Infectious Greed (2 page)

These changes spread through financial markets like a virus through the population. Before 1990, markets were dominated by the trading of relatively simple assets, mostly stocks and bonds. The sine qua non of the 1980s was the junk bond, a simple, fixed-income instrument no riskier than stock. The merger mania of the 1980s—driven by leveraged buyouts, in which an acquirer borrowed heavily to buy a target's stock—involved straightforward transactions in stocks and bonds.

Back then, individual investors shied away even from stocks, and most people kept their savings in the bank or in certificates of deposit, which paid more than 10 percent annual returns during most of the decade. Mutual funds became popular briefly—with stock-picking legend Peter Lynch of the Fidelity Investments' Magellan Fund attracting several billion dollars—but from 1968 through 1990, individuals sold more stock than they bought and money flowed out of the market. Few stocks traded at prices of more than twenty times their annual earnings, and stocks with no earnings were shunned.

Derivatives—the now-notorious financial instruments whose value is derived from other assets—were virtually unknown. The two basic types of derivatives, options and futures, were traded on regulated exchanges and enabled parties to reduce or refocus their risks in ways that improved the overall efficiency of the economy. Customized over-the-counter derivatives
markets—where derivatives were often used for less laudable purposes—were a fraction of one percent of their current size, and most complex financial instruments still had not been invented. It is telling, for example, that in
Barbarians at the Gate,
the classic book about 1980s finance, derivatives are not even listed in the index, and stock options merit only a footnote on page 364.
²

Some companies used basic forms of derivatives during the 1980s, including so-called “plain vanilla” interest-rate swaps, where one party agrees to pay a fixed rate of interest to another party, who agrees to pay a floating rate. But the forms of structured financing and over-the-counter gizmos that later would bring hundreds of companies to their knees simply did not exist. Moreover, the exchange-traded derivatives some investors bought and sold were not especially risky; they had changed little from financial instruments the ancient Greeks created and used.

Even stock options—the derivatives that became the primary source of executive compensation during the 1990s—were relatively uncommon. A typical 1980s executive received cash salary and bonus, with perhaps a little stock, but few or no options.

The legal environment during this early period was harsh. The go-go 1980s led prosecutors to clamp down hard on securities fraud, indicting dozens of financial-market participants, nearly 100 in January 1989 alone. Looking back on the decade, the
Wall Street Journal
noted that “the word ‘indictment' became almost as central to Wall Street lexicon as stock or bond.”
³
The financial-market watchdogs made investors feel secure—almost smug—about financial fraud.

In several high-profile cases, judges imposed heightened duties on corporate directors, bankers, accountants, and lawyers, who came to understand that they violated the law at their peril. Regulators tightened rules against insider trading and other financial abuses. Joseph Grundfest, a commissioner of the Securities and Exchange Commission during the 1980s, opened a 1988 speech by saying, “It's a pleasure to appear before so many unindicted participants in the financial markets.”
⁴
The decade closed with Judge Kimba Wood sentencing the infamous financier Michael Milken, of Drexel Burnham Lambert, to ten years in federal prison. By that time, prosecutors certainly had Wall Street's attention.

Top managers of large companies lived with another fear, too. Well-known corporate raiders—including Ivan Boesky, Carl Icahn, Ronald Perelman, and T. Boone Pickens—routinely bought large stakes in companies and then ousted ineffective managers to boost the value of shares.
Greed was good for these raiders (and, sometimes, for shareholders), but it wasn't good for the managers, who scrambled to create defenses against these takeovers and thus preserve their jobs. To the extent the 1980s involved complex financial dealings, they were focused on these increasingly intricate takeover defenses.

Still, most finance professionals—even highly paid investment bankers—were technologically primitive, without e-mail or the Internet. They used HP12C calculators instead of computer spreadsheets and statistical software. Few had formal finance training, and almost no one had a math or finance Ph.D. A 1980s trader would be virtually unemployable today; his HP12C would be about as useful on a trading floor as an abacus.

Individuals were technologically primitive, too. Investors placed orders to buy and sell stock by letter or over the phone, not with the click of a computer mouse. People learned how their stocks were performing at most once a day, from the financial pages of the morning newspaper, not in real time on television. Financial analysis was available through the mail at a price, not on the Internet for free.

In sum, the 1980s were a relatively primitive period on Wall Street. Life was uncomplicated, if aggressive. Participants were labeled barbarians, predators, even thieves. At the same time, the financial markets became increasingly competitive and profit margins dwindled. The stock market crash of October 19, 1987, didn't help matters. After the Dow Jones Industrial Average tumbled 508 points, or more than 22 percent, in one day, investors became skittish. As analysts struggled to explain the collapse, the investment bankers' business sputtered. The last years of the decade were likely to be lean, and the future looked grim. It was not a good time to be working on Wall Street.

All of this was about to change.

A
ndy Krieger was one of those kids who, it seemed, could do everything. He was an excellent high school student, and was admitted to the University of Pennsylvania, where he was elected to Phi Beta Kappa.
¹
He was a competitive athlete and briefly played professional tennis on the European circuit.
²
He was an advocate for the poor, and was especially interested in the plight of lepers in India. As a graduate student during the late 1970s, he studied South Asian philosophy, translated obscure Sanskrit texts, and planned for a career in academia.
³
He was a vegetarian.

One day, Krieger's dissertation adviser told him that although his work had been first-rate, he would not be able to land an academic job until one of a handful of people working in his area died. Krieger wanted to help the poor, not become one of them, so he decided to trade careers. After six years of graduate study, he enrolled in business school.

Almost immediately, his life was transformed. Krieger studied finance at the Wharton School of Business, whose graduates included the infamous financiers Michael Milken and Donald Trump, men who had thrived in the relatively simple 1980s world of junk bonds and corporate takeovers. Krieger took a course in international finance, and was captivated by a new, more esoteric phenomenon: trading in foreign-currency options, the rights to buy and sell currencies at specified times and prices.

The curriculum at Wharton—which now includes dozens of specialized courses in finance—barely touched currency options when Krieger was there.
⁴
But J. Orlin Grabbe, a young finance professor at Wharton and a pioneer in the area,
⁵
became Krieger's mentor and taught him just enough to whet his appetite.
⁶
Krieger sought to reinvent himself as a currency options specialist; in 1984, he wrote a computer program to assess the value of currency options, and when he learned that Salomon Brothers, the New York investment bank, would be interviewing Wharton students for a position trading currency options, he submitted his résumé.

At Wharton, Krieger had learned how foreign currencies whose value had been linked to gold or to the U.S. dollar were now floating freely. Instead of requiring that their currencies be exchanged for a fixed amount of gold or dollars, various central banks—including the Federal Reserve—were permitting the value of their currencies to fluctuate in the market. Trading in these currencies was increasing exponentially, and companies had moved beyond simply exchanging U.S. dollars for Japanese yen, or German marks for British pounds, to betting on dozens of currencies in all sorts of new and fantastic ways.

During school, Krieger did a stint at O'Connor & Associates, an options trading firm in Chicago. He found that in currency trading, “you're pitted against some of the sharpest minds in the world.”
⁷
The currency markets were intensely competitive, with hundreds of billions of dollars changing hands every day. Firms that traded the more exotic instruments—including currency options—were cleaning up. When Krieger discovered that some of these traders were making millions in bonuses, he quickly found “an inner drive to see how good I could be.”
⁸
So much for Sanskrit.

Krieger gave up his tennis career and put his academic interests to the side. He persuaded the interviewers from Salomon that his brief experience as a trader, plus his detailed understanding of currency options, plus his knowledge of foreign languages and cultures, made him the ideal hire.
⁹
Salomon agreed, and Krieger began his career there after graduation.

Four years later, during early 1988, Krieger briefly was as well-known as some of the men who had come before him at Wharton. The publicity didn't last long, and few people remember Krieger today. But Krieger's story from that time is an object lesson in the risks associated with financial innovation.

I
t was 1984, and few bankers knew much about currency options. The Chicago Mercantile Exchange had just introduced them, and they had been trading for less than two years on the Philadelphia Stock Exchange, where Andy Krieger had traded a bit during business school.
¹⁰

Few bankers knew about the theory of options pricing, either. A decade earlier, three economists—Fischer Black, Myron Scholes, and Robert Merton—had published formulas for evaluating options, coincidentally at the same time the Chicago Board Options Exchange opened for business.
¹¹
Within six months, Texas Instruments was advertising that traders could calculate options values by plugging the formulas—known generally as the Black-Scholes model (Merton, unfortunately, lost out on credit)—into a calculator.
¹²
Within twenty years, virtually every company would use the Black-Scholes model to evaluate options, and the formulas would be taught in introductory finance courses in business school.

But bankers are slow, and it took more than a decade for options theory to migrate from the trading pits of Chicago to the banks of Wall Street. At Citibank in the early 1980s, only one trader on the trading floor even had a computer, a clunky Radio Shack TRS-80, which was primitive even for its time.
¹³
At J. P. Morgan, one customer persuaded a treasurer named Dennis Weatherstone (who later became the bank's chairman) to do a currency option, but the bank's traders had no idea how to price the option and ended up losing money.
¹⁴
Options were a mystery to most bankers, who were wary of these new markets.

In fact, the state of knowledge on Wall Street in 1984 was such that if you read the next five paragraphs, you will know just as much as a typical investment banker knew at the time.

In simple terms, an option is the
right
to buy or sell something in the future. The right to buy is a
call
option; the right to sell is a
put
option. Options on all kinds of commodities were traded on exchanges during the 1980s, mostly in Chicago but also in Philadelphia. These options were straightforward and standardized, and currency options were no exception. They were simply options to buy and sell amounts of various currencies at a specified time and exchange rate.

To understand how currency options work, suppose you are planning to take a vacation in Mexico a month from now. If the Mexican peso weakens during the next month, you can plan to eat some fancier dinners during your trip, because you will be able to buy more of the weakened pesos when you arrive. But if the peso strengthens, you might be eating at taco stands.

To hedge this risk, you might pay someone money today for the right to buy pesos at a set price a month from today. For example, if one dollar is worth ten pesos today, you might want to lock in that rate. You could pay a foreign-exchange broker a fee (called a
premium
) in exchange for the right to buy pesos at the ten-for-one rate in one month. If you did so, you'd be buying a peso call option.