Table of Contents Praise Also by Frank Partnoy Title Page Dedication Epigraph Introduction STAGE ONE - INFECTION Chapter - PATIENT ZERO Chapter - MONKEYS ON THEIR BACKS Chapter - WHEAT FIRST SECURITIES Chapter - UNRECONCILED BALANCES Chapter - A NEW BREED OF SPECULATOR STAGE TWO - INCUBATION Chapter - MORALS OF THE MARKETPLACE Chapter - MESSAGES RECEIVED STAGE THREE - EPIDEMIC Chapter - THE DOMINO EFFECT Chapter - THE LAST ONE TO THE PARTY Chapter 10 - THE WORLD’S GREATEST COMPANY Chapter 11 - HOT POTATO EPILOGUE NOTES Acknowledgements INDEX ABOUT THE AUTHOR Copyright Page 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 NationsBank NationsSecurities, Term Trusts and Navigant Negative tips Netherlands Netmarket.com Netscape New-deal profit New York Federal Reserve Bank New York magazine New York Mercantile Exchange New York Review of Books New York Stock Exchange New York Times New Yorker, The New Zealand Newman, Frank N NewPower Holdings Nicholas, Nicholas J., Jr Niederhoffer, Victor 1980s Nitec Paper Corporation Nixon, Richard M Non-recourse financing Noonan, Timothy North, Oliver Notational value Novell Nuclear waste (Wall Street term) Nutrition 21, Inc O’Conner, William O’Conner & Associates Off-balance sheet transactions 1992 speech expressing concern about Enron and Special Purpose Entities (SPEs) and swaps Offshore activities, corporate Ohio Pharmacy Board Olofson, Roy Omega Partners On-the-run/off-the-run Treasury bond trade O’Neill, Paul Ong, Belita Optics of a trade Options basic explanation of call long-term stock-index Meriwether’s Arbitrage Group and premium put options valuing See also Currency options Orange County, California Over-the-counter markets for currency options Overseas Chinese Bank Ovitz, Michael Owens Corning Oxford Health Plans Pacific Asset Holdings Pacific Gas & Electric Pai, Lou PaineWebber Palm Pappas, Jay Parity (put-call parity) Parker, Dane Parsons, John PCG Telecom Peat Marwick PERCS Pereira, Paulo V Ferraz Perella, Joseph Perelman, Ronald PERLS Perrone, Joseph P PG&E Philippines Phillips Petroleum Pickens, T Boone Piper, Tad Piper Jaffray Institutional Government Income-Portfolio Pitt, Harvey PNC Financial Poland Pomrenze, Jay Powers, William, Jr Preferred stock novel types of Preiskel, Barbara Scott Prepaid swaps Prepayment risk President’s Working Group on Financial Markets Price/earnings ratios PricewaterhouseCoopers PRIDES Private placements Private Securities Litigation Reform Act of 1995 Procter & Gamble Procter & Gamble v Bankers Trust Proxy basket of currencies Prudential plc PT Adimitra Rayapratama PT Dharmala Sakti Sejahtera Pulliam, Susan Put options Putnam Management Quantum Fund Quattrone, Frank Qwest Communications Raabe, Matthew Ramius Capital Random Walk Down Wall Street, A (Malkiel) Random walk hypothesis Ranieri, Lewis Reagan, Ronald Receivables, transferring See Structured finance Recommendations Rector, William Reg FD (fair-disclosure rule) Regulation and regulators British credit ratings’ importance to criminal prosecutions and derivatives exemption of over-the-counter derivatives from federal regulation failure to punish financial malfeasance foreign companies, prosecution of Japanese loss-of-control daisy chain prosecuting fraud recommendations for shifting from rules to standards See also Deregulation; specific agencies Regulatory arbitrage Rekenthaler, John Related Party transactions Enron and Reliant Energy Restricted stock Revco Rhythms NetConnections Rigas family Risk-Adjusted Return on Capital (RAROC) Risk arbitrage Risk models Value-at-Risk (VAR) Rite Aid RJR Nabisco Robertson, Julian Rogue Trader Rohrbach, Clayton J Roll Call Rooney, Pace Rooney, Phillip Rose, Charlie Rosenfeld, Eric Rubin, Howard Rubin, Robert Rusnak, John M Russia S G Warburg & Co Sallie Mae Salomon Brothers Arbitrage Group bonuses at DECS and derivatives subsidiary (Salomon Swapco) Krieger at Meriwether at mortgage bonds and risk management at WorldCom and See also Grubman, Jack; Mozer, Paul Salomon Swapco Samuelson, Paul Sandoz Corp Sanford, Charles S., Jr Sarbanes, Paul Saunders, Ernest Savings-and-loan crisis Saylor, Michael Jerry Scanlon, Jack Schmidt, John Scholes, Myron Schultz, Paul Scott Paper Sears Securities analysts conflicts of interest Enron collapse and Internet securities and rating of stocks by See also names of individuals Securities and Exchange Commission (SEC) Arthur Andersen and Bankers Trust and Bruntjen and disclosure of derivative risks in financial reports and enforcement powers Enron and Howard Rubin and IPO schemes and jurisdiction of Kidder Peabody and Levitt and NationsSecurities and Orange County and Piper Jaffray and Pitt and private placements and Regulation FD revenue recognition practices and Rite Aid and Rule simple fraud cases, tendency to prosecute Sunbeam and three percent rule and treatment of traders in complex-financial instruments WorldCom and Securitization Collateralized Bond Obligations (CBOs) mortgage bonds Self-regulatory approach to the markets Sellers, Patricia Sequa ServiceMaster Shanks, Eugene Sharpe ratio Shaw, David Shearson Lehman Brothers Shelf registrations Shlieifer, Andrei Shore, Andrew Shorting stock Sidgmore, John W Siegel, Jeremy Siegel, Martin Signature Brands Silicon Valley high-technology companies IPOs Silverman, Henry R Simon, United States v Single-stock futures 60 Minutes Skilling, Jeffrey Skinner, Doug Smith, Randall Smith, Roy Smith Barney Société Générale Soros, George Sosin, Howard Sotoudeh, Mohamad Southampton Place (Enron partnership) SPDR Trust (Spiders) Special Purpose Entities (SPEs) disclosure requirements and Enron and origin of three-percent rule Sperry Lease Finance Corp Spiders (SPDR Trust) Spiegel, Thomas Spitzer, Eliot St Olaf College Stamenson, Michael Standard & Poor’s Corp (S&P) Orange County, California and See also Credit-rating agencies State of Wisconsin Investment Board Steinhardt, Michael Steinhardt Partners Stepanian, Ira Stewart, Martha Stock-index options, long-term Stock market crash of 1987 Stock market speculative bubble of 1990s CEOs and See also IPOs (Initial Public Offerings); Securities analysts Stock options accounting for caps on corporate tax deduction for corporate salaries and effect on behavior of corporate executives at Enron grants of stock versus indexed outperformance reloading of repricing of valuation of Stocks betting against Stocks for the Long Run (Siegel) Stone, Andrew Stout, Lynn A Strauss, Thomas STRIPS principal-only Structured finance Collateralized Bond Obligations (CBOs) Enron and purpose of Structured notes complexity of correlation risk of credit ratings of described inverse floaters issuers of Quantos sellers of Thai Baht Basket-Linked Notes Student Loan Marketing Association (Sallie Mae) Subprime mortgages Suharto family “Suitability” rules Sullivan, Scott Sumitomo Corporation Summers, Lawrence Sunbeam Corporation Supreme Court Swaps Bankers Trust and currency “diff” difficulty of evaluating complex Enron and of Indefeasible Rights of Use (IRUs) Japanese banks’ use of as off-balance sheet transactions plain-vanilla prepaid as unregulated and immune from disclosure requirements See also Credit default swaps; Interest rate swaps; International Swap Dealers Association (ISDA) Sybase Systemic risk Takeovers corporate raiders Tappin, Todd Tauzin, W J “Billy” Tax-avoidance trades Taylor, Justice Gary L Technology and financial trading See Financial technology Technology Crossover Ventures Tele-Communications Inc Telecommunications industry See also individual companies Tellabs Temple, Nancy Teneco Tesobonos Texas Instruments Thai baht structured notes and Thailand Thaler, Richard Three-percent rule 3Com 3M Employee Retirement Income Plan Tiger Management Tjiwi Kimia Tokyo Securities Towers Financial Toyota Tracking stock Treasurers, corporate Treasury-bond auctions Mozer’s activities 35 percent rule when-issued market Treasury Department, U.S Treasury-Linked Swap TriCapital Ltd Trimedia Trump, Donald Tudor Investment Corporation Tversky, Amos Tyco International Underwriters Financial Group Underwriting disclosure of fees NASD Rule of Fair Practice 44(c) Union Bank of Switzerland United Services Advisors United States v Simon Universal banking Unterberg, Thomas Uptick rule Urbani, David U.S Bankcorp USA Waste Services VA Linux Value-At-Risk (VAR) measures Value Line Vanguard VAR (Value-At-Risk) measures Vazquez, Mitchell Veribanc Inc Vinson & Elkins Volatility of currencies implied volatilities of mortgages negative convexity and objective measures of of options Volvo Vranos, Michael W R Grace Wachovia Wachtell, Lipton, Rosen & Katz Wakeham, Lord John Waldron, Murray Walker, Richard H Wall Street (film) Wall Street Journal Walsh, Brian Washington Post Wasserstein, Bruce Waste Management Watkins, Sherron Watson, Charles Weather derivatives Weatherstone, Dennis Welch, Jack F., Jr Kidder Peabody and Whalley, Greg Wharton School of Business Wheat, Allen at Bankers Trust at CS First Boston CSFP and White, Thomas Whitehead, Edwin Wilczynski, Melvin Williams Companies Winnick, Gary “Winnick House” Withit.com Wood, Judge Kimba World Bank WorldCom board of directors credit-rating agencies and IPO line costs and manipulation of financial statements Xerox Yahoo! Yeutter, Clayton Yield curve Yoon, Jennifer Young, Judge H Peter Yukihusa Fujita Z-bonds Zero-coupon Treasury bonds Zero-margin loans ZZZZ Best ABOUT THE AUTHOR FRANK PARTNOY is the author of F.I.A.S.C.O.: Blood in the Water on Wall Street and The Match King: Ivar Krueger, the Financial Genius Behind a Century of Wall Street Scandals He has worked as an investment banker at Morgan Stanley and as a corporate lawyer, and has testified as an expert before both the United States Senate and House of Representatives A graduate of Yale Law School, he is the George E Barrett Professor of Law and Finance at the University of San Diego PublicAffairs is a publishing house founded in 1997 It is a tribute to the standards, values, and flair of three persons who have served as mentors to countless reporters, writers, editors, and book people of all kinds, including me I F STONE, proprietor of I F Stone’s Weekly , combined a commitment to the First Amendment with entrepreneurial zeal and reporting skill and became one of the great independent journalists in American history At the age of eighty, Izzy published The Trial of Socrates, which was a national bestseller He wrote the book after he taught himself ancient Greek BENJAMIN C B RADLEE was for nearly thirty years the charismatic editorial leader of The Washington Post It was Ben who gave the Post the range and courage to pursue such historic issues as Watergate He supported his reporters with a tenacity that made them fearless and it is no accident that so many became authors of influential, best-selling books ROBERT L BERNSTEIN, the chief executive of Random House for more than a quarter century, guided one of the nation’s premier publishing houses Bob was personally responsible for many books of political dissent and argument that challenged tyranny around the globe He is also the founder and longtime chair of Human Rights Watch, one of the most respected human rights organizations in the world For fifty years, the banner of Public Affairs Press was carried by its owner Morris B Schnapper, who published Gandhi, Nasser, Toynbee, Truman, and about 1,500 other authors In 1983, Schnapper was described by The Washington Post as “a redoubtable gadfly.” His legacy will endure in the books to come Peter Osnos, Founder and Editor-at-Large eISBN : 978-0-786-73355-2 Copyright © 2009 by Frank Partnoy Paperback edition published in 2004 by Holt Paperbacks, Henry Holt and Company, LLC Revised paperback edition published in 2009 in the United States by PublicAffairs™, a member of the Perseus Books Group All rights reserved No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews For information, address PublicAffairs, 250 West 57th Street, Suite 1321, New York, NY 10107 PublicAffairs books are available at special discounts for bulk purchases in the U.S by corporations, institutions, and other organizations For more information, please contact the Special Markets Department at the Perseus Books Group, 2300 Chestnut Street, Suite 200, Philadelphia, PA 19103, call (800) 810-4145, ext 5000, or e-mail special.markets@perseusbooks.com Library of Congress Cataloging-in-Publication Data Partnoy, Frank p cm I Securities fraud—United States Financial services industry—Corrupt practices—United States Corporations—United States— Corrupt practices Corporations—Auditing—United States Fraud—United States—Prevention I Title: How deceit and risk corrupted the financial markets II Title HV6769.P37 2003 338.6’041’0973—dc21 2002040898 ... 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. .. from the start He traded all day long, from the early morning when the London markets opened until the early evening, when the New York markets closed Then he went home, and traded the Tokyo markets. .. options were new, they were based on the currency markets themselves Most traders agreed that they could not outguess or even affect currency markets in the long run Then how did Andy Krieger make