Infectious Greed

How Deceit and Risk Corrupted the Financial Markets


By Frank Partnoy

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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 evolving paradigm moved farther and farther beyond the understanding — and regulation — of ordinary investors and government overseers, leading inevitably to disaster.


More praise for Infectious Greed
“Partnoy has written an important book that provides a well-reasoned blueprint for fighting corporate corruption and restoring the integrity of America’s financial markets. Unfortunately, it appears that the cops on Wall Street and the regulators in Congress are not ready to heed his advice.”
—Robert Bryce, The Washington Post Book World
“Imbued with a deep understanding of finance.”
—Roger Lowenstein, The Wall Street Journal
“Ambitious . . . A useful book, bringing together details of half-forgotten scandals from the past fifteen years.”
—Floyd Norris, The New York Times Book Review
“Readers are unlikely to find a more readable explanation of how the financial system has changed since the 1980s and who came unstuck.”
Financial Times
“Partnoy makes it appallingly clear that as these hedges against debt have evolved and become increasingly convoluted, the number of takers who will never understand them, much less profit from them, has continued to swell. . . . Riveting.”
Kirkus Reviews
“Original, reversing the popular perception by claiming Enron was a profitable company that should have survived, while WorldCom and Global Crossing had no economic substance.”—Publishers Weekly
“Partnoy expains just about every significant financial blowout of the past fifteen years, from Gibson Greetings to Global Crossing, via Joseph Jett, Nick Leeson, Orange County, Long-Term Capital Management, Enron and many others.”
Investors Chronicle
“A breathtaking chronicle of greed and stupidity on an operatic scale . . . A compelling portrait of corruption on the scale of the last days of Rome.”
Management Today
“A robust case . . . for the exceptional circumstances of the past fifteen years. Partnoy’s protagonists are . . . a parade of macho or geeky grotesques with overdeveloped quantitative skills. . . . The pursuit of self-interest and maximum pay-off trickled down from traders to CEOs to equity analysts.”
The Guardian

Also by Frank Partnoy
F.I.A.S.C.O.: Blood in the Water on Wall Street
The Match King: Ivar Krueger, the Financial Genius Behind a Century of Wall Street Scandals

For Fletch

“An infectious greed seemed to grip much of our business community. . . . It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed have grown so enormously.”
—Alan Greenspan, testimony before the Senate Banking Committee, July 16, 2002
“In principle, the losses will be spread across a broader range of investors than in past debt crunches, suggesting risks have been well diversified and the financial system is secure. In practice, financial market and corporate innovation during the 1990s has meant it is impossible to be sure, a source of concern to financial regulators.”
—Stephen Fidler and Vincent Boland, Financial Times, May 31, 2002

Many people know the story of the 2008-2009 financial crisis, but few remember what happened just before that. This book is a financial history, a story of the dramatic changes in markets during the two decades before the subprime mortgage boom and bust. It brings together the most important characters and events of this period, connects the dots among them, and explains what happened—and why. It shows how the levels of deceit and risk grew so dramatically, so quickly, and offers suggestions about how to avoid another round.
The recent happenings in financial markets are mysterious to many investors. The names alone evoke vague memories of scandal, but few common denominators. Think not only of Lehman Brothers and Merrill Lynch, but back to WorldCom, Global Crossing, Enron, and the dotcom bubble, the panic surrounding the collapse of Long-Term Capital Management, the fall of the venerable Barings Bank, the bankruptcy of Orange County, the financial crises in Mexico and Asia, and so on. Most investors recall some of these events, but few people understand how they interconnect.
Each story is remarkable, but the headlines can seem isolated, like distinct cells within different bodies. Even when scandals pique the attention of investors, the details are evanescent, and any links to events of the recent past slip away. Investors become outraged, and the media seize on indignities, but over time everyone seems to lose the ability to relate back—especially as markets begin going up again.
This was especially true during the 1990s, a decade of persistently rising markets—ten solid years of economic expansion, with investors pouring record amounts into stocks and pocketing double-digit returns year after year. That stock-price boom was the longest-lived bull market since World War II. Some stocks or sectors suffered periodically, but almost anyone who remained invested throughout the decade made money.
During this time, individuals came to believe in financial markets, almost as a matter of religious faith. Stocks became a part of daily conversation, and investors viewed the rapid change and creative destruction among companies as investment opportunities, not reasons for worry. In 1990, the ten largest U.S. firms—including companies such as Exxon and General Motors—were in industrial businesses or natural resources. By 2000, six of the largest ten firms were in technology, and the top two—Cisco and Microsoft—had not existed a generation before. These stocks almost always went up. Microsoft met analysts’ expectations in 39 of 40 quarters, and for 51 straight quarters the earnings of General Electric—a leading industrial firm that was also heavily involved in financial markets—were higher than those of the previous year.
The decade was peppered with financial debacles, but these faded quickly from memory even as they increased in size and complexity. The billion-dollar-plus scandals included some colorful characters (Robert Citron of Orange County, Nick Leeson of Barings, and John Meriwether of Long-Term Capital Management), but even as each new scandal outdid the others in previously unimaginable ways, the markets merely hiccoughed and then started going up again. It didn’t seem that anything serious was wrong, and their ability to shake off a scandal made markets seem even more under control.
When Enron collapsed in late 2001, it shattered some investors’ beliefs and took a few other stocks down with it. But after a few months, many investors began yawning at Enron stories, confident that the markets had survived yet another blow. Few considered whether the problems at Enron were endemic, or whether it was possible that Enron was only the tip of the iceberg. Instead, investors shrugged off the losses, and went back to watching CNBC, checking on their other stocks.
Then, Global Crossing and WorldCom declared bankruptcy, and dozens of corporate scandals materialized as the major stock indices lost a quarter of their value. Congress expressed outrage and mollified some investors with relatively minor accounting reforms. But most investors were perplexed. Should they wait patiently for another upward run, confident that Adam Smith’s “invisible hand” would discipline the bad companies and reward the good? Or should they rush for the exits?
The conventional wisdom was that markets would remain under control, that the few bad apples would be punished, and that the financial system was not under any serious overall threat.
The recent financial crisis seems unrelated to prior scandals, and the revised, new conventional wisdom is that the collapse of 2008 was unique, a financial lightening strike. If only government can repair the damage to banks, the markets will recover and return to their prior well-functioning days.
The argument in this book is that the conventional wisdom is wrong. Instead, any appearance of control in financial markets is only an illusion, not a grounded reality. Markets came to the brink of collapse several times during the past decade, with the meltdowns related to Enron and Long-Term Capital Management being prominent examples. Today, the risk of system-wide collapse remains greater than ever before. The truth is that the markets are still spinning out of control.
The relatively simple markets that financial economists had praised during the 1980s as efficient and self-correcting are gone. Now the closing bell of the New York Stock Exchange is barely relevant, as securities trade 24 hours a day, around the world. The largest markets are private and don’t touch regulated exchanges at all. Financial derivatives are as prevalent as stocks and bonds, and nearly as many assets and liabilities are off balance sheet as on. Companies’ reported earnings are a fiction, and financial reports are chock-full of disclosures that would shock the average investor if she ever even glanced at them, not that anyone—including financial journalists and analysts—ever does. Trading volatilities remain sky high, with historically unrelated markets moving in lockstep, increasing the risk of systemic collapse.
During recent years, regulators have lost what limited control they had over market intermediaries, market intermediaries have lost what limited control they had over corporate managers, and corporate managers have lost what limited control they had over employees. This loss-of-control daisy chain has led to exponential risk-taking at many companies, largely hidden from public view. Simply put, any appearance of control in financial markets has been a fiction.
If investors believe in the fiction of control, and ignore the facts, the markets will rise again. But if investors continue to question their faith, as they have more recently, the downturn will be long and hard. As investment guru James Grant recently put it, “People are not intrinsically greedy. They are only cyclically greedy.”1 The most recent cycle of greed appears to have ended, but at some point, inevitably, the next one will begin.
This book traces three major changes in financial markets during the fifteen years before the recent crisis. 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.
These changes spread through financial markets like a virus through the population. Before 1990, markets were dominated by the trading of relatively simple assets, mostly stocks and bonds. The sine qua non of the 1980s was the junk bond, a simple, fixed-income instrument no riskier than stock. The merger mania of the 1980s—driven by leveraged buyouts, in which an acquirer borrowed heavily to buy a target’s stock—involved straightforward transactions in stocks and bonds.
Back then, individual investors shied away even from stocks, and most people kept their savings in the bank or in certificates of deposit, which paid more than 10 percent annual returns during most of the decade. Mutual funds became popular briefly—with stock-picking legend Peter Lynch of the Fidelity Investments’ Magellan Fund attracting several billion dollars—but from 1968 through 1990, individuals sold more stock than they bought and money flowed out of the market. Few stocks traded at prices of more than twenty times their annual earnings, and stocks with no earnings were shunned.
Derivatives—the now-notorious financial instruments whose value is derived from other assets—were virtually unknown. The two basic types of derivatives, options and futures, were traded on regulated exchanges and enabled parties to reduce or refocus their risks in ways that improved the overall efficiency of the economy. Customized over-the-counter derivatives markets—where derivatives were often used for less laudable purposes—were a fraction of one percent of their current size, and most complex financial instruments still had not been invented. It is telling, for example, that in Barbarians at the Gate, the classic book about 1980s finance, derivatives are not even listed in the index, and stock options merit only a footnote on page 364.2
Some companies used basic forms of derivatives during the 1980s, including so-called “plain vanilla” interest-rate swaps, where one party agrees to pay a fixed rate of interest to another party, who agrees to pay a floating rate. But the forms of structured financing and over-the-counter gizmos that later would bring hundreds of companies to their knees simply did not exist. Moreover, the exchange-traded derivatives some investors bought and sold were not especially risky; they had changed little from financial instruments the ancient Greeks created and used.
Even stock options—the derivatives that became the primary source of executive compensation during the 1990s—were relatively uncommon. A typical 1980s executive received cash salary and bonus, with perhaps a little stock, but few or no options.
The legal environment during this early period was harsh. The go-go 1980s led prosecutors to clamp down hard on securities fraud, indicting dozens of financial-market participants, nearly 100 in January 1989 alone. Looking back on the decade, the Wall Street Journal noted that “the word ‘indictment’ became almost as central to Wall Street lexicon as stock or bond.”3 The financial-market watchdogs made investors feel secure—almost smug—about financial fraud.
In several high-profile cases, judges imposed heightened duties on corporate directors, bankers, accountants, and lawyers, who came to understand that they violated the law at their peril. Regulators tightened rules against insider trading and other financial abuses. Joseph Grundfest, a commissioner of the Securities and Exchange Commission during the 1980s, opened a 1988 speech by saying, “It’s a pleasure to appear before so many unindicted participants in the financial markets.”4 The decade closed with Judge Kimba Wood sentencing the infamous financier Michael Milken, of Drexel Burnham Lambert, to ten years in federal prison. By that time, prosecutors certainly had Wall Street’s attention.
Top managers of large companies lived with another fear, too. Well-known corporate raiders—including Ivan Boesky, Carl Icahn, Ronald Perelman, and T. Boone Pickens—routinely bought large stakes in companies and then ousted ineffective managers to boost the value of shares. Greed was good for these raiders (and, sometimes, for shareholders), but it wasn’t good for the managers, who scrambled to create defenses against these takeovers and thus preserve their jobs. To the extent the 1980s involved complex financial dealings, they were focused on these increasingly intricate takeover defenses.
Still, most finance professionals—even highly paid investment bankers—were technologically primitive, without e-mail or the Internet. They used HP12C calculators instead of computer spreadsheets and statistical software. Few had formal finance training, and almost no one had a math or finance Ph.D. A 1980s trader would be virtually unemployable today; his HP12C would be about as useful on a trading floor as an abacus.
Individuals were technologically primitive, too. Investors placed orders to buy and sell stock by letter or over the phone, not with the click of a computer mouse. People learned how their stocks were performing at most once a day, from the financial pages of the morning newspaper, not in real time on television. Financial analysis was available through the mail at a price, not on the Internet for free.
In sum, the 1980s were a relatively primitive period on Wall Street. Life was uncomplicated, if aggressive. Participants were labeled barbarians, predators, even thieves. At the same time, the financial markets became increasingly competitive and profit margins dwindled. The stock market crash of October 19, 1987, didn’t help matters. After the Dow Jones Industrial Average tumbled 508 points, or more than 22 percent, in one day, investors became skittish. As analysts struggled to explain the collapse, the investment bankers’ business sputtered. The last years of the decade were likely to be lean, and the future looked grim. It was not a good time to be working on Wall Street.
All of this was about to change.


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.1 He was a competitive athlete and briefly played professional tennis on the European circuit.2 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.3 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 now includes dozens of specialized courses in finance—barely touched currency options when Krieger was there.4 But J. Orlin Grabbe, a young finance professor at Wharton and a pioneer in the area,5 became Krieger’s mentor and taught him just enough to whet his appetite.6 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.”7 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.”8 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.9 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.10
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. 11 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.12 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.13 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.14 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.


On Sale
Sep 8, 2009
Page Count
496 pages

Frank Partnoy

About the Author

Frank Partnoy is the author of F.I.A.S.C.O., Infectious Greed, and The Match King. Formerly an investment banker at Morgan Stanley and a practicing corporate lawyer, he is one of the world’s leading experts on market regulation and is a frequent commentator for the Financial Times, the New York Times, NPR, and CBS’s 60 Minutes. Partnoy is a graduate of Yale Law School and is the George E. Barrett Professor of Law and Finance and the founding director of the Center for Corporate and Securities Law at the University of San Diego.

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