A Review of: F.I.A.S.C.O. Blood in the Water on Wall Street

by Frank Partnoy (W. W. Norton & Company, 1997)
by C. Gary Dean

Derivatives have been around for centuries, but in the 1990s they made front page headlines as leveraged bets led to financial havoc and bankruptcies for many players in the derivatives market. Well-publicized examples are the $1.7 billion loss by Orange County and the collapse of Barings P.L.C., a respected 233-year-old British bank. The variety and complexity of derivatives has exploded and, according to the author, derivatives were a $55 trillion market in 1996, the largest market in the world!

Derivatives can reduce financial risk. A farmer can buy futures contracts, one type of derivative, linked to the market price of his crops to hedge his investment in production costs. A drop in market price of his crops will be counterbalanced by profits from the futures contracts. A company may enter into a forward contract for currency exchange to reduce its exposure to swings in exchange rates. But the speculator who uses derivatives to bet on the direction of future commodity prices, interest rates, exchange rates, and so on, risks big losses if things don’t go as hoped. The book looks at this dark side.

Frank Partnoy created and sold derivatives on Wall Street from 1993 to 1995. During his time in the Derivative Products Group (DPG) at Morgan Stanley, his group was by far the biggest moneymaker in the firm with total fees around $1 billion. They made money not by investing in derivatives and assuming the risk, but as intermediaries who created, packaged, and sold them.

The author emphasizes the aggressive profit-driven culture within DPG and their disdain for potentially disastrous consequences for their clients. F.I.A.S.C.O. is an acronym for Fixed Income Annual Sporting Clays Outing where colleagues blasted clay pigeons with shotguns, seen by the author as a metaphor for their treatment of clients. His discomfort with this culture is displayed throughout the book. He now specializes in financial market regulation as an assistant professor in the University of San Diego law school.

Insurance companies and pension funds are mentioned repeatedly as naive buyers of derivatives. Investment managers are lured by promises of higher yields, but risks are misunderstood or ignored. Other managers purchase derivatives to circumvent investment restrictions. Some derivatives may look like bonds and receive good ratings from Standard and Poor’s. These securities appear to be low risk, but payments of interest and principal are linked to other events.

Many derivative products are described including PERLS (Principal Exchange Rate Linked Securities). PERLS are a kind of bond called a structured note, but principal repayment is linked to various exchange rates and they act like leveraged bets on exchange rates. On the surface a PERLS can look like an AAA-rated federal or corporate bond. The author reports, "PERLS were especially attractive to devious managers at insurance companies, many of whom wanted to place foreign currency bets without the knowledge of the regulators or their bosses."

Other investors did not know the risk of PERLS. One such manager at a "stodgy insurance company" saw $85 million invested in PERLS shrink to a fraction of his original investment. His reaction when he became aware that he had bet on foreign exchange rates? "Foreign exchange bet? What the hell are you talking about? We didn’t bet anything, and we shouldn’t have lost anything. We didn’t make any foreign exchange bet. We’re an insurance company, for God’s sake. We aren’t even allowed to buy foreign exchange."

PLUS I notes were derivatives created to help Banco Nacional de Mexico (Banamex) remove undervalued and illiquid bonds from its balance sheet. These were peso-denominated bonds issued by the Mexico government. U.S. and Asian buyers had money to buy but needed investment grade bonds denominated in U.S. dollars. The task required considerable financial engineering plus the creation of a Bermuda company to buy the bonds from Banamex. The result was a dollar-denominated bond with an AA- S&P rating. For the rating S&P required a huge fee and a disclaimer on the Offering Memorandum that the rating did not reflect currency fluctuation risk.

The MX was a custom-designed derivative that enabled a Japanese client to book instant and enormous profits. The downside for the client company, but not its current managers, is that a large non-performing asset has to be carried on its balance sheet for decades. If it sells the asset, income will take a big hit. When the asset matures in thirty years, a big loss will be recognized. This financial sleight-of-hand involved buying and selling a type of collateralized mortgage obligation and zero coupon bonds. The details are clearly explained in the book. Morgan Stanley reaped an incredible $75 million setting this up for the client!

Along the way the author describes derivatives that led to the downfall of Robert Citron in Orange County and Nick Leeson at Barings. Citron had been an easy mark for an aggressive salesman from Merrill Lynch. Citron’s leveraged investments had produced high returns for a while, but things fell apart when interest rates rose in 1994. Leeson made steady profits as he worked arbitrage trades to profit from price differences in Nikkei-225 stock index futures between the Singapore and Osaka, Japan exchanges. His crash and Barings’ came when he made big one-sided bets on the direction of the stock index.

Actuaries working with the asset-side of the balance sheet should be knowledgeable about the risks of derivatives. As explained by the author, derivatives can be cloaked in innocuous looking wrappers. This is not a textbook on derivatives-there are no mathematical formulas. But, in 250 pages the author weaves entertainment and an education in derivatives. It can be read in a few evenings. His real-life examples and anecdotes are a good supplement to a rigorous study of the topic. And at every turn he reminds the reader of a favorite actuarial concept-RISK!