From 1993 to 1995, I sold derivatives on Wall Street [at First Boston and Morgan Stanley.]
My group [at Morgan Stanley] was the biggest moneymaker at the firm by far. Morgan Stanley is the oldest and most prestigious of the top investment banks, and the derivatives group was the engine that drove Morgan Stanley. The $1 billion we made was enough to pay the salaries of most of the firm's ten thousand worldwide employees, with plenty left for us. The managers in my group received millions and millions in bonuses; even our lowest level employees had six-figure incomes. And many of us, including me, were still in our twenties. Other banks—including First Boston, where I worked before I joined Morgan Stanley, could not match Morgan Stanley's aggressive new sales tactics.
The derivatives group received its marching orders from the firm's leader, John Mack. Following Mack's lead, my ingenious bosses became feral multimillionaires: half geek, half wolf. When they weren't performing complex computer calculations, they were screaming about how they were going to "rip someone's face off” or "blow someone up.” Outside of work they honed their killer instincts at private skeet-shooting clubs, on safaris and dove hunts in Africa and South America, and at the most important and appropriately named competitive event at Morgan Stanley: the Fixed Income Annual Sporting Clays Outing, F.I.A.S.C.O. for short. This annual skeet-shoot tournament set the mood for the firm's barbarous approach to its clients' increasing derivatives losses. After April 1994, when these losses began to increase, John Mack's instructions were clear: "there's blood in the water. Lets go kill someone.” We were prepared to kill someone, and we did. The battlefields of the derivatives world are littered with our victims.
At the time, I wasn't exactly a derivatives guru. I had attended law school, not business school, and the knowledge I had acquired, mostly from reading academic treatises, was useless on a fast-paced trading floor. Nor had my training courses at First Boston helped much. The year before I arrived, DPG [the derivatives products group] had arranged hundreds of derivatives transactions and had raised more than $25 billion of funding for clients. The group's new products included derivatives with names I'd never even heard of.
These were heady days at Morgan Stanley. No one seemed to care about how risky many of the hundreds of derivatives deals were. No one seemed to care about whether clients actually understood what they were buying, even when the trades had hidden risks. The group simply continued to pile trade on top of trade. Year by year, client by client, trade by trade, the venerable House of Morgan was building a precarious house of cards.
Early on I learned about one derivatives trade that I think exemplifies the group's business. This particular trade, and it's acronym, were among the group's most infamous early inventions, although it still is popular among certain investors. The trade is called PERLS. PERLS are a kind of bond called a structured note, which is simply a custom-designed bond. Structured notes are among the derivatives that have caused the most problems for buyers.
Morgan Stanley's derivatives salesmen made millions selling PERLS to investors throughout the world. These investors had little in common except that each of them would pay Morgan Stanley enormous fees, and many would lose a fortune on PERLS.
I discovered there are two basic categories of PERLS buyers; I call them "cheaters” and "widows and orphans.” If you are an eager derivatives salesman, either one will do just fine. Most PERLS buyers—the cheaters—were quite savvy. With PERLS, investors who were not permitted to bet on foreign currencies could place such bets anyway.
Morgan Stanley, in contrast, had nothing to lose. The firm would profit regardless of what happened to the various rates because it would hedge its foreign exchange risks in separate transactions with other banks. At the same time the firm would charge the investors millions of dollars in fees. In 1991 Morgan Stanley charged more than 4 percent for its multiple-investor PERLS. For $100 million of PERLS that would be $4 million of fees.
But there were other types of PERLS buyers who lacked the training and experience to understand them at all. They looked at a term sheet for PERLS, and all they saw was a bond. The complex formulas eluded them; their eyes glazed over. The fact that the bonds' principal payments were linked to changes in foreign currency rates was simply incomprehensible. These are the buyers I call widows and orphans. These are the buyers salesmen love. I don't mean to suggest that all derivatives salesmen sold PERLS to widows and orphans. But certainly some did. And many more salesmen tried to sell bonds similar to PERLS. The combination of simplistic appearance and complex fundamentals made PERLS a potentially lethal mix.
[One] salesman [who] had earned a giant commission on [a] PERLS trade asked me if I knew what it was called when a salesman did what he had done to one of his clients. I said I didn't know. He told me it was called "ripping his face off.”
"Ripping his face off?” I asked, wondering if I had heard him correctly.
"Yes,” he replied. He then explained, in graphic, warlike detail how you grabbed the client under the neck, pinched a fold of skin, and yanked hard, tearing as much flesh as you could. I never will forget how this salesman looked me in the eye and, with a serious sense of pride, almost a tear, summed up this particular PERLS trade.
"Frank,” he said "I ripped his face off.”
|He then explained how you grabbed the client under the neck, pinched a fold of skin, and yanked hard, tearing as much flesh as you could.
I began to crave the sensation of ripping someone's face off. At First Boston I had never actually ripped a client's face off, and I certainly had not blown up anyone. Now, as I watched Morgan Stanley's derivatives salesmen in action, I began to like the idea.
Morgan Stanley carefully cultivated this urge to blast a client to smithereens. It was no surprise that I had caught the fever so soon. Everyone had caught it, especially the more experienced managing directors. My bosses were avid skeet shooters, constantly practicing at their private skeet shooting clubs, gathering for weekend hunting trips, and even traveling together on safaris and dove hunts throughout Africa and South America. When they screamed, "Pull!” they imagined a client flying through the air.
This kind of aggressive fervor was new to me. I had never belonged to a militia before. Even in its training program, First Boston had not been nearly as warlike. The salesmen at First Boston might have played practical jokes on their clients, but they certainly hadn't discussed firing shotguns at them or blowing them up or ripping their faces off. In contrast, Morgan Stanley was a savage cult. I marveled at how quickly the firm had seized on such a fierce creed.
The Pre4 Deal
In 1992, the Republic of Argentina issued the ugliest bond in history. The enormous $5.5 billion bond issue was popularly known as BOCONs.
The new bonds were issued in various series, one of which, called BOCON Pre4s, was by far the ugliest. It was almost impossible for the owners of BOCON Pre4s to determine what the bonds should be worth, and consequently investors hated them.
The Pre4s were not my first choice when my bosses instructed me to look for a derivatives trade in Argentina. They were too unwieldy. Nevertheless, with the end of the year approaching, we were looking for a home run to ensure that we could claim responsibility for plenty of profits at bonus time. We still were looking for the derivatives group's "trade of the year.”
We heard from a client that Goldman, Sachs had recently completed a large derivatives deal in Argentina. One of the DPG salesman quickly obtained a copy of the Goldman prospectus for the deal. It appeared that Goldman had taken some of the BOCONs, simplified them using derivatives, and sold the resulting mix to U.S. investors. They had made the purchase of BOCONs hassle free, and U.S. investors had purchased more than $100 million worth. By our calculations, Goldman had made several million dollars.
We began copying the Goldman deal shamelessly. The idea was simple enough, and Goldman's deal had some structural problems, which we began to correct. Investors loved the deal, and we had no trouble selling it.
The Pre4 Trust fit the pattern of RAVs [repackaged asset vehicles] we had been selling throughout the past year. First we found bonds that were subject to some type of costly investment barrier or restriction in a country outside the U.S. Then we found a way for the investors outside the country to buy the bonds and bypass the barrier. That formula had generated deals with sizable fees. Our trades also typically had one lead buyer, known as the lead order. The Pre4 Trust was no exception, and the lead order came from an insurance company in the heartland. Other Pre4 Trust buyers were more sophisticated.
However, even the most sophisticated investors obviously did not understand the mechanics of the trade. It was incredibly difficult to calculate the value of exchanging the ugly payments for simple payments. We had built an elaborate computer model to make these calculations, but I don't believe any of the buyers were able to create anything similar. If they had, they likely would not have agreed to pay Morgan Stanley several million dollars more than we thought the trust was worth. The excess payments were our fees.
A few investors had expressed concern about whether we would buy the trade back at a fair price. Many buyers didn't want to have to hold a trade for more than a few years and were worried that because the bonds were so unusual, they might not be able to find anyone other than Morgan Stanley to buy them. In such a predicament they feared Morgan Stanley would rip their faces off. They were right to be afraid. Morgan Stanley would commit to repurchase the bonds, but it wouldn't commit to do so at a fair price.
Despite these protests, the bonds proved easy to sell. A dozen or so investors were satisfied with the terms of the trade and agreed to buy. All told, we sold $123 million of Pre4 Trust units. The profits from the Pre4 Trust—approximately $4 million—exceeded those of any Morgan Stanley derivatives trade in 1994. The Pre4 Trust was our trade of the year, a clear home run, and my first "elephant.” The derivatives group was euphoric.
|My bosses were avid skeet shooters, constantly practicing at their private skeet shooting clubs. When they screamed, "Pull!” they imagined a client flying through the air.
It looked as if I would have to close the Pre4 Trust alone. As I worked with the lawyers in Argentina and the U.S. to close the trade, several other DPG salesman tried to tell me that a $4 million fee was no big deal. One said he had made $8 million on one leveraged swap. Other salesmen said they had charged 5 or even 10 percent fees for derivatives trades. Even [the head of the derivatives group] burst my bubble, telling me a 4 percent fee was "OK, but it's not that great. We've taken more than that out, ten, twenty or more points.” I couldn't believe DPG had received a 20 percent fee on any trade, regardless of how stupid the buyer was.
There were two potential disasters on the Pre4 Trust deal. The first one involved the question of whether we should call the Pre4 Trust a "derivative.” Although the term was becoming more popular at the time, in reality, this was a minor point. Everyone knew the Pre4 Trust was a derivative. Nevertheless, I thought a clear statement that the trust units were derivatives would bolster the firm's case somewhat in any future litigation.
When [my immediate boss] returned from Mexico, I handed her a freshly printed prospectus and told her we were right on schedule. Boxes of prospectuses were on their way to the various investors, and I had a large box of them ready to distribute to the salesmen tomorrow. A few minutes later, I heard a blood curdling scream. When [she] saw the word "derivative” in the prospectus, she exploded. She began screaming at me, calling me every name she could think of.
"Godammit, this says derivatives! These aren't derivatives! Why does this say derivatives? Who told you these were derivatives?” She refused to let any of her deals be called a derivative, now that the term had such a negative connotation, and ordered me to halt distribution of any prospectuses with that filthy word in them. I conceived Federal Express to remove the prospectuses from their planes, just in time.
By Friday, September 30, [1994,] the details were done. The deal would close the following Monday, as planned. I stayed late Friday night, after everyone had left for the weekend, just to make sure I hadn't forgotten anything. I was alone on the deserted trading floor. Without the bedlam of angry traders and frantic salesmen, the place was spookily quiet. The phone rang. I was about to experience the second potential disaster on the Pre4 Trust deal.
It was the small insurance company from the Midwest, the lead buyer for the Pre4 Trust.
"We've decided not to go ahead with the Pre4 Trust deal.”
Pause. "Pardon me?”
"We've decided that the deal isn't right for us. I hope this doesn't cause any inconvenience for you?”
I tried not to panic. If they backed out now it would be a catastrophe. I looked everywhere on the trading floor. No one. It was now 7:30 p.m. I tried calling various managing directors at home, but no one answered. I tried calling the in-house Morgan Stanley lawyers, but they were gone, too. After leaving more than a dozen messages, I reached the partner from Cravath. Lawyers at Cravath were always at work.
I will not reveal the substance of our conversation other than to say that he used the phrases "What the fuck?” and "Shove it up their ass” more than a Cravath partner typically would. After I had briefed him, we called the insurance company.
For almost an hour [the client's attorney] raised numerous objections, each of which we batted down, until finally there was only one issue remaining. They wanted an amendment to the trust deed for the deal. They said if Morgan Stanley could agree to this amendment that night, they would stay in the deal. If not, they were out.
Just minutes before I was about to commit Morgan Stanley to these new obligations on my own, [my boss] called me from home. I quickly explained the situation, and she agreed to the amendment. The deal was saved. I was a nervous wreck, sweating and delirious. There was no one there to congratulate me. My bosses better give me some credit for this, I thought.
The next day, when Peter Karches, the head of the trading floor, walked over to DPG and asked, "Who did this Pre4 trade?” [The head of the derivatives group] took credit. I was angry and wished I had been able to claim full credit for my efforts. However, I understood the firm's hierarchy. At least if anything went wrong with the deal, everyone would blame him, not me.
[He] seemed happier now. He and I previously had argued, in a congenial way, about whether financial markets were efficient, with me taking the more commonly espoused view that they were. Now he told me "If I ever hear you talk about efficient markets again, I will make you go stand in the corner.” I laughed. He had a point. How could you make $4 million virtually risk free in so little time in an efficient market?
|Everyone I knew who had been an investment banker for a few years, including me, was an asshole. The fact that we were the richest assholes in the world didn't change the fact that we were assholes.
DPG suffered some anxiety in early December , when one buyer of the Argentina Pre4 Trust said it wanted to buy some more. Two months earlier we had told the same buyer that the price was around $95. Since then the price of the bonds had declined. While we were trying to calculate the new value of the bonds, one derivatives trader stopped by for an update. The trader was nervous about whether we were offering to buy the bonds at a fair price. He was still concerned that if we lowered the price too much, the investors might realize how much money Morgan Stanley had made on the trade.
The Argentine Pre4 Trust was among the victims [of the December 1994 peso crash]. It lost $50 million in a few weeks. Investors were furious, and called constantly for explanations and up-to-the-minute prices. Traders no longer had to worry about whether a fair price was $90 or $95. Suddenly, $60 seemed pretty good. One trader said we should prepare to be sued.
The Pre4 Trust wasn't even close to the worst-performing derivative. One of the buyers of the Pre4 Trust, a fund manager from Morgan Stanley's own asset management group, said the Pre4 Trust was only his second worst performing investment. Another bank had sold him a Mexican peso structured note that had dropped from $100 to $27 in one day. I heard about several other derivatives that had dropped from $100 to zero. By comparison, the Pre4 Trust didn't look so bad.
As the Latin American markets continued to crash, the Pre4 Trust was among the worst-hit victims. The DPG trader who was giving out Pre4 Trust prices was about to snap. When one client called for a price, he said, "Use fifty, sixty, I don't give a shit, We're all fucked any way.” By mid-January, DPG was offering to buy the Pre4 Trust at $42, and offering to sell at $50. An eight point bid-offer spread was unheard of. Could it get any worse? One of the salesmen said he was a big buyer of the Pre4 Trust at zero.
By April 1995 I had become, in my judgment, the most cynical person on Earth. I now believed everything was a fraud, and I had a well-founded basis for my beliefs. Derivatives were a fraud, investment banking was a fraud, the Mexican and Japanese financial systems were frauds. It was depressing.
Everyone I knew who had been an investment banker for a few years, including me, was an asshole. The fact that we were the richest assholes in the world didn't change the fact that we were assholes. I had known this deep down since I first began working on Wall Street. Now, for some reason, it bothered me.
I don't mean to get on a moral high horse here. There is nothing impressive, from an ethical perspective, about my quitting a high-paying investment banking job. If anything it was idiotic. What I mean to convey is the reason why I decided to quit so quickly. For most people in the financial services industry, their job is morally ambiguous. That's the only way to survive. I had believed mine was, too. Moral ambiguity is just fine, especially while your salary is increasing. However, when I began to think, unambiguously, that what I was doing with my life was fundamentally wrong, I simply couldn't do it anymore. I had no choice but to stop.
What lessons did I draw from my experience selling derivatives? I believe derivatives are the most recent example of a basic theme in the history of finance: Wall Street bilks Main Street. Since the introduction of money thousands of years ago, financial intermediaries with more information have been taking advantage of lenders and borrowers with less.
If you still want to buy derivatives, you may as well buy them from Morgan Stanley. You can give them a call or just stop by the firm's new building at 1585 Broadway, just off Times Square. Don't tell them I sent you.