Vanguard News Network

By George Lenz

For two years in the early 1990s, Frank Partnoy worked for a couple of investment banks, CS First Boston and Morgan Stanley, selling derivatives. He has been highly successful in this, yet eventually quit over ethical objections to business practices employed. Based on his experience, he wrote a book under the title “FIASCO: Blood in the Water on Wall Street” about his time at Morgan Stanley. It is interesting to examine the way the book depicts the relationship between U. S. (and increasingly global) investment banks and their clients. These books provide significant ammunition to those interested in regulating the securities markets by portraying the investment banks as willing and able to take advantage of their clients’ naiveté. Similarly, they are of interest to those of us concerned with norms that operate in investment banking. Morgan Stanley is portrayed in FIASCO as interested only in short-term profits at the expense of long-term relationships. Partnoy details a world where customers are routinely and systematically swindled and tricked into buying inappropriate, high-risk derivative securities that provide ultra-high commissions to the Morgan Stanley traders.

PERLS are fixed-income investments in which the issuer calculates the amount of principal owed at maturity by taking the nominal or stated principal amount and multiplying it by a formula linked to foreign currencies. Thus, PERLS permit investors and issuers to hedge and speculate on foreign currency movements. Partnoy explains one type of PERLS security this way: “one popular PERLS, instead of repaying the principal amount of $100, paid the $100 principal amount multiplied by the change in the value of the U.S. dollar, plus twice the change in the value of the British pound, minus twice the change in the value of the Swiss franc. The principal repayment was linked to these three different currencies, hence the name Principal Exchange Rate Linked Security”. Partnoy forcefully asserts that his colleagues at Morgan Stanley sold PERLS to unsuspecting customers who thought they were buying simple AAA-rated bonds. These buyers, according to Partnoy, had absolutely no idea what they were doing, or what risks they were assuming. Such customers “looked at a term sheet for PERLS, and all they saw was a bond. The complex formulas eluded them; their eyes glazed over. The fact that the bonds’ principal payments were linked to changes in foreign currency rates was simply incomprehensible”. Furthermore, Partnoy speculates that Morgan Stanley customers were not only too unsophisticated to realize the risks they were assuming, but that Morgan Stanley salesmen systematically duped them into making highly leveraged bets on foreign exchange rates. The motivation for this deception was the fact that salesmen earned a higher commission on the sale of PERLS than on the sale of ordinary bonds.

To support his allegations, Partnoy recounts a story that he claims to have heard shortly after joining the derivatives product group at Morgan Stanley. A derivative salesman told Partnoy about a conversation he had with a “senior treasury officer” from an insurance company that had recently bought $85 million in face amount of PERLS. The officer called the Morgan Stanley salesman who had consummated the trade to find out the current value of the investment. The salesman broke the news that, in a matter of weeks, the PERLS had plummeted to a fraction of their original value. When the insurance company official expressed shock and incredulity, the salesman went on to explain that, in purchasing the PERLS, the officer had assumed a foreign exchange risk that went sour. According to Partnoy, “this salesman had earned a giant commission on this PERLS trade, and he laughed uncontrollably at his story. When the salesman finished his story, he asked me if I knew what it was called when a salesman did what he had done to one of his clients. I said I didn’t know. He told me it was called “ripping his face off””. Partnoy goes on as follows: “Ripping his face off?” I asked, wondering if I had heard him correctly. “Yes,” he replied. He then explained, in graphic, warlike detail how you grabbed the client under the neck, pinched a fold of skin, and yanked hard, tearing as much flesh as you could. I never will forget how this salesman looked me in the eye and, with a serious sense of pride, almost a tear, summed up this particular PERLS trade. Frank, he said, all ripped his face off”. Partnoy is clearly under the impression that the investment banks and their salesmen, motivated by greed, purposely mislead investors. And sadly, his story is credible.

In addition to hedging and speculating-and avoiding investment restrictions in the case of insurance and pension funds-derivative instruments are created to clean up the balance sheets of certain corporate clients. Sometimes these balance sheet operations are ethical, and sometimes they are not. Partnoy, however, regards this financial tool as highly unethical. In his view, firms in countries with lax accounting standards or compliant regulators use derivatives to mask holes in their balance sheet. Perhaps the best example of how derivatives are commonly used for purposes of accounting or regulatory obfuscation involves the Japanese banks. According to FIASCO, Japanese banks liked to use U.S. investment banks with branches in Tokyo rather than Japanese investment firms when structuring fraudulent transactions because Japan’s Ministry of Finance had no regulatory authority over U.S. investment banks. As Partnoy acknowledges, U.S. banks were the only firms with the sophistication to structure the complex and likely unethical transactions that the Japanese clients wanted. This was the real reason many Japanese firms gave their business to U.S. investment banks.

The derivative instrument Morgan Stanley created for the Japanese was called an AMIT (“American Mortgage Investment Trust”). An AMIT is comprised of two components: a particular type of CMO (“Collateralized Mortgage Obligation”) called an ioette and a zero coupon bond. The first part of the AMIT, the customized CMO, is created from mortgage-backed securities, which are bonds where the cash used to make principal and interest payments comes from bundling together pools of home mortgage obligations. To create a CMO, the issuer combines the principal and interest payment obligations on a mortgage-backed security and divides it into sub-parts, called strips. Usually the strips are either interest-only strips (IO) or principal-only strips (PO), but other, more exotic combinations exist. An ioette is a strip that is comprised of a particular combination of IOs and POs. In an ioette, the IO portion of the security is many times the size of the PO portion. Because the interest portion of an ioette vastly dominates the smaller principal portion, the market price of these securities is a large multiple (called a premium) of the face amount of the bond components.

Morgan Stanley created ioettes by buying large amounts of mortgage-backed securities and carving out most of the principal payment obligations. Morgan Stanley then kept the majority of the principal payment obligations in its inventory, and sold the interest payment obligations as the first component of the AMIT. The customer who purchased the ioette was then obligated under the terms of the trade to give Morgan Stanley an option with respect to the inventoried principal payment obligations. Specifically, the client had to agree to make up for any losses that Morgan Stanley might suffer from market fluctuations that caused the principal-only portion of the ioette to lose value. Besides the ioette, the second part of an AMIT is comprised of a simple zero coupon bond. These are bonds that do not make periodic interest payments. The investor’s return comes from the difference between the price he initially pays for the security and the price he receives from the issuer at maturity. Zero coupon bonds are the opposite of ioettes in that they trade at a large discount from the face amount of these bonds.

As created by Morgan Stanley for its Japanese clients, an AMIT is a combination of ioettes and zero coupon bonds in equal face amounts. While the face amounts of the two parts of the AMIT were the same, the market value of the components, if traded separately, would be much different because of the different intrinsic characteristics of ioettes and zero coupon bonds. In particular, the ioettes would be worth a lot more than the zero coupon bond. In addition to receiving the face amount of the ioette as a return on their investment, buyers would also receive a series of future payments, namely the interest portion of the ioette. By contrast, from the zero coupon bond, investors would receive only the principal payment, which would not be realized for quite some time. Despite the fact that the two pieces of these AMITs were worth vastly different amounts, the Japanese investors would pay the same price for each half of the AMIT. This meant that the investors were paying too little for the ioette portion, and too much for the zero coupon bond portion.

According to Partnoy’s account of Morgan Stanley’s AMIT trades, immediately after purchasing the AMITs, the Japanese investor would resell to Morgan Stanley the one-half of the face amount of the AMITs that was comprised of the ioettes. By repurchasing the ioette at the market price shortly after selling the securities at a drastically discounted price, Morgan Stanley permitted the Japanese investors to book a huge paper profit. Of course, the Japanese bank should show a huge loss from the zero coupon bond component of the AMITs, because it had overpaid for them. However, the firms to which Morgan Stanley was selling these derivatives did not have to account for the market value of these instruments on their books, so they would not have to show the loss for many years. Furthermore, although Morgan Stanley took a loss in repurchasing the ioettes at market price after recently selling them at a discount, the investment bank did not mind, because it was more than able to make up for the losses on repurchase through a combination of its profits from the sale of the zero coupon bond portion of the AMITs and the huge fee it collected for structuring the transaction. To bring things full circle, after Morgan Stanley repurchased the ioettes, it would recombine the interest and principal components of the ioette with the remaining principal component that it had stripped out and inventoried when originally creating the ioette. Morgan Stanley would then sell these reconstituted mortgage-backed securities back to Fannie Mae, the government agency from whom it had bought them in the first place.

FIASCO contains an account of a particularly large pair of AMIT trades ($471.5 million) that took only two weeks to put together and thanks to which Morgan Stanley made a profit of $75 million. The interesting aspect of these AMIT transactions is that they were designed specifically to exploit accounting loopholes in order to permit the clients purchasing these derivatives immediately to book huge gains for accounting purposes, while postponing for years the need to show the concomitant losses. As Partnoy observes, “the AMIT proved to be the most efficient means anyone has been able to devise for generating false income for Japanese investors”.

Japan was not the only venue in which Morgan Stanley has assisted its customers to accomplish accounting gimmickry. In 1994, Morgan Stanley created a new derivative, called PLUS notes (“Peso-Linked U.S. Dollar Secured Note”), to permit certain Mexican banks to remove what Partnoy describes as “undervalued and illiquid” inflation-linked bonds from their balance sheets without having to record any losses for accounting purposes. Mexican banks were unwilling to simply sell the bonds, which are known as adjustable bonds of the Mexican government, because a straight forward sale would have forced the bank to record an accounting loss. U. S. investment banks were trying to help Banco Nacional and other Mexican banks sell Mexican sovereign debt to institutional investors in the United States and Europe faced the problem that these investors wanted highly rated securities, and they wanted them denominated in U.S. dollars rather than in Mexican pesos. These twin preferences were problematic because only Mexican debt denominated in pesos was investment grade. This was due to the fact that rating agencies are very comfortable in assuring investors that the Mexican government will pay back its obligations that are denominated in pesos, because the government can always simply print more pesos to cover its debt. But if the peso falls in value against the dollar, the Mexican government might not be able to meet its obligations to repay in dollars. It might, for example, suspend the convertibility of its currency, as it had done in the past. Thus, the bonds that Banco Nacional wished to sell were given a high, investment grade AA- rating by Standard & Poor’s, but they were payable in Mexican pesos rather than in U.S. dollars.

In order to rid Banco Nacional of its bonds, Morgan Stanley created a Bermuda corporation, which in turn created and sold its own bonds backed by the Mexican securities. These were the bonds known as PLUS notes. Unlike the adjustable bonds, the PLUS notes were denominated in U.S. dollars. Morgan Stanley convinced Standard & Poor’s to give the new bonds issued by the Bermuda company the same AA- rating given to Mexico’s peso-denominated sovereign debt, instead of the much lower rating given to Mexico’s U.S. dollar-denominated debt. The PLUS notes enabled Banco Nacional to do what it wanted-rid itself of the adjustable bonds without recognizing a sale for accounting purposes. Banco Nacional did this by assuming ownership of the Bermuda company that issued the dollar-denominated derivative bonds. This ownership allowed Banco Nacional to include the assets of the Bermuda company as its own assets. Because the assets of the Bermuda company included the adjustable bonds, Banco Nacional had not sold these securities and therefore did not need to show an accounting loss.

Partnoy suggests that every aspect of the PLUS notes sale contains some element of sleaze. First, he suggests that the public did not want the bonds being sold, claiming that the seller “was looking to do the impossible: sell bonds into a market that didn’t want the bonds, without having to admit publicly that it was selling them”. Second, Partnoy conveys the image that this transaction bordered on illegal fraud, and could only have been consummated with the help of a corrupt government in Bermuda.

Thus the derivatives market in general and the Morgan Stanley derivatives group in particular has been in derivative business mainly to dupe unsophisticated, unsuspecting customers. According to Partnoy, the only norm at work among those who sell derivative securities is the desire to create a false sense of security in order to induce customers to buy, and to “lure people into that calm and then just totally rob ’em”. FIASCO portrays the business of creating and selling complex derivative instruments as one in which norms of good behavior are completely lacking. Partnoy’s solution for the lawlessness he sees in the derivative industry is regulation. He blames the lack of regulation of the derivatives industry on a combination of “healthy campaign contributions” and the fact that high powered lobbyists “have persuaded our elected representatives to reduce the amount of derivatives regulation, by arguing that derivatives are used primarily for hedging” and “risk reduction purposes. Partnoy bemoans the fact that “regulators lack both power and money, and are doomed to remain several steps behind the finance industry”. On its merit, Partnoy’s argument about the lack of regulation in the derivatives industry is convincing.

A colleague once asked me, why I would cite the non-fiction writer’s account, as a part of evidence of alleged abuses within the derivative industry. The answer is, that this account, although most likely overstated, is supported by quantitative and qualitative evidence that has accumulated since 1990s: it corroborates the case for heavy regulation, and perhaps outright outlawing some forms of derivatives in a form more accessible to the member of general public. Sadly, the regulation is highly unlikely: the Congress has been placated by heavy donation on behalf of the industry, and federal judges have so far refused to intervene: it will take a major financial crisis or two for the regulatory work to commence. Thus, an investor is largely on his own, and must take proper precautions. A good thing to do would be to check whether a bank where one holds his account uses derivatives, and if so, should bank in question (especially if small or medium sized community bank) engage in derivative trades, consider switching to a non-using derivatives bank or at least a larger bank. Although most deposits are FDIC-insured, it takes months to get it out of the failed bank: and for a small to medium sized community bank that uses derivatives failure is almost a certainty. And of course, one should speak out against the use of derivatives in appropriate circumstances: letting the banks know that one is against the use of derivatives, especially if one is a shareholder, drives the point home, since these days banks listen to their customers more attentively.

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The market has corrected slightly to around 12 300, although the trend is uncertain: it may go slightly up before going down further. It looks like unflavored macroeconomic evidence has largely been ignored by market participants: so far irrational exuberance still reigns, and investors refuse to acknowledge prospective losses. I am looking into AIG, to re-open a closed position (current market value $67.2 vs. intrinsic value $81.3), what holds me back so far is its prospective mortgage exposure in riskier markets and market segments. Thus my current recommendation is hold: when the price will correct further to below $65, my recommendation is buy.