Table of Contents
Title Page
Copyright Page
Chapter 1 - Rude Awakenings
Chapter 2 - The SEC Steps Out
Chapter 3 - Short People
Chapter 4 - Belgian Waffles
Chapter 5 - Aremis Soft and the Deemster from Hell
Chapter 6 - Taking Out the Eurotrash
Chapter 7 - In the Shadow of Enron
Chapter 8 - The Easter Bunny Cometh
Chapter 9 - Mired in Muck
Chapter 10 - Our Tax Dollars at Work
Chapter 11 - Warming the Bench
Chapter 12 - The Overstock Flame Wars
Chapter 13 - The Bird in the Bush
Chapter 14 - The Collapse of the American Financial Sector in One Easy Lesson
Chapter 15 - Ashes, Ashes, All Fall Down
About the Author


For Eileen and Neal, two good eggs

The pure products of America
Go crazy
—William Carlos Williams

At the advanced age of 38, I joined the U.S. Securities and Exchange Commission as a lowly staff attorney. The year was 1990. I was coming off a stint suing boiler-room consumer frauds for another federal agency and, before that, my extended and largely misspent youth had included episodes as a screenwriter, semiprofessional student, and reluctant law firm flunky.
I remained at the SEC for 13 years, confounding previous doubts about my employability, and even crawled up a few rungs on the bureaucratic ladder. Most of that time was spent chasing financial frauds, beginning, as one colleague put it, “before that was cool.” Before, that is, Enron and WorldCom and other turn-of-the-century financial scandals made people wonder whether our business leaders should be seen as presumptive felons, including those paragons of capitalism who loom like stuffed predators from the covers of Fortune and Business Week. Including them most particularly. And, of course, long before the events of these last turbulent years led many to question whether the stock market is at bottom a huge confidence game that can collapse as abruptly as a carnival tent in a windstorm.
The SEC did more than pay the mortgage. It took me to odd parts of the world. It allowed me to work with some tenaciously admirable people in an environment not calculated to bring out the best in any of us. It gave me the satisfaction of helping to recover many millions of dollars for investors and banish some bad people from the financial world. It also gave me insomnia and migraines and a reluctance to believe any opinion on American business and its regulation that has taken on the color of consensus.
I left in 2003 to become a partner in a law firm and defend public companies against my former colleagues, no longer seen as dedicated public servants but now as the jack-booted thugs of The Man. The work was easier than it sounds, it being generally more difficult to acquire a substantial client in the face of rabid competition from other law firms than to lead that prize, once acquired, past the snares of law enforcement. Unless, that is, the client had attracted serious press attention. Or engaged in some category of conduct denounced in a recent speech by an agency notable. Or stupidly admitted his transgressions before retaining counsel. Then it takes more work.
Less conventionally, I bolted the law firm after a few years to become an analyst and legal advisor with a “short-biased” fund in California, Copper River Management. Among other things, I did research on companies suspected of cooking their books or otherwise misleading the investing public.
A short sale is a bet that a stock will decline because of negative facts not yet apparent to the market. Management is making up the numbers. Or the company’s key product is a passing fad. Or its business sector is due for a fall. Soon others will see this and the stock will tumble.
Or not. That is the gamble.
Copper River—which at its peak managed almost two billion dollars of investor funds—made the gamble pay for more than 20 years, its survival a statistical improbability that ended at the very point the fund should, by rights, have enjoyed its greatest success. Like other “bear” funds, Copper River was positioned to profit from a market decline. Perversely, however, the largest decline in recent history left the fund’s expectations brutally disappointed, its assets stripped away, offices closed, and partners and staff unemployed.
The events of late 2008 carried away a number of bears with the greater number of bulls. That was not how it was supposed to work. Those who believed the markets—however unpredictable in other ways—are subject to a single and revealed set of rules found, to their surprise, that a second set existed, housed behind a glass marked “break in event of panic.” This lesson was learned at great expense by many who are no longer in a position to benefit from it.
An acquaintance whose political views line up roughly with those of the Unabomber once told me that my employment at the SEC placed me squarely “in the belly of the beast.” I said he should be pleased. I would surely put the hurt on more corporate plutocrats, made rich from grinding the faces of cubicle-dwelling proles, than anyone else he would ever meet. He was not convinced and would probably have viewed my path from law enforcement to corporate legal defense as a further slide into infamy. As, for that matter, did many of my former colleagues at the SEC, where joining a private firm was referred to, not-altogether-jokingly, as “going over to the dark side.”
My fall from grace became complete with my move from the law firm to a short-selling hedge fund. In America, the only thing less admired than our government is the hedge-fund industry, with its shadowy transactions and elephantine profits, and a particular enmity is reserved for those funds that bet on a decline in the market inimical to the hopes of others, and who celebrate when others despair. In the halls of Congress such creatures have been denounced as parasitic, vulpine, even unpatriotic: a secret society sworn to spread banana skins in the path of American business. They are allegedly given to “bear raids” on randomly targeted stocks and accused of spreading misinformation that unfairly contradicts the misinformation spread by the companies they short.
Richard Fuld, former CEO of the now-defunct investment bank Lehman Brothers, said: “When I find a short-seller, I want to tear his heart out and eat it before his eyes while he’s still alive.” Many corporate leaders, it seems, have harbored this dark appetite. Some have attempted to satisfy it—at least figuratively—by filing lawsuits and lobbying government agencies to pursue their short-seller critics for transgressions real or imaginary.
Copper River—known for getting all up in the face of corporate management it deemed less than credible—suffered such attacks to an unmatched degree. It was sued for hatching elaborate conspiracies with other people it had, in fact, never met or previously suspected to exist. It was investigated by the government for conduct that would have been incontestably legal if done by anyone other than a short-seller. When it appeared on the verge of profiting from the possibility that stocks of bad companies might actually go down, at least in a down market, the government prevented that unacceptable outcome through an episode of regulation by ambush.
All of this was what Copper River might have expected. After all, those who insult the gods of commerce by questioning their integrity earn their displeasure and tempt the lightning bolt. Few will trouble themselves over the firm’s fate and many will think it well-deserved.
Looking back, I view my history as a sort of Rake’s Progress. Taking me from government thug to corporate legal flak to minion of the great short-seller conspiracy, it traced a downward spiral through increasingly dark strata of the financial world.
But this did not make it a dead loss. The experience provided a broad if eccentric education in the ways our capital markets work and—quite often—don’t. A worm’s-eye view into the follies of the American financial behemoth as it marches boldly from crisis to crisis. The perennial frauds reborn for each generation, changing only in outward appearance over time. And the fables we are told to make us believe the dislocations and disruptions, from the most minor to the catastrophic, are in every case the fault of others—never ourselves and those we choose to lead us—and will not happen again.
Perhaps there is some small return to be gained from that.

Chapter 1
Rude Awakenings
The spring of 1987 stands as the bittersweet coda to my protracted adolescence. I was then 35. I had been happily ensconced at Harvard Law School working on an advanced degree of little practical utility other than to serve as an excuse for several years of scholarly lassitude. After getting my first law degree and enduring a year in a vertical lawyer ghetto in Century City, California, I made the discovery that I hated practicing law and could do without most lawyers. So I did what any sensible person would under those circumstances. I went back to school. My vague hope was to become an academic—like my father and grandfather and great-grandfather and God-knows-how-many other pedantic forebears—and never, ever go back to the billable hour treadmill of private legal practice.
The first year in the graduate program was a long slog of course-work, but after that I found I could freely indulge the attention deficit disorder I had previously struggled to repress. Poking around somnolent bookstores in Harvard Square . . . watching the squirrels outside my of fice window as they scampered across the Yard . . . plugging away on a doctoral dissertation on an obscure aspect of American economic history . . . and, in the late hours, writing amystery novelthat would even tually be ignored by the reading public. All the while, the school and my employed wife Eileen paid the bills.
This idyll, however, could not survive the news of a pending ex pansion of our family. While profoundly welcome, the prospect was unsettling. Academic bohemianism is all well and good when you don’t have extra mouths to feed. Now responsibility knocked with brutish authority. Eileen seemed less concerned. Coming from a family of eleven, she accepted that children just sort of spring up around cou ples like mushrooms after a rain-storm. While I fretted daily over what would become of us, she would put on the purple bathing-suit that, as her pregnancy progressed, made her look more and more like an eggplant with feet, waddle cheerfully off to the university pool, and split a lane with an elderly gentleman she thought was John Kenneth Galbraith.
My plan, to the extent that I had one, was to find a not-too- demanding government job while I finished my doctorate and also dealt with the responsibilities of parenthood. I sent out resumes to a raft of federal agencies, not including the SEC. Its application form was oner ously long and focused on the applicant’s experience with the securities laws, of which I had none. The first to respond was the Federal Trade Commission’s Bureau of Consumer Protection. Apparently the bar was not set very high. After a quick interview in Washington, employment was offered and accepted. We loaded our new son and old furniture into a U-Haul truck and migrated from Cambridge to a rented apartment in northern Virginia, across the Potomac from the imperial city.
Every organ of the federal bureaucracy has its own peculiar mores and practices related in some vague anthropological way to its regulatory goals, and which determine whether those goals are to any degree met. The Credit Practices Division of the FTC had a finger into every aspect of the nation’s consumer credit industry. With a staff of less than twenty attorneys, it was in charge of so many rules and regulations that some attorneys had a statute or two they were expected to enforce all by themselves from one end of the continent to the other. This was on top of the division’s duty to protect the public from every form of credit fraud.
Obviously, this presented the opportunity for chaos. The division was staffed, however, by mild-mannered government lifers, who had no tolerance for chaos. The issue was resolved by drawing constrictive lines around the rules that were enforced, buttressed by onerous procedu ral hurdles to frustrate any potential deviation from accepted practice, no matter how slight. In this, it was not unique among government agencies.
The FTC’s effectiveness was further undermined when then- president Reagan inflicted on it an administration heavy with eco nomists. Economists are like accountants, only more so. They do not count beans so much as argue over whether the beans exist and, if so, which among them deserve to be counted. The FTC economists conducted cost-benefit analyses to determine if Congress had erred in deciding certain practices should be prohibited. Mostly they decided it had. It has been suggested that, during this period, the FTC could see no harm to the American public in any practice not involving actual gunplay.
It might seem this situation offered the opportunity to draw a decent salary without really doing anything. But there is a fine line between not doing anything and not accomplishing anything. In government, the former is sternly frowned upon, but the latter not so much.
My indoctrination to this critical distinction came from a brush with a prominent Texas mortgage company. The experience also provided my initial exposure to the art, well known to large financial entities, of finessing, evading or simply ignoring inconvenient regulations.
In early 1987, the Federal Reserve Board, spooked by rising infla- tion, cranked up the interbank discount rate a full percent (100 basis points). This gave home mortgage rates a jolt, and lenders were caught between the rock of hundreds of millions of dollars in pending mort gage applications with rates contractually “locked in” and the hard place of a sudden rise in their cost of funds. In short, the loans would be unprofitable. The large Dallas lender Lomas Mortgage elected to shed its lock-in agreements by claiming they applied only when rates went down. This made them the equivalent of flood insurance that protects only against losses incurred during a drought. Other mortgage companies performed variations on this theme. Burned applicants eventually figured out that—under our fragmented, incomplete, and incoherent system of financial regulation—the sleepy little Credit Practices Division of the FTC had jurisdiction over the lending practices of some mortgage companies, Lomas among them.
Together with a younger attorney, who was fresh out of law school, I spent months trying to cajole the company into honoring its lock-in agreements. Lomas fielded a platoon of white-shoe lawyers in its defense. In lead-dog position was Harriett Miers, later nominated unsuccessfully by George W. Bush to the Supreme Court. Counsel was indignant that the government would attempt to tamper with bona fide transactions between corporate lenders and their borrowers, merely because the contracts happened to work out in favor of the (well-lawyered) lenders who drafted the contracts and—eschewing persiflage about items of small print—slid them past the (clueless) borrowers.
Lomas wouldn’t budge. This meant the FTC either sued or dropped the matter. There followed months of meetings and memos. Much anguish was expressed over proposed legal theories. The FTC, by statute, is empowered to punish “unfair or deceptive” trade practices. But, it was argued, “unfair” could mean almost anything. That being unacceptable, it followed that it must mean nothing at all. And how were these contracts “deceptive” when one could, with careful reading, spot the lurking escape clause? Should people be excused from reading what they sign? Down that road lies perdition. But finally the commission agreed that, even in the era of caveat emptor, the company’s conduct was beyond the pale. Shortly before I left the FTC in 1990, we gave Lomas the bad news: settle or be sued. I assumed it would be a matter of weeks before an action was filed.
Three years later, the FTC announced a settled action against Lomas. Nothing in the order indicated there might be anything unfair in drafting contracts so as to render them, in practical application, illusory, as I believed these contracts were. Lomas would pay a total of $300,000, trickled out to claimants in $1,000 increments, and agree that henceforth it would make sure its borrowers clearly initialed any weasel language Lomas put in its contracts. The amount paid for redress was likely less than Lomas paid its attorneys for copying and paralegal assistance. Ms. Miers, in her failed confirmation hearing, described the settlement with admirable modesty as “acceptable to Lomas.”
In sum, much time and effort was expended to achieve a result of no real value to the public. But I learned from this a useful lesson. After being mired in this and other cases in which policy concerns trumped common sense, I determined to avoid “issue cases” and look for matters even an economist could love. This meant blatant frauds.
Fortunately, these were not in short supply.
In the days before the Internet, scam artists were largely dependent on the U.S. mail to hook potential marks. Boiler-room operators would send out postcards by the tens of thousands, offering impossibly great deals as part of a purported contest or market survey, and employ squads of telephone salesmen to field the leads that the mailers generated. The object was to extract the caller’s credit card number. At that point, the fish was in the boat. The only question was how many times the person would be billed before he or she realized the charges were for unwanted goods. These operations infested beach communities full of transient young people desperate for employment and disinclined to ask questions.
Typical of these scams was a Venice, California, operation that pumped out mailers promising the recipient “a four-person outboard motor boat” in return for participating in a market survey. The boat, constructed of “pneumatically pressurized compartments,” was described as “suitable for ocean fishing.” Those who called to claim their prize were told yes, the boat was theirs. There was, however, the small matter of a $300 fee to cover incidental expenses: taxes, the cost to ship the boat “by commercial carrier,” and charges for “transfer of title.”
Tens of thousands of dollars had changed hands before the complaints began to pile up. The phrase “four-person outboard motor boat” had conjured in the minds of many trusting souls something other than an inflatable plastic dingy with an egg-beater motor. And they were pissed. A federal judge in Los Angeles saw their point and, without notice to the company, granted the application of the FTC for an order shutting the operation down and freezing its bank accounts. Judges were usually accommodating in this way—as I discovered after similar experiences in courtrooms across the country—especially once they recognized the defendants’ social stratum (white trash) and the consequent near-certainty that no one would challenge the orders. The company was located a few blocks off Venice Beach. The building, when I found it, looked abandoned: paint peeling from salt breeze and sun, screens torn, litter decomposing in the alcove beside the entrance. But the sign on the door for American Nautical Adventures looked new and, inside, the place was jumping. Rows of young men in T-shirts and cut-offs slouched in surplused office chairs, each with a telephone cradled between shoulder and ear as he earned his rent.
An inflatable plastic dingy hung from the rafters, shifting in the draft from the open loading dock at the back of the large, uncarpeted room. However innocent in appearance, it was easily identifiable as the source of hundreds of complaints to the FTC.
From a raised dais at one end of the room, a man in his late 20s monitored the activities of the salesmen. His right leg was covered to the knee in a grimy cast and propped on a battered metal desk, an huarache sandal dangling from the exposed foot. His sun-streaked mud-brown hair bulged from under a backwards baseball cap and his T-shirt advertised a bar in Ensenada. The appearance of a suit and tie caused him visible concern. It could only mean trouble. His arms flailed as he righted himself and stood hunched away from his broken leg. He read the order slowly, moving his lips, and winced in dismay when I told him a federal judge had frozen all his assets, personal and corporate, including whatever loose change he had in his pockets.
But a true salesman is never at a loss for words.
A mistake had been made, he tried. Maybe there was another company by the same name. Or one of his competitors was slandering him. It was that kind of business.
Yes, those were his mailers. Sure, that was his boat. But so what? It wasn’t like anyone had lied about anything here.
I mentioned a few points where he might have failed to reach a true meeting of the minds with his customers. That was too just much for him to take. Now he was upset. He pointed at the boat dangling overhead and offered to show me it could seat four people or more. If I didn’t believe it was good for ocean fishing, there was an ocean just a few blocks away. I could try it for myself. Due to a skateboarding mishap—he knocked on the cast—he couldn’t demonstrate the capabilities of the craft himself, but any of his employees would be only too happy.
He had answers for everything. The phrase “pneumatically pressurized” meant you had to blow the thing up. What else? And what he sought to convey by the phrase “the costs of transferring title” was, well, what you paid for the boat. The “commercial carrier” that tossed the boat onto your doorstep in its little plastic bag was the very reputable United Parcel Service. And it was also nothing less than the truth that the company was conducting a market survey. That is, it was a survey to determine if people would be more willing to buy a boat if told it was being offered as part of a market survey than if someone just called them up and asked if they wanted to buy an inflatable boat.
I told him he would have every opportunity to make these very compelling arguments to a judge or jury. He did not seem to find this reassuring.
The next day I went by to make sure no sales were taking place and found the office deserted and the local unemployment rolls swelled overnight by the addition of two dozen surfers, dopers and aspiring actors. The phones were gone, but no one had bothered with the furniture.
And the boat was still there, dangling in midair and spinning slowly like a big, clunky mobile.
When sued, these operations usually stole away with whatever was in the till.1 The challenge was to find and freeze their bank accounts before they got wind of what was coming. That meant figuring out in advance which banks they used. Sometimes it was possible to get this information from the cancelled payment items of their victims, but not always. I tried driving in expanding circles away from the target company office to serve with a freeze order every bank within, say, a mile radius. But this too was hit-or-miss. Once, for a particularly egregious Florida scam, I hired private detectives to search its garbage for financial records.
The detective agency had its office in an old frame house in Daytona Beach. When I walked in to see the evidence it had collected, I found two burly ex-FBI agents jumping up and down, high-fiving each other and yelling as if they’d just won a football pool. They explained their euphoria by pointing to the image flickering on a video monitor. While hiding in a bush, one of the detectives had captured on tape the purportedly crippled victim of an auto accident in a game of beach volleyball, blithely spiking his claim against the insurance company employing the detectives.
They had also achieved solid results in their trash runs for the FTC. Among the pizza cartons and cigarette butts, they found bank statements that revealed where the company stashed its loot. The bulk of the garbage, however, consisted of letters of complaint from people the company had bilked. They were there in the hundreds: crumpled, coffee-stained, and all but a few unopened.

Chapter 2
The SEC Steps Out
October 19, 1987, is remembered on Wall Street as Black Monday. The New York Stock Exchange fell over 22 percent, the biggest one-day drop in its history. Other countries’ exchanges also took a beating in a worldwide contagion of panic selling. Sales orders came in such torrents that the NYSE’s order entry system was overwhelmed and the tape reflected prices from some uncertain point in recent history. For one day, everything was broken.
I owned not a single share of stock and my job then had nothing to do with the securities market. But the shock waves reached everywhere, even to my little regulatory closet. Little was done that day around the FTC as everyone watched the financial news and tried to gauge how badly their retirement accounts were bleeding and worried what this might mean for the American economy.
The day’s distress was increased by confusion as to the source of the rout. The market had risen substantially over a period of many months—some thought too far to hold onto its gains. It had experienced some rough days in the previous two weeks, which made traders nervous. But few spotted the severe fragility that could lead to a full-scale collapse.
The impetus for the “market correction,” as the government chose to call it, is still the subject of debate 20 years later. Plainly, there were certain developments kicking at the legs of a tiring bull market. Congress was fooling with an adjustment to the tax code that would have made certain business combinations less attractive. Specifically, the interest on debt used in leveraged buy-outs (LBOs) would, under the proposed bill, no longer be deductible. These were the late years of the mergers and acquisitions boom, so many stocks were fattened by takeover speculation. The proposed legislation caused some of those bets to be taken off the table. This was on top of the stress fractures opening in the junk bond world as a result of increasing prosecutorial interest in some of its major players, including the biggest, Drexel Burnham Lambert. Not to mention that there were simmering worries over the increased debt load carried by American companies as a result of the LBO craze—leverage and risk being always joined at the hip.
Also, the dollar was wobbly. It had weakened significantly during the previous few years—a boon to American exports (which became cheaper and hence more competitive) but not to domestic and international creditors—and the Reagan administration was making noises that the trend might be allowed to continue. This made our trading partners unhappy and invited repercussions, as well as raising inflation worries.
Whatever started the ball rolling, the momentum it developed has been blamed in large part on certain novelty items of financial technology. The double-edged nature of innovation is a theme that echoes through every boom and bust of modern finance. Here the two related culprits were “program trading” and what was called, with unintended irony, “portfolio insurance.” Program trading is exactly what it sounds like: feeding buy and sell orders into a computer to be executed when portfolio positions hit specified price points. Although a helpful tool in managing a fund with numerous positions, its role in the 1987 crash has been portrayed as much like that of the evil computers in the Terminator movies. Take a long weekend in the Hamptons and what happens? Artificial intelligence takes over from the human variety and goes haywire. You return to your office to find a smoking ruin.
Portfolio insurance was one of those something-for-nothing schemes peddled by Wall Street technocrats that work wonderfully . . . until they don’t. The idea was to build into money management a one-way ratchet that would limit potential losses without similarly reducing potential gains. The appeal was obvious: Heads I win, tails I don’t lose much. Portfolio insurance came in different flavors. The most straightforward involved simply going to cash should the investor’s positions decline to hit its predetermined loss tolerance and, conversely, moving increasingly from cash to equities as prices rose. Other varieties directed that the investor respond to market declines by writing futures contracts on the Standard & Poor 500 index. The cash received for selling the S&P futures would supposedly offset losses to the firm’s equity positions. Should the market go up, on the other hand, the cost of honoring the futures contracts would in theory be more than offset by portfolio gains.
Whether this ever made sense at the firm level was probably beyond the knowledge of many of the money managers who gobbled up these wonky products. But it made them feel safer and, for that reason, many went more heavily into equities than they would have had they not been “insured.” This arguably contributed to the market bubble. What these investors did not consider, however, was the systemic risk that occurs when many investors respond to a certain set of circumstances by doing the same thing at the same time.
Portfolio insurance—a “trend-following dynamic hedge”—res ponds to changes in portfolio value by trading in the same direction as the market. In a rising market, this means adding to the upward mo mentum, perhaps helping to inflate a bubble. In a falling market, such as that occurring in mid-October 1987, it means dumping equities. Given the widespread adoption of portfolio insurance, this resulted in a demand for liquidity that exceeded the market’s capacity to deliver without sig nificant price erosion. As Nobel laureate William Sharpe put it, “We learned in the 1987 market crash that if everyone wants the upside and no one wants the downside, then everyone can’t get it.”
Under the versions of portfolio insurance utilizing S&P 500 futures, investors sold futures as the market declined. The increased supply would cause their price to decline. The futures market is predictive of the short-term direction of equities. The sudden cheapness of S&P futures in October 1987, therefore, sent a signal to potential buyers to stand clear of equities, leaving the market to sellers. Further, when the price of futures on the index fell below the aggregate of its component stocks, an arbitrage opportunity was created. By buying S&P 500 futures (cheap) while selling short its component stocks, arbitrage funds could lock in the spread between two equivalent assets. The result of this linkage between the derivatives and equities markets was a tsunami of short sales by arbitrage funds that were exploiting a temporary decline in the price of S&P futures caused, in turn, by program trading in the service of portfolio insurance.
Admittedly, not everyone takes this view. While the SEC and others have fingered portfolio insurance, often operating on autopilot through program trading, as a primary cause of the crash, others point out that declines on exchanges in other countries did not correspond in size to the local popularity of portfolio insurance. This suggests to them that the root cause of the crash was the underlying fragility of a global market inflated to bubble proportions by speculative forces. What no one disputes, however, is the failure of the system to meet the challenge of Black Monday. Its inability to absorb the day’s huge trading volume contributed greatly to the meltdown. Potential buyers stood on the sidelines, waiting for an indication that a bottom was in sight or at least for the return of reliable quotes. Uncertainty increased throughout the day and took much of the buy side out of the market.
The following day, the Federal Reserve Board (under its new chair man, Alan Greenspan) turned on the liquidity spigot and the market reversed course and began a lengthy recovery. Thereafter it became an item of faith that the Fed would come to the rescue to halt major mar ket declines. This faith and the Fed’s dutiful attempts to justify it are suspected by those sensitive to concerns of “moral hazard” to have en couraged a culture of indifference to some forms of financial risk, the painful consequences of which are very much with us today.
The regulators responded to the October 1987 market break by dealing with the mechanical side of the problem, providing “circuit breakers” to halt trading during rapid market drops and measures to handle spikes in trading volume. There was no serious attempt to come to grips with the bigger issue: the destabilizing effects of widespread adoption of new investment techniques. The October 1987 calamity has not been replayed precisely, but the market has subsequently suffered different calamities that, in some respects, were not so very different at all. A common theme in each case has been the systemic risk presented by financial innovation. These unruly creatures have included the highly leveraged hedge fund and various new forms of derivates, including complex asset-backed products and credit default swaps. First out of the pen, however, was a simpler financial beast—the junk bond.
While the Federal Trade Commission (FTC) continued to earn its sobri quet as “the little old lady on Pennsylvania Avenue,” the late 1980s were remarkable years for the SEC. Seen widely as a golden era for the agency, it witnessed the rise and fall of junk-bond king Michael Milken and a raft of splashy insider trading cases against Wall Street heavies. These matters raised the profile of the SEC and created a legacy of expectation that influenced its enforcement agenda for a decade.
The 1980s may be recalled without nostalgia as an era of strutting takeover kings who feasted on household-name companies with the help of Machiavellian bankers and their wicked weapons of financial destruc tion, of leveraged buyouts, downsizings and greenmail, when everything was in play and nothing secure. And the dark wizard most responsible for loosing these financial demons upon the land was a balding introvert from Encino, California: Michael Milken. If not a straight-up criminal like master pyramid-builder Bernie Madoff, he nevertheless played the capital markets and their regulations like a pinball machine, with the Tilt function disconnected.
It is a stretch to call Michael Milken an innovator. The financial empire he created from his X-shaped trading desk in Los Angeles rested on extensions and refinements of ideas appropriated from others. First among these was the perception that the risks and rewards of own ing low-grade corporate debt become more predictable when spread across a number of different bonds. This was nothing more than ba sic portfolio theory applied to junk bonds. A similar insight—however misapplied—lies behind the recent boom and bust in subprime mort gage loans. It was contended by various academics that the average risk- adjusted return on “high-yield” corporate debt was disproportionate to that of other asset categories. Buyers were scarce, however, because of the serious likelihood of default—and the lack of reliable information—on individual bonds. Milken perceived there was money to be made in packaging these assets in a way that fit within the risk tolerance of major financial institutions and other potential buyers—or at least seemed to do so after the application of Milken salesmanship.
He began by developing a secondary market for existing debt is sues, exploiting the large potential margins available to middlemen in an illiquid market, and enhanced the attractiveness of this market by provid ing analysts’ reports though his firm, Drexel Burnham Lambert. Over time, he put together a network of compliant buyers, including insur ance companies (traditional bad asset magnets) and desperate-for-yield S&Ls, that allowed his firm to bring out sizeable original issues. This provided greater access to capital to various struggling firms—mostly a good thing—and fueled the mergers and acquisitions boom of the 1980s—a mixed blessing at best.
Through its ability to quickly gin up enormous amounts of debt financing, Drexel became the investment bank of choice for some of the decade’s most voracious corporate raiders. It also trafficked in management-led leveraged buy-outs that bled to death target companies by draining off cash to pay for their own acquisition. In theory, the cor porate takeover provides a means of giving the shove to entrenched and complacent management. In practice, it has often eroded shareholder value through the short-sighted cashing in of assets to service debt or turn a quick profit, and was attended by job losses and other social costs. Here the “creative destruction” of capitalism had nothing creative about it.
Milken’s influence grew until he dominated every facet of the junk bond market. This allowed him to control both supply and demand in particular issues, and thus their prices. The result was an increasingly artificial market. His ministrations imparted an inflated value to many of the bonds he bought, sold, brokered, and underwrote that could not be sustained forever.
In 1986, the government began to unravel a skein of criminal con duct associated with the M&A subculture. An insider trading ring had coalesced around plump and bumbling investment banker Dennis Levine and arbitrageur and Milken crony Ivan Boesky, built on swapping tips about pending deals and trading through offshore accounts. Nothing requiring much imagination. After flourishing undetected for years, it came to grief at last when the greed of its participants outstripped their caution. The SEC was alerted to Levine’s suspicious trading by a call from Merrill Lynch compliance, which noticed that several of its bro kers had been mimicking consistently prescient trades made through a client Swiss bank. Once the bank was induced to disclose that its cus tomer was a U.S. investment banker, the dominoes toppled as members of the ring flipped on each other to curry prosecutorial favor. The SEC did the initial legwork. The U.S. Attorney’s Office in Manhattan, run at that time by Rudy Giuliani, brought the muscle.
First to take the drop was Levine, a casualty of his own crimi nal ineptitude, in both senses. The trail then led through several lesser players to Boesky, who ratted out Milken in exchange for reduced jail time. Milken’s misconduct was far more complex and sophisticated than the crude insider trading of Levine and his immediate circle. It was largely directed toward maneuvering companies into play and rigging their acquisition so Drexel could profit from the deal flow, with Milken personally raking off the bulk of those profits. Much of his conduct was unsavory but not illegal. And what was illegal was not easy to prove.
In 1988, nevertheless, Milken was indicted on 98 counts of stock fraud and racketeering. After much legal maneuvering, he pled guilty to six felony counts of charges of a technical nature, most of which involved facilitating the evasion of stock ownership reporting rules by other participants in his schemes. He paid a $600 million fine and accepted a ten-year prison sentence, served less than two, and left jail a billionaire.2
In 1989, the junk bond market Milken had done so much to promote collapsed, as did various S&Ls and other clients Milken had stuffed with risky bonds. Although this was not the fate of all his clients—some survive and prosper to this day—the number left face-down in the weeds was substantial.
A card sharp’s adage has it that every game includes a mark. Look at the players around you and, if you can’t recognize the mark, you’re it. Milken constructed financial transactions rigged so the rewards would flow to him and the risk of loss to those clients who did not see they were the designated marks in Milken’s game of junk bond poker.
The most dangerous situation for a government attorney to be in is to be handed a high-profile case. It brings to mind the ancient Chinese curse, “May you live in interesting times.” Credit-grabbing and blame-ducking are predictable companions to the spotlight of publicity, and whatever the final result of the case, there will be those who find it inadequate. The press has an ingrained belief that penalties should reflect the degree of public outrage at the defendants’ conduct, as interpreted by the press, and has no patience with complicating factors. In the rush to roll up the trading network, settlements were reached on the fly, some of them less onerous than they might have been. After the Levine and Boesky settlements, the SEC was soundly trashed by the press for not leaving the perpetrators, as a later SEC chairman would phrase it, “naked, homeless, and without wheels.” Once the media turned hostile, the SEC and the U.S. Attorney’s Office fell out, SEC attorneys squabbled among themselves, and the commission harshly criticized its legal staff.
On Main Street, however, the whole episode proved reassuring. It was a morality play that had come to its proper conclusion. Good had triumphed over evil and the financial world was secure once more. Few worried about the details. And it helped that the primary villains could be seen as Wall Street intruders and interlopers, shady characters pushing dubious merchandise like hostile takeovers and leveraged buy-outs. It wasn’t the old guard that was at fault. The established brands like Goldman and Merrill lost little of their cachet, despite having employees among the indicted.

Chapter 3
Short People
The media circus over Milken and his playmates thrust the SEC into prominence. It was seen as an exciting place to work and attracted a flood of resumes, mine included. Although the application form had not gotten shorter during my two years at the FTC, I risked rejection on the off-chance I might sneak in and be allowed to investigate real frauds—defined as frauds not committed by people whose primary means of locomotion is the skateboard. The boiler-room cases had begun to seem like exercises in cockroach-stomping, neither challenging nor greatly socially beneficial. The SEC, by contrast, did complicated cases. Cases that mattered. The New York Times said so.
A friend of a friend arranged an interview. I met a series of people in the SEC’s general counsel’s office, all very cordial until the last on my list. The most junior person I spoke with that day, he was by turns sarcastic, abrasive, and coldly dismissive. He stopped just short of tearing up my resume and showering me with the pieces. Later, it was explained to me that he had been under great personal stress. It had been his misfortune to be caught in a stairwell in an advanced stated of intimacy with another SEC employee. Twice. Both times by an elderly commissioner who apparently suffered from an aversion to elevators.
Although nothing came of that attempt, shortly after, as a result of L’Affair Drexel, Congress ponied up additional funds for the SEC. The result was a cattle call for new attorneys and in early 1990 I found myself rounded up with the herd and destined for the Enforcement Division.
The people in the group in which I landed were mostly either boring family types like me or young careerists looking for the next step up the ladder. The latter category included the occasional overachiever who wore his resume like a sandwich board and needed you to know that his inner child was an honor student. But most were simply bright young men and women who, as undergraduates, had come to the realization that for anyone interested in making a middle-class living, all majors in the liberal arts are synonymous with “Pre-Law.”
Some had retained a frisky undergraduate mentality. One morning not long after joining the agency, I heard cries of distress from a nearby office so pitiable that I assumed a loved one had passed away unexpectedly. Two young attorneys were crammed into that office. The source of the outbursts, first name Chris, was sitting at his desk, madly flipping though a testimony transcript. He would stop, read a few moments, and then swear profusely. “No!” he shouted. “That’s not right. That can’t be right! I didn’t fucking say that!”
His officemate, John, was staring at the wall with a constipated expression, breathing constricted.
Chris often pored over his transcripts as if reading a favorite novel. Although he had not been at this long, he considered himself a natural and liked to dwell on his achievements in questioning witnesses. Sometimes he read aloud passages he considered particularly adept, uninvited, to his officemate. Never again, however, after today.
When John’s composure ruptured into uproarious laughter—joined by several neighbors who were in on the joke—the truth was disclosed.
John had grabbed an incoming transcript, undid the shoelace bindings, removed various pages and replaced them with his own creations, carefully typed on the lined paper used by the reporting service. In the substituted version, Chris made various admissions to a presumably startled witness about his legal abilities and mental state. “You must understand,” he said, “that sometimes my mind shuts off. I forget where I am. What day it is. I ask questions that make no sense. I think they do but they don’t. And sometimes I believe I am someone else. An entirely different person. I can’t help it. If that happens, please call my supervisor and tell him I’m doing it again.”
What the group had in common, as was true of the Enforcement Division broadly, was a meager understanding of the capital markets. With few exceptions, everyone had come to the commission straight from law school or, at best, after a few years of concentrated abuse as a law firm associate. That was to be expected. The ideal enforcement attorney combines the expertise of a seasoned litigator with that of a law professor, a forensic accountant, and a Wall Street trader. No such animal exists and, if it did, would not work for what the government can pay. So the SEC takes what it can get. In most cases, happily, this is a reasonably talented and motivated young attorney who in time gets more things right than wrong.
Like many of my new colleagues, I had never taken a course in securities law. I asked my immediate supervisor what I should read to begin mastering the field. She eyed me as if I were a very curious item indeed and said, “Don’t bother. There’s too much of it and, anyway, you won’t remember anything you haven’t actually used.”
In retrospect, right she was.
The federal securities regulations fill a thousand pages, single-spaced, with opaque and convoluted legalese. Published court decisions fill rooms. And whatever architectural structure the securities laws once possessed has been obscured by decades of regulatory kudzu. Anyone trying to master it all by proceeding from beginning to end would resemble the “self-made man” of the modern French novel who read through the books in the public library in alphabetical order.
The commission churns out five or six hundred enforcement actions a year. While these numbers are inflated to impress Congressional appropriators, that’s still a lot of cases. Many come down to paint-by-numbers exercises in penalizing hapless crooks whose schemes blew up in their faces. And the majority don’t require great financial sophistication. Someone lied to someone about something or blabbed something he shouldn’t have. The facts may take some effort to prove, but the legal issues are clear.
Yet if many cases can be handled by any decent lawyer, some violations—weighted toward the most significant—require specialized knowledge to recognize and prove-up. This is where the commission has often come up short. In theory, its enforcers can tap into the full resources of the agency, including the divisions that review corporate fil-ings, regulate mutual funds, and inspect broker-dealers. In reality, these other offices function like separate agencies that happen to share the same building. Partly as a result of revolving doors into the entities they regulate, they have sometimes looked at their areas of the securities industry as their true clients, rather than the SEC Enforcement thugs who can be mean to prospective employers. The Enforcement Division is not immune to the same considerations but the incentives bend less in that direction, particularly for the rank-and-file, which is rewarded for bringing in scalps, not making friends.