How Deregulation Led to Predation

The following is an excellent excerpt from the book “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism” by Yves Smith from Chapter 6 “How Deregulation Led to Predation” on page 127 and I quote:

“In manufacturing, the market price is set by the smartest guy with the best, cheapest production process.  In securities markets, the price is set by the dumbest guy with the most money to lose.”                                   –William Hayman, former head of market regulation, SEC

In 1994 and 1995, Bankers Trust, a premier derivatives trading firm, was getting a lot of bad press.  Federal Paper Board, Gibson Greetings, Air Products and Chemicals, and Proctor & Gamble had sued the bank, claiming that it had taken advantage of them on derivatives trades and that they should recover their losses.

On the surface, none seemed to have much of a case.  The lawsuits looked like a desperate effort to welsh on bad bets.  After all, these were large corporations with sophisticated treasury departments, particularly Proctor & Gamble, with globe-spanning operations, routinely delaying in foreign exchange and interest rate markets.  How could a savvy multinational claim to have been duped?  And as the details emerged, the companies had policies against undue risk taking in their treasury departments, and their staff had violated them.

The situations for all four plaintiffs were broadly similar: the members of their treasury departments had gotten used to dealing with fairly easy-to-understand (“plain vanilla”) derivatives.  The experience of the treasury departments with other professionals, like attorneys, accountants, and doctors, had habituated them to trust what they were told.  Moreover, people assume that someone in an ongoing business relationship will not take advantage of them, or at least not very much.

Perhaps thinking that using more complex products was a sign of sophistication, Gibson and its brethren had become emboldened enough to venture into the world of custom derivatives (derivatives that were not standardized and in many cases unique), with the encouragement of Bankers Trust.

But using customized derivatives made customers dependent upon BT, who had the models for pricing the derivatives.  For these arcane, highly customized trades, there would be no way to get an independent price.  They had to go to BT to find out whether they were making or losing money on their positions.  In less complicated cases, it would have theoretically been possible for the companies to build their own models and calculate prices.  But even then, some of the key inputs, like implied volatility (a measure of how much an instrument’s price is expected to move up and down, usually during the next thirty days), would be well-nigh impossible for a nonmarket participant to guesstimate.  The firms could have gotten other bids, but that might have annoyed Bankers Trust, and another bank might not have provided a very good price anyway.

But being dependent upon information and advice from another party is a vulnerable position, and BT took full advantage of this dependence.  For instance, Gibson had made a trade that had worked out well.  BT called and offered to close it out for a $260,000 profit.  But that was a rip-off; the profit should have been at least $550,000, perhaps as much as $750,000.  The fact that Gibson had closed out an initial, fairly simple trade for much less than it was worth told BT it had a sucker ready to be fleeced.

Gibson lost out on its next trade, and then entered into increasingly complex and risky wagers to try to dig itself out of the resulting hole.  On its last gamble, Gibson was down $17.5 million, and rolled the loss into a new swap that, depending on how events transpired, would have either reduced the deficit to $3 million or increased it to as much as $27.5 million.  That gambit failed and left Gibson with a loss of $20.7 million.  At this point, Gibson sued Bankers Trust.  BT had made $13 million from Gibson’s various swaps, and all Gibson had ever wanted was a cheap hedge for fixed-rate debt.

Proctor was clearly a more sophisticated player, but even it appeared to be losing its case until BT was forced to produce some damning tape recordings.  A few of many damaging remarks:

“We set ’em up.”

“They would never know.  They would never be able to know how much money was taken out of that,” says one salesman.  In reply: “Never, no way, no way. . . that’s the beauty of Bankers Trust.”

The objective was “To lure people into the calm and then just totally fuck ’em.””

Procter obtained recordings from eight BT clients and all of them contained similar evidence of a deliberate effort to exploit customers.  Procter added RICO (Racketeer influenced and Corrupt Organizations Act) charges to its suit, tripling the amount of the damages that would be awarded if Proctor won the lawsuit.

BT settled the cases, and the claimants ended up clawing back a large percentage of the losses they had incurred.  BT also paid a $10 million fine to federal securities regulators over the charge that it had deliberately misled Gibson on derivative prices.

Like many other institutions that became addicted to pushing the envelope, BT was unable to change its behavior.  Bankers Trust was done in four years later by a second, unrelated scandal, this one criminal (failing to turn over abandoned property to the state of New York and other states), which led to a takeover by Deutsche Bank.

The BT story is different in degree but not in kind from a lot of Wall Street behavior.  The 1990s and 2000s saw a broad deterioration of conduct in the financial arena.  Incidents include the Salomon Brothers Treasury bond fraud (which we discuss in chapter 7), the E.F. Hutton check-kiting scandal, and Citibank gaming a Eurobond order system.

With each scandal, the same drama played out: a flurry of press stories, once in a while some Congressional grandstanding then back to business as usual.  The Bankers Trust case and these other abuses raise a host of important and puzzling questions:

  • Why did supposedly sophisticated players, like Procter & Gamble, buy risky products that they did not understand?
  • Why did financial firms decide it made sense to hoodwink customers on a large-scale basis? Bankers Trust’s actions look bizarre, beyond comprehension to a Main Street businessman.  You don’t prey on your customers, at least if you plan on ending up with something more enduring than a fly-by-night scam.  How did Wall Street come to operate with vastly different rules?
  • Why was it easy for financial firms to exploit their customers?
  • Why did people who were supposed to be neutral arbiters in financial markets (such as regulators and ratings agencies) for the most part fail to recognize and address these practices?

Answering these questions is key to getting to the bottom of this financial crisis:

The customers of financial firms not only did not expect those firms to take advantage of them in the course of ongoing business relationships, but they were also reassured by a steady chorus of voices that proclaimed that new and clever ways had been found to manage their risks.  In other cases, the customers were themselves hoping to use exotic financial products either to evade regulation or to ramp up their profits.  At the same time, many investors such as pension fund managers were not particularly concerned about engaging in risky behavior, as long as they had plentiful company.  In fact, competitive pressures meant that from a career standpoint, it was much safer to go with the crowd than stand out and possibly show lower investment returns.  As Keynes remarked,

“A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.”

Financial firms were once contained within a regulated environment in which they were assured moderate but steady profits in exchange for services that contributed to the stability of the economy as a whole.    Deregulation (and the failure of regulators to respond to the industry’s attempts to escape restraints) changed everything, leading financial companies to become much more like the fiercely competitive firms idealized in neoclassical (Webster’s dictionary: the movement for a revival or adaption of a classic style) economics.  With each company fighting for market share and profits, the aggressive impulses that had been checked by oversight and by quaint notions like propriety were now unleashed.

It was easy for predatory firms to take advantage of their customers thanks to the rapid growth of a “shadow banking system,” involving, in particular, over-the-counter markets derivatives.  The financial services industry developed a range of products and services that were both very difficult for their clients to understand and also substantially outside of the reach of regulation.

In order to be ready to take advantage of fleeting profit opportunities, large financial firms also became more decentralized.  Consequently, if misbehavior did come to light, it was often difficult to prove that top management had been responsible.

Finally, the people who were supposed to oversee financial markets had either absorbed enough of the ideas of neoclassical economics and the world view of the financial services industry that they had no interest in intervening (regulators, some judges in key decisions), or else they had a vested interest in keeping the party going (ratings agencies, along with accommodating accountants and attorneys).

Manias typically depend on funding sources becoming cavalier about risk.  Normally, enthusiasm over new technology stokes escalating momentum trading, rationalized with “this time it’s different” theories.  But this pattern was a departure.  Here we had people who should have known better falling for technology of a different sort, instruments that enabled them to take very particular wagers.  This wasn’t the typical “get on the bandwagon or you’ll lose out” dynamic.  Instead, it involved naive parties taking on far more risk than they thought they were absorbing.  The initially poor risk/reward tradeoff is worsened by being cheated badly on pricing.  Overpaying can turn even a sound deal into a turkey, and many of these transactions were not sound to begin with.

The result, that the cunning swindled the chumps, was predictable to anyone who had studied the 1920s, or had experience in a real market.  Yet it ran afoul of “freemarket” dogma, which assumes that buyers and sellers are equally well informed and can watch out for their own interests.

That rosy view fails to operate, not just in financial markets, but also in many walks of life.  How can you be sure your doctor or your attorney is skilled?  Unless you are in the same profession, you really do not know.  You resort to proxies, like bedside manner, reputation, credentials.  But they are not necessarily valid indicators.

In fact, as we will see here and in later chapters, deregulated markets showed abuses on a far more evasive scale, and with much greater losses, than those with sound rules, even in the recent environment of lax enforcement.

Let’s look at another example.  This is 1994.  You are a portfolio manager at a mutual fund.  A salesman from Morgan Stanley calls and offers something that sounds really appealing, and AA-rated instrument that makes payments that are markedly higher than typical AA-rated paper.  He tells you that there is one hitch: if the value of the Mexican peso falls more than 20%, then the payments you receive from the bond (the instrument) will start falling in proportion to further decreases in the price of the peso.  You know Mexico is a little rocky, but 20% is a very big cushion, so you take the plunge.

Now how does this deal work?  Most important, who is taking the risk of the first 20% loss?  Mexican banks.  The first deal was done by one of the largest, Banamex.  Remember, since this deal is with a party that is making payments in pesos, but you only want to be paid in dollars, someone has to bear the risk of changes in the value of the peso.  If the peso devalues, provided that the fall in the value of the peso is less than 20%.  From then on, you’re on the hook for any additional losses.

The structure managed to create the seeming miracle of allowing Banamex to sell some bonds that had fallen in value while keeping the bonds with the bank from an accounting standpoint.  The bank thus freed up cash but avoided reporting a loss.  It achieved this magic via a “cost” that looked free, that of taking the first and large loss on a peso devaluation, which the rating agencies clearly regarded as a near certainty.

Banamex was responsible for taking the losses due to the first 20% of peso price declines.  The ratings agencies clearly thought that the peso was likely to fall.  The grade they gave to Mexican government debt, denominated in dollars, was BB, a junk bond rating, while its peso debt was rated AA-.  Yet bizarrely (or maybe predictably in light of what happened later with subprime ratings) Standard & Poor’s assigned the same rating to these new dollar-denominated bonds as it had to Banamex before the deal, the same AA- it gave to Mexican government peso debt.

Why was this a danger sign?  The rating was tantamount to saying that odds of the peso falling further than 20% were nil.

But when central banks lose the battle in holding currency pegs or bands, the falls can be catastrophic.  For instance, when the United States went off the Bretton Woods system in 1971, which had required that the greenback be backed by gold, the dollar plunged 50% in short order in gold terms.

So you have circumvention of regulations (“regulatory arbitrage”) and probable misrating in one lovely package making this deal viable.  No wonder it was so profitable.

Morgan Stanley peddled over $1 billion of paper along these lines to big name investors like AllianceBernstein, Scudder, and Merrill Lynch Investment Managers.  Other banks copied the structure.

Risks that may be tolerable on a limited scale become a different kettle of fish if they mushroom.  Having a shot of Scotch is different than downing a fifth.  The Mexican banks and U.S. mutual funds went on a bender.  Mexican banks had already been seen as a solvency risk as of the early 1990s, before they went on this binge.  Irresponsible domestic lending, turbocharged by money inflows from U.S. mutual funds that were linked to currency bets, only made a bad situation worse.  These loans of “hot money” were convenient for the Mexican banks, but they could dry up quickly, and if they did, the Mexican banks would be in trouble.

Back to 1994.  The deals continue as doubts about Mexico were intensifying.  Dollar-based investors are withdrawing from the country, putting even more pressure on the peso, which is at the bottom of its managed band.  Salesmen at Morgan Stanley are placing bets on whether the currency will collapse. The firm, worried that it will go bust if Mexico suspends convertibility of the peso to dollars, creates some peso convertibility bonds that pay a mere extra 50 basis points (0.50%) to get customers to absorb that risk.  It targets the most clueless, who cheerfully buy the paper.

The investment banks that were intermediating these dollar/peso bets could see a crash was imminent; the only question was how bad it would be.  Yet in the late stages, Mexican banks were hoovering up a product peddled by Morgan Stanley called the Cetes swap, which was the derivative equivalent of borrowing in dollars to buy higher-yielding Mexican bonds.  They were stepping in front of the steamroller, piling on bets that would create huge losses if the peso tanked at precisely the time when Morgan Stanley was desperately arranging hedges to protect itself against the very same possibility.  The banks acted as if the 8% spread between the dollar-based interest rate it was paying to borrow and the peso-based interest rate it earned when it invested the proceeds was free money.

A general rule in finance: if it looks too good to be true, it is.

These wagers were not just wildly imprudent, but were also a regulatory end-run.  The banks were already at their legal borrowing limits, but the Cetes swaps permitted them to evade these rules by entering into deals that were the economic equivalent but did not have to be disclosed to regulators or the public at large.  So banks that were already exposed to failure skirted restrictions, took on even more risk, and predictably went bust.

Morgan Stanley’s analysts were touting the prospects for Mexico while others inside the firm were reducing their Mexico exposures.  In the dot-com era, 10 firms paid a total of nearly $1.5 billion in fines when the analysts pushed stocks that they said internally were rubbish.  Would the firms’ staff acting to reduce Mexico risk when they were still peddling to clients have been an SEC violation?  No, because derivatives, unlike stocks, aren’t regulated by the SEC.

Did Morgan Stanley and its cohort knowingly push the Mexican banks toward the brink?  Ex-Morgan Stanley derivatives salesman Frank Partnoy, who helped to peddle the Mexican deals, suggests as much:

“At the time, many US bankers regarded the Mexican banks as cash pinatas and were eager to smash them open. . . if they were pinatas, they weren’t even close to full yet. . . . Our plan was to fatten the banks some more. . . . An easier path to a Mexican bank’s wallet was through his stomach.

What could we feed the Mexican banks?  Obviously, it should be high margin and high volume.  We wanted to make as much money as we could.  It should be addictive too, so the banks would gorge themselves.  Once the banks were bloated and couldn’t eat another bite, it would be easy to bat them down.  Then, at the appropriate moment one little nudge would cause the entire obese Mexican banking system to topple like Humpty Dumpty.”

During the month before the Mexico implosion, one of Partnoy’s colleagues gloated, “You have to be a criminal to be good at this business.”

In late December 1994, the Mexican government tried relieving pressure on the peso by widening its trading band with the dollar, a de facto 15% devaluation.  Chaos ensued as everyone realized the game was over and raced for the exits.  A mere three days later, the government capitulated and floated the currency.  The peso fell 55% and later stabilized at an over 40% loss.

Ironically, the popularity of the peso gambles was probably Morgan Stanley’s salvation.  So many investors held peso-linked dollar paper that no one looked particularly stupid for having gotten on the bandwagon.  Moreover, the damage was so widespread that Uncle Sam rode in to the rescue.  The United States provided a bailout in the form of a $50 billion emergency loan.  Congress had voted down the rescue, but Treasury Secretary and friend of Wall Street Robert Rubin broke open a Treasury piggy bank (the Exchange Stabilization Fund, a Depression-era creation to support the dollar) for an unintended purpose, namely, assisting U.S. banks and investors by propping up the peso.  Some argued at the time that it would have been better to structure a bailout of the Mexican economy rather than of U.S. investment banks and investors, but too little avail.”


YVES SMITH is creator of the influential Naked Capitalism, a top-ranked economics and finance blog with over 250,000 unique visitors each month.  Smith has appeared on CNBC, CNN, and FOX Business News, and has written over 40 articles in venues such as The New York Times, Slate, and The Christian Science Monitor.  She lives in Manhattan.”


LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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