Infectious Greed (43 page)

Brickell and Levitt were trying to reframe the collapse of Barings to deemphasize these new financial instruments and to persuade the media and regulators not to fan the derivatives flames in the United States with new scandals abroad. Their argument was that the various financial fiascos abroad were caused more by the unique lack of controls at foreign banks than by the instruments themselves. In other words, deceit mattered more than risk.

But this argument ignored the fact that deceit and risk were feeding off of each other: simply put, it was easier to commit financial misdeeds with derivatives. It was no coincidence that many of the control problems at non-U.S. banks during the mid-1990s involved new financial instruments. Barings was far from alone. Britain's National Westminster Bank lost more than $80 million on options trades that senior managers were unable to evaluate in an incident that was eerily similar to earlier valuation difficulties at Bankers Trust and Salomon Brothers.
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Deutsche Bank, Germany's largest bank, also suffered from lax controls, and fired a rogue trader in March 1995, although its losses were only about $15 million.
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Union Bank of Switzerland's “crown jewel”—its sophisticated equity-derivatives group—lost $240 million on long-dated stock options.
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During this time, Sumitomo Corporation and Daiwa Bank—two Japanese firms—also experienced billion-dollar-plus scandals involving complex trading strategies. In each case, a rogue trader placed large bets, allegedly without the knowledge of supervisors. Several major Wall Street dealers were involved.

Sumitomo reported the largest derivatives loss to date: $2.6 billion, in unauthorized trading of copper futures by the firm's chief trader, Yasuo Hamanaka. The Sumitomo debacle was unfathomably complicated and provoked a Dickensian legal battle, ranging from a prosecution by the CFTC, alleging manipulation, to numerous lawsuits against Sumitomo to a dispute between Sumitomo and J. P. Morgan over alleged loans. J. P. Morgan reportedly paid $125 million to settle a suit by Sumitomo alleging that Morgan had given Hamanaka an off-balance-sheet loan so that he could continue his trading (J. P. Morgan later would make similar loans to Enron, before Enron collapsed). Sumitomo blamed Hamanaka for doing
2,000 unauthorized deals a year for ten years, and for forging records and signatures needed to give him the authority to trade. Hamanaka was charged with forgery and manipulating copper prices, and was sentenced to an eight-year prison sentence in Tokyo. Merrill Lynch was charged with contributing to the manipulation, and agreed to pay a $15 million fine.

At Daiwa, Toshihide Iguchi's story was similar to Nick Leeson's, but it lasted four times longer. In 1984, Iguchi lost about $200,000 while trading U.S. Treasury bonds at Daiwa's New York branch. During the next eleven years, Iguchi made about 30,000 unauthorized trades in an attempt to dig out of the loss. He was quite possibly the worst trader in history. From 1984 until 1995, he lost an average of almost half a million dollars a day, $1.1 billion in all.
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He covered up the losses simply by not booking the sales of securities he sold at a loss. No one knew the bonds had been sold, because Iguchi—like Leeson—was involved in the back-office booking of trades. The bonds were held on Daiwa's behalf by Bankers Trust, and Iguchi had obtained some Bankers Trust letterhead, and printed forged financial statements on that, just as Leeson had forged his own position reports.
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During this time, U.S. banking regulators had examined Daiwa ten times and had never spotted the losses, even though the trading involved simple financial instruments issued by the U.S. government. The banking regulators ignored various “red flags,” including the fact that Daiwa lied to the Federal Reserve in 1993.
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One can only imagine what might have happened if complex derivatives had been involved.

Iguchi was an unlikely rogue trader, and he lacked formal training in finance. He had moved to the United States from Kobe, Japan, to attend college at Southwest Missouri State University, in Springfield, Missouri, a school known more for its proximity to Lake of the Ozarks than for any programs in finance. Iguchi studied psychology and art, and was a cheerleader.
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After graduating in 1975, he worked at a car dealer before joining Daiwa's back office, the same first job as Nick Leeson.

Yet Iguchi wasn't even an unusual hire for Daiwa, which also hired Mohamad Sotoudeh, a trader whose experiences demonstrated the close connections among various financial scandals. Managers at J. P. Morgan, where Sotoudeh worked before Daiwa, reportedly had asked him to resign when they discovered a $50 million discrepancy in the monthly mark-to-market values of his trades in mortgage derivatives, the same risky instruments that had destroyed Askin Capital Management and Worth Bruntjen.
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When Daiwa hired Sotoudeh in 1992 to be its first
mortgage-derivatives trader, Andrew Stone, head of Daiwa's mortgage group, remarked, “We have a lot of people with unusual backgrounds and work histories. He won't stand out much.”
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Compared to Toshihide Iguchi, it was true.

In July 1995, Iguchi wrote a 30-page confessional letter to his bosses, saying, “After 11 years of fruitless efforts to recover my losses, my life is filled with guilt, fear and deception.” His bosses responded by immediately trying to cover up the losses, too. When officials at the Japanese Ministry of Finance discovered the losses, they, in turn, also tried to cover up the losses, this time from U.S. regulators. A few months later, when U.S. regulators finally learned of the scandal, they returned the favor, prosecuting Daiwa and Iguchi with a vengeance. Iguchi was sentenced to four years in prison, where—like Leeson—he wrote a book about his experiences. In
The Confession,
Iguchi alleged that other traders at Daiwa also had engaged in unauthorized trading, and claimed that his bosses in the United States had promised to protect him so long as he agreed to hide his losses from the firm's Japanese managers.
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Daiwa ultimately resolved its sordid case by paying a $340 million penalty, the largest fine for financial fraud in U.S. history.

 

 

I
t was embarrassing for Europe and Japan that Barings, National Westminster, Deutsche Bank, Sumitomo, and Daiwa were their elite financial institutions. But even Barings and Daiwa ran tight ships compared to companies and governments in East Asia during the 1990s. Managers of companies in Indonesia, Malaysia, the Philippines, and Thailand borrowed billions of dollars, which they invested in largely frivolous new projects, especially in real estate.

Governments encouraged the borrowing by propping up their currencies, in the same way Mexico had supported the peso. For example, the government of Thailand committed to maintain the value of its currency, called the baht, at an overvalued level based on a basket of several other currencies. Recall that it was this basket that formed the basis of the Thai baht-linked structured notes sold by CSFP, Allen Wheat's firm, during the early to mid-1990s.

Individual investors were drawn to the apparently high returns in these “Asian Tiger” economies until 1997, when some traders finally questioned the dubious nature of corporate investments in East Asia, and predicted that governments would not be able to sustain overvalued currencies
for much longer. These traders used over-the-counter derivatives to bet tens of billions of dollars against those currencies until July 2, 1997, when Thailand—in a repeat of Mexico a few years earlier—finally gave up trying to maintain the value of its currency. The baht devalued by 15 percent in one day, just as the Mexican peso had fewer than three years earlier. Other countries soon followed.

Investors in East Asian companies hadn't paid much attention to the fact that they were not entitled to the protections available to shareholders in the United States and England.
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They generally could not file private suits, and securities regulators were much less effective. Boards of directors did little to monitor managers, and the threat of a corporate takeover was minimal.
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In international rankings of the rule of law, countries in East Asia consistently received the lowest ratings.
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One reason was the concentrated family ownership of East Asian companies. Buying a million dollars of stock in an Indonesian conglomerate was like buying a single share of a small family business in the United States or England: you might make money, but your investment really depended on how much the family decided you should receive. Outside shareholders, even in aggregate, had little influence on family-controlled corporations, even in countries with strong legal protections.

In Indonesia, the Philippines, and Thailand, ten families controlled half of the corporate sector.
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The Suharto family in Indonesia controlled 417 listed and unlisted firms through business groups led by children, other relatives, and business partners.
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The Marcos family controlled almost one-fifth of the value of all stocks in the Philippines. Although commentators complained about Japan's “keiretsu,” which bound together firms with cross-ownership, ownership of Japanese companies was highly diversified compared to ownership in East Asia, where a handful of mostly corrupt families controlled many of the largest companies in the region.

Not surprisingly, managers at these firms didn't always tell investors the truth about their investments. For years, companies hid bad loans and failed real-estate projects, while borrowing more money, often in surprisingly unsophisticated ways (the “commercial paper” markets in Indonesia and Thailand included postdated checks and notes scribbled on the backs of envelopes).
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As more foreign investment arrived, the value of shares increased, but the value of the projects underlying those shares declined.
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It was an ugly picture, and yet money continued to flow in. Why? The
simple explanation was that investors were irrationally optimistic, swept up into the first stage of a cycle of manias, panics, and crashes economic historian Charles P. Kindleberger had argued applied generally to financial crises.
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Mutual funds investing in East Asia generated double-digit returns in the mid-1990s, and those returns attracted new money, driving up the value of stocks. The markets weren't efficient, in part because it was too difficult, expensive, and risky for sophisticated investors to bet against stocks. Shorting stocks was even more difficult in East Asia than it was in the United States, and even an outside investor betting against an obviously overvalued company might lose money, temporarily, if wealthy and powerful families—or even the government—provided temporary support. As a result, manic investors, instead of sophisticated ones, drove prices, and stocks were temporarily overvalued.

But that explanation was only part of the story, because sophisticated investors, including major hedge funds and investment banks, also were putting money into these countries, not betting against them. Why would sophisticated investors believe they could make money by providing loans to East Asian companies and governments, even if those institutions were in poor shape? This is where the central banks enter the picture.

If interest rates in Thailand were 15 percent, an investor from the United States could borrow at, say, 5 percent, lend money in Thailand, and keep a profit margin of 10 percent, so long as Thailand's currency did not devalue. Even if some of the borrowers defaulted, a U.S. lender would still make money, so long as the Bank of Thailand (the central bank) continued to support the baht. This strategy—borrowing in U.S. dollars and lending the money in another country's currency—was called a carry trade, and it resembled the strategy many investors followed within the United States during the early 1990s, borrowing at low short-term rates and investing at higher long-term rates, hoping to earn the difference. Foreign carry trades began in Malaysia in 1991, and followed in Thailand and Indonesia in 1993.
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The increase in these carry trades might not have been problematic if they had been disclosed and monitored by investors and regulators. But because of restrictions on borrowing and lending in East Asia, much of the trading was done in the over-the-counter derivatives markets, where there was no centralized information and no requirement that trades be reported on companies' financial statements.
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As a result, no one knew how much money particular East Asian companies or countries had borrowed.
It was difficult to predict when a company had borrowed so much that it would be unlikely to repay, or when a government spent so much of its reserves that it would no longer be able to defend its currency.

In fact, the derivatives used in East Asia during this time were even more hidden from view than they had been a few years earlier, because banks were selling structured derivatives transactions with a new twist: the Special Purpose Entity, a company or trust created specially for a particular transaction. Like derivatives, SPEs could be used for good or ill. An SPE could be a necessary component of a deal to build a new power plant in Indonesia, or to distribute interests in leases to new investors; or it could be an otherwise useless add-on that enabled a company to create false profits, hide losses and liabilities, and remove the details of various risks from its financial statements.

During the early 1990s, banks had enabled institutional investors to bet on various currency rates by purchasing structured notes or entering into currency swaps. (Remember, a structured note was simply a debt, issued by a highly rated company, with payments that were linked to financial variables, such as the value of a foreign currency; a swap was an agreement between two parties to exchange payments linked to such variables.) These were the instruments Bankers Trust had sold to various investors, including many in East Asia.