea Co. actually subsidized the purchase of its own shares by investors, so as to keep demand high and the stock price constantly rising.

Balen's book is an aperitif. Partnoy is the main course. In Partnoy's own words, the keys to his big narrative are threefold: "First financial instruments became increasingly complex and were pushed underground, as more parties used financial engineering to manipulate earnings and to avoid regulation. Second, control and ownership of companies moved greater distances apart, as even sophisticated investors could not monitor senior managers, and even diligent senior managers could not monitor increasingly aggressive employees. Third, markets were deregulated, and prosecutors rarely punished financial malfeasance."

What does it all add up to? In a worst-case scenario: quite a bit of trouble. In the long run, "risk" is being sold off by people who know best how to evaluate it to people who don't know what they're in for. As government for the most part looks the other way, the stability of the financial markets is increasingly an illusion. In the last decade alone, the markets have come closer than most people realize to collapsing. Unless serious steps are taken to change the status quo, disaster could be imminent. We haven't seen the last of the bubbles, by any stretch of the imagination. We seem, in fact, to be addicted to them.

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