Infectious Greed (31 page)

Instead, the case focused on the potential abuses of securities litigation. In a 5-to-4 decision, Justice Anthony Kennedy argued for the majority that liability for securities fraud demanded “certainty and predictability,” citing testimony that in 83 percent of cases, accounting firms paid $8 in legal fees for every $1 paid in damages to investors. Just a few years after the decision, few people would have such a sympathetic view of accounting firms.

In 1995, Congress joined the Supreme Court in limiting securities lawsuits. The legislative limitations had been in the works since 1991, when Richard C. Breeden, the previous SEC chairman, had testified before Congress that “because baseless securities litigation amounts to a ‘tax on capital,' which undermines economic competitiveness, there is a strong public interest in eliminating meritless suits.” In 1992, Representative W. J. “Billy” Tauzin, a Democrat from Louisiana, had introduced legislation limiting liability for securities fraud.

Arthur Levitt supported these limitations. In January 1994, Levitt began arguing in speeches that abusive litigation imposed tremendous costs on issuers of securities. He said the legal system failed to distinguish between strong and weak cases. Many lawyers viewed Levitt—in
his words—as “the single greatest threat to the continued viability of private remedies against fraud.”
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The proposed legislation was directed at one lawyer in particular, Bill Lerach, a well-known and much-feared litigator in the San Diego office of the law firm known as Milberg Weiss. Lerach had recovered billions of dollars for shareholders, although his reputation had been tarnished by some less meritorious suits. Companies commiserated about being “Lerached,” which meant they had been sued by Bill Lerach for securities fraud. As the cost of defending these suits increased, the support for restrictions increased.

(Surprisingly, Lerach and Milberg Weiss were largely missing from the lawsuits related to derivatives. The cases were extremely complicated and costly to pursue, and it wasn't at all clear they would succeed. At the time, Lerach preferred simpler suits involving insider trading or blatant financial fraud.)

When Republicans captured the House of Representatives in November 1994—for the first time since the Eisenhower era—securities-litigation reform was assured. In a January 1995 speech, Levitt outlined the limits on securities regulation that Congress later would support: limiting the statute-of-limitations period for filing lawsuits, restricting legal fees paid to lead plaintiffs, eliminating punitive-damages provisions from securities lawsuits, requiring plaintiffs to allege more clearly that a defendant acted with reckless intent, and exempting “forward looking statements”—essentially, projections about a company's future—from legal liability.
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The Private Securities Litigation Reform Act of 1995 passed easily, and Congress even overrode the veto of President Clinton, who either had a fleeting change of heart about financial markets or decided that trial lawyers were an even more important constituency than Wall Street. In any event, Clinton and Levitt disagreed about the issue, although it wasn't fatal to Levitt, who would remain SEC chair for another five years.

The PSLRA, as the law became known, made securities-fraud suits more difficult for plaintiffs to sustain. Many legislators believed that result was a positive one; investors' advocates thought it was a negative. Although there were arguments on both sides, it seemed that, with the government no longer aggressively pursuing criminal prosecutions for financial fraud, and with new limits on plaintiffs' lawyers, corporations and their managers would be governed more by their own moral values and reputations than any legal constraint.

One money manager, James S. Chanos, was skeptical that the markets alone would provide sufficient discipline to Wall Street, major corporations, accounting firms, and lawyers. Reflecting on the dramatic increase in financial fraud from 1995 through 2001, he told the House Energy Committee that the PSLRA was responsible for many of the abuses that followed: “That statute, in my opinion, has emboldened dishonest managements to lie with impunity, by relieving them of concern that those to whom they lie will have legal recourse. The statute also seems to shield underwriters and accountants from the consequences of lax performance.”

 

 

T
he losses at Kidder Peabody were a prime example of how legal rules did not prevent or deter financial manipulation. They did not create incentives for managers to control their employees at the outset, and they did not punish them for failure to supervise them after damage was done. As Kidder Peabody showed, the only remaining penalty was the destruction of the corporation, a penalty that was imposed more on shareholders than on the perpetrators who caused the loss.

The $350 million of losses at Kidder were even more troubling than the hundreds of millions of dollars in unreconciled balances at Bankers Trust and Salomon Brothers, for two reasons. First, they involved much more straightforward financial instruments than Bankers Trust and Salomon had traded, instruments for which there was a liquid market and there were even daily quotes in the newspaper. Second, unlike Bankers Trust and Salomon Brothers, whose shareholders understood that those firms' focus was on financial markets, Kidder Peabody was owned by General Electric, whose shareholders considered that firm to be primarily industrial in focus. GE shareholders never imagined the company was taking speculative bond positions in the range of $40 billion, twenty times the biggest trades Andy Krieger had made at Bankers Trust.

The news about Kidder was a black mark on the record of John F. Welch Jr., the longtime chairman of General Electric. Welch had a reputation for building top businesses, slashing costs, and producing consistent profits. When he began running General Electric, Welch fired one in four employees, even as he spent $25 million on a new guest house and conference center at GE's corporate headquarters.
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He became known as “Neutron Jack” for his practice of buying firms and leaving the buildings
intact while eliminating all the people.
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His strategy was to be first or second in a business, or abandon it. He set firm quarterly and annual targets for his businesses, and managers met them—or else. The strategy seemed to work: for fifty-one straight quarters, GE's earnings were higher than those of the previous year.

Welch was also legendary for his brusque temper and management style; not surprisingly, he was livid about the losses at Kidder. General Electric had purchased Kidder in 1986, when the investment bank was suffering through a series of 1980s insider-trading scandals. (Martin Siegel, Kidder's investment-banking superstar, did time in prison.)

After GE bought Kidder, Welch provided special support for Kidder's personnel, including Edward Cerullo, the head of bond trading. Welch was reportedly “intense” in his determination to fix Kidder, although analysts questioned his obsession with bond trading, and wondered why it was so “critical” or “vital” to a company like General Electric.
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But Welch knew of the profits at Bankers Trust, First Boston, and Salomon Brothers. Although shareholders still thought of General Electric for its lightbulbs, in reality GE under Welch already had become much more like an investment bank. It increasingly depended on GE Capital, the subsidiary that had issued billions of dollars of structured notes. By 1993, GE Capital was responsible for more than a third of GE's earnings. Although Welch lacked experience in modern finance, he had great confidence in his employees, and he gave them free rein to meet his performance targets.

At first, GE seemed to have turned Kidder around, cutting costs and even acquiring Drexel Burnham Lambert's trading floor when that firm went under in 1990.
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Kidder's employees were well paid and morale was high. Ed Cerullo stressed that Kidder would reward people based purely on their performance. Two of Cerullo's top hires fit this performance focus: Melvin Mullin, a mathematics Ph.D. who built Kidder's structured notes and options businesses into profitable lines that made $58 million in 1993,
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and Michael Vranos, a shy mathematics undergraduate who turned Kidder into one of the top mortgage-trading firms on Wall Street. By 1993, Kidder would succeed Salomon Brothers as the top mortgage-trading firm; it was the firm that sold Worth Bruntjen and David Askin many of their inverse IOs.

Jack Welch didn't meddle in the details of Kidder's business, but he provided unwavering support, giving the firm more than a billion dollars of capital, and introducing Kidder bankers to GE's top clients. Throughout
the late 1980s and early 1990s, Jack Welch sent one simple message to Kidder employees: “stretch goals.”
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Welch wanted GE to be the dominant firm in
all
of its businesses. With Kidder, Welch could add a top Wall Street trading operation to GE's diverse mix of businesses.

Several experts questioned whether Welch was asking for trouble by combining a hands-off approach with a relentless focus on producing profits. Samuel Hayes, a professor at Harvard Business School, said Welch “has built a culture of individual fiefdoms, and that decentralized responsibility leaves a firm like GE vulnerable.”
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Edward Lawler, director of the Center for Effective Organizations at the University of Southern California, said, “Welch is intimidating, tough. GE's culture is results oriented, and that's the reason they do well and also break rules. It's the opposite side of the same coin.”
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Welch began learning about some of these broken rules in early 1994, even before the Fed raised rates. In January, Kidder fired Clifford Kaplan, a 28-year-old derivatives vice president who had made a laughingstock of the firm, not only by costing Kidder almost $2 million in cost overruns on a botched derivatives deal involving Italian government bonds, but also by showing that he could keep a job at Kidder while also being employed by the U.S. unit of La Compagnie Financière Edmond de Rothschild Banque, of Paris.
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Kidder had paid Kaplan a $500,000 bonus the previous year, even though he did not even have a securities license while he was marketing the Italian deal.

Then Kidder discovered that one of its swaps traders had hidden $11 million in losses on a bond derivatives deal with NationsBank, and that one of its options traders had hidden $6 million in losses on French and Spanish government-bond options. It looked like no one was minding the store, and Jack Welch seemed concerned. He told
Fortune
magazine, in a March 7, 1994, interview about Kidder, “Things tend to grow to the sky, get momentum. ‘Let's make it a little higher, a little higher.' I think we've learned a lot about that.”

Some employees blamed the problems on 46-year-old Melvin Mullin, the math Ph.D. who had developed Kidder's derivatives businesses and then ran its government-bond trading desk. But in many instances, Mullin appeared to be simply following his marching orders from Jack Welch. When Clifford Kaplan said, “Mel was totally ‘hands off.' Mel was purely driven by profit—profit, always profit,” it wasn't clear if the comment was praise or criticism.
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Was it a negative when Mullin permitted Kaplan to work on a derivatives deal without a proper securities license? Was it a negative when Mullin ignored warnings about a deal that violated Japanese banking laws? Was it a negative when he hired and supervised his wife, helped her determine her own bonus of $900,000, and then inadvertently double-hedged her options portfolio, costing Kidder $2 million?
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Okay, the last one was obviously a negative, but the others were arguably consistent with the culture Jack Welch was trying to create, and Mullin's “hands-off” approach seemed to be generating profits.

In 1991, Mullin took the step that would destroy his career, as well as the career of his boss, Edward Cerullo, and would bring down Kidder Peabody. He hired a young bond trader named Orlando Joseph Jett. When Melvin Mullin interviewed Joseph Jett, he said Jett “seemed like a hard worker with quantitative skills.” Kidder wasn't bothered by the fact that First Boston had just fired Jett, or that he had lasted only a short time before that at Morgan Stanley, his first job after graduating from Harvard Business School. Jett began working at Kidder in July 1991.

Mullin assigned Jett to trade long-maturity U.S. government bonds called “STRIPS.”
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STRIPS were
zero-coupon
Treasury bonds, meaning obligations of the U.S. government that repaid principal at maturity but did not pay any coupons in the interim. STRIPS were created from the Treasury bonds traders like Paul Mozer, at Salomon Brothers, bought through a federal-government program called “Separate Trading of Registered Interest and Principal of Securities” (hence, the acronym STRIPS).

The “stripping” resembled the separating of interest and principal on mortgages, except that the Federal Reserve Bank of New York did all the hard work. As a trader at Kidder, Jett could simply buy a Treasury bond and present it to the Fed. In return, he would receive a collection of STRIPS: one small STRIPS for each semi-annual interest payment, and one big STRIPS representing the repayment of principal. Each one gave him the right to receive a single payment in the future, but no interim coupons. For example, if Jett presented a $1 million, 30-year bond that paid 10 percent interest on a semiannual basis, he would receive sixty coupon STRIPS representing the right to receive $50,000 every six months ($100,000 per year), and one principal STRIPS representing the right to receive $1 million in 30 years.

Jett could also reverse the transaction. If he gathered up the sixty-one
STRIPS necessary to “reconstitute” the Treasury bond, he could present all of those STRIPS to the Fed, and receive the actual Treasury bond in exchange.