Reinsurers are taking on risks they are unable to monitor, Frank Partnoy tells
Why should I invest in something I can't even spell?" This was the Southern sensibility of David Bronner, head of the Alabama state pension fund in 1992 when Wall Street traders tried to sell him some complex derivative deals. Officials from California's Orange County called Bronner "antiquated" and bragged about their investment returns. Those boy geniuses at Orange County, who eventually gambled away $1.7bn of public funds on the then new-fangled financial instruments invented by Wall Street's rocket scientists, were led by the county's treasurer, 70-year-old Robert Citron, who did not have a college degree and had visited New York just four times in his life. Citron used structured derivatives to bet on low interest rates but lost out when the Federal Reserve raised its rates on 4 February 1994. Asked the previous year how he knew that interest rates would not rise, Citron replied, "I am one of the largest investors in America. I know these things." But when the scale of his losses became known Citron was humble. "I am an inexperienced investor," he pleaded to a California State Senate Committee.
So as reinsurers today become significant players in the derivatives markets, how much do they know about the nature of the risks they are taking, or even how much they hold? "People don't really know how much they hold. They only know that they hold a substantial amount. It's one of the problems with a market where you don't have exposure," Frank Partnoy tells Global Reinsurance. Partnoy, a former derivatives trader and corporate lawyer, and now Professor of Law at the University of San Diego, chronicles the last 15 years of financial scandals from Orange County to Enron, WorldCom and Global Crossing in his latest book Infectious Greed *. This title was taken from the remarks last year by Federal Reserve chairman Alan Greenspan who told a Senate banking committee that "infectious greed" had gripped the business community in the 1990s and that "too many corporate executives sought ways to harvest some of those stockmarket gains". It was not that humans had become greedier than in generations past, Greenspan explained, but that "the avenues to express greed have grown so enormously."
But corporate executives' understanding of those "avenues", as opposed to recognising that there was an opportunity for a bet, has not grown. Indeed, there is a serious problem today that senior executives are not prepared to admit their ignorance, as Alabama's wise 'Good Ol' Boy' David Bronner did in 1992. "I think it's a more serious problem the more senior you get in a company. A CEO would be unlikely to admit that she didn't know something. This is often the case with the supposedly sophisticated buyers of these instruments," Partnoy thinks.
Warren Buffett, that sage of Omaha, is both old enough and wise enough to admit what he doesn't know. "When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running," Buffett wrote in his year 2002 message to Berkshire Hathaway shareholders. But if there is one thing an ambitious 20-something Wall Street (or City of London) dealer in the 1990s knew how to do, it was to exploit the unacknowledged ignorance of the gullible investor. Like grand opera teetering on the brink of Greek tragedy, Infectious Greed spins a breathtaking narrative of how these suckers were led up the garden path by their noses and dumped.
Circumventing the rules
In the late 1980s, Japanese insurance companies discovered derivatives as a way of circumventing legal rules that prohibited them from investing in stocks. This was through a Bankers Trust invention which Partnoy terms a "cross-continental ménage à trois"; a prototype equity derivative which enabled the insurers, Canadian banks and European investors to bet on the Nikkei 225 index, the major Japanese stock market index. US insurers had heavily taken up derivatives instruments by the time the Federal Reserve hiked interest rates in 1994 for the same reason as their Japanese counterparts: there was nothing in the rules to say they couldn't and what rules did exist certainly had no reference to the complex financial instruments being invented. These were the years when structured finance, something which had been around since the 19th century in the form of bonds backed by mortgages, was being fashioned by the latter day whizz-kids, who are known in the jargon as 'quants', into something you would need a mathematics doctorate to understand. One of the most significant of these developments was the Collaterised Bond Obligations (CBOs) whose last 15 years of professional history ranges from the convicted fraudster Michael Milken, to the First Boston bank's pioneering securitisation packages for credit card payments, equipment leases etc, to Enron and WorldCom, by which time the CBOs had metamorphosed into today's much-loved credit derivatives.
The pain caused by the earlier investor misjudgment was palpable. The US life insurance industry lost about $50bn on bonds in 1994; property and casualty insurers lost $20bn, more than they paid in claims for Hurricane Andrew. But these losses didn't show up in financial statements because insurance companies recorded their bond investments at their historical cost. Some firms were prescient and abandoned their bets before the interest rate hike in 1994. AIG Financial Products made more than $1bn on derivatives between 1988 and 1992, but AIG's chairman, Maurice ('Hank') Greenberg, decided in 1993 that his firm was taking too many risks. The head of AIG Financial Products, Howard Sosin, left the firm along with a reported $200m in compensation.
Partnoy explains that the earlier losses which insurance companies suffered were due to their taking on risk using instruments that technically fit within the scope of their guidelines, but that enabled them to take on much greater risks than any regulators had anticipated. Today's reinsurers are more sophisticated, hopefully. "Maybe they are not the most sophisticated people in the world but they are more sophisticated than managers at insurance companies, especially US insurance companies," Partnoy says. AIG, ultimately Salomon Brothers and now Warren Buffett all realised that it may not be worth being in these markets because it's sometimes difficult to quantify the risks. This is particularly true of credit derivatives.
But today's reinsurer appetite for credit derivatives shows that banks have been able to offload huge amounts of risk they have held traditionally and that's created all sorts of problems in terms of moral hazard. "Who is doing the monitoring of the ultimate borrowers?" asks Partnoy. Banks were originally set up to monitor directly the people they were lending money to but reinsurers are not in the same position. "They don't have access to the borrower - oftentimes they don't know the details of who the borrower is. They know the name sometimes, but not much more than that."
Furthermore, the contract in a credit derivative is between a bank and a borrower. Reinsurers don't have a direct contract with the borrower at all. Their only relationship is with the bank, not the borrower. So if they are concerned about something or want to find something out, they can't. "If they (the reinsurers) go to another Enron and say 'look, we hold this billion dollars-worth of credit derivatives on you. We'd like you to improve your practices and not take on so much risk,' then this 'Enron' can tell them to go to hell."
Reinsurers have argued that they are developing a greater expertise in the derivatives field. But Partnoy asks, "if you are smart and you understand credit risk, you are not going to make a loan to someone with whom you can't have any contact. That proves the point that reinsurers can't be right about being as expert as the banks." His book explains step-by-step how many risks were disguised by complexity and no one seemed to be bothered about evaluating them. The standard measure of one-day Value at Risk (VAR) - a statistical technique which estimates the maximum probable loss in one day for a particular portfolio - has been accepted by US regulators as the obligatory method of risk disclosure. So an enormous industry has grown around looking exclusively at VAR. But this looks at just part of a risk distribution which may or may not be relevant. It doesn't give you a worst case scenario and reinsurers, surely, need to know about the worst case scenario. A VAR-type measure in a geographic area of Southern California that hasn't had an earthquake for 20 years would show that the risk was zero. VAR didn't indicate any financial earthquakes either. Enron reported in 2000, at a confidence level of 95%, a one-day VAR for all of its trading operations was $66m. That was the maximum investors would be expected to lose. The reality was orders of magnitude worse.
Nearly one and half years after the Enron bankruptcy, none of the company's senior executives has been convicted of anything. The reason is obvious. "Enron people weren't stupid," Partnoy says. "They weren't completely avoiding the law. They were structuring complex transactions that arguably complied with the letter of the law." Such a rules-based system of financial regulation allows people to get away with this behaviour. Markets are always going to be ahead of the rules set by regulators. The real secret of profitable derivatives trading is not its complex mathematics but understanding the relationship between finance and the law, Partnoy says. That is how transactions can be used to avoid the rules.
The answer to this dilemma is to have general standards rather than rules. This will be far better if regulators don't want people to avoid them. "We have general standards to say you can't commit murder. They don't say you can't kill someone with a knife or you can't kill someone with a noose. Or then someone comes along and kills someone with a ballpoint pen and we say, 'oh, that falls beyond the scope of the law'".
But don't expect the regulators to bring in such standards. This is the task of hard-nosed legislators who, for all their reported vested interests, are still less pliable than regulators who are easily swayed by lobby groups. Partnoy's greatest wrath is directed at the International Swap Dealers Association (ISDA) which has now changed its name to the more user-friendly International Swaps and Derivatives Association. Not so much a professional organisation rather an effective lobby group, ISDA has been instrumental in softening a push in the US Congress under the Sarbanes-Oxley Act to increase disclosures related to companies' off-balance sheet transactions. Regulators wanted the terms governing disclosure of certain events to change from "reasonably likely" to "may", the implication being that more such events would have to be disclosed. This suggestion went out for comments from the capital markets. But the lobbyists poured in and argued that it was impossible to ask for such greater disclosure, and the old rules remain in place. "So I think that the regulators have shown that they cannot be trusted to implement even the disclosure regimes that legislators ask for," asserts Partnoy. Any real change has to come from the legislative process, he thinks.
In theory, derivatives are a natural fit for reinsurers, since they are all about transferring risk. So the question is how to find the most efficient risk bearer. But is that risk bearer necessarily the person who can best price it? "We think the risk is being shifted to the person who is best able to bear it. But what is often happening is that the risk is shifted to the person least able to price it, and who ends up either under-assessing it or undervaluing it." In addition, the ultimate risk holder is not just a third party, but one with a diversified portfolio, meaning he or she has even less of an incentive to do any monitoring. Recently, Warren Buffett famously described derivatives as "financial weapons of mass destruction". But rather than moving away from this market, Partnoy thinks that Buffett is just the kind of investor who should be in it. He is the kind of person who should be figuring out a way to tell people what they are worth; the fact that derivatives are complex does not mean that the trades should not be done. "What it means is that there should be honest people valuing the positions. I think investors are gong to be worse off without Buffett in those markets," says Partnoy.
by Frank Partnoy. Profile Books £20 hardback ISBN 186197 4388
By Maria Kielmas
Maria Kielmas is a freelance journalist and consultant.