Infectious Greed (6 page)

For options traded on an exchange, the value of the option was set by supply and demand, and was easy to determine. The value of such options was whatever people would pay for them, and those amounts were published every day. But Krieger's options were traded in the over-the-counter markets, where there were no published prices and not as many buyers. Consequently, the value of these options was more open to question.

No one had seriously questioned the values of Krieger's trading positions when Bankers Trust issued its press release. But now the control teams were concluding that the volatility estimates used in marking Krieger's trades were higher than they should have been. According to one report, the volatility measurements for Krieger's portfolio were overstated
by as much as 25 percent.
⁴¹
That meant that the value of Krieger's positions was overstated by—in aggregate—$80 million.
⁴²
In other words, Krieger had only made $220 million, not $300 million, as everyone at the bank originally had anticipated. Krieger was no longer as much of a hero. And Bankers Trust no longer had a profit for 1987.

By late February, the managers at Bankers Trust were in a serious bind. Their January press release had included the $80 million of phantom profits. It had been inaccurate, and now they knew it. They were approaching the deadline for the bank's 1987 annual report and Form 10-K, the annual filing public companies were required to make with the Securities and Exchange Commission. If they now admitted that the January press release had contained an $80 million mistake, shareholders almost certainly would sue, and the media would vilify them for their recklessness in issuing the press release. Even worse, without the $80 million, the bank's tiny profits from 1987 would be wiped out, and Bankers Trust would record its first loss since the 1930s.

But if they didn't include the mistake in their Form 10-K, they would be knowingly committing securities fraud. In the late 1980s, federal securities prosecutors were aggressively pursuing criminal securities-fraud cases. And every banker knew the scene from Oliver Stone's 1987 film
Wall Street,
in which federal agents lead Bud Fox from the floor in hand-cuffs. That scene was based on a real case, and no one at Bankers Trust wanted to be in the sequel.

Now the rumors were really swirling, and Bankers Trust's managers continued to deny them, saying they believed any impact on earnings related to Krieger's departure would be “immaterial.” They admitted—in a private phone call to a group of stock analysts—that someone at the bank had mispriced several one-year currency-options contracts, based on Japanese yen, West German marks, and New Zealand kiwi.
⁴³
They pleaded with the analysts that such options were extremely difficult to value; it could happen to anyone. Shareholders were not privy to this call, and as far as they knew Bankers Trust was still profitable.

Krieger said he was out of the country when the options were valued.
⁴⁴
He also said he rarely acted alone at Bankers Trust: “I sat next to the worldwide manager for forex [foreign exchange], Jay Pomrenze, and he was my boss. We had loss limits, and everything was worked out.”
⁴⁵
The most likely explanation for the mistake was that someone at Bankers Trust had tapped into the wrong data source for the volatility numbers used to
value Krieger's trades. Other traders at Bankers Trust had experienced similar problems, when the computer system occasionally applied volatility numbers from a simulation, instead of from a live data feed. As Krieger put it, “I don't know exactly what happened, but they certainly didn't have Victor Haghani from Salomon writing their systems.” Whatever the truth was, by the time Bankers Trust's managers were trying to decide whether to disclose the fact that $80 million of income had “disappeared,” Andy Krieger had resigned and was no longer involved in the decisions, and no one at Bankers Trust was claiming responsibility.

What could Bankers Trust do? The choices were bleak. They consulted their outside accountants, from Arthur Young & Co., now part of Ernst & Young. Arthur Young was conducting its annual audit of Bankers Trust and was preparing to issue its opinion that Bankers Trust's financial statements were “fairly presented.” This opinion was a crucial part of the bank's Form 10-K filing.

The question was: how could the bank account for the missing $80 million? Was there a way Bankers Trust nevertheless could claim to have earned a $1.7 million profit, even though it now knew it had $80 million less in trading profits?

Remember, this was 1988, more than a decade before dozens of companies—from Cendant to Enron to WorldCom—were accused of inflating revenues and reducing expenses to meet quarterly earnings targets, and two decades before the collapse of major financial institutions from subprime mortgage-related risks they hadn't disclosed. Some senior managers back then were willing to whisper information about the upcoming quarter to the securities analysts covering their companies, but few would consider manipulating their accounting statements to fit expectations. That was fraud, after all, and reputable managers simply didn't do it.

Someone—it remains unclear who—suggested that Bankers Trust could resolve its problems and avoid the need to correct its January press release by simply reducing its compensation expenses by $80 million, to offset the loss exactly. Was it possible? Could the managers really argue that bonuses would be lower because of the losses, that the $80 million of phantom profits was offset by exactly $80 million less in bonus payments? That position would provide cover for Bankers Trust managers, who could argue they were not knowingly making any misstatements. Instead, they were relying on their accountants' advice that it was reasonable to reduce the bank's compensation expense.

And they did it. The accountants at Arthur Young made an entry
reducing by $80 million an account that recorded Bankers Trust's obligation to pay employees' future bonuses. The bank issued its Form 10-K, reporting the same profit it had announced in its January press release. Arthur Young issued a signed opinion that this profit was fairly presented. And the bank's shareholders didn't know a thing about any of it. Bankers Trust was gambling that no one would discover the $80 million reduction that exactly matched the $80 million of missing profits.

The bank might have gotten away with this accounting sleight of hand if a few sharp-eyed banking regulators at the Federal Reserve hadn't spotted the $80 million discrepancy in a banking call report Bankers Trust filed privately with the Fed. They forced the bank to file an amended call report. In their view, the accounting entry was dubious at best. Hidden accounts for future reserves were illegal, and the $80 million exact match was too much of a coincidence. Besides, Bankers Trust's bonuses couldn't be cut, because they had already been paid, and one person whose bonus arguably should have been reduced—Andy Krieger—was no longer an employee. An $80 million compensation reduction was absurd.

With the cat out of the bag, Bankers Trust was forced to adjust its Form 10-K filing after all. The Securities and Exchange Commission—and the bank's shareholders—were about to learn the truth.

On July 20, 1988, six months after Krieger's profits were first reported to investors—and five months after Krieger resigned—Bankers Trust announced $80 million of “adjustments” to its income from the previous year. The Bankers Trust press release stated that the company and its auditors believed the adjustments were “not material.”
⁴⁶
The managers put on the best spin they could. Chairman Charlie Sanford said, “What's the big deal? There's nothing sinister here. There's no effect on earnings. The company is worth the same amount. It's just an accounting thing.”
⁴⁷

Securities analysts appeared to be furious, even though many of them had known about the discrepancy for months. They called the bank's valuation process “loosey-goosey,” something “you could drive a truck through,” and threatened that the bank “is going to pay for this.”
⁴⁸
One analyst said, “I don't want to invest in a casino.”
⁴⁹
Another summed up the sentiment: “Everybody in the world would like to see Bankers take a hiding.”
⁵⁰

Other banks distanced themselves from Bankers Trust's risky trades. A spokesman for Chase Manhattan said, “The majority of our business is customer driven. We don't take the same large bets that other banks take.”
⁵¹

But, surprisingly, the Securities and Exchange Commission and the Department of Justice did not take any action. They didn't bring charges against Bankers Trust, Andy Krieger, or any other current or former bank employee. It wasn't an unwillingness to prosecute securities fraud. They were bringing dozens of insider-trading cases, and Michael Milken was about to go on trial. So why didn't the federal prosecutors bring charges in this case?

One reason was that the charges related to options valuation were extraordinarily complex and novel; most prosecutors had never heard of the Black-Scholes model. Another was that it was an election year, and it might not have been such a good idea to bring a high-profile case against a top investment bank and a top accounting firm when those two industries were also top campaign contributors. The federal government took the position that Bankers Trust and Arthur Young had corrected the mistake; that was enough.

In fact, the details of the episode remained a secret for more than three years, until
Fortune
magazine—in an article entitled “How Bankers Trust Lied About $80 Million”—unearthed the discrepancy. The article was ruthless, calling the events “mind-boggling,” and asking whether the regulators' decision not to bring a case implied “that it is okay for companies to falsify line items?”
⁵²
Again, there was no response from the government. In 2002, when the memories of most of the participants had faded, one former federal official involved in the decision not to bring a case, who wished to remain anonymous, still clung to the notion that the accounting judgments had been reasonable under the circumstances.

 

 

A
ndy Krieger is an important first case in understanding the trajectory of financial markets during the past two decades. His trading of currency options was an early example of how financial instruments were becoming more complex, and how traders were quick to exploit new trading strategies. Krieger's experience also showed how easily an employer could lose control of its employees dealing in these instruments: Krieger was permitted to take substantial risks with options, and no one at Bankers Trust was able to evaluate his profits from complex trades. In addition, the government, by not prosecuting anyone involved in the Bankers Trust accounting scandal, signaled to the financial community that it would not closely scrutinize the largely unregulated over-the-counter markets.

These three changes—increasing complexity, loss of control, and lack of regulation—would become the most important issues in financial markets. Financial instruments would become more complex and, increasingly, would be used to avoid legal rules; control and ownership of companies would move further apart, leaving individual managers unable to monitor increasingly aggressive employees; and markets would become deregulated, as prosecutors continued to avoid complex financial cases, and accounting firms and banks were insulated from private lawsuits. These developments began with Andy Krieger, but soon would spread throughout Bankers Trust, then to CS First Boston and Salomon Brothers, and then to numerous other financial institutions and their clients.

For many bankers, the news about Krieger's trading was a wake-up call. It was time for them to go back to school, to learn to use computers and spreadsheets, and to delve into the details of options pricing and finance theory. Notwithstanding its problems in 1988, Bankers Trust was well positioned in the over-the-counter derivatives markets, which would soon become the largest markets in the world, far surpassing the New York Stock Exchange in overall size.

With these new instruments, a rogue employee could inflate trading profits, or even put much of a company's capital at risk, all in a matter of seconds. Bankers could easily dodge regulators, who were overwhelmed. Lawmakers, if lobbied effectively, were unlikely to subject these markets to much scrutiny. In this new world, shareholders—and even boards of directors—would quickly become lost, struggling to decipher their company's financial statements. If a financial officer's direct supervisors couldn't monitor or accurately evaluate his trades, how could shareholders or directors be expected to do more?

The major financial fiascos of recent years would have been unimaginable during the time Andy Krieger was at Bankers Trust. The financial markets were still relatively simple in 1988. But Bankers Trust's approach to evaluating Krieger's trading was a foreboding precedent, and as the seeds sown in this saga began to take root, the previously inconceivable would soon become commonplace. Bit by bit, the markets were losing control. And several Bankers Trust employees who had followed in Andy Krieger's footsteps were about to take a different and more troubling path.

W
hen Andy Krieger left Bankers Trust in early 1988, the markets were in decline. Charles S. Sanford Jr., the newly appointed chairman and CEO of Bankers Trust, had put out the fire surrounding Krieger's currency-options trading. But now, in only his second year at the helm, Sanford confronted a much bigger problem. The future of Bankers Trust—and the future of banking generally—was in question.

The go-go period of the mid-1980s was ending, and Wall Street was hurting. Merger-and-acquisitions work was stagnant, and investors were pulling money out of stocks. Many banks were posting losses. Although Bankers Trust had reported a slim profit for 1987, in truth—without Andy Krieger's $80 million of phantom earnings—the bank had lost money. Sanford couldn't count on another last-minute bonanza from one of his traders, and no one at Bankers Trust wanted to depend on another Krieger. To avoid another losing year, Sanford needed to find a new and reliable source of profits, fast.