In this episode, Paul talks with Frank Partnoy, the George E. Barrett Professor of Law and Finance and director of the Center on Corporate and Securities Law at the University of San Diego. Among other topics, they discussed how investors' unrealistic desires for fortune have played into the hands of financial managers ready and willing to take advantage of them.
, about the 1920s markets and Ivar Kreuger, who many consider the father of modern financial schemes. He has been interviewed on
So I'm here today with Frank Partnoy, author of The Match Game which is newly out in paperback and is a wonderful book on financial crises of the past, I suppose; Infectious Greed, a great look at derivatives and synthetic structures and how all that stuff came together in a fairly prescient time because, you know, Frank wrote it well before the current financial meltdown; and a wonderful book that I push on people on a regular basis, so I should probably get some kind of commission for it, which is F.I.A.S.C.O. about Frank's time in the bond markets. And in his spare time, I guess, he's the George E. Barrett Professor of Law in Finance at the University of San Diego. Frank.
Partnoy: Hi, Paul.
Kedrosky: Thanks for doing this. So I thought we could have a kind of wide ranging conversation given the sort of things you do in terms of capital markets and the role of sort of risk and the evolution of capital markets and how they thought about risk. But let's go way back and tell me a little bit about yourself first. So make sure I have this straight. You're a math guy turned lawyer turned trader. How did you end up on Wall Street and give me a little bit of your personal background.
Partnoy: Sure. Well, born and raised Kansas and I was a math guy. I was very interested in math and ended up going to law school and wanted to do work on Wall Street in some capacity, but never imagined I could get a job as a trader or on the floor of one of the derivatives groups, but just got lucky and sort of stumbled into a job first at First Boston and then at Morgan Stanley working in derivatives, structuring and selling a lot of the instruments that blew up firms in the mid 1990s. So mea culpa, sorry about that. But after a couple of years became interested in some of the bigger picture questions about policy related to these instruments and ended up practicing law for a little while doing some white collar criminal defense, helping out some of the people who were being accused of financial fraud related to these instruments and then came to the University of San Diego in 1997 and I've been in San Diego ever since. It's hard to leave.
Kedrosky: I know. It's the curse of good weather. So let's go back, way back to the – you tell so many great stories in F.I.A.S.C.O. about your time on Wall Street. And talk a little bit about what were some of the most eye opening things at the time in terms of this, you know, what you thought or discovered about fiduciary relationship and how it was thought of in terms of how you folks worked with clients with respect to raising money, whether it's younger companies or older larger companies. I really don't care. But just talk a little bit about it and maybe, you know, tell us a couple of stories about what that was like and how it worked and how you felt.
Partnoy: Yeah, sure, happy to, and I'll try to minimize the use of profanity which may be difficult. But I think it relates to this distinction that Congress and the banks are struggling with between counterparty and client. And the idea being that a counterparty is just somebody you're dealing with on an arm's length basis and have no duties to at all and a client is somebody who you are looking out for and have fiduciary duties to. And one of the things that was happening that I found so surprising initially was that Morgan Stanley and other firms – but I was at Morgan Stanley – were regarding clients as the enemy and as someone who not only do you not owe fiduciary duty to, but you almost took joy in watching them explode. And I remember very clearly some of these deals, very complicated Mexican peso base derivatives, for example, that were being sold to people like the Wisconsin Investment Board or various pension funds and insurance companies. And I remember talking to one of the salesmen at Morgan Stanley and he was just joyous about how he had plugged this particular institution with a bunch of these complicated Mexican based derivatives. And he looked at me and he said, "You know what I did? I ripped their face off.' And that's become a common phrase in the industry. It's just – it was so shocking to me at the time to hear somebody say about their client, who we'd just seen them in a meeting and on calls talking about what was in the client's best interest, then behind closed doors talking about the joy of ripping their face off. And it was just a, it was striking to me that the culture of sales had become such that the clients really were just counterparties.
And so one of the fascinating things has been, you know, we have this financial system and these capital markets and for most people their only relationship with them is to, you know, go if they need to borrow money, they need to raise capital, they need to invest for the long term, and yet it has become this incredibly important part of the economy and an incredibly destructive part of the economy. And I think you can trace a lot of it back to that kind of aggressive change in culture that happened in the mid 1990s. I mean, there were a lot of other kind of bawdy things that happened, sort of the locker room antics of the trading floor with a managing director paying an attractive female sales assistant $500 to eat a pickle covered with hand lotion and then joyously watching as she vomited on the trading floor. I mean, there was certainly plenty of that and I assume that's why you recommend F.I.A.S.C.O. to your friends for that sort of prurient detail. But there's I think a more interesting, maybe even more interesting point about the cultural devolution of finance and investment banking and the move away from this kind of old notion of looking out for your client. And where it's come out today is in this kind of standardized notion that Wall Street is only dealing with counterparties and at arm's length relationship. I don't know if there will be a thoughtful kind of continuum approach to that where people will try to say, you know what, there's a middle ground between a mom and pop client and a large institution. But I think it all started back then.
Kedrosky: And I don't want to spend, as much fun as the stories are and as much of a sucker as I am for that stuff, I mean, how much of that is a functio of the job itself and how much of it is a function of the way, say, capital markets are structured versus say the personalities that are attracted to entering, and specifically on the fixed income and derivative side of things? I'm trying to, you know, sort of parcel it out as we think going forward how things are going to change.
Partnoy: Yeah, it's a great question and I think they're related because I think the structural conditions that create opportunities for massive profit, you know, for a group like the 70 people I worked with to generate a billion dollars in fees in two years. Back then, you know, that was pretty good money. And it's related to some structural reasons, but I think it also draws people and then influences them in the cultural ways you mentioned.
So I think the structural piece of it is really twofold. I think that there is this kind of systemic information gap between buyers and sellers of financial instruments that's just endemic. It's always there and you've got, and really in any market, but particularly in complex financial markets, you've always got a gap, an information gap, between buyer and seller. And that's an opportunity for people to make money. You know, there's this kind of big question about how risk moves on Wall Street and for a long time, connection with [inaudible] risk flows to the parties who are best able to bear it. And then there's a contrary view often espoused by Marc Mayer and others that risk flows to the people who are least able to understand it. And you know, there's money to be made in that second view of the world. And so that's one piece and information asymmetry is just another, you know, fancy way of saying, "ripping someone's face off,' and it's just something that's part of the way markets work and there's not necessarily much you can do about it. We have common law regime and legal rules that try to level the playing field a bit, but part of the idea behind a capitalist market economy is that you want people to transact even if they don't know as much as each other.
So there's that one piece. And then there's a second piece which I think maybe even fits better with your idea of the commonalities between the culture and the structure, which is this idea of regulatory arbitrage which is binding some legal rule, tax, accounting, credit rating related and inventing transactions that are designed to take advantage of some idiosyncratic regulatory cost. And that also is a way to make a lot of money, particularly as instruments become more complex. And it's also a thing that affects your culture. You know, it's kind of like the mafia. Right? Is it really surprising, if you're living in the shadows of the law, is it really surprising that the culture that would develop would be consonant with that? And if you're living in a world where you make money off of regulatory arbitrage, is it really surprising that it might lead a kind of lack of respect for legal rules or a kind of dangerous subculture in the dark part of the market? So I think the two, the two really kind of go hand in hand. So Paul, you can have your cake and eat it too. You can have the smarmy stories and still have an air of intellectual respectability by talking about information asymmetry and regulatory arbitrage at the same time you're talking about people committing acts of sexual harassment.
Kedrosky: Yeah, that's the delights of the capital markets. And not to push this too far, but do you – and I think you kind of alluded to this – but I often argue that you can't really have it without both. And I don't mean by that, the random acts of sexual harassment. I mean, more that you – capital markets don't work in a pure sort of pristine agency only basis. That as long as there have been capital markets, there have been people in the capital markets acting as both principals and agents and the notion that somehow there's a vestigal world of pristine markets we can go back to where people purely traded on the behalf of clients and are only interested in raising money for wonderful fast growing small businesses is delusional.
Partnoy: Yeah, I think you're absolutely right. And in law, you know, for people who care about the interface of law and finance, the whole idea of conflictive transactions and the duty of loyalty doesn't arise from sort of knee jerk reaction to people who are conflicted, doing something wrong. It's not that conflicts are nefarious. It's really a recognition that this is just a state of the world. You know, you're, either you own the land next door to the golf course or you don't, and if you do, it doesn't make you a bad person. It just creates a different kind of dynamic in the transaction when the, you know, when the company operating the golf course goes to buy the land. Yes, there's a conflict and the duty of loyalty arose to try to mitigate some of those problems, but I don't think anyone in any kind of capitalist market is under the illusion that that's going to go away, that it really is just something that's part of the transaction and I think you're right.
Kedrosky: One of my favorite quotes and it gets repeated all the time, and I want to sort of use this as a way to jump forward, but is, you know, the great James Carville quote about how he wants to come back as the bond market so he can intimidate everybody. And there's a great one from Paul Mason who writes wonderfully over at, and does some honorary stuff at the BBC. Had a quote this week and I'll just read it in full because it's just too good to lose. He says, "What gives,' – people are asking why is the bond market so mean, why aren't bond markets friendlier in terms of how they deal with people and deal with countries, more specifically. "What gives the bond markets their ruthless character is ... the determination of millions of middle class retirees to buy a cottage in the country, a Labrador and globetrot like grey nomads, the archeological wonders of the world.' And I wonder, I mean, to me that resonates entirely. And I wonder if one of the things that people are missing as we think about how equity markets are changing in terms of, you know, the absence of IPOs and the growth of fixed income bonds and synthetic securities is that an awful lot of this is a reflection of this transformation in the capital markets towards this requirement, this need to create all of these instruments who can generate – and I'll say this advisedly – you know, predictable and regular kinds of fixed income for retirees who are so ruthlessly wanting to buy a cottage in the country, a Labrador and globetrot to the archeological wonders of the world.
Partnoy: Yeah, it's a great quote and it's a really interesting set of questions. And one way of thinking about it is in a way that's connected to this recent crisis is what has been driving this thirst for triple A? Is it some kind of fundamental shift in human nature? You know, is it the thirst for the Labrador and the cottage? Or is it something that's driven by regulation that isn't really something that we can blame on the downstream human actors? And I think that there are a set of stories that support each. Certainly, you know, the people in our neck of the woods in southern California who extended themselves and didn't have income and yet bought $600,000 homes are partly to blame. But, and that certainly doesn't match up with the pension funds and others who are supposedly saving for the long term with 40 year time horizons.
But I think that part of the connection between this, that sort of Labrador seeking human actor and the institutional thirst for triple A is a different one. And in some ways, I mean, it's very complicated, but it's driven by two things. And maybe I'm just biased because these are the only two things I know. But I think it's driven by law and math. But in the law piece of it is the requirements that so many people have to have safety, have to buy AAA. These legal rules are everywhere and if we had more judgment instead of just legal rules, I don't think you would ever transform all of the, you know, the cottages into safe, reliable investments. I just don't think they naturally fit.
And then the math piece of it is, you know, it has to do with the increasing complexity of the world, generally, and our capacity to understand it. But these models that we're supposed to look at all of these human actors and put them together in some sort of a sensible way, and then spit out a risk profile at the end, didn't work at all, or rather were radically misinterpreted. And the idea that you could slice out the – you know, of the people who are out there getting their cottages with their Labradors, some small group of them are buying cottages on earthquake faults and are buying Labradors who have miraculously made it to age 16 and are just about to keel over. And we've sliced it, we've sliced them out and had people make a trillion dollars worth of side bets on whether those people would be around a few years from now and believe that a mathematical model would answer that question with a yes, when in reality anyone looking at it with common sense would say, "Oh come on, this is not going to work.'
So I think that, you know, it's a really interesting set of questions. Now, I guess going back to the first part of the quote, I mean, does it relate to why the bond market is mean? I'm not sure the bond market really is mean. I mean, it seems mean relative to those of us who are, who think of ourselves as being nice. But it's really just unemotional in every way. But the bond market, one of the beauties of the bond market and the derivatives market is that it really doesn't care at all. And in some ways, the rhetoric today about counterparties is, it does sound ruthless and mean, but it's really a-emotional. It's not mean or nice, it's simply devoid of emotion. So I like the quote as well. It's the first I've heard of it. I hope it will withstand the test of time.
Kedrosky: Well, I think it captures a lot. Like the Carville quote. It captures a lot of at least the perception that this is this Borg-like thing that, you know, is unthinking, unfeeling, and you know, which can look mean I suppose to an outside observer, but the effect is that, you know, we end up forcing countries and companies into taking actions that they wouldn't otherwise take. And somehow that, I think, strikes people as mean. And I guess, you know, what's interesting to me is, is that, I just take it up a level and think about this transformation in capital markets. And what most people don't realize, you know, is that how much larger fixed income markets are than equity markets even in the first place. That this isn't exactly new.
Partnoy: No, and even larger than equity markets for a long time. And now the figure being thrown around, we're getting close to a quadrillion. You know, a trillion was big for awhile, but we've hit five to six hundred trillion in terms of derivatives notional amount, as compared to the equivalent equity notional amount, a significant multiple. And I think people don't under-, people are resistant to the idea that this market that doesn't really do anything, I mean, it's not like other – it's not like an IPO or an equity market where it's tied to something tangible. But yeah, people have to react to it. I think it may have started with Carl [inaudible], but there was also the famous Clinton quote around his reelection when he said, "If you need to tell me my reelection depends on the (now expletive, deleted) bond market...' And I think people are realizing more and more that the fed and interest rates and monetary policy and the US balance sheet and the bond market and the derivatives market are all linked in very powerful ways that affect everyone. Well, you can think that you're immune from it because you're an all equity company and you've thought about this, but really we're all associated to it. And that rhetoric was what led to the engineering of the government bailouts in fall 2008. But yeah, I think it's mind boggling, really, isn't it, that there are so many of these instruments that they couldn't possibly be tied to any underlying asset. There are significant multiples. I think you have to ask sort of the basic, commonsense question about why it is that that's happening. Is it due to some fundamental, underlying, traditional purpose that the financial markets have served? And it's hard to answer that question with a yes. It's hard to say, "Well, you know what? This person took out a mortgage in Riverside County, California to buy a $600,000 home even though they didn't have any income.' And the fact that people were betting on whether that person will default or not a hundred times, that that's serving a useful purpose. I mean, I like side betting. Every week, I amaze my kids by telling them when we watch American Idol. I go on to intrade.com where people are betting on who will survive American Idol and who will be voted off and I'm able to tell them with precision based on the gambling every week in advance, here's who's going to be voted off. And the derivatives market do that in a kind of brilliant way. I mean, the side betting on credit default swaps was a very good predictor of which banks would end up being in trouble. But you have to ask, well, other than that, is there any sort of public or beneficial purpose being served?
Kedrosky: So ...
Partnoy: [Inaudible], it's a very tough question.
Kedrosky: Well, and it is. And I mean, so let's use that as a way to sort of jump forward into sort of reforms to capital markets and how they can do a better job I suppose, if you buy the argument, do a better job of servicing sort of the fund raising needs of companies and others. I mean, there's a story that made the rounds this week for – it was actually a blog post about things by Mark Cuban who was, you know, a [inaudible] active entrepreneur and made a few billions selling something to Yahoo!, called broadcast.com. And he has a post, he had a blog post this week that got passed around madly called, "What business is Wall Street in?' And I'll just, he calls it the best analogy for traders, that they're really sort of hackers searching for an exploiting operation system and application shortcomings. But the key, the money quote, I suppose, literally is this one and I'm curious what you think. "The important issue is recognizing that Wall Street is no longer what it was designed to be. It was designed to be a market in which companies provide securities from which they receive capital ... to which companies provide securities from which they receive capital that would help them start, grow and sell businesses. Investors made their money by recognizing value where others did not, or by simply committing to a company and growing with it as a shareholder, receiving dividends or appreciation and so on.' And he asks the rhetorical question that he quite obviously has his own answer to. "What percentage of the market is driven by investors these days?' Now again, this kind of goes back to the sort of, you know, [inaudible] discussion we had earlier about rose colored visions of what capital markets do. But is he completely awry here?
Partnoy: No, I think there's a lot of wisdom in that and the sort of fundamental purpose of markets and looking at value is something that a lot of people want to do, want to do more of. But you can make a lot more money doing this other stuff. And so, you know, it – and the one thing you know about Wall Street is that people will go where the money is. But I think it's a, you know, it's a serious policy question, but it's also a practical question for entrepreneurs and for people who are thinking about interfacing with the capital markets. And I think, you know, one fundamental thing that requires a massive rethink is this short term, long term problem. And the amount of trading, in addition to the bond market, it's even in the equity market – the amount of focus on short term and the amount of trading that's focused on short term profits and the institutional investor interface. You know, what some have called the separation of ownership from ownership has gotten so wide that it's very difficult to talk about [inaudible] capital and this notion of private patient capital or patient private capital, however we phrase it, I think are really important concepts for us to talk about going forward because you just can't have financial markets that are focused only on making money in those two areas I mentioned before – information asymmetry and regulatory arbitrage.
Partnoy: We've got to get back to the kind of fundamental stuff that Mark is talking about.
Kedrosky: So let's get into that, maybe in a little bit more detail. I mean, if you think about some of the biggest problems that, you know, we sort of at least convinced ourselves that we face societally with respect to, you know, an aging population, the sort of impending demographically driven problems with respect to the solvency of the United States, issues with respect to energy and this sort of apical transition away from carbon based fuels. If you accept that all of these are major problems in one form or another that have, you know, that have a huge root, have roots back in capital markets both in terms of the valuations of existing companies, but maybe more importantly in terms of the allocation of capital towards people, entrepreneurs and others who would like to solve these problems, how do we kind of, either through the front door or back door, begin thinking about sort of how the capital markets become more patient? Or is that just completely antithetical to the notion of patience in capital markets? These things just don't go together.
Partnoy: Yeah, I hope it's not a multiple oxymoron. But I do think that there's, you know, there are two radically different theories about it and both of them again go back to law. One is we need a new set of rules that would encourage the formation of long term capital, that will benefit those people who are able to see value and that will discourage the kinds of short term focused trading strategies that led us to this crisis and that have been part of Wall Street's core for a long time. So one is kind of, I don't know if you call it on the left. You know, that's the sort of proposal on the left. And then there's the proposal on the other side, which is that part of the problem stems from legal rules themselves, that we have a lot of bad legal structure that has created this monster and that what we really need to do is eliminate those rules and sort of free up the markets and that the markets rationally, if left to their own devices, would be longer term.
And I think it's instructive to look at regulated traders versus unregulated traders and people always point to hedge funds as being the villain in all this. But it turns out, if you look at the data, that the unregulated hedge funds that are not subject to the same sorts of draconian rules that apply to mutual funds or pension funds actually hold on average for longer term and are much better at spotting value than a regulated mutual fund which has a very short turnover or even a pension fund. So I think that, you know, these big policy issues that you're talking about with energy and the deficit and Social Security and Medicare, Medicaid and so forth, these entitlement issues going forward, these are all issues that have to involve law and the decisions on both sides of the axes about whether we need to eliminate rules or put in more rules.
And so I guess, you know, maybe it's just that I feel like I'm one of the downtrodden law professors constantly having to hold out a cup and say, "Please pay attention to legal rules.' But I do think that one of the things – it's not a coincidence that Wall Street has been an incredibly effective lobbyist over the last decade and has spent hundreds of millions of dollars on political contributions and lobbying expenditures. They've gotten a regulatory system that is unbelievably complex and opaque. It's sort of Frankenstein's monster that creates huge profit opportunities. And so I think we really need to focus on ... it's going to require government intervention. So for people who are on the right, who don't like government intervention, the way I pitch it is as we've already got these rules in place. So we've got to make sense of them and make them make more sense. And for people on the left I think are already sold on this, but they actually recognize that we just can't afford everything that we've already agreed to do going forward. It's a very, it's a very bleak set of issues looking forward and that's why I think it's so important to have someone thinking carefully about how it is that we create incentives for parties to invest and create value over the longer term.
Kedrosky: If you could sort of, horrible question, wave a wand and create a couple of those incentives in the minute or so that we have left, what would a couple of those incentives be structurally? Would they be law changes, changes specifically in the law? Would they be changes in terms of the structure of the actors with respect to say, you know, rolling back the integration of banks and brokers, flipping out sort of proprietary trade? What sorts of things would at least help us down the path in terms of instant policy actions or reforming that? Or, is it just simply simplification and getting rid of regulatory arbitrage?
Partnoy: Well, from the finance perspective, I think that the best thing to do from just a big picture perspective in finance would be to move away from ex ante rules and this sort of highly specific approach to regulation, to a more commonsense ex post standards based approach. And there's some push for this to happen in certain areas. In international accounting, there's been some of it. But there's really not been much of it in the areas that matter the most which would be enforcement, tax, and other areas. I mean, a bee in my bonnet which will be too precise in response to your question, but I actually think might make a major difference in terms of allocation of capital at least in the debt markets, is reform of the credit rating agencies. In particular, the web of regulatory reliance on ratings that has led to this kind of dysfunctional search and thirst for AAA ratings that we were talking about before. But I think in general, even outside of the financial sector, I think the kind of mantra that I've been pressing is capturing the power of markets, is recognizing more where the comparative advantage of regulation is as opposed to markets. And so implementing regulatory structures that don't become cemented in place and subject to these kinds of problems. And that involves a lot of transparency as well as a lot of deference to the markets. But I think, you know, some of it seems like it might be moves in the wrong direction. Some of it would encourage trading of claims in the future, but I think that in concrete terms, those are some of them. And I also think just in terms of small "d' democracy, that we'd be well served by harnessing the power of information technology and the web and, in addition to regulatory change, trying to figure out some mechanisms, some kinds of open source mechanisms for private actors to read out problems at private institutions. And I'm thinking primarily of banks and AIG, but maybe also it would work in the energy area where, you know, not just regulatory structures, but also publicity and reputational costs might be approaches that would make sense.
So I'm a kind of traditional, common law – I like the homesy notion of law as a prediction of what a judge will do. I think if people are thinking about how to array their affairs and where to invest, if they're thinking not about some massive government structure dictating how they'll, whether they've done right, whether they've complied, whether they've dotted all the "I's' and crossed all the "T's' ex ante, but if they're thinking about what some wise man or woman would say about what they've done ten years from now or 20 years from now, I'm heartened by the fact that some companies, you know, particular like Sempra in town, you know, the CFO of Sempra, Mark Snell, is a very smart guy and he thinks long term. He thinks about projects well into the future. He has a time horizon of ten years, 20 years, even 40 years. And I'm hopeful that there's a way for private actions like that to be encouraged. That's a very long winded way ...
Kedrosky: No, no.
Kedrosky: No, it's good. I think it's ...
Partnoy: I get paid by the, I get paid by the word as a lawyer. So, you know, you're interviewing a [inaudible].
Kedrosky: That's right. We'll get into billable hours problems. It must have been tough to wean yourself off the bullet points on Wall Street. That's actually a semi upbeat place to stop in terms of giving us some specific actions going forward. So I'll stop us right there and say thanks very much, Frank, for doing this. I appreciate having you on.
Partnoy: Of course. Thanks for all the thoughtful questions. It's my pleasure.
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