Infectious Greed (9 page)

However, the Fed was not all-powerful, and it could not make the economy turn on a dime. The year 1990 was a horrific one on Wall
Street. Every financial asset collapsed: junk bonds, commercial real estate, investments related to savings and loans, even Japanese stocks. On February 13, 1990, Drexel Burnham Lambert—Michael Milken's bank—which had epitomized the 1980s financial culture, filed for bankruptcy. That marked the end of an era, and it seemed unlikely that banks would ever again generate 1980s-like profits. Even traditionally profitable businesses were hurting: stock commissions paid to Wall Street during 1990 were a relatively paltry $8.9 billion.

Wall Street, by becoming so ruthlessly efficient, was destroying itself. New markets became competitive more quickly than ever, with profit margins narrowing, within months, as other financial institutions entered the business. Bankers Trust was in a quandary: every time it discovered a new source of profit, it was victimized by this inevitable competition. Yes, Bankers Trust's employees had quantitative and risk-management skills that were superior to those of any bank. But how could it use them to make a consistent profit?

The answer came from an unlikely source. Merton Miller, a Nobel-laureate economist at the University of Chicago, was an enthusiastic supporter of swaps and other derivatives. He agreed with many dealers that swaps were important financial innovations that enabled parties to allocate risks more efficiently.

But Miller also believed these instruments served a different, perhaps more dubious, purpose. In 1986, Miller argued that a major impulse for financial innovation was a desire to avoid regulation.
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Financial-market participants faced very different regulatory environments, and they often were governed by rules they would prefer not to follow. By using derivatives, they could avoid rules that seemed senseless to them. Miller was a free-market economist and thought these rules were senseless, too, so he applauded companies' efforts to avoid regulation, efforts that came to be called “regulatory arbitrage.”
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The accounting rules for swaps were a perfect example. Swaps were simply investment contracts, and they were economically equivalent to many other financial instruments, including exchange-traded futures and options, all of which were regulated. Yet swaps were unregulated and immune from most securities-law disclosure requirements. Merton Miller's insight implied that companies would do swaps not necessarily because swaps allocated risk more efficiently, but rather
because
they were unregulated. They could do swaps in the dark, without the powerful sunlight that securities regulation shined on other financial instruments.

And here was the crucial point: to the extent companies and their financial officers could use custom-tailored swaps to avoid regulation or to hide risks, Bankers Trust's profits from selling swaps to those companies might not disappear so quickly. Corporate treasurers hoping to benefit from such swaps would pay a premium—it wasn't
their
money, after all—if the swaps were structured in a way that created more opportunity for profit, but hid the risks from their bosses. Just as the Japanese insurance executives paid large fees for equity derivatives, even fully informed financial officers would pay a hefty premium if they could avoid disclosing the risks of swaps to shareholders and regulators. Unlike the plain-vanilla instruments from earlier years, these swaps could have all sorts of hidden bells and whistles, and shareholders and regulators might not ever even know about them.

Substantial fees from these complex swaps would persist so long as companies valued the difference in legal treatment between swaps and their regulated brethren. And if other banks were reluctant to sell such swaps to companies in the shadow of the law, there wouldn't be as much competition for Bankers Trust.

Finally, a business that might last for more than a year! Bankers Trust began gearing up to sell custom-tailored swaps.

 

 

G
ibson Greetings, Inc., was a Cincinnati, Ohio, company that made and sold greeting cards. Gibson had a traditional commercial-banking relationship with Bankers Trust, dating back to 1983.
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To finance its business, Gibson borrowed money from various sources, including a standard revolving-credit agreement arranged by Bankers Trust.

In May 1991, Gibson borrowed $50 million in a straightforward debt deal arranged by a different bank, at an interest rate of 9.33 percent.
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As interest rates fell during fall 1991, Jim Johnsen, the company's treasurer, began to explore the idea of using interest-rate swaps to reduce the interest rate on its debt.
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In an interest-rate swap with a bank, Gibson could agree to receive a fixed rate (offsetting the fixed rate on its debt deal), and pay a much lower floating rate. In other words, Gibson could reduce its effective interest rate in exchange for the risk that rates might rise, just as a homeowner could switch from a fixed-rate mortgage to an adjustable one. Such plain-vanilla swaps were well established by 1991, and margins were low. A basic $50 million interest-rate swap would cost around $50,000.

When Johnsen told various banks Gibson might be interested in a swap, he was besieged by proposals, in the same way a homeowner who indicated an interest in refinancing would be bombarded by mailings and early-evening calls. Banks, having tasted the profits from equity derivatives and other similar transactions, were aggressively seeking new customers. Gibson was a perfect candidate for a new custom-tailored swap. It was big enough to do a deal, but not sophisticated enough to understand how to evaluate it properly.

Gibson had an ongoing relationship with Bankers Trust, run by two senior commercial bankers. But the two salesmen who flew out to see Johnsen in November 1991 were much younger and much more sophisticated than these commercial bankers. Two of Charlie Sanford's nerds—Gary Missner and Mitchell Vazquez—made just the right pitch to Gibson. Jim Johnsen remembered the salesmen as “forthright and honest, not like hard-sell securities salesmen who call you up at home during dinner.”
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On November 12, 1991, Gibson agreed to do two interest-rate swaps with Bankers Trust, each for $30 million.
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Although these two swaps initially appeared to be plain vanilla, they actually were a bit more complicated. The first was a “two-year” swap, in which Gibson agreed to pay a low fixed rate of 5.91 percent and receive a floating rate. The second was a “five-year” swap, in which Gibson agreed to do the opposite: pay a floating rate and receive a higher fixed rate of 7.12 percent.
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The effect was to create two different payment periods for Gibson. For the first two years, Gibson would pay a low rate (5.91 percent). For the three years after that, it would pay a floating rate. Bankers Trust would hedge its position in the market, so that it pocketed a fee, but did not put its capital at risk.

This trade had what the dealers called attractive
optics.
It looked simply marvelous. Gibson reduced its interest cost by several percent for the next two years. It took on some risks in years three through five, but rates might be low then, too. Who
wouldn't
do this trade?

In fact, this was a fairly common trade at the time,
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and it turned out to be a winner. Interest rates declined during early 1992 and the swaps moved in Gibson's favor. Seven months later, in July 1992, Johnsen got a call from Bankers Trust with good news: Gibson could close out its positions right away, at a profit of $260,000. What would he like to do?

What would you do, in Johnsen's situation? Could you determine whether $260,000 was a fair payment? One way to do it would be to
create a computer model, and input various data and assumptions regarding interest rates, credit risk, and other variables to come up with a valuation. But few corporate treasurers—including Johnsen—were capable of this in 1991. He could have called another bank for a second opinion. But that risked offending Bankers Trust, and he wouldn't necessarily get a better price. Besides, as long-standing advisers to Gibson, Bankers Trust wouldn't fudge the valuation of a couple of simple interest-rate swaps, would they?

Johnsen should have made a few calls, but he apparently didn't think it was necessary. He decided to trust Bankers Trust and closed out the swaps for a $260,000 gain. That decision would cost Gibson dearly. The actual value of the swaps to Gibson at the time has been disputed, but it was at least $550,000 and probably closer to the amount Gibson ultimately claimed in a lawsuit: $750,000.
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The difference of several hundred thousand dollars was gravy for Bankers Trust.

Gibson's willingness to close out the swaps at such a bad price meant that Gary Missner and Mitchell Vazquez had found a sucker. If Gibson couldn't evaluate a reasonably simple trade, it would have no chance with a complex one, and that meant Bankers Trust could charge an even higher fee for a more complex deal. Missner and Vazquez were doing exactly what Charlie Sanford had indicated he wanted: generating big profits, with little capital at risk.

From November 1991 to March 1994, the nerds of Bankers Trust lobbed salvo after salvo of complex swap proposals at the greeting-card maker. Many of them hit, and before it was all over, Gibson and Bankers Trust would enter into twenty-nine derivatives transactions, in which Gibson placed huge interest-rate bets, and Bankers Trust booked huge profits.

Gibson's second swap, in October 1992, made the first one look like a plain U.S. savings bond. In this deal, also for $30 million, Gibson agreed to receive a fixed rate of 5.5 percent and to pay a floating rate, squared and then divided by 6 percent.
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That's right: squared, as in “to the second power.” The swap payments would be based on the London Interbank Offered Rate, known as LIBOR, multiplied by itself and then divided by 6 percent. Let me repeat: Gibson's payments would be LIBOR multiplied by itself and then divided by 6 percent.

Why on earth would anyone buy a LIBOR-squared swap? One possible reason was that they didn't know it was a LIBOR-squared swap, or that they didn't understand what squared meant. But that hardly seemed
plausible. Jim Johnsen knew plenty of math to understand that, and surely he had been able to spot the little “2” in the numerator.

No, the more likely reason was greed: the squared feature was a way to bet big on declining interest rates. If floating rates remained low, as they had been, Johnsen could turn his little treasury operation into a profit center. For example, if floating rates stayed at 3 percent, then Gibson would be obligated to pay just one-and-a-half percent (the math was 3 times 3 divided by 6). But if rates increased, losses would increase, well, exponentially. If rates hit 6 percent, Gibson would owe 6 percent. If they hit 10 percent . . . well, no one wanted to think about that. Moreover, even a small increase in rates in the short run—to, say, 3.5 percent—would create big losses for Gibson, because it would increase the chances that, during the term of the swap, rates would go higher, causing Gibson exponential losses.

The squared feature magnified the bet's risks and potential returns, much as a
trifecta
bet—which names, in order, the top three horses to finish a race—magnifies the risks and potential returns relative to a simple win, place, or show bet. Treasurers bought squared swaps for the same reason gamblers played trifectas. (Gibson wasn't alone in gambling: one former Bankers Trust salesman even claimed that a client had bought a LIBOR-cubed swap—raised to the third power—although he wouldn't say which client it was.)
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Thanks to ISDA's lobbying against regulation of swaps, Gibson could make this bet in secret, in an unregulated market. A swap that was being used to hedge debt—as Gibson might argue its loony swap was—did not need to be disclosed to shareholders at all. But even if the swap wasn't obviously a hedge, the disclosure requirements were minimal. In any event, Gibson couldn't possibly tell its shareholders about such a bizarre trade, and it did not.

Unfortunately, rates began rising during the final months of 1992, and even a fractional increase was enough to cause Gibson some serious pain. LIBOR rose from 3.0625 percent to 3.375 percent, and by the end of the year—with that increase squared—Johnsen was facing a loss of $975,000.
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Or at least that was what the salesmen at Bankers Trust told him.

Gibson wasn't capable of discerning the swap's actual value, but that didn't matter much. Gibson wasn't about to walk away from the gambling tables with a million-dollar loss. During the next fourteen months, Gibson did deals with Bankers Trust that it described as “even more
volatile and risky than the ‘Libor Squared' transaction.”
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These were the financial markets' version of the
superfecta,
a horse-racing bet like the trifecta, but with all of the top four horses.

In a so-called
Treasury-Linked Swap,
Gibson agreed, among other things, to receive the lesser of $30.6 million or an amount determined by the following formula: $30 million-(103 ✕ 2-year Treasury Yield/ 4.88%)-(30-year Treasury Price/100). Another trade, called a
knock-out
option, became worthless when rates hit a specified level (it “knocked out” at that point). Financial economists would spend the next several years attempting to create pricing models for knock-out options. Still another Gibson trade, called a Wedding Band, was too complex to describe without a mathematician and a psychotherapist.

Gibson's swap smorgasbord included the most sophisticated derivatives anyone had invented, and they all were hidden from regulators and shareholders. In its 1993 annual report, Gibson disclosed $96 million of swaps outstanding, without any detail as to their risks.