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The World According to Frank Partnoy

Frank Partnoy, the author of F.I.A.S.C.O.: Blood in the Water on Wall Street, was an associate at Morgan Stanley's derivatives products group in 1994 and 1995. He started his career in 1993 in a similar position at First Boston. Partnoy left Morgan Stanley to practice law in Washington D.C., and is now an assistant professor at the University of San Diego School of Law, where he specializes in financial market regulation. He received degrees in mathematics and economics from the University of Kansas and a law degree from Yale Law School. Partnoy spoke with editor Joe Kolman in October.

Derivatives Strategy: What inspired you to write this book?

Frank Partnoy: The inspiration was really from the fact that no one else wrote it. When I arrived at Morgan Stanley, I was so surprised by everything I saw. My colleagues and I often talked about the idea that somebody someday is going to write a book about all this. After I left I continued to wait, and every month that went by I thought that the book would come out, the story would come out, either about Morgan Stanley or about Bankers Trust or about any of the other banks that were involved in the various derivatives fiascoes of 1994 or 1995. But nothing came out. So I said "This book has to be written” and I put together a proposal.

DS: You make quite a point in your book about how people used derivatives to get around investment guidelines, which I think almost everybody would agree was a fairly common phenomenon. But some investors were allowed to buy structured notes. Is there anything inherently wrong about selling a note to an investor who was allowed to buy it and knew what he was buying?

FP: Let me give you an example of what I think is inherently wrong. There's a deal I talk about in the book that was driven by Morgan Stanley's desire to get rid of convertibility risk. They had exposure to the Mexican government not defaulting but saying they would pay in pesos instead of dollars.

"I sold to cheaters, not widows and orphans. That was the moral high ground if there was a moral high ground in derivatives. I sold to cheaters.”

DS: It was purchased by a Midwestern insurance company…

FP: The Midwestern insurance company can buy that bond because, from a regulatory perspective, they've satisfied all the requirements they need to satisfy. And yet that instrument—if you look at it on its face—is inherently wrong. It makes no sense. There's no reason why anyone should want to buy many of these instruments. I would make that statement even more bold. I would say that the entire structured note business in inherently wrong. Why should anyone ever want to buy a structured note unless it's to get around some investment guidelines?

DS: In your mind, all the people who brought structured notes were either "cheaters” or "widows and orphans.” The cheaters are the people trying to get around the guidelines, and the "widows and orphans” are the people that didn't understand how the notes worked. Is that a fair...

FP: That's right.

DS: Yet there were some people in another category that had permission under their investment guidelines and understood in some fashion how the notes worked and were nevertheless willing to buy them.

FP: I call those the cheaters...

DS: A hedge fund wouldn't be cheating if it had the authority to buy a note.

FP: Well, a hedge fund would have to be out of its mind to buy a structured note unless it was mispriced. Hedge funds are not subject to these regulations and are not widows and orphans, so they're smart enough to assess the value of a structured note. I would be stunned to find that any significant portion of the structured note market was purchased by hedge funds. I certainly wouldn't put money in a hedge fund that bought structured notes.

DS: Don't you think some people were making a lot of money on structured notes that were not cheating or totally ignorant of what was going on?

FP: Let me give you an example. What do you call an insurance company that bought equity-linked notes? Where does it fall in? It says, from an insurance company's perspective, I would really like to have some exposure to the stock market, but I can't based on my regulatory structure.

DS: Well clearly, it would fall into your category of cheaters.

FP: Right.

DS: Yet there are some institutional investors who have the authority, who are not cheating and who feel it is an inconvenience to buy a note linked to the differential between German and Dutch rates and don't feel like watching the trade all day long themselves. They would rather by it in a note form. Is your argument that those people were an extremely small part of the market?

FP: I don't think that those people exist. I think that if you dig beneath the surface you'll find that one of two things happened: either they mispriced the note or they were buying the note to evade some investment guideline. If they wanted to put on a foreign exchange bet and leave it, they could do that in the form of a foreign exchange bet...

"I'm not sure I would use the word relief to describe my feelings leaving Wall Street when I look at how much money people in the derivatives business continue to make. I might use the word stupidity instead of relief.”

DS: They could go into the market and do the trade themselves...

FP: Right. This is a simplification, but the structured note is essentially composed of a zero plus an option. What do they care about buying the zero?

DS: Let me raise a question about Procter and Gamble. There was a reference in your book to a salesman who sold to P&G and who said he was certain that P&G knew what they were buying. Do you think that P&G knew what they were buying or were they a cheater or a widow and orphan?

FP: P&G bought a swap, and I would distinguish between swaps and structured notes. Swaps can be used to evade the guidelines, but structured notes are always used to evade guidelines. I'm making a pretty strong claim here. Swaps are not always necessarily used to evade guidelines. They can be used for other reasons.

The complete P&G story has never been told. There's evidence of both. There's evidence that its managers were cheaters and there's evidence that they were widows and orphans. The evidence that there were cheaters at P&G comes from the fact that once the swaps were discovered, P&G sent the treasurer out to pasture. So although it's not necessarily the case of P&G cheating in terms of evading regulations, there's an argument that someone at P&G was going well beyond what the swaps program was intended to do.

There is even more evidence that P&G managers were widows and orphans. The swaps were very complicated and difficult to price. You would need a reasonably sophisticated pricing model to price the swap. Bankers Trust admitted it made a lot of money on the swaps. The fact that Bankers Trust made so much money from swaps is evidence that P&G didn't completely understand what it was buying.

DS: When you were on the desk, did you sell notes to people that you thought didn't understand them?

I hope that people who are in the derivatives business will think, before every action that they take, that this action may be the subject of a book at some point. I think that there are other books out there to be written and I hope that people in the business worry about that.”

FP: I didn't sell structured notes.

DS: Then let's just say structured products...

FP: For every product I sold, I spent an enormous amount of time trying to educate the client as to the risks in the trade and how they were priced. Luckily I was not involved in the sale of these structured notes. If I were I would not have written the book.

DS: But you had sold other complicated structures of one kind or another. I guess you're arguing that none of the people who bought the things you were associated with was a widow or an orphan because all were well-educated.

FP: Right. The trades that I did were larger trades—they were structured transactions. Typically the people who buy those kinds of deals know precisely what they are doing. Often they come to you and say, "Here's this regulation we need to get around. Here's this law we need to skirt. How can you come up with a way for us to do it?”

"The entire structured note business is inherently wrong. Why should anyone ever want to buy a structured note unless it's to get around some investment guidelines?”

DS: So you sold to cheaters, not widows and orphans.

FP: I sold to cheaters, not widows and orphans. That was the moral high ground if there was a moral high ground in derivatives. I sold to cheaters.

DS: One of your assumptions is that if Morgan Stanley makes $7 million on a trade someone loses $7 million on a trade. You imply that a couple of times in the book. Is that really what you want to imply? Because it doesn't always work that way.

FP: No, not for all trades. Certain trades are zero-sum games. This doesn't only hold for derivatives. There are zero-sum games across all markets. There are certainly situations in which both the investment bank and client purchasing the derivative win. These are very common.

I don't mean to imply that all derivatives are zero-sum games. But typically if these are privately negotiated contracts and they're not creating any synergy or any additional value, then someone's losing. For example, in an equity swap, the bank that sells the swap makes money, and the purchaser of the equity swap makes money because they effectively get to liquidate a portion of their stock position without paying tax. They both win.

DS: But the government loses.

FP: The taxpayers lose. Not all trades are zero-sum games, but many derivatives trades are. If you look at the size of the derivatives market, whether the notional value or the market value, it's so large that it's inconceivable that there's value created in each trade. There's just no way to have a $60 trillion face amount market and have it be creating any kind of appreciable value. I can't believe that would be disputed.

DS: Many times you imply that the risk to Morgan Stanley on some of these deals was minor, that the hedging was sort of bread and butter. In other parts of the book, there are situations in which no one at the firm really knows what the prices of these things are, and the firm is exposed a lot of model risk and so on. How do you deal with that contradiction? Were the fees Morgan Stanley was charging compensating it for the risks it was taking on?

FP: If you look at the deals that I talk about in the book, the vast majority are riskless transactions—basically agency transactions—where the bank acts as a middle person. The most striking thing about the size of some of the fees is not even the size, although they're huge. It's the fact that Morgan Stanley or any other bank is being compensated for acting as an agent and not taking on any appreciable risk.

DS: So I guess the fees on those kinds of deals were high, but as more people were able to do them they got lower.

FP: Right, the fees on these deals have gone down substantially since I left the industry.

DS: I guess what it shows, in part, is that if you come up with some sort of financial innovation or tax scam or hedge or whatever you want to call it, you can be compensated well until everyone figures it out.

FP: Right. Let's suppose you come up with a trade that will save an investor $10 million from taxes. If you're the only person with that trade, you can charge the investor, say, $9 million. But once the trade idea gets out, somebody else is willing to do it for $8 million, then $7 million, and the price drops down very quickly. I saw that all the time. We would do a deal or someone else would do a deal and try to protect the prospectus, try to protect the document. But they would get faxed around Wall Street within minutes of the deal being done and everybody would have copies.

"I would be stunned to find that any significant portion of the structured note market was purchased by hedge funds. I certainly wouldn't put money in a hedge fund that bought structured notes.”

It doesn't take a lot of rocket science to reverse the deal once you've got all the paperwork. Fees would go down on the deal almost immediately. This is one of the reasons why Wall Street never bothers to get intellectual property protection. Nobody would ever bother because once the idea's out, you have 30 seconds worth of protection and then everybody else is immediately in the market going after you.

DS: Let's discuss the role of lawyers in the derivatives market. What is the role lawyers play in what you believe is the deceptive aspect of the trades.

FP: I don't think that lawyers play a role in the deceptive aspects of the trades. My personal experience, both professionally and with friends who are lawyers, is that they often are on the periphery of the trade.

DS: I'm thinking of the disclaimers on the bottom of the page of transactions.

FP: Sure, you put a disclaimer on everything. That's not by outside counsel—that's driven by management at the bank. You always want to have a disclaimer. That just makes good business sense.

Here's the troubling aspect of the disclaimers and the role of attorneys. Imagine that you have a business that's going to engage in some illegal activity—like the mob. And you estimate up front the probability of lawsuits and the expected cost of a lawsuit from what you know is illegal activity. Then you estimate the revenue from the illegal activity. It's perfectly rational for you to engage in the illegal activity as long as you can put up these defenses to lawsuits in advance.

So at least to some extent, the role of the internal legal department in a bank is to do just that. It is to make sure up front that the business decisions—whether they're "legal” or not—are well-protected from a litigation perspective. That to me is the troubling aspect of how lawyers inside banks are used, and I use the word used intentionally. But I don't think the lawyers have a participatory role. Lawyers don't generate revenue in a bank. They're regarded as a hurdle.

DS: You obviously felt some sort of relief leaving Wall Street to practice law. Do you think the same kind of book could have been written about Cadwalader or any of the other big law firms on Wall Street?

FP: I'm not sure I would use the word relief to describe my feelings leaving Wall Street when I look at how much money people in the derivatives business continue to make. I might use the word stupidity instead of relief. Even if this book is a best seller, it still would have been economically rational for me to stay in the business. So I wouldn't use the word relief.

Although there have been books written about law firms, I don't think that a book about any law firm's role in the derivatives business would be very interesting. It would be a story about proofreading, it would be a story about lawyers struggling to find out what on earth is going on in this deal because it doesn't make any sense on the face of the prospectus. It would be a sad, depressing and unreadable story.

I am surprised the same story hasn't been written about another bank. I think there are many books to be written. One of the messages I wanted to send in this book is that I hope that people who are in the derivatives business will think, before every action that they take, that this action may be the subject of a book at some point, that all of my colleagues may read about what I'm about to do.

A lawyer once told me about the practice of putting at the top of all legal pads a header that says "The New York Times said today that ...,” to make people realize that whatever they write on the legal pad could be the subject of an article. I think that there are other books out there to be written and I hope that people write them. I also hope that people who are in the business worry about that.

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