Frank Partnoy

FIASCO

Author's Preface

My group 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.

How did we make so much money? In part, it was because we were smart. I worked with the greatest minds in the derivatives business. We mastered the complexities of modern finance, and it is no coincidence that we were called "rocket scientists."

This was not the Morgan Stanley of yore. In the 1920s, the white-shoe investment bank developed a reputation for gentility and was renowned for fresh flowers and fine furniture, an elegant partners’ dining room, and conservative business practices. The firm’s credo was: "First class business in a first class way."

However, during the banking heyday of the 1980s, the firm faced intense competition from other banks and slipped from its number one spot. In response, Morgan Stanley’s partners shifted their focus from prestige to profits—and thereby transformed the firm. By the time I arrived in 1994, Morgan Stanley had swapped its fine heritage for a slick sales-and-trading operation—and a lot more money.

Other banks—including First Boston, where I worked before I joined Morgan Stanley—could not match Morgan Stanley’s aggressive new sales tactics. By every measure, the firm had been recast. The flowers were gone. The furniture was Formica. Busy managers ingested lunch, if at all, at a crowded donut stand jammed between two hallways along the trading floor. Aggressive business practices inspired a new credo: "First class business in a second class way." After decades of politesse, there were savages at Morgan Stanley.

The derivatives group received its marching orders from the firm’s leader, John Mack. Mack had worked his way up from the depths of the trading floor, where he still was known as "Mack the Knife." On his desk, Mack kept a large metal spike, upon which, it was rumored, he would threaten to impale inept employees. For one banking deal, in place of the traditional firm memento—a clear rectangular block with a copy of the firm’s "tombstone" advertisement—Mack had received a smashed phone handset encased in lucite, a legacy from his job working the trading floor phones. With Mack at the helm, the halcyon days of J. P. Morgan obviously were over.

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-shooting 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. Let’s go kill someone."

We were prepared to kill someone, and we did. The battlefields of the derivatives world are littered with our victims. As you may have read in the newspapers, at Orange County and Barings Bank and Daiwa Bank and Sumitomo Corporation and perhaps others no one knows about yet, a single person lost more than a billion dollars. At some companies it took more than one person to lose a billion dollars. Dozens of household names, including Procter & Gamble and numerous mutual funds, lost hundreds of millions each, billions total, on derivatives. The $50 billion Mexican currency debacle included its share of derivatives victims, too. As the late Senator Everett Dirksen once said, "A billion here and a billion there, and pretty soon you’re talking about real money." If you owned stocks or mutual funds during the past few years, a portion of the real money lost on derivatives very likely was yours.

Derivatives have become the largest market in the world. The size of the derivatives market, estimated at $55 trillion in 1996, is double the value of all U.S. stocks and more than ten times the entire U.S. national debt. Meanwhile, derivatives losses continue to multiply.

Of course, plenty of firms made money on derivatives, including Morgan Stanley, and the firm’s derivatives group is thriving, even as derivatives purchasers lick their wounds. Some clients tired of having their faces ripped off or being blown up, and business declined briefly in 1995 and 1996. Many of us quit during this period, some leaving for less brutish firms. Morgan Stanley transferred a few of the group’s most aggressive managers to more "suitable" areas of the firm. But several employees remained. Today the group survives, reconstituted but still profitable, poised for the next battle, prepared to fire on command.

Chapter 1: A Better Opportunity

I was waiting for a call from an executive recruiter—a "headhunter"—who already had called me several times during the past few days. His timing was flawless. Bonus time was approaching, derivatives were hot, and I had been a featured speaker at a recent emerging markets derivatives conference. I was marketable, willing to switch jobs, and I was especially valuable to the headhunter: If he placed me at a new firm, he would receive one-third of my starting salary. Good Wall Street headhunters made millions of dollars, and I knew this guy wasn’t calling me to be nice. He wanted my head.

It wasn’t easy camouflaging these calls. If you’ve ever seen a trading floor, you might wonder how a salesman can even speak to a headhunter without arousing suspicion from the other salesmen just a few feet away. I knew detection could be fatal. Several salesmen had been disciplined or fired for negotiating with headhunters at work. To be safe, we devised elaborate systems to conceal our job searches, including code language and late-night meetings. My new system, copied from a colleague, was simple but not foolproof: The headhunter called using a friend’s name, and I picked up the phone and pretended to be talking to the friend while the headhunter described the job he had to offer. If I wanted to discuss the job, I would hang up, leave the trading floor, and call the headhunter from one of the pay phones in the lobby. Others used this system, too, and around bonus time, salesmen besieged those phones.

Thus far I had risked several trips to the lobby and listened calmly to many job offerings. Each time I said no. The jobs were at firms of First Boston’s caliber—that is, they were second tier. Although First Boston had been a top firm in the early 1980s, it had slipped several notches in the past decade, and numerous employees had left for better firms. I was tired of second-class status, and I, too, wanted to move up. I coveted one job in particular, at the firm I thought had the hottest derivatives group on Wall Street. I told the headhunter if he could get me that job, I would take it. He promised to explore and to let me know what he discovered.

Finally, the phone rang. It was the headhunter, and he sounded excited.

"Frank?" he whispered.

"Yes?" I whispered back. A nearby colleague eyed me suspiciously. No one whispered on a trading floor.

"I’ve got it."

"You’ve got what?"

"It." He paused. "Your job. The job you want. Call me."

Now I was excited. I told my colleague I’d be back in a few minutes. He seemed to know what I was doing. I practically sprinted to the lobby pay phone.

As I waited for the headhunter to answer, I grabbed a pen and paper to take notes. The phone rang for what seemed like a full minute. I looked around the lobby and smirked at my firm’s new logo: a blue-on-white sailboat placed next to the firm’s new name, CS FIRST BOSTON. The CS stood for Credit Suisse, a large Swiss bank and the firm’s new owner. However, the stylish new logo couldn’t change the fact that First Boston’s voyage had been neither cosmopolitan nor smooth sailing. The boat looked like it belonged in Boston, not Berne, and the only thing global about my firm was its losses.

I recalled one example, when First Boston had loaned $450 million—40 percent of its equity capital—to just one firm, Ohio Mattress, in a disastrous deal Wall Street wits had christened "the burning bed." Profits at First Boston were so pathetic that the firm had to sell a stake in its derivatives business just to pay bonuses. Meanwhile, it was rumored that Allen Wheat, the firm’s new chief executive officer, had received compensation of $30 million, although reports later indicated his compensation was a mere $9 million. The firm had been tagged Wheat First Securities, a reference to a small-time, relatively impoverished brokerage firm. It was no surprise that top salesmen were fleeing in droves. I, too, wanted out.

The headhunter finally said, "Hello."

I began whispering again. "What do you have?" I scanned the lobby, to be sure no one was listening.

He must have sensed my anxiety because he began toying with me cruelly. "It’s a hot derivatives group at a very prestigious investment bank, and they’re looking for an emerging markets salesman. It’s you. It’s perfect. You’re all over this."

I cut him off. Emerging markets was my area, but there were many "prestigious" investment banks. "Who is it? Just give me the name."

He hemmed and hawed for a few minutes as I struggled to remain calm. I pressed him again. Finally he spilled the name. "Morgan Stanley."

I knew that for negotiating purposes I should pretend to be only mildly interested in the job. That way my headhunter wouldn’t think I was desperate or that I would switch jobs for a pittance. I knew I should preserve my bargaining power. The key to negotiating was saying I liked the job . . . but not that much. I fought to contain my excitement.

I couldn’t. I nearly screamed. "I want it! I want it! Get me this job! When can I talk to them? I want it! I want this job!" I looked around the lobby to see if anyone was watching me.

"How soon do you want to talk to them?"

I couldn’t help shouting. "Now! Soon! This afternoon! Tomorrow, at the very latest!"

The headhunter laughed confidently, knowing he had me lassoed. "Whoa, boy. Calm down. I’ll try to set it up for tomorrow. I’ll call you tonight at home and let you know the details."

When I replaced the receiver, my hand was trembling with excitement. I scrambled back to the desk and hoped no one had noticed my absence—or heard my shouting. Fortunately they hadn’t; my previously suspicious colleague had settled comfortably into his second chocolate Dove Bar of the morning.

That night my headhunter called me at home, telling me, "You’re done." He already had arranged a full interview schedule for next Monday, February 7. He said Morgan Stanley’s decision would be quick, probably within a week.

I awoke early the day of my interview and called in sick to First Boston. My bosses would interrogate me, but I didn’t care. My only concern was impressing the derivatives salesmen at Morgan Stanley. The firm’s derivatives group was the best in the world, and its business was booming. Although I knew the firm needed emerging markets people, I suspected they would hire only one or two of the top candidates. I prayed for Morgan Stanley to hire me.

When I arrived at Morgan Stanley for my interview, the firm’s cavernous trading floor was buzzing. As with other trading floors I had seen, space was at a premium; even the gray reception area was windowless and cramped. Although Morgan Stanley encouraged clients visiting the investment bankers on the top floors of its Sixth Avenue skyscraper to gawk at the building’s glass-rimmed views of Manhattan, it did not afford the same luxuries below, in the bowels of the fourth-floor trading dungeon.

If you haven’t had the pleasure of physically comparing different Wall Street trading floors, you needn’t bother. They are all basically alike. The floor itself is a checkerboard of stained carpet squares covering a maze of twisted wires and electronic equipment. These removable squares serve as the lid of a massive trash can, and hidden below are dozens of half-empty Chinese food containers and mice. (Mice love trading floors, and banking employees are constantly discussing creative ways to trap and kill them.) If you stop by virtually any trading floor on Wall Street, this is what you will inevitably encounter:

Hundreds of telephones are ringing. Television monitors are blasting news and flashing scattered bond quotes. One of the checkerboard squares is upended, and several maintenance men are taking a break to yell at each other in front of a pile of circuits and cables. Dozens of traders and salespeople are standing at three-foot intervals face-to-face at several long rectangular desks, which are stacked with a rainbow of colorful computers, flashing monitors, blue Reuters and green Telerate screens, beige Bloomberg data systems, and customized black broker quote boxes.

Every few seconds a nearby loudspeaker hoots a deafening stream of gibberish: "Fifty GNMA eights to go at a half." "Nonfarm payrolls expected down thirty." "The long bond buyer I saw earlier is now in the two-year sector, putting on a butterfly spread." The loudspeaker is appropriately named the hoot and holler, or just the hoot for short. Every salesman and trader is tapped into the hoot and holler, using it to announce important issues, to publicize requests to the entire trading floor, or to broadcast to everyone that the head government bond trader is, once again, acting like an asshole. If you only want to speak to one or a few people instead of the entire floor, and they are more than ten feet away, you have to call them by phone. Yelling is useless in the din, and unlike commodities traders in the Chicago trading pits, Wall Street traders typically do not use hand signals, except when they are flashing someone a middle finger. Everyone does read lips, however, just enough to distinguish the infrequent "You’re done" from the more commonly used "You motherfucker."

Even in this maelstrom, it’s easy to differentiate traders from salesmen. The traders are the men with rolled up sleeves and loosened ties, who hold several phones each and periodically smash one phone against a desk, computer, or trading assistant, and then grab another donut out of a monstrous box. In contrast, the salesmen calmly adjust their cufflinks while they hold one phone to each ear and, by alternatively squeezing hidden mute buttons inside their handsets, carry on several composed conversations at once. A good salesman can simultaneously schmooze a client, discuss tonight’s Knicks game with his bookie, order his assistant to steal a donut from the traders, and explain to his wife where he had been last night until 4 A.M.—and none will be aware of the other conversations or the nearby pandemonium.

Despite the apparent bedlam, there is a sense of protected order on the floor. Traders and salesmen live harmoniously, safeguarded in their locker-room surroundings from decades of race- and gender-related legislation, social regulation, and informal workplace changes. There are a few minorities and women on most trading floors, but many of them wear janitors’ overalls or very short skirts. The only evidence of any socially progressive act is an occasional toppling stack of empty yogurt cartons.

My training class at First Boston had been representative: predominantly white males from Harvard, Yale, and Oxford or from wealthy families. One white male trainee was bound for San Francisco, two white males were bound for Philadelphia, one white male for Chicago, and a dozen or so white males each for New York and London. Evidently First Boston had been unable to find a white male who was fluent in Japanese, so it had hired a native Japanese woman for the Tokyo office.

Of the thirty-seven trainees, thirty were men. As far as I could tell, First Boston had not hired any people of color to work in the U.S., although—in the firm’s defense—many of the trainees were quite tan. Of the seven female trainees, some already had proven to be successful First Boston employees for several years and only now were permitted to participate in the training program; others were new to First Boston but looked as if they had been pulled off the cover of Elle. First Boston had safely navigated the treacherous waters of affirmative action and political correctness, with impressive results: more than 80 percent men, mostly white; a few Asians working abroad; no African or Hispanic Americans; and only seven women.

Investment banks selected female employees with special care. Several salesmen had stressed to me the ever-important "babe factor" in interviewing and hiring. From their perspective, female trainees were either dependable servants or ravishing starlets. In either case, the women promised to be a pleasure for the men to work with; just in case they weren’t, banks often hindered their advancement by preslotting them into the least desirable jobs. In fact, many of the female hires in First Boston’s training program were "asked to leave" within months after the program began and did leave, although several sued the firm, at least one successfully.

First Boston was so plagued with harassment and discrimination problems that it hired a consultant to train the salesmen and traders not to sexually harass female interviewees. But the training was hopeless. Much to the horror of the middle-aged female consultant, during one training session, a male employee opened a mock interview by asking the prospective female employee, "So, babe, do you want to fuck?"

The smarter females turned the locker room mentality to their advantage, and not merely by displaying their goods in tight dresses and leather pants. One saleswoman I met willingly put her sex life on public display. Early in the morning, a gaggle of salesmen would encircle her to hear her tales of debauchery from the previous night. No one cared if she embellished the stories a little, and I certainly will not forget the description, in exquisite detail, of the "perfect blow job" she had given one lucky guy after he bought her an expensive dinner the previous night. After hearing this story, one salesman told me, "Now that woman has a future at this firm."

The head of the sales department had a rotating harem of secretaries, one of the longest lived of which was a six-foot blond goddess whose job was to wear as few clothes as she possibly could and walk laps around the floor. She did this with extraordinary verve. The interweaving of her one-woman fashion show with the pandemonium of billion-dollar bond trading was heady stuff. And when that wasn’t sufficiently entertaining for the boys, a manager would pay a junior female employee to perform some obscene act on the trading floor. One senior mortgage trader paid a notably attractive sales assistant $500 to eat, slowly and carefully, a large pickle covered with hand lotion. A throng of traders admired her as she performed the feat, accepted the cash, and then puked violently all over the trading floor.

I suppose it is a bit of a character flaw that I beheld the financial orgy of a trading floor with such desire. But I did. The trading floor was my home. Fortunately I knew if I left First Boston for Morgan Stanley, I would not lose the feel of the trading floor. My environment would change about as much as that of a goldfish moved from one bowl to another.

My interviews with the derivatives group at Morgan Stanley went smoothly, and I struggled not to seem too eager. The group was called DPG—short for Derivative Products Group. One manager mumbled something about "First class business in a first class way." Another said he thought much of DPG’s growth would be in emerging markets, my area. He promised that if I came to Morgan Stanley, I would be invited to an important derivatives gathering, coming up in April 1994, called "F.I.A.S.C.O." I had heard of it and wanted to go, but I knew that when a salesman at an investment bank promises you something, there is virtually no chance it will ever happen. Still, I was hopeful because I knew he was one of the group’s leaders, and he was rumored to be the father of the event.

Several salesmen focused on how many "bars" they made. To derivatives salesmen, a "bar" is not a place to go for drinks. A "bar" is a salary, a huge salary, with a long line of zeros, at least six of them. On Wall Street, you never said, "I make a million dollars a year." You said, "I make a bar." Lots of DPG employees made bars, often several. Of course, I, too, wanted to make bars, and by the end of the day I was salivating.

I desperately wanted to be a part of Morgan Stanley’s money-making machine. I prayed, Please, please let me work here! The firm’s derivatives group was my dream job. They made more money than anyone on Wall Street, they hired the smartest people, and they sold the most innovative derivatives.

Although the trading floors looked the same, in at least one critical way Morgan Stanley’s was vastly different from First Boston’s: It made more money. That was a big difference. To me, the DPG trading floor looked like a pot of gold.

While I was waiting to hear if DPG would hire me, I considered the differences between First Boston and Morgan Stanley. First Boston’s relative poverty suggested deeper problems. If you think two seemingly prestigious investment banks with similar trading floors couldn’t be too different, let me try to explain a few of the contrasts.

First Boston was a bank of the past, of the 1980s. It became clear to me that First Boston was second rate the first time I tried to locate its building. The firm’s majestic address was Park Avenue Plaza, and I had been told the building was between 52nd and 53rd Street. I assumed that meant it actually was on Park Avenue.

However, as I walked up and down Park Avenue, I couldn’t find it anywhere. Finally I asked a passing businessman if he knew where Park Avenue Plaza was. He laughed and pointed west. The building wasn’t on Park Avenue; you couldn’t even see it from Park Avenue. The 150-foot walk between Park Avenue and the firm’s entrance was my first taste of the small but real gap between First Boston and other top banks.

The building, if you can find it, represents the failures of 1980s urban planning as much as First Boston itself represents the failures of 1980s investment banking. The forty-story skyscraper, built in 1981, resembles a giant green-glass aquarium, propped vertically between two older and shorter gray bookends. The ostentatious lobby has a thirty-foot ceiling, sheets of deep green marble, a roaring waterfall, massive silver pillars, and numerous boutiques, including a coffee shop, an upscale newsstand, and a swanky Swiss chocolatier. The lobby was a perfect milieu for wealthy 1980s bankers hurrying to work.

Unfortunately, as many of you may know, the wealth of the 1980s sometimes came with a price. According to the security guards at Park Avenue Plaza, the developers of the green-glass aquarium, in negotiating the right to build the gaudy structure, originally had agreed to preserve the lobby as an indoor natural park, complete with real grass and trees. It soon became clear that this plan was ludicrous, and much of it was abandoned. However, a few trees had already been planted in the lobby, and they continue to struggle to stay alive in the hostile indoor environment. The grass floor was marbled over and still is. Today, the only remaining nod to urban planning is the overwhelming presence of homeless people. Because the lobby is a regulated public space, the security guards can’t throw loiterers out. As a result, even though First Boston’s somewhat-less-wealthy 1990s bankers didn’t have to step through a freshly mowed lawn on their way to the trading floor, they did have to bypass clusters of bums. (First Boston recently relocated, to an even less-prestigious address downtown.)

In contrast, Morgan Stanley’s building was prime real estate, in Rockefeller Center just across from Radio City Music Hall and overlooking the famous Rockefeller skating rink. The firm’s lobby was simple and clean. Most importantly, it was easy to find.

Morgan Stanley also had a newly designed logo, a modern Mercator-style map of the world, which loomed large against the First Boston boat. Morgan Stanley’s public relations campaign included glossy print advertising with global themes; any recent explosions or disasters had been kept out of the financial press. So many salesmen and traders had left First Boston for Morgan Stanley that they now were calling the firm Second Boston. Morgan Stanley was a truly global firm, with offices throughout the Americas (Chicago, Houston, Los Angeles, Menlo Park, Mexico City, Montreal, New York, San Francisco, and Toronto), Europe (Frankfurt, Geneva, London, Luxembourg, Madrid, Milan, Moscow, Paris, and Zurich), Asia (Beijing, Bombay, Hong Kong, Osaka, Seoul, Shanghai, Singapore, Taipei, and Tokyo), and elsewhere (Johannesburg, Melbourne, and Sydney), and the firm’s aggressive leaders, President John Mack and Chairman Richard Fisher, were planning to expand the firm’s global presence and to increase total worldwide employment to more than 10,000. The non-U.S. offices were generating a growing portion of the firm’s profits and new jobs. Of course, First Boston—er, CS First Boston—also had proclaimed to have offices throughout the world, but it was closing some of them and firing people in droves.

The fraternity antics also seemed more muted at Morgan Stanley. During my visit, I hadn’t seen any sales assistants throwing up or traders having their heads shaved on a bet or secretaries parading the floor in skimpy dresses, all of which were prominent at First Boston. I had noticed several copies of Guns & Ammo magazine and G. I. Joe dolls scattered on the trading desks, but the bottles of scotch and pornographic magazines were stashed inside desk drawers. Morgan Stanley was Morgan Stanley, after all; it would have been unimaginable for anyone to suggest changing the firm’s name.

To be fair, I should mention that First Boston hasn’t always been a cut below. For several decades, beginning in the 1940s, Morgan Stanley and First Boston were of comparable elite status. After World War II, when the newly formed World Bank began borrowing to finance post-World War II reconstruction, Morgan Stanley shared the limelight with First Boston, and the two firms alternatively received top billing on World Bank prospectuses. Much, but not all, of First Boston had deteriorated since then, and the firm could claim superiority over Morgan Stanley in only one pathetic area: elevators.

First Boston had allocated an entire bank of sleek lifts to the traders and salesmen, who, like me, hated early-morning delays. The elevators were roped off from the public and protected by a line of security guards. They resembled those on the starship Enterprise, except they were slightly faster. When I arrived at the Park Avenue Plaza aquarium every morning, an elevator was always waiting. I would tap an enormous rectangle labeled FIXED INCOME, and whoosh, I would be on the trading floor. I had to admit, Morgan Stanley’s unguarded and slow elevators were a disappointment by comparison.

One of the biggest differences between First Boston and Morgan Stanley at the time was in derivatives expertise. You’ve undoubtedly heard of derivatives by now, from newspaper and magazine articles and from televised news reports, about the billions of dollars recently lost on them. Derivatives have even been discussed on 60 Minutes. But what are they?

Many people at First Boston didn’t know. Although my group—emerging markets—was hugely profitable, with $30 billion of annual trading volume, and was first in various emerging markets rankings, with $10 billion of recent stock and bond issues, even we had developed a serious weakness in derivatives. By 1993 other banks had begun selling huge emerging market derivatives deals. Morgan Stanley in particular was the new leader, selling more than half a billion dollars of Mexican derivatives alone, along with billions of dollars of other structured derivatives. Waves of profitable derivatives deals were rolling by First Boston, and my group had missed the boat. When several salesmen and researchers—including my group’s former intellectual leader and senior salesman—left First Boston for other derivatives groups, the emerging markets derivatives group at First Boston was left with only one person: me.

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 (although I had received the highest score in their training program).

I knew a derivative was defined as a financial instrument whose value is linked to, or derived from, some other security, such as a stock or bond. If you’ve read anything at all about derivatives, you’ve probably seen that definition. If you’ve recently purchased shares in a company or mutual fund that invested in derivatives, you might know them by an alternative definition: financial gizmos that suddenly become worthless and then appear on the front page of the Wall Street Journal.

Whatever your current knowledge, in the next few pages I will tell everything you need to know about derivatives to understand the tactics of Morgan Stanley’s derivatives group, including much of what I already had learned by February 1994, when I was trying to move to Morgan Stanley. I will do you the favor of omitting many of the complex topics you might find in a derivatives treatise, topics bearing frightening names such as modified duration, option adjusted spread, put-call parity, bond basis, and negative convexity. My advice, even to investment bankers reading this book, is don’t spend even one minute thinking about these concepts. They will not make you any money—ever. And if you believe more intimate knowledge of these concepts might make you a well-rounded person, you’d better keep that belief to yourself, especially if you work on a trading floor. The only way to become well rounded on a trading floor is by eating fattening foods. Of course, if you can use knowledge of complex derivatives mathematics as a smoke screen to hide important facts from your clients, fine. But if you actually want to acquire knowledge that has no monetary value, forget it. You’re in the wrong business.

Later, I’ll educate you as to how Wall Street has made, and continues to make, huge amounts of money on derivatives by trickery and deceit. First, though, you need some background information. Learning about derivatives today poses the same problem I faced in February 1994: Only a handful of derivatives salesmen know the closely guarded secrets of how derivatives are actually used, and those elite few have no reason to share secrets worth millions of dollars with me or you. Derivatives insiders often won’t even tell their colleagues the most valuable secrets. One reason I wanted to move to Morgan Stanley’s derivatives group was that they seemed to know more of these secrets. Even for me as a derivatives salesman at First Boston, it was almost impossible to learn the details of the most profitable derivatives deals on Wall Street. Imagine how difficult it still must be for journalists and regulators, who can learn only what the derivatives insiders are willing to tell them. Now you understand why you haven’t heard this story before.

I don’t blame anyone in Morgan Stanley’s derivatives group for not sharing these secrets. As you’ll see shortly, some of the more questionable practices have the potential to generate serious problems for some of these people. At a minimum, their clients would not be pleased to hear how they were duped. Even if there were no negative repercussions to divulging these secrets, why share the wealth? If a golden goose arrived at your doorstep and began laying golden eggs, what would you do? Call the press? Share the eggs? No, you would hide them from the world.

Let me start with the most basic question: What are derivatives? Again, here’s the standard definition: A derivative is a financial instrument whose value is linked to, or derived from, some other security, such as a stock or bond. For example, you could buy IBM stock; alternatively, you could buy a "call option" on IBM stock, which gives you the right to buy IBM stock at a certain time and price. A call option is a derivative because the value of the call option is "derived" from the value of the underlying IBM stock. If the price of IBM stock goes up, the value of the call option goes up, and vice versa.

Most finance textbooks will tell you there are only two types of derivatives: options and forwards. However, although these books will explain options and forwards in detail, they don’t exactly make it easy. For example, even one of the simpler-to-read books, Options, Futures, and Other Derivative Securities, by Professor John Hull, a well-known derivatives consultant who hosts expensive corporate conferences, has several excruciatingly difficult passages on derivatives, many of which he warns you about on the back cover: "Complete treatment of numerical procedures, Monte Carlo simulation, the use of binomial lattices, and finite difference methods." If that doesn’t deter you, try flipping through pages of tiny Greek symbols and rows of formulas and graphs. And if you’re still considering purchasing the book, look at its price tag: $76.

Instead of reading Hull’s book, think about options and forwards in terms any derivatives salesman would appreciate: Corvettes.

An option is the right to buy or sell something in the future. The right to buy is a "call option"; the right to sell is a "put option." So if you knew several new Corvettes would be arriving at a car dealership in a month, you might pay the dealer $1,000 now to reserve a Corvette for you to buy at a certain price, say $40,000. When the cars arrived, you would have a call option—the right but not the obligation—to buy one for $40,000. Because you owned a call option, you would want the price of new Corvettes to increase: if the price increased to $50,000 your option to buy a Corvette for $40,000 would be worth about $10,000. Also, with a call option, your downside is limited. If the price were to drop to $30,000, you could simply let the dealer keep your $1,000 (called the option premium) and buy the Corvette for the lower price.

The other type of derivative—a "forward"—is an obligation to buy or sell something in the future. This obligation is called a future if it’s traded on an exchange, but the concept is the same. Suppose you knew you wanted to buy a new Corvette, but you didn’t want to pay $1,000 for an option. Instead, you could enter into a forward obligation to purchase the Corvette for $40,000 in a month. When the new Corvettes arrived, you would be obligated to buy one for $40,000 even if the actual price were lower. As with a call option, you would want the price to increase. But with a forward, your downside is no longer limited, so you especially wouldn’t want the price to drop. Even if the Corvette’s price were to drop to $30,000, you still would have to buy it for $40,000. Despite this downside risk, there’s at least one good reason to buy a forward instead of an option—you would save the $1,000 option premium.

Options and forwards are traded on all kinds of financial instruments, including stocks, bonds, and various market indices. Some are traded on organized exchanges throughout the world. Others are traded only in privately negotiated transactions, called over-the-counter, or OTC. Exchange-traded derivatives are more highly regulated, more liquid, and more dependable than OTC derivatives. To get information about an exchange-traded derivative, you can simply look in the Wall Street Journal or call a broker. In contrast, you might never be able to discover certain information about an OTC derivative unless you worked in the derivatives group at an investment bank.

All derivatives are combinations of options and forwards. Much activity in the derivatives market—including the trades I will tell you about—involves combining different options and forwards and selling them in packages. The most difficult aspect of creating these packages is calculating how much each component is worth. These calculations are the one element of derivatives sales that truly resembles rocket science, and mistakes can be catastrophic.

I knew very well how painful such mistakes could be. If you ever decide to buy derivatives, I hope you never have an experience similar to the one I had. It involved another bank you may recognize as a derivatives culprit: Bankers Trust.

Years earlier, I had been interviewing for a job at Bankers Trust, known on Wall Street as "BT." Bankers Trust recently has acquired quite a reputation for selling exploding derivatives to unsuspecting clients, and the firm has been reprimanded by regulators and sued by numerous clients. However, years ago, when I was struggling to get a job on Wall Street, BT was relatively clean.

BT had one of the top sales-and-trading training programs on Wall Street. It was a sophisticated, highly quantitative bank, and anyone who made it through BT’s rigorous training was guaranteed success. All over Wall Street, salesmen and traders with BT experience were making bars. I had felt good about BT and was optimistic about my chances there. I was confident that if I could get a job there, I would become rich.

At the time, BT wasn’t yet known as the bank where—according to one infamous derivatives salesman—they "lure people into that calm and then just totally fuck ’em." To most of the world, this was still a secret. I had assumed that BT was in business to make as much money as it could. Had I known BT’s approach to clients was to "totally fuck ’em," my favorable view of the bank might have changed. Perhaps it would have improved.

In any event, I remember very well my first interview at BT. It was my very first interview for any job on Wall Street. The personnel director led me through the glassed-in reception area to the bond trading floor. I had never seen a trading floor in person, and I surveyed the bustling place in awe. It was filled with blinking trading screens and clamoring salesmen. The noise was deafening. Almost everyone was screaming, either into a phone or at someone else nearby. The atmosphere was electrifying, and I was nervous.

I noticed one bespectacled guy poking a Hewlett Packard 19BII turbo calculator at me. The personnel director said he was a derivatives trader and walked away. I extended a sweaty hand.

I followed the silent trader into a plush window office and sat. He stared at a row of green, blinking Telerate screens reporting up-to-the-second prices of various financial instruments, then picked up the phone and mumbled some numbers and coded language I didn’t recognize. I watched the BT trader for a few minutes until I was no longer merely nervous. I was terrified. His eyes darted across the screens, and he seemed oblivious to my presence. I couldn’t understand a word he was saying. My mouth was dry, and I couldn’t swallow. I scanned the room for a water cooler.

The trader finally spoke to me. He dispensed with small talk, ignored my résumé, and simply proposed to sell me a derivatives trade. I listened carefully as he described the terms. As I understood it, the trade was a mixture of forward derivatives trades on Treasury bonds. I knew the forward trade was a contract to buy Treasury bonds at a set future time and price. If the trade moved against me, I would be obligated to pay him an amount of money based on a complex formula.

I thought about the forward trade. It was an over-the-counter trade, so its price would not be quoted on any of the trading screens. I could find the value of the underlying Treasury bonds on a Telerate screen, but it would be up to me alone to use those values to calculate the price of the trade he was proposing. I was wary. Potentially, this trade was incredibly risky. As with the Corvette forward trade, if I committed to buy these bonds at a set price and that price dropped, I could lose a lot of money.

Still, I understood in principle how to value the components of the trade. The trade was leveraged, meaning I would have to multiply the value of each component by a leverage factor. The leverage factor was simply a number you multiplied times the specified size of the trade to determine gains and losses, not unlike the doubling cube in backgammon. For example, with a leverage factor of 10, a $1 million trade really was worth $10 million. I would need to calculate the value of the forward contracts I was buying, and then subtract the value of the forward contracts I was selling. After subtracting, if the resulting value was greater than zero, I would make money from the trade and should do it. If the value was less than zero, I should say no. Simple?

The derivatives trader asked me if I wanted to do a $10 million trade. I glanced at the green, blinking Telerate screens to check the Treasury bond prices and did some quick calculations. He told me I had one minute. I eyed his Hewlett Packard 19BII turbo calculator anxiously, then thrust my sweaty hand into my pocket, searching in vain for my own calculator. Nothing. It was still sitting on my desk at home. Damn! My adversary pointed at the paper and pencil on the desk next to me. I mulishly shook my head. No primitive pencils and paper for me. I needed to impress this guy, and I thought I could perform these calculations in my head. I checked the blinking screens again and crossed my fingers. He raised an eyebrow. I tried to clear my throat, and when it wouldn’t clear, I prayed that it at least would produce a sound. "OK."

He stared at me coldly. "You’re done." The words hung in the air like clouds. "You’re done" is trader’s lingo, used when a trade has been executed. If someone tells you "You are done," quite simply, you are done. There’s no getting out of the trade. Your word is your bond, so to speak. So I was "done" for $10 million. That was fine. I thought I had made money on the trade.

He proposed another $10 million trade, same terms. I felt confident about my previous calculations, and the numbers on the blinking screens had not changed much. I eyed his turbo calculator a little less nervously and nodded. He stared back and frowned. "You’re done." I was still nervous, but I was virtually certain I had made money on the first two trades. I tried to appear sanguine.

The trader shifted in his chair and proposed a slightly different trade for $100 million. I stared at the screen, then glanced at the paper and pencil. For the first time, I began to wonder about my previous calculations. Could I have made a mistake? I didn’t think so. But I wasn’t sure about the effect of the slight change the trader had made. Although the new trade was larger, its terms were similar to those of the two previous trades—assuming the market had not changed in the past few seconds. I looked at the blinking numbers on the screen, and I thought they had moved in my favor. But I could no longer remember precisely what the numbers had been a minute ago. Because of the leverage factor, even a small mistake would cost me millions. I stared again at his turbo calculator and paused. I felt just confident enough to nod again, and I did.

For the first time the trader smiled. "You’re done," he said. My mind began to wander back to the previous trades. . . .

The trader interrupted my thoughts. "Same trade, one billion dollars." His voice was firm and confident. I sank in my chair.

Apparently, I had made a mistake. Now I was faced with a choice. Either I admitted I couldn’t understand the trade—and risked being rejected as a novice with limited derivatives proficiency—or I guessed.

Today, as I look back on my decision, I know that the amount of money I was about to lose may not seem that surprising. Eventually several derivatives buyers would lose even more than I lost that day. But back in 1992, most people, including me, thought derivatives were relatively safe. You could still pick up a newspaper and not find one article about an individual who had lost a billion dollars on derivatives. It was well before Robert Citron of Orange County lost a billion dollars, Nick Leeson at Barings Bank lost a billion dollars, Toshihide Iguchi at Daiwa Bank lost a billion dollars, and Yasuo Hamanaka at Sumitomo Corporation lost two billion dollars—all on derivatives. It was before companies with long, foreign-sounding names like Metallgesellschaft lost a billion dollars on derivatives. It was even before George Soros lost . . . well, he only lost a half billion dollars on derivatives, but it was before that, too.

It was early fall 1992, and I was about to become the very first person to lose a billion dollars on derivatives.

I looked at the trader and nodded that, yes, I would accept the terms of this trade.

The derivatives trader removed his glasses and gave me one last, "You’re done." He pointed his finger at the door. "Congratulations, you just lost one billion dollars. That will be all."

I was stunned and could not respond. That will be all? I was shattered.

I stumbled out of the office and wandered back to BT’s trading floor, where I stared in disbelief at the blinking screens. Had I really just lost a billion dollars? I tried to think about the mathematics of the trade and the effect of the leverage factor. What would my friends say? It had gone so quickly. I was worried, and rightly so. A billion dollars was a lot of money to lose.

I tried to cheer myself up. After all, I hadn’t really lost a billion dollars. I tried to put the loss in perspective. The financial markets traded trillions of dollars daily. The size of the entire derivatives market in 1992 was $40 trillion. The foreign exchange markets alone traded about $1 trillion a day. Nobody got upset about a lousy $1 billion loss these days, did they?

I had to admit, my first interview at an investment bank had not exactly gone well. Earlier I had wondered how anyone could make so much money selling options and forwards. And if Wall Street was making so much money on derivatives, who was losing money? Now I had firsthand knowledge of precisely how one person could make, and another could lose, a billion dollars on derivatives. I had learned some important rules to live by.

First, there are winners and losers in every derivatives trade, and you didn’t want to be a loser, especially one who lost a billion dollars. Second, I needed to be able to make quick and complex calculations with great facility, preferably in my head. Most people, including the majority of employees at an investment bank, didn’t need the ability to perform such feats, but if I were to succeed in derivatives, I did.

To help me along the road to making bars, I needed to master one more concept essential to understanding derivatives, and closely related to the calculations the BT trader had asked me to perform: present value. "Present value" is the value of a payment, expressed in today’s dollars. For example, the present value of $100 to be received today is $100. However, the present value of $100 to be received in a year is less than $100. In general, the present value of an amount to be received in the future is less than the present value of the same amount to be received today.

You probably have some understanding of this notion, at least its most basic terms, from the maxim "A bird in the hand is worth two in the bush." Some people think this means a bird in the hand is more certain, and therefore more valuable, than two in the bush. To an investment banker, this maxim means that the present value of one bird to be received today is greater than the present value of two birds to be received in the future. Believe it or not, this concept is critical to understanding derivatives, so before we move on to Morgan Stanley, here’s what you need to know about present value.

Although an enormous body of finance scholarship is built around bond mathematics and present value, the basics are actually very simple. The essential issue in valuing stocks and bonds, and the essential issue in finance generally, is this: A dollar today is worth more than a dollar tomorrow. That’s it. Why is a dollar today worth more than a dollar tomorrow? That answer, too, is easy. Put a dollar in the bank today, and tomorrow you’ll have more than a dollar. Or, if you only need a dollar tomorrow, you can deposit less than a dollar, say 99 cents, today. The interest you earn is composed of a "real" return (say, 3 percent) plus an inflation component (usually a few percent). The interest rate varies, based on when the money will be paid. Under normal circumstances, the longer the term, the higher the interest rate.

If you understand these basics, you can understand much of modern finance theory and most of how the bond and derivatives markets operate. If you don’t understand it right away, don’t worry, you’re in good company. Many fund managers and corporate CEOs had only a limited understanding of the bond and derivatives markets until very recently. Even President Clinton reportedly admitted surprise when he discovered the importance of—in his words, according to one source—a bunch of "fucking bond traders." Allow me to explain the most important concepts.

For valuing bonds, the precise question is: How much more is a dollar today worth than a dollar tomorrow? Suppose you have the choice between receiving $100 today and receiving $100 in one year. Obviously, you’d choose the $100 today. But what if the choice is between $100 today and $106 in one year? The answer then depends on what interest rate you could earn during the next year. If the one-year interest rate is 8 percent, you would prefer the $100 today because it would be worth $108 in one year. On the other hand, if the one-year interest rate is only 4 percent, you would prefer to have $106 in one year because $100 today would only be worth $104.

To compare $100 today with $106 in one year, we must express them both in the same terms. This is done using the concept of "present value." We simply ask, "What is the value of each today?" The value of $100 today is easy—$100. What is the value of $106 in one year? If the one-year interest rate is 6 percent, the value of $106 in one year also is $100 today because $100 invested today at 6 percent will be worth $106 in one year. Using the 6 percent rate, we "discount back" the $106 in one year to its value today: $100. The 6 percent rate is called the discount factor. If the discount factor, or interest rate, were higher—say, 8 percent—then $106 to be received in one year would be worth less than $100 today. Similarly, if the discount factor were only 4 percent, then $106 to be received in one year would be worth more than $100 today.

To calculate the price of a bond, we simply think of the bond as a series of cash flows, just like the $100 payments in the previous paragraphs. In fact, a one-year bond with an annual coupon of 6 percent is exactly the same as a payment of $106 in one year. At the maturity of the one-year bond, the bondholder would receive his principal ($100) plus interest ($6), for a total of $106. Most bonds pay interest twice a year, but the idea is the same. For example, to value a ten-year bond with a 6 percent coupon, simply calculate what each of the interest payments and the principal repayment are worth today, in terms of present value. The sum of these individual values is the bond’s total value.

Put in terms of the bird maxim, for a bird in the hand to be worth more than two birds in the bush, assuming an interest rate of 6 percent, you must not expect to catch the two birds any time in the next twelve years. That’s about how long it takes an amount growing at 6 percent per year to double, and that’s too long for most birds. Thus, present-value concepts demonstrate the wisdom of an age-old maxim. But you probably knew what it meant already.

A more advanced course in finance would include not only present value, but also two other concepts: duration and convexity. The bird-bush metaphor doesn’t work very well for these concepts, and when business school students—and most salesmen and traders—hear either of these two words, they run screaming. There’s no need to run. Even if you work at an investment bank, you should forget about mastering these concepts. Just remember this:

"Duration" tells you how risky a bond is. The greater the duration, the greater the risk. For example, a ten-year bond has greater duration—and greater risk—than a one-year bond. That’s it.

Mathematically, of course, duration is more complicated than this. It’s the length of time until you receive the average present value-weighted cash flow, and is itself a derivative (in calculus terms), of the partial differential equation that describes the price behavior of a bond. Most bond salesmen forgot this definition long ago, if they ever learned it. In simpler terms, think of a bond as a series of blocks—each representing a single cash payment—laid out along a seesaw, moving in time from left to right. Most of the blocks (coupon payments) are short, and the block to the far right (principal repayment) is much taller than the others. The duration of the bond is the length to the balancing point of all the blocks, at the fulcrum.

"Convexity" is an incredibly complex topic far beyond the scope of this book. All you need to know about convexity—in fact, all that 99 percent of people who work on a trading floor know about convexity—is this: Convexity is good. The more convex a bond is, the more money you will make on it when interest rates change. This explanation works for the bizarre term "negative convexity," too.

Here’s a final examination question for you: If convexity is good, what do you think about "negative convexity"?

If you answered that negative convexity is bad, you are correct. Congratulations. You now know enough to begin selling derivatives.

Back at First Boston, I, along with everyone else, was pacing through the last interminable week before bonuses were paid. Soon thereafter many employees would quit. Most investment banking employees are rational economic actors who know that once they’ve received a bonus payment, they’ll have to wait an entire year for another. If you were planning to leave a firm, you never stayed more than an hour or so past bonus time if you could help it. Otherwise, according to the math of the trading floor, you were basically working for free. Most salesmen and traders thought this way because their salaries—usually around $75,000 to $100,000—were only a fraction of their total annual compensation, including bonus. I thought this way, too. If I could get an offer from Morgan Stanley, I planned to quit the instant after I deposited my bonus check.

Finally, just a few days before bonus day, Morgan Stanley made me an offer I couldn’t refuse. I said I would accept the offer immediately after First Boston paid bonuses. I knew I couldn’t accept the offer on the spot because if I did and First Boston discovered it, I might not receive my bonus. Every smart employee of an investment bank knows the bank will go out of its way to screw employees who plan to leave for a competitor. So I kept my plans quiet and waited until February 15.

Bonus day at First Boston is known as the Valentine’s Day Massacre, and its employees view themselves as serfs subject to the bloody rite of the firm’s relatively meager bonuses. By the time bonuses are paid, most salesmen and traders are so infused with greedy, revolutionary fervor that no matter what amount the firm actually pays them, they automatically think they have been screwed. I was intrigued by this odd phenomenon. Could a salesman who received several million dollars really be irate?

Sure enough, by 9:30 A.M., the cavernous trading floor echoed with the angry protests of surly salesmen and testy traders who, minutes earlier, had received checks ranging from several hundred thousand dollars to several million. Even the lowest-paid employees received a significant multiple of the average income of an American family. But perspective is not one of Wall Street’s qualities, and the firm’s employees were mad as hell.

"Man, I got fucked. They fucked me again. Can you believe it? Did you get fucked?"

"Yeah, I got fucked."

The normally jovial salesmen were so angry, and morale was so low, that whenever an underpaid employee did quit First Boston, he or she would receive a standing ovation from the entire trading floor. The loudest applause would be for salesmen leaving for Morgan Stanley, and there would be more than a few of those.

On bonus morning I took my check to the Citibank branch around the corner from the Park Avenue Plaza aquarium, joining a line of hundreds of disgruntled First Boston employees. You might assume First Boston would have been sophisticated enough to pay its employees by instantaneous "direct deposit." However, the stingy firm needed to pinch pennies, and the firm’s managers knew that if they paid us with physical checks, we’d have to deposit those checks in person. That might take a day or so. Meanwhile, the firm would earn the interest on our bonuses. Remember "present value"? For employees with big bonuses, even one day of interest was worth a lot. In aggregate, the interest was worth a fortune. First Boston knew all about the bird in the hand, and, as a result, the line was out the door.

When I returned to announce my departure, I was in good company. Several other salesmen had announced they were leaving, and senior management was deciding whether to offer them more money or let them go. This was a standard Wall Street ritual. You obtained an offer from another bank, then used that offer to try to persuade your current employer to give you a raise. It’s the only way to get ahead at an investment bank, and senior managers, though furious when you do this, will think you are a loser if you do not. It’s not uncommon for a new salesman or trader to multiply his starting salary by as much as ten times in a few years, using such negotiating tactics.

My bosses pressured me to stay. They said the firm would increase my compensation dramatically, although they also noted it would take a few days to confirm this in writing. I said I was walking out of the firm within the hour. One manager offered to write me a personal check for $20,000, in case First Boston ultimately balked at increasing my pay. I told him I was flattered but that I would make many times that amount at Morgan Stanley. In Morgan Stanley’s derivatives group, $20,000 was cab fare. An average employee there generated $20,000 in fees per day.

Fortunately one of the managers from Morgan Stanley had prepared me for this onslaught, warning me that my bosses at First Boston would persist in trying to persuade me to stay. He had suggested that if I used the words "better opportunity," they would back down. I was waiting for the right moment to try those words. When the sales manager again offered to whip out his personal checkbook, I finally said: "The offer from Morgan Stanley is a better opportunity."

He stopped in his tracks. Those two words—"better opportunity" — are Wall Street code for "more money than you can possibly pay me." I recommend them highly to anyone trying to cut short a negotiated exit from a sales-and-trading job. When I spoke those words, like magic, the managers gave up.

The sheer brutality of Wall Street is never clearer than when senior managers finally realize an employee is going to quit. There are no farewell dinners. No one sheds a tear. Cordial working relationships evaporate. Friendships forged out of necessity on the closely knit trading floor are terminated immediately.

I hadn’t expected sad good-byes, but nevertheless I was surprised that my colleagues reacted with such anger. One salesman made a few kind remarks and admitted he was a little jealous of my move. One trader said he would call me next week. But most of my colleagues, including my immediate bosses, were hostile. Not only did they instruct me to leave the firm immediately, they sent for a security guard to escort me out.

I was especially surprised to discover that a search was among the exit procedures at First Boston. Certainly, an exit search wasn’t without justification—investment banking employees commonly looted a firm’s documents and computer files before leaving for another firm—however, smart employees usually did this several days, if not weeks, before leaving. Apparently, past First Boston employees had been dumb enough to try pilfering files on their last day of work. Fortunately my briefcase was squeaky clean. I gave my identification and firm credit cards to the security guard and left. My days in the second tier were over.