A few weeks ago, I flew to San Francisco to cover the annual meeting of the International Swaps and Derivatives Association, a large over-the-counter derivatives lobbying group. For two days I listened to ISDA executives convince journalists that derivatives “regulation” should remain as is. Even renowned Stanford economist and former Treasury Undersecretary John Taylor—of the Taylor Rule—said repeatedly that derivatives were not a cause of the financial crisis.
I’ve read cautionary tales about Wall Street, as told through Michael Lewis’s “Liar’s Poker.” I’ve read the story about how former CFTC Chairwoman Brooksley Born confronted former Treasury Secretary Robert Rubin, former SEC Chairman Arthur Levitt and former Fed Chairman Alan Greenspan about the need to regulate the OTC derivatives industry in the late-1990s.
But no account about the OTC derivatives market has been as convincing or damning as Frank Partnoy’s “F.I.A.S.C.O.: Blood in the Water on Wall Street.”
As the notional value of the derivatives industry swelled to $55 trillion, Partnoy, a law and finance professor at the University of San Diego who spent the early 1990s structuring derivatives products at First Boston and Morgan Stanley, was instrumental in the creation of BIDS and MEXUS derivatives, complex derivatives products based on Brazilian bonds and peso-denominated, inflation-linked bonds. Partnoy was also responsible for FP Trust, derivatives based on the Philippines state-owned electric company, the National Power Corporation (NPC) and bundled with AAA-rated U.S. Treasury bonds in order to secure a safe investment rating.
While Lewis’s book raises a red flag about Wall Street excesses, Partnoy is wildly waving multiple flags while leading a massive marching band down Main Street. Partnoy isn’t just a derivatives expert: he’s a reformed derivatives trader who saw the evils of derivatives and is trying to warn everyone about its destruction throughout the book.
Instead of immediately delving into a “derivatives are bad” diatribe, Partnoy compares the rise of derivatives with the evolution of Morgan Stanley from “first class business in a first class way,” to “first class business in a second class way,“ a reference to the bank’s new aggressive style of business that feasted on the fear and greed of its customers.
Partnoy recalls a rousing speech from the brokerage firm’s former president, John Mack, following a period of massive derivatives losses: “There’s blood in the water. Let’s go kill someone.” (Appropriately enough, F.I.A.S.C.O. is an acronym for Fixed Income Annual Sporting Clays Outing, a recreational gun-shooting event at Morgan Stanley.)
Partnoy interweaves the immoral behaviors and conversations of coworkers with detailed explanations about the derivatives deals that took place, leaving nothing to the reader’s imagination. From beginning to end, you know exactly how the derivatives products were created and how they sold them and what happened to the customers, which were mostly pension funds and retirement systems.
So while Partnoy provides intricate details about the derivatives his group created and sold, he revealed the consequences of ripping off one’s face, like devoting an entire chapter about the Orange County bankruptcy, the largest municipal bankruptcy in U.S. history. Using complex derivatives, some of which were highly rated bonds tied to interest rate changes, the county amassed at least $1.5 billion in derivatives losses.
As Partnoy continues through his Wall Street travails, we might not be able to remember what a Trigger Note does or the exact purpose of PEARLS, but we do sense that derivatives are not right. There’s a reason Warren Buffet referred to derivatives as “financial weapons of mass destruction.”
Partnoy left Wall Street following his stint at Morgan Stanley and began teaching in 1997. While “F.I.A.S.C.O” was published toward the end of that year, there was prescience to his experience. At the end of the original edition, which was published in 1997, Partnoy wrote:
“Given the dearth of regulation and proindustry balance of power, you don’t need a psychic to predict that there will be another Orange County-like fiasco some time soon. The financial services industry will continue to pay tens of millions of dollars to lobbyists and congressional campaigns to fend off regulation. Derivatives will continue to cause billions of dollars in losses by hundreds of derivatives victims, all along the way destroying reputations, twisting lives, and emptying bank books.”
This was a year before the collapse of Long Term Capital Management, three years before President Clinton signed the Commodity Modernization Act, which exempted the OTC derivatives market from regulation, and 10 years before collateralized debt obligations, credit-default swaps and the collapse of Bear Stearns and Lehman Brothers.
In his updated afterword Partnoy said, “F.I.A.S.C.O. is the story of my journey through the gluttony and dysfunctionality of 1990s Wall Street.” It’s also the story of a young Wall Streeter who said, “I told you so.”