Risk mismanagement

It may be tempting, when you review the evolution of the stock market over the past few centuries, to denounce the whole thing as a rigged game of blackjack. But that would be too simple. Take, for example, the issue of credit derivatives, one of the more recent wrinkles in high finance.

Credit derivatives are basically a highfalutin form of insurance. An entity with a liability -- say, a big bank that has loaned a couple of hundred million dollars to Enron -- can actually sell the risk of Enron defaulting on its loan to someone else. In fact, it can sell pieces of that risk to many different parties, and those parties don't have to be banks -- they can be all kinds of different companies. Enron itself bought and sold billions of dollars of credit derivatives.

The idea at the heart of credit derivatives is risk management: By spreading the risk around in the form of credit derivatives, a bank lowers its own risk of being substantially harmed if a bunch of its big clients go bankrupt. Credit derivatives, says Partnoy, actually work, at least for the banks -- one reason why we haven't seen any big banks go out of business as a result of the rash of bankruptcies in the past few years is that they had mostly covered their potential liabilities through credit derivatives.

Sounds smart -- the best financial management that money can buy. Except there's one problem: Banks are in the business of evaluating whether loans are risky or not. Now they are in the habit of selling off their risk to companies that aren't in that business. Risk is being passed off to entities who don't have the tools to evaluate their liabilities. In the long run, there's no telling how this is going to end up, but in Partnoy's view, the potential for trouble is disquieting.

"As William Donaldson, chairman of the New York Stock Exchange [and now head of the Securities and Exchange Commission], put it in 1992," writes Partnoy, "'No matter how much hedging is done, somebody winds up holding the hot potato when the music stops.' The goal of [securities law] was to ensure that the people who could best bear the risks would, in fact, end up bearing them, so that the hot potato landed in the right place. But as the derivatives markets were beginning to show, risks in modern financial markets were moving in the opposite direction, migrating progressively to less-sophisticated investors."

A tenet of free-market faith and financial theory is that, left to itself, the market will efficiently value risk. Under this reasoning, shareholders who don't scrutinize quarterly statements closely have only themselves to blame if they get burned in the market. Companies that commit fraud, like Enron or WorldCom, eventually crash and burn -- that's the "genius of capitalism," as former Treasury Secretary Paul O'Neill put it. If you put all your retirement funds in Enron stock, well, too bad. That was dumb, and stupidity gets punished.

This nice bit of Darwinian economics ignores the fact that in the current marketplace shareholders don't have a chance of understanding what is really going on in corporate reports. This is not just because they don't have advanced degrees in mathematics, or haven't the spare time to effectively evaluate derivatives. It's because, as Partnoy devastatingly details, the system is rigged to prevent the kind of transparency that would give shareholders, from Joe Daytrader to the biggest pension fund, a chance to figure out what is really going on.

The most complex financial innovations are the ones that are the least regulated, thanks to bulldog lobbying by the derivatives industry. The investment banks that sell ever more complex financial products are counting on the fact that their purchasers, companies as big and theoretically smart as Procter & Gamble, don't have the wherewithal to understand what the real risks are. And, as has been well documented, the securities analysts who supposedly are the professionals with the tools to evaluate public companies are hopelessly corrupt.

Partnoy is partly joking when he describes one derivatives trade, known as a "Wedding Band," as "too complex to describe without a mathematician and a psychotherapist," but underneath he's dead serious. The rise of the kind of complicated financial modeling that has only become possible in the computer era is making it steadily more difficult for anyone outside of the inventors of new financial products to know exactly how they will be affected by sudden swings in interest rates or currency values or other variables. The combination of this computer-driven complexity with a systematic lobbying effort to ensure that these products remain unregulated has left the public with ever-flimsier protections. (This lobbying, by the way, has been aided and abetted by both Republican and Democratic administrations. Partnoy is bitingly fierce on the topic of how Bill Clinton, and his SEC appointee Arthur Levitt, helped the bond traders do as they pleased.)

Complexity is also its own lure. As best documented in "When Genius Failed," Roger Lowenstein's account of the spectacular rise and fall of the Long Term Capital Management hedge fund, the sight of Nobel Prize winners waving around their software models and promising unbelievable rates of return can be highly seductive, not just to dazzled individuals like you and to me, but to the smartest investment banks on Wall Street. It is all too human to want to believe that risk can be authoritatively valued, that we are making steady progress as a civilization in figuring these things out, and that, if you put the right group of really smart people together with the fastest computers and the best models, you can make a whole lot of money.

But it's just as human to believe too much in your own (or anybody else's) brilliance, and not enough in the likelihood that even the best and brightest can screw up -- or be screwed. The combination of the inherent unpredictability of markets with the pressures of greed can result in a big mess. Long Term Capital offers a perfect example: First, the models of the high-powered traders gathered together by John Meriwether didn't take into account the possibility that things could simultaneously go wrong in every market that they were trading in. But even worse, they weren't prepared for the likelihood that the many, many enemies they had made on Wall Street would pounce on their weakness, and make their position worse.

Maybe, before anyone is allowed to invest, they should be required to take a course in the South Sea Bubble. In the early 1700s, the government of Britain had amassed a huge national debt, in part by selling long-term annuities to help fund its various wars. The South Sea Co. offered to take that debt off the government's hand, and offered stock in itself in exchange for the annuities.

Never mind the fact that the South Sea Co., which was supposed to have an underlying business of trading goods in the New World, never made close to a profit as a trader, and indeed, for most of its existence wasn't doing any trading at all. The company first raked in cash by privately buying up annuity shares in advance of its deal with the Crown, thus profiting when the value of the annuities started rising, as investors bought into the hype that the South Sea Co. was going to make everyone millions of dollars.

Since the South Sea Co. had no underlying business to speak of, everything hinged on ensuring a continually rising stock price. This was achieved by constantly offering new shares to the public, which could not only be paid for on an installment plan, but for which a large portion of the initial price would be paid for by the South Sea Co.!

It worked, for a while, until it didn't. And if it all sounds a bit too similar to what a host of dot-com companies were up to in the late 1990s, well, the feeling is intentional. Balen's account of the bubble is specifically intended to parallel the dot-com boom, and it does so in an understated but extremely effective fashion.

It would be trite to say that nothing has changed since the 1720s. Lots of things have changed. Great economic disasters tend to provoke a reaction of their own, a tightening up of rules and regulations and oversight. The Great Depression, for example, gave birth to modern securities regulation. And even now, the excesses of the dot-com era, and the bankruptcies of companies such as Enron, have resulted in some limited reforms. Accounting regulations have been tightened slightly, investment banks have been forced to pay fines.

But after reading "Infectious Greed," you're not likely to view any of the current changes as more than cosmetic. Derivatives trading is still mostly unregulated, and even when the investment community catches up to the latest scandal, it's usually too late -- by that time, writes Partnoy, "the financial markets would be on to the next game."

It's no doubt impossible to be fully vigilant against all excess, fraud and skulduggery. There will always be a next game, and it's impossible to regulate in advance against the innovations of tomorrow. But there's such a huge gap between where we are now and where we should be that such theoretical considerations are moot. At the end of his book, Partnoy lists a series of prescriptions for curing, or at least assuaging, the current disease. Some are fairly technical, some are fairly straightforward -- such as putting real teeth into the enforcement of penalties on white collar criminals, and regulating derivatives just as other financial instruments are treated.

But perhaps the most important prescription to be taken from "Infectious Greed," in conjunction with the long view encouraged by a refresher course in the South Sea Bubble, is to constantly question our own faith in markets, and the very concept of "risk management." And to remember that, if we can't understand what they're doing, that's in part because we're not supposed to, and we would probably be better off steering as clear as possible of the oncoming train wreck.

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