Bulls and blaspheming beasts

May 16, 2003

Frank Partnoy, who saw what the regulators missed in Enron's public accounts, tells Karen Gold that financial markets are spinning out of control and in danger of collapse

Between 1996 and 2000, the US energy giant Enron told shareholders that its profits amounted to $1.8 billion. Over the same period, Enron submitted accounts to the US tax service claiming that the company made a trading loss totalling $1 billion. Both figures were in the public domain. But until Enron's spectacular collapse in October 2001, no one had brought them together.

The man who did was Frank Partnoy, a law professor at the University of San Diego with a special interest in corruption and financial markets. Giving evidence to the congressional committee investigating Enron in 2002, he cited a host of published accounting discrepancies that should have alerted auditors, regulators and investors long before the company hit the rocks.

"When I testified before the US Senate, the things they found most outrageous were things I had got out of reading Enron's annual report," he says. "At one point, I said something about Footnote 16 (a small-print reference to a dubious stock-swap deal that implied large profits but lost millions). One senator joked that 'Oh yes, I'm very familiar with Footnote 16'. But I was serious. He should be familiar with Footnote 16. That's where crucial things were disclosed."

The kind of "crucial things" engaged in by Enron included creating company partnerships to disguise debts, forming offshore borrowing schemes to avoid tax and speculating in its own shares and in high-risk derivatives. Partnoy has made a career of exposing such dodges. In his latest book, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets , Partnoy notes that none of these activities was against US law: "Relative to many of its peers, Enron was a profitable, well-run and law-abiding firm."

Instead, the tactics were outside the law: the result of a "beat the regulator" culture that Partnoy dates to the early 1990s, when manufacturing companies, traders, banks, insurance companies, auditors and regulators - with a wink from politicians - spotted the lucrative potential of the 24/7, information-rich world created by the internet.

Today, the derivatives market (a derivative is a bond whose value depends on the outcome of a bet on, say, currency movements), which did not even exist in the 1980s, is worth trillions of dollars - and is even more vulnerable to bubble-bursting activity such as the bets with which Nick Leeson brought down Barings Bank, Partnoy says.

Deals are so complex, he adds, that regulators, shareholders and prosecutors seem to have given up hope of even understanding them. "Any appearance of control in today's financial markets is only an illusion. The markets are spinning out of control. The risk of system-wide collapse is greater than ever."

Partnoy knows all this because for two years he was a member of the high-living, hard-drinking, skeet-shooting, blaspheming club that created it. In 1993, Partnoy, a bright Kansas boy with maths and law degrees, went to work for Morgan Stanley, the once-genteel investment bank turned aggressive money-maker in the late 1980s.

Having sold himself to MS as a useful law expert - "People buying deals often came to you and said, 'Here's this regulation we need to get around. Can you come up with a way for us to do it?'" - he joined its derivatives trading desk. Over two years, the 70-strong group made MS $1 billion in fees.

Partnoy's work culminated in his living in a top-floor suite at Tokyo's Imperial Hotel and designing bonds to allow Japanese banks and insurance companies to skirt the bars on their speculation in foreign currencies. Along the way, he had worked alongside or on deals that looked like safe investments in US bonds but were in fact high-risk bets on Thai bahts or Mexican pesos.

He had watched as Proctor and Gamble lost more than $100 million on such bets and as Orange County's chief finance officer speculated away the district's pension fund. He had heard his colleagues boast of "ripping the faces off" their clients.

And yet, he says, quitting the trading floor to teach law was not a moral decision. He had learnt all he needed to know about how markets worked, and he simply didn't like working there. "We used to play a game on the trading floor about what jobs we would rather do if the money was the same.

Everyone, male and female, agreed they would prefer to be a prostitute, dig holes, work in a fast-food restaurant or shovel manure. The primary reason people do these jobs is to make large amounts of money. For me, the money wasn't important enough."

Analysing the experience in his first, best-selling, book, which came out in 1997 - F.I.A.S.C.O: Blood in the Water on Wall Street - as well as in his new book, he points the finger firmly at regulators' failure to intervene as it became obvious that traditional controls on companies, banks and markets were not working.

In England, Partnoy says, the rules were tougher and willingness to prosecute stronger: "Howard Davies (chairman of the Financial Services Authority) really does understand these markets. He knows where the bodies are buried." But in the US, the Securities and Exchange Commission was not only weak, it was overrun by lobbying and political pressure to push self-regulation.

Five separate attempts by Congress to regulate derivatives trading have failed, Partnoy says. Each time, lobbyists got politicians to water down the proposals. Presidential change made no difference: it was Bill Clinton who, after a run-in with Wall Street in his 1992 election campaign, famously said: "You mean to tell me ... that my re-election hinges on the Federal Reserve and a bunch of ****ing bond traders?"

Only this year, Partnoy says, in an effort to prevent another Enron, Congress passed legislation insisting that companies include in their annual reports details of any transaction that "may" affect their financial position. When the SEC published the final rules, the word "may" had been changed to "reasonably likely" - a phrase specifically rejected by the law-makers as too weak.

Universities, too, must bear some responsibility for the culture of greed.

The laissez-faire intellectual framework that enables a deregulated free-for-all was the invention of academe, Partnoy says. "There's a whole generation of professors of finance from the University of Chicago who believe markets are efficient. All the people in positions of power, CEOs, government regulators, were educated by these people with an almost religious belief in markets."

Such people set the tone, and they hired new-style traders, the "geeks and rocket scientists" with maths degrees and PhDs, who turned the nice-but-dim tradition of banking into a rapacious monster. "Business schools didn't take ethics seriously. It used to be a joke that business ethics was an oxymoron. After F.I.A.S.C.O , I had letters from students everywhere, America, Dublin, London, saying they were thrilled to read about Morgan Stanley as such a cutting-edge company and how could they get a job there."

That free-for-all mood is changing, he says, but regulation is still failing. Rules must moderate the derivatives market just as they do other markets, Partnoy argues. It is no use saying that corporate investors can protect themselves. "Large companies can be babes in the wood compared to Wall Street bankers." Credit agencies need to be reformed and prosecutors encouraged to bring cases of complex financial fraud.

Above all, individual investors need to band together to exert pressure on the people who take their money and put it in pension funds or promise a mysterious extra half-per cent interest. No one should touch companies whose annual reports are not crystal clear, Parnoy argues. "I don't understand why people don't try to get answers about companies that they are investing in. One person can't look after themselves on their own. But if people - rather than just investing in a mutual fund - spent half an hour a month looking at financial statements, there would be enormous pressure. If you think about how much time people put into buying a car, then I don't have a lot of sympathy if they throw up their hands and say, 'I can't possibly understand it'.

"Enron is the tip of the iceberg. But not every company is bad, not every manager is corrupt. Some businesses are what they say they are, and it's important for the global economy that investors find them and put their money in them. Otherwise, the markets really are doomed."

Infectious Greed is published by Profile Books (£20.00).

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