Review: Infectious Greed

"Infectious Greed" by Frank Partnoy chronicles the development of the financial environment that led up to the Enron an Global Crossing scandals. It then reveals in depth what really happened. Partnoy argues that Enron and Global Crossing were not isolated incidents spawned by one or two "bad apples". Rather they were a result of the financial culture that arose in the 1990s that was unfettered by regulation or proper accounting procedures.

Mr. Partnoy builds his case for the rise of a new predatory financial environment anecdote by fascinating anecdote. The last fully prosecuted incident happened to be Michael Milken in the late 1980s. Since that time considerable new "derivatives" appeared. Derivatives are financial instruments that are based on another financial instrument, usually stocks. Thus an option to buy or sell stock in the future is a derivative. Yet these derivatives were becoming more and more complex and could be based on anything from the price of General Motors to the score at the Superbowl to the annual rainfall in Seattle. The SEC and other regulatory agencies were reticent to create new rules or even apply old ones to these complex financial contracts.

Complex derivatives based on interest rates actually caused huge losses in 1994, and stalwart companies such as Proctor and Gamble and Gibson Greeting cards were badly burned because their financial officers did not understand the deals they were making (really just extreme bets on interest rates). Even the traders had difficulty valuing these instruments. They could easily talk financial officers into unwittingly putting the entire capital of their company (and more) at risk on no more than a throw of the dice. But such instruments were favored because risks were easily hidden by accounting gimmicks.

Because of the lack of accounting standards to handle new financial instruments and lax enforcement of old standards other gimmicks were invented. Some companies like Enron created partnerships to assume their debt. The partnership's dealings did not appear on the books of the partner's members as long as they did not own more than 50%. This made many companies employing questionable partnerships appear far more sound than they were in reality.

Financial statements are one of the fundamental ways in which investors can value a company. Hiding losses and debt to bolster the stock price of a company can only be described as fraudulent behavior. Mr. Partnoy points out that such practices were epidemic primarily because they were LEGAL. Yet investors have other tools, all of which seemed to be of limited value during the late 1990s. Besides the failure of auditors such as Arthur Andersen there was a breakdown in the major ratings organizations such a Moody's and Standard and Poor, both of which gave far better ratings to many bonds and companies than was warranted by the evidence. Mr. Partnoy hints that their generous ratings could have been partially attributable to the desire for future fees from investment banks who were always creating new derivatives. It also made investors think the company was doing better than it was in actuality.

Many economists believe that markets are efficient. There is much to be said for this theory. Buyers and sellers tend to push the price of a stock or commodity or derivative in a direction based on what they understand as the true value of that financial instrument. Nevertheless, this action requires that those trading have an accurate knowledge of the factors involved. When accurate information is hard to come by, prices will not be an accurate reflection of the value of a stock or bond, and when the accurate information finally does come to light the correction can be devastating, with severe losses by those who relied heavily on the mis-information.

This is exactly what happened at Enron. People thought that Enron had made billions of dollars when, in fact, Enron should have recorded losses. A stock that was $80.00 per share based on the balance sheet (and projected positive future earnings) was in reality only a few dollar stock, if that.

Mr. Partnoy is adept at making complex financial dealings understandable. He also has a facility for making them interesting and immediately important. There are even some entertaining episodes in "Infectious Greed" such as an incident involving Kidder Peabody, its parent company (General Electric) and one of its traders, Joseph Jett. Mr. Jett found a glitch in the accounting system at Kidder that allowed him to value current bond instruments at a future higher value in the present. It was like he had found a gold-mine. He simply valued everything in the future, and it seemed as though he was making a fortune. He was rapidly promoted through the ranks and received huge bonuses for several years...until the accounting glitch was found. When he heard the news, the legendary Jack Welch blew a gasket and ended up selling the company. Poor Mr. Jett had reinvested all his bonus money in Kidder and pretty much lost it all. Joseph Jett now runs his own off-shore investment firm which has a website at www.josephjett.com. Based on the evidence one must believe that he was more naive than criminal.

Another factor in the increase of misinformation was the fact that regulators became reticent to fully prosecute cases based on intricate financial dealings. Mr. Jett was barely punished and many of his contemporaries walked away with millions of dollars as a result of their dealings.

On balance, "Infectious Greed" is entertaining to anyone interested in financial markets. It is also a cogent warning, because it is clear that what has happened before (Enron, Global Crossing, et al) can happen again. As a "laissez faire" conservative/libertarian I am generally an advocate of the slogan "buyer beware". Yet Mr. Partnoy has ably made his case that some regulatory change is in order. A market works best when there is a free and honest flow of information backed up by the law. The epilogue of "Infectious Greed" is a catalogue of the reforms Frank Partnoy has in mind, and they make sense in a world that is increasingly dependent on the stability of the marketplace.

This is an excellent book for anyone who puts money at risk in the markets, destined to be a much used reference in the tradition of "Irrational Exuberance". Frank Partnoy is right on the money. Highly recommended.

This book is available at Amazon.com