Partnoy's complaint

Philip Sadler on the unsettling lack of control in financial markets

The 1990s were a decade of continually rising share prices and related investor confidence, the longest running bull market since the second world war. The period also saw a large number of financial collapses, scandals and cases of fraud. But as each new debacle outdid its predecessors in scale and complexity, the strength of the bull run and the confidence of investors remained unshaken. The general view was that the financial markets were not spinning out of control; bad apples would inevitably appear from time to time and would be dealt with, but the financial system was not under serious threat.

Frank Partnoy, a former Wall Street trader turned university law professor, argues the case for a more pessimistic view and believes that the appearance of control in today's financial markets is an illusion.

Although a handful of regulators or Wall Street managers have known about some of the systemic problems, individual investors have been largely oblivious to the very real dangers of a market meltdown.

Partnoy points to a number of changes since the 1980s that have contributed to the growing fragility of the system. They include the growth of 24-hour trading, the deregulation of markets, the increasing complexity of financial instruments, the growth of private contracts (so-called over-the-counter trades) and the increased separation of ownership from control in large corporations.

In the 1980s, derivatives, that is, financial instruments whose value is derived from other assets, were relatively unknown. The two basic types of derivatives in use at that time - options and futures - were traded on regulated exchanges and enabled money managers to reduce their exposure to risk. Also in use, but in a minor way, were 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.

Stock options for top executives were uncommon. Most financial professionals were technologically primitive by today's standards, lacking email, the internet, spreadsheets or statistical software. Few had received formal training in finance, and PhDs in mathematics were rare indeed. At the same time, the markets were well policed and prosecutors clamped down hard on cases of fraud. Individual investors, too, lacked today's technology.

Partnoy offers the reader accounts of some of the most notorious financial scandals and scams of the 1990s. Although they are highly technical, Partnoy has a very readable style. He relates the exploits of traders who became legendary on account of the profits they made and the bonuses they earned - people such as Frank Quattrone who, in the late 1990s, was reputed to be earning $100 million (£64 million) a year. Partnoy goes into detail about such illicit trades as the currency speculations carried out by Nick Leeson, which eventually led to the collapse of Barings. The sins of such august institutions as CSFB, Salomon Brothers, Bankers Trust, Merrill Lynch and Deutsche Bank are well documented.

One of the most interesting cases is that of the bankruptcy of Orange County, California, and how the treasurer's investment strategy led to losses of $1.7 billion. Instead of buying US treasury bonds, he bought a form of derivative known as structured notes, mainly from Merrill Lynch.

These contained complex formulas that, in essence, were a bet on interest rates remaining low. He not only bet $7.4 billion of taxpayers' money, he also borrowed about $13 billion and invested that. The trades were very profitable for Merrill, which made $62.4 million from Orange County in 1993 and 1994. The treasurer lost his bets when the Federal Reserve raised interest rates.

Partnoy is highly critical of the role played in this and other financial disasters by the credit rating agencies, Standard and Poors and Moody's.

Not only did they give AAA ratings to the structured notes, thus enabling the treasurer to fit his large interest rate bets within the technical limits of his investment powers, they gave Orange County's own bonds AAA ratings right up to December 1994 when the county filed for bankruptcy.

At the heart of this affair and many others lay the greatly increased complexity of derivatives, which was making it virtually impossible for even the most sophisticated investors to evaluate the risks. In consequence the treasury departments of many blue-chip companies such as Procter and Gamble lost millions. In many cases, the complexity reflected ingenious ways invented by traders to enable their companies to avoid regulations.

For example, Japanese insurance companies were prohibited from investing in equities, a rule that was frustrating as long as the Nikkei index continued to rise. Bankers Trust developed a form of security known as an equity derivative enabling the Japanese to circumvent the rule. It was, in effect, a bet on the Nikkei, so when the Japanese stock market declined a year later, the companies suffered substantial losses.

Probably the best known of all the financial debacles as a result of the use of derivatives is that of Long Term Capital Management. LTCM, a so-called top-of-the-range hedge fund, was founded by an outstandingly successful trader, John Meriwether. He employed some highly qualified people including two Nobel prizewinners. Investors rushed to put money with the team and banks were equally keen to make them unsecured loans. From April 1994 LTCM enjoyed a four-year run of substantial profits. Banks that were selling complex derivatives to their clients began to pay LTCM to take on the more esoteric risks. By 1997, the fund employed no fewer than 25 PhDs. It had about $4.7 billion of equity that it used to borrow $125 billion and enter into $1.25 trillion of derivatives. In August 1998, Russia defaulted on some of its debts, triggering a crisis in the markets as financial institutions that had borrowed to buy Russian bonds were forced to sell other investments to raise cash. In particular, they were dumping stocks and bonds in emerging markets in Latin America, Eastern Europe and Asia. LTCM's computer models had assumed that losses in some investments would be compensated by gains in others. At this time, however, almost every market went down and LTCM's position began to unwind rapidly.

Faced with the prospect of the worst financial crisis the world had experienced in half a century, 14 banks agreed to contribute $13 billion in return for a 90 per cent stake in the company. The crisis was avoided, but the downside was that others drew from the events the lesson that if you failed on a large enough scale, either the government or other players in the system would bail you out.

Partnoy's thoroughness is evidenced by the fact that he devotes one whole chapter of more than 50 pages to the story of Enron's collapse, a story that is more complex than the accounts given in the financial press at the time. Important as it was, Enron's collapse was one example of many of what can happen when top executives start running companies in their own interests rather than in the interests of shareholders and other stakeholders. Partnoy points to the role of share options and the obsessive concern with shareholder value as contributory influences.

He makes six recommendations to help prevent serious damage to the investment system. First, treat derivatives like other financial instruments, that is, make them subject to the same prohibitions on fraud, the same disclosure requirements, the same banking regulations and so on.

Second, shift away from narrow rules that parties have been able to circumvent and adopt broader standards. Third, eliminate the "oligopoly of gatekeepers", such as auditors, lawyers and, especially, credit-rating agencies. Fourth, prosecute complex financial fraud effectively. Fifth, encourage informed investors to bet against stocks to prevent speculative bubbles. Sixth, encourage investors to control and monitor their investments.

These recommendations are forcefully argued but leave one feeling that, even in the unlikely event that they were all adopted, infectious greed would still prevail.

Perhaps the best indicator of the extent to which this book can engage the reader is the fact that while reading it on the train from London to my home, I missed my station.

Philip Sadler is vice-president, Ashridge Business School.