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TERRY GROSS, host:

This is FRESH AIR. I'm Terry Gross. My guest, Frank Partnoy, spent two years selling derivatives, those complex financial instruments that helped sink our economy.

He made a lot of money as a broker with Morgan Stanley, but by the time he left in 1995, he thought he'd become the most cynical person on Earth. He believed derivatives were a fraud and investment banking was a fraud. He's been warning the public ever since.

He's going to tell us about his experiences selling derivatives, and he'll take us through the history of how they got us into so much trouble and how the swaps and derivatives lobby succeeded in getting credit default swaps exempted from regulation.

Frank Partnoy's 1997 Wall Street memoir, "Fiasco," has just been published in a new edition, and he has a new book about to come out called "The Match King: The Financial Genius Behind a Century of Wall Street Scandals."

Partnoy is a professor at the University of San Diego Law School, specializing in financial market regulation. Frank Partnoy, welcome to FRESH AIR. You were kind of there at the beginning, selling derivatives at Morgan Stanley. Give us a sense of what derivatives were like when you started selling them. What were they then?

Professor FRANK PARTNOY (Author, "The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street"): They were wild financial instruments. They were side bets. They were relatively a large market. They were in the billions and billions of dollars at the time.

I worked with a group of about 70 professionals in New York who generated $1 billion in fees in two years. That was pretty good money back then, about $15 million a person. And it was a wild scene.

This was before a lot of the sex discrimination lawsuits changed the culture on Wall Street, so the trading floor was a bawdy place. There were lots of - behavior that people there probably aren't very proud of now and some of which I probably can't discuss on your show. But it was a very energizing, incredibly interesting experience, lots of money changing hands and lots of money being made.

GROSS: Just give us an example of a derivative that you would sell.

Prof. PARTNOY: For example, we would sell derivatives linked to bonds issued by foreign countries. So we would go to Argentina, and we would buy up some bonds there, and we would repackage them and enter into a swap and sell those bonds to investors in the United States.

And sometimes the investors understood what they were buying, and sometimes they didn't. But we would basically try to find assets that we thought were cheap, and then we would enter into these transactions to repackage them in ways that would be attractive, we thought, to investors.

GROSS: How do you make Argentina bonds more attractive to investors through derivatives?

Prof. PARTNOY: A lot of the way you make them attractive is by going to the credit rating agencies, Standard & Poor's and Moody's, and trying to pitch them and pay them a fee to call these bonds AA or AAA, and we would often find these assets that were very risky. Sometimes they were mortgage securities, even back in the '90s. Sometimes they were other risky bonds. And we'd go to the credit rating agencies and we'd say, would you be willing to rate this AAA? And they often did.

In fact, there was a transaction that we did involving the National Power Corporation of the Philippines' bonds, which ended up getting rated AAA. And I always thought that somebody would call me on that. They'd say no, there's no way you were able to get a AAA rating on that for First Philippines Trust.

And so I named it FP Trust. I suggested that we name it FP Trust after First Philippines Trust, but I wanted that name there for good. It was a 15 year security, and so those were my initials so that I could always point back and say no, no, no. This is something we really did.

(Soundbite of laughter)

GROSS: FP for Frank Partnoy. How do you convince the ratings agency to give you a good rating when you know the bonds that you're selling aren't worthy of it?

Prof. PARTNOY: Sometimes it's easy, sometimes it's very hard. The rating agencies use models, which the investment banks developed. They could get very complicated, sometimes they involved complicated math. And we would make an argument to them that this was more like a General Electric bond than a risky bond.

We would try to demonstrate that the bond would perform well over time, and it didn't hurt that we paid them substantial fees. Some people don't realize that but S&P and Moody's, the rating agencies, are paid by issuers. They're not paid by investors. They're paid by the companies and the trust structures whose bonds they rate. And so they would get a bigger fee. They'd get a higher fee for a complicated deal.

GROSS: So you know, in your memoir, "Fiasco," you write about how aggressive your sales methods were. So give us an example of an aggressive way of selling derivatives back in the mid '90s when you were selling them.

Prof. PARTNOY: Well, the key parts to the aggression were not telling clients about the risks associated with the securities, and these are not individual clients all the time. These are sophisticated clients like Proctor & Gamble. You might remember Orange County, which went under because of investments in these risky instruments.

GROSS: Right.

Prof. PARTNOY: And the people who approached these institutions, who worked at investment banks, would go in with a feral attitude. The phrase that was used the most often was: I ripped their face off, which seems so violent and contrary to the idea that you would be looking out for a client's best interest, but the idea was that you were going into the client to try to sell them something that was massively overpriced, that hid risks that the client wouldn't understand. And the idea was always that you'd make as much money as possible. You'd gorge the client. This is how 15 people could generate $1 billion in mostly riskless fees in two years. You can't do that while taking into account your client's best interest.

So the people who went into Orange County and Proctor & Gamble, they were selling them unfathomably complicated instruments that they knew the buyers couldn't possibly understand.

GROSS: And most of your customers were big institutions, not individual investors.

Prof. PARTNOY: They were the largest institutions. See, this market, even back then, was a $50 trillion market. So these are massive institutions that are making massive bets. But the information gap is still huge. The institutions are not nearly as sophisticated as the people who are selling these things on Wall Street.

GROSS: So you eventually left because you grew so disillusioned with the derivatives and the methods of selling them, but while you were still doing it, how did you feel good about it?

Prof. PARTNOY: Well, I'm not sure I can say I felt good about it, but it is fascinating, and it was an incredibly interesting time, developing all of these new products and new methodologies, and it was energizing to be at the center of the universe.

I mean, the derivatives trading desk was the engine that drove the profits at most financial institutions until - really until very recently. So this is the hotbed. It's where information is flowing from all over the world, and we're creating these new products that have never been seen before. We're using math and financial techniques that have never been used.

So it was incredibly interesting. And I was a lawyer, I was a person with a law background. I had studied math, but for me to see the interaction of regulation and finance was absolutely fascinating.

That wasn't something that I was going to do for my whole life, but I'm certainly glad that I was able to see it from the inside. Even today, at financial institutions as they're crumbling, I think the derivatives area is a really interesting area.

GROSS: So why did you leave selling derivatives, and when did you leave?

Prof. PARTNOY: Well, unfortunately, I didn't care enough about the money. I left in 1995, and I can say some of my best friends are in the derivatives industry, or were until recently, and I left in part because I had learned enough.

I didn't want to do this for the rest of my life, and like a lot of people who I went to law school with, we had in the back of our minds becoming an academic and being able to sit back and comment on issues and talk about policy.

I didn't want to do that just from the ivory tower. I wanted to get some experience first, and after two years, I thought that was about enough.

GROSS: If you're just joining us, my guest is Frank Partnoy. He's a law professor at the University of San Diego Law School, and he used to sell derivatives for Morgan Stanley in the mid '90s.

He has a memoir about that called "Fiasco: Blood in the Water on Wall Street," that was just rereleased in paperback. And he has a forthcoming book called "The Match King: Ivar Krueger, the Financial Genius Behind a Century of Wall Street Scandals."

So we're talking about derivatives, which you used to sell at Morgan Stanley. Now, part of what made them profitable was that they weren't regulated like stocks or like bonds. So there was a lot of flexibility, so to speak…

(Soundbite of laughter)

GROSS: …that you had when you were selling them. Why were they seen as different from stocks and bonds in terms of them being in a category that didn't require regulation where stocks and bonds did? What made them different?

Prof. PARTNOY: This was no accident. This was a carefully engineered distinction that was run through regulators in Congress by some of the most powerful and effective lobbyists ever.

And they began the deregulatory moves in the 1980s, as soon as it became apparent that the derivatives industry would generate huge profits and also create these massive risks.

The story really goes back to Bankers Trust, which a lot of people don't' remember. It was this stodgy old bank that a man called Charlie Sanford transformed into a risky trading operation.

He was quite successful. He hired quants, people who understood physics and mathematics. And in 1985, when accounting regulators said hey, we should really start regulating these instruments, in two weeks, Bankers Trust and nine other banks formed a group called ISDA, I-S-D-A, which now goes by ISDA as the International Swaps and Derivatives Association. Then it was called the International Swap Dealers Association.

And they became this incredibly powerful lobby. And they had a number of friends, and the most powerful of their friends were the Gramm family, Wendy Gramm and Phil Gramm. And Wendy Gramm and Phil Gramm really together, from the late 1980s through 2000, orchestrated a massive deregulation of derivatives, which I think we can really point to as being one of the major causes for why we're in so much trouble.

GROSS: When you say deregulation, were they ever regulated?

Prof. PARTNOY: They were. And derivatives have been subject to various legal claims based on regulation over time, and in fact where Wendy Gramm came in was to eliminate that uncertainly.

Common law always applies to any kind of instrument. And there were bucket-shop laws that prohibited gambling in states, and people made claims that derivatives are really just side bets. And in fact, some derivatives really were like gambling. There were derivatives based on how many games the Utah Jazz would win in a year, how many albums David Bowie would sell.

Derivatives really could be based on just about anything, and people said, well this is really gambling. And it wasn't until Wendy Gramm and the Commodity Futures Trading Commission came along that derivatives were taken out of the regulatory structure in any clear way. And she was - people might remember her as Ronald Reagan's favorite economist. She was a conservative, very smart woman who came along and headed this regulatory organization. And when she left in January of 1993, she signed an order that exempted these derivatives from regulation, and many people describe that as her farewell gift to the derivatives industry.

And very shortly after that, not coincidentally, she was nominated and began serving on the board of Enron.

GROSS: So you know, you're talking about the lack of regulation of derivatives. When you were selling derivatives, were they easier to sell and easier to make big profits selling them because they weren't regulated?

Prof. PARTNOY: Absolutely. They were in the dark. They were in the dark corners of the markets. And you knew that they wouldn't be disclosed. You knew that the companies who were buying them wouldn't make disclosures about the risks associated with these instruments.

If you sold to a company, for example, you were confident that the disclosures about what you had just sold wouldn't make it to the public. They wouldn't see that this company had taken on some massive risk, and no one would know how much you had charged. The commissions wouldn't appear anywhere. There wasn't a competitive market, really.

And so it was a dark, shadowy, but very large, multi-trillion-dollar part of the market where people could make a lot of money, and this is where the banks survived.

Much of investment banking became a kind of commodity business where you couldn't make a lot of money. You can't make money in the sunlight in banking. It's just not possible. People come in too quickly. So you have to make money in the dark.

And derivatives were kept in the dark, and that's why people gravitated there, and derivatives really kept the banks afloat for many years. That was the place where they were able to make money, charge large commissions, take on risks themselves and have their clients take on these huge risks because nobody would ever know about it.

GROSS: So because derivatives weren't regulated and aren't regulated, an institution that invested in them, they wouldn't have to put that on their books.

So that part of their value is completely opaque, and you just - you as an investor in that company wouldn't know the real value of the company.

Prof. PARTNOY: You couldn't possibly figure it out. So even now, today, when people are going to companies like AIG and trying to figure out what the risks are associated with these companies, they can't figure out what the risks are.

And back then, there were virtually no disclosures about derivatives. You got something called the notional amount, which would be the size of the underlying bet, and that was it. And many companies wouldn't even tell you the notional amount.

AIG only began disclosing the notional amount of this massive business, this second pillar of secret credit default swaps in mid 2007, but they had massive exposures. They had been involved in that business for a long time.

GROSS: My guest is Frank Partnoy. His 1997 memoir about selling derivatives on Wall Street, "Fiasco," has just been published in a new edition.

We'll talk more about derivatives and how they helped get us into this economic crisis after a break. This is FRESH AIR.

(Soundbite of music)

GROSS: If you're just joining us, my guest is Frank Partnoy. He's a law professor at the University of San Diego School of Law, where he teaches financial markets, derivatives and structured finance. And he used to sell derivatives for Morgan Stanley in the mid '90s.

And since leaving, he's really tried to blow the whistle on the lack of regulation of derivatives and swaps. His books include "Fiasco," which is a memoir about selling derivatives, that's just out in a new edition, in paperback. And he has a forthcoming book called "The Match King: Ivar Krueger, the Financial Genius Behind a Century of Wall Street Scandals."

We've been talking about the deregulation of derivatives. I want to talk with you about the infamous credit default swaps, but first I want you to give your best crack at defining what credit default swaps are.

Every guest we have on who talks about the financial meltdown, we ask them to give it their best shot, and eventually, we will all understand what credit default swaps are.

Prof. PARTNOY: A credit default swap is a bet on whether someone will default. It's that simple. I will enter into a bet with you, and I'll bet on whether you will default on your home mortgage or some other debt that you have.

And the person who's betting on a default wins, and the person who's betting against a default loses. It's that simple. It's a side bet based on whether an individual or a company will default.

Now, credit default swaps can become incredibly complicated in terms of trying to figure out how to value them, what's the underlying event of default, how do you assess them when portfolios of them are combined. If you have a bunch of subprime mortgages, and you put them together, and then you bet and enter into this side bet based on default, that can become very complicated to evaluate. But the basic bet is very simple: Will you default or not?

GROSS: But they function basically as unregulated insurance, too, don't they?

Prof. PARTNOY: That's right. So credit default swaps are essentially like insurance, and if you write a credit default swap, you're basically writing an insurance policy.

This is why AIG, which was traditionally an insurer of lives and cars and all kinds of risks - fires, securities litigation - it saw this business as attractive and fitting in with its normal business line.

That's what AIG was. It had $1 trillion worth of assets. Its pillar - if you can think about it as being one pillar of its business - was this very traditional insurance business. It looked at credit default swaps, and it said, oh look, here's another insurance business. I can write insurance. I can insure against the defaults of different individuals or companies.

And that's what it did. That business, that pillar, grew to where it was really almost a second, free-standing pillar - a second business that was almost as big and maybe even more profitable than its traditional business. It grew to half a trillion dollars. That was the size of its credit default swaps.

And credit default swaps overall grew to $55 trillion. And these were just side bets that were basically like insurance: somebody is betting on a default, and someone else is insuring against a default. And if there is a default, then there's - a payment will exchange hands.

GROSS: Give us an example that relates to subprime, to the famous subprime.

Prof. PARTNOY: For example, the reason we ended up in this crisis was that people entered into these subprime mortgages, and then it was apparent that they would begin defaulting in much higher numbers than anyone anticipated.

Now, if there were no derivatives based on those subprime mortgages, the actual losses would've been relatively small. We're talking about maybe a couple hundred billion dollars of losses or something like that.

But the problem is that the derivatives market enabled people to bet on whether an individual would default on a mortgage over and over again. There's no limit. You could bet 100 times on whether Frank Partnoy will default on his mortgages.

And those bets then get bundled up and repackaged in all sorts of very complicated ways that weren't disclosed at all. And that's why we ended up in this trillion dollar mess because large financial institutions, many of the banks and AIG, they all wrote insurance against many of these people defaulting on their subprime mortgages, and when they defaulted, that was a tail wagging a very big dog.

GROSS: Now, credit default swaps were kept exempt from regulation through the Commodity Futures Modernization Act of 2000, which has one or two really interesting stories behind it.

First of all, give us an overview of the bill.

Prof. PARTNOY: Well, it's quite a mouthful, but basically what the bill was intended to do was to cement the deregulatory status of derivatives. So these shadowy instruments had been taken out of the regulatory structure, but they had only been taken out through letters from regulators and regulations, not through an actual statute, and there was still some uncertainty.

And the very powerful derivatives lobby wanted to cement the deregulated status. And so this was the last thing they needed. This was the nail in the coffin. And just as Wendy Gramm had started off the deregulation back in the late 1980s and early 1990s, Phil Gramm finished the job in 2000 with this CFMA legislation.

And it's important to go back in time and think about what was happening in December of 2000. This is the aftermath of Bush against Gore, and people are focused on hanging chads, not on derivatives. Derivatives are not the focus of the legislative agenda.

And this legislation had been sitting on the back burner. The derivatives lobbyists had been waiting to pounce. And then on December 14 in the House and December 15 in the Senate, they pounced.

And Phil Gramm added the provision in the evening, just hours before the Christmas break. It was never debated in the House. It was never debated in the Senate. It was shoved into an 11,000 page omnibus budget bill. It was passed by unanimous consent in the Senate. There wasn't even a vote, and then President Clinton signed it on December 21.

It was his last major piece of legislation before everyone left for the holidays, and nobody even knew about it. There was no reporting on it. The focus was on the conflicts in the presidential election. And the derivatives industry quietly celebrated at the end of 2000, knowing that they had cemented the deregulatory status, and then they were off to the races over the last eight years, doing everything that led to this current crisis.

GROSS: Frank Partnoy will be back in the second half of the show. His Wall Street memoir, "Fiasco," has just been published in a new edition. His book, "Infectious Greed," will be republished later this year, and he has a new book about to come out, "The Match King: The Financial Genius Behind a Century of Wall Street Scandals."

I'm Terry Gross, and this is FRESH AIR.

(Soundbite of music)

GROSS: This is FRESH AIR. I'm Terry Gross. We're talking about how derivatives helped get us into this financial crisis. My guest, Frank Partnoy, sold derivatives at Morgan Stanley from 1993 to '95. He left disillusioned and has been warning about their dangers ever since. He is a professor at the University of San Diego School of Law. His Wall Street memoir, "Fiasco," has just been published in a new edition. When we left off we were talking about the legislation that further deregulated derivatives and credit default swaps, the Commodity Futures Modernization Act of 2000.

Now, you write in your book that the person who actually drafted the part of the bill that cemented in the deregulation of derivatives was a lobbyist from the financial lobby group, the International Swaps and Derivatives Association. Tell us about that.

Prof. PARTNOY: He was an extraordinary powerful guy, this guy Mark Brickell, and he was one of the central characters in this group ISDA, the International Swaps and Derivatives Association. And he would show up in the halls of Congress and he would be there drafting legislation. He was a vehement opponent of Jim Leitch, who was one of the leaders in favor of regulating derivatives, and he really worked Washington. He also used the complexity of derivatives against the members of Congress and their staffs. Whenever the staffers or members of Congress would ask questions about derivatives, he would be there to almost mock them, to belittle them.

He also engineered a very interesting lobbying campaign targeting the media, in particular the Wall Street Journal, and ISDA, this trade group, insisted that the Wall Street Journal not even use the word derivatives. And I found this correspondence in which the Wall Street Journal was praised over a period of time when it gave up on the word derivatives because it sounds so inflammatory - it sounded inflammatory at the time - and they started calling them things like securities instead of derivatives, and - and that won the praise from ISDA and Mark Brickell.

GROSS: So if Mark Brickell of the finance lobby group basically wrote the part of the bill that kept swaps deregulated, who invited him in?

Prof. PARTNOY: Oh, he invited himself.

GROSS: Well, somebody from Congress had to allow him to draft part of the legislation.

Prof. PARTNOY: Well, that's right, but - but these are not people on the staffs of Congress at that time who are experts in this market, so they need advisers to talk to them about how to respond to a crisis. And let's also remember that ISDA is a trade group and that these banks are very large contributors to both parties. Every bank is giving money to Democrats and Republicans across the board, and so although ISDA invites itself in, they invite themselves in having bought a bunch of tickets in advance.

And so when they come in, it's not a surprise that they're given time and even allowed to draft legislation.

GROSS: So when the Commodity Futures Modernization Act was passed in the very final days of the Clinton administration, ensuring that credit default swaps would remain deregulated, the Treasury secretary at the time was Lawrence Summers. This was President Clinton's Treasury secretary. He is now President Obama's chief economic adviser. Did Summers support this bill and support the deregulation of swaps?

Prof. PARTNOY: I don't know whether he supported the bill. He certainly supported the deregulation of swaps. He was part of the president's working group that supported deregulation. And some of the members of that group have apologized. I think Arthur Levitt has come forward and said that this was a mistake. Even Alan Greenspan, when cornered, said that this was one of the mistakes that he had made. But certainly the brain trust at that time supporting deregulation of derivatives was lead by Alan Greenspan, but the other members were certainly Bob Rubin and Larry Summers and Arthur Levitt.

GROSS: So earlier were we talking about how you think the ratings agencies like Moody's and Standard and Poor's basically enabled the people selling derivatives to overprice them by giving high, you know, high ratings to the products when they weren't worthy of them. Do you think that the rating agencies need to be more regulated than they are?

Prof. PARTNOY: Well, I think the rating agencies need to be more accountable than they are. I think they need to be subject to liability. They've been arguing that they have First Amendment rights in their opinions, just like the opinions expressed on your show, except that they're actually being paid many, many millions of dollars for their opinions, and I think…

GROSS: In my field you call that conflict of interest.

(Soundbite of laughter)

Prof. PARTNOY: Well, there's a big conflict of interest at rating agencies, and hopefully Congress is going to do something about that. People don't realize, there is something called Section 11 of the 1933 Securities Act, and it applies to create liability for banks and accounting firms and law firms, lots of participants in the financial markets. The rating agencies are explicitly exempt from that statute. They cannot be held liable. And they generally have not been held liable in the past. They need to be much more responsible when they engage in reckless conduct.

They've had a pretty good run. They have had 50 percent operating margins, higher than any other company, really any other publicly traded companies in the U.S. So they need their feet held to the fire little bit more, not just in terms of people pointing fingers at them but also in terms of liability.

But I'm not sure what we need is more regulation. Part of the reason we got into this situation in the first place was because of regulation. It was because of too much of the wrong kind of regulation. Essentially what happened - and it goes back to the great crash, actually, of 1929, when we started deferring regulatory decisions to the credit rating agencies. We started saying, well, regulators like the Federal Reserve or the SEC, they can't figure out which bonds are safe and which one's aren't safe, so they're going to differ to the credit rating agencies. And they continue to do that.

In fact, this most recently announced plan by the Obama administration defers to the credit rating agencies, even after they've gotten almost everything wrong. They rated AIG Triple-A before its collapse. They rated Lehman Brothers very highly before its collapse. They rated Enron investment grade before its bankruptcy. They rated Orange County Triple-A before its collapse.

They've gotten almost everything wrong, particularly on these sub-prime assets, and yet regulators and investors continue to rely on them. And I think what we need to do is take a step back and ask why do we continue to rely on these incredibly dysfunctional and inaccurate credit raters, and please can we try to create a new regulatory structure that will not only supervise them and hold them accountable but that will also give us some other metric. And one of the metrics I've been suggesting regulators should use is the market. They should look to market prices rather than these conflicted rating agencies which are charging for their ratings.

GROSS: My guest is Frank Partnoy. His 1997 memoir about selling derivatives on Wall Street, "Fiasco," has just been published in a new edition. We'll talk more about derivatives and how they helped get us into this economic crisis after a break. This is FRESH AIR.

GROSS: If you're just joining us my guest is Frank Partnoy. He is a law professor at the University of San Diego Law School. He used to sell derivatives for Morgan Stanley in the mid '90s. He has a memoir about that called "Fiasco: Blood in the Water on Wall Street," that was just new re-released in paperback. And he has a forthcoming book called "The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals." What are you most pleased with what you've heard so far about the Obama administration's plans to reform the finance system?

Prof. PARTNOY: The thing that I'm most pleased about is that they're smart and careful and incremental and they're proceeding in a flexible way. So when they're talking to the markets, the most recent news from both Geithner and Obama suggests that they've had many, many conversations with sophisticated people in the markets to make sure that they understand that they need to partner with the private sector. They understand that they need to harness the value of markets.

Let's remember, these credit default swaps, which we're agreeing now, many people are agreeing should be regulated, these are powerful indicators of problems. If you looked at the credit default swap market, these side bets, they would have told you there were problems at AIG, at Bear Stearns, at Lehman Brothers. They were canaries in the coal mine early on. And I think the administration understands that they need to regulate these markets but they also need to harness the power of markets.

GROSS: Paul Krugman, the New York Times columnist - he's a Nobel Prize winner and a liberal economist - was very critical of the Obama administration's plan to help private investors buy toxic assets by loaning money and shouldering a lot of the risk. Krugman says that the plan is based on the idea that the bad assets on banks' books are really worth much more than anyone is currently willing to pay for them.

So he is afraid that we're going to help private investors buy these toxic assets, that the assets aren't going to be worth much in a long run, and that if the investors pay more than they're really worth, we're going to owe a gazillion dollars. It's going to be the taxpayers who have to pay the bill. Are you as concerned as he is?

Prof. PARTNOY: I am somewhat concerned about that, because we do need to put these two parties together to make it work. The banks have to be willing to sell and the private sector has to be willing to buy. And right now the gap between the price at which the banks are willing to sell and the price at which the private sector is willing to buy is very wide. And basically what the government has done is to come in and say we'll subsidize the private sector purchases, we'll encourage the private sector by providing these loans on attractive rates. And hopefully they'll try to persuade the banks, which now they can exert some control over, to be willing to sell the assets at lower prices. I think whether Krugman is right or not will depend on what price the banks are willing to sell at. If they're willing to sell at lower prices and the private sector is willing to move up, then the market will clear and these transactions actually will take place.

I do think his concern is still there though, which is quite a legitimate one, which is that much of this, much of what we're doing now, is similar to the same sort of gambling the banks were doing initially when they entered into these credit default swaps and other derivatives transactions.

If the market continues to tank, then we could lose as taxpayers even more money. And so really all of us collectively are now going to be invested in this derivatives market and hoping, and our futures will depend on, this derivatives market improving.

GROSS: So you know, I got to ask you, we started our conversation by talking about how you used to sell derivatives in the mid-'90s and then you ended up trying to blow the whistle on them, saying that, you know, this could be trouble. When you left Morgan Stanley after selling derivatives, did you keep investments in derivatives or did you worry about them so much that you got rid of whatever you had? Maybe that's too personal and I shouldn't ask, but I'm just kind of curious.

Prof. PARTNOY: Well, I don't invest in derivatives. Most of the people who sell derivatives wouldn't touch them. One of the things I was so struck by, working at Morgan Stanley, was that when you went to the traders of the most complicated instruments and asked them what they invested in, they all invested in just one thing. They bought Treasury bills. They knew what the markets were like. There was no way they were going to speculate based on these complicated assets that they were trading all day. So, now I don't think I - I haven't and I don't think I'd put very much money into these instruments.

GROSS: Interesting. I guess in some ways I didn't need to speculate because you were making a fortune on Wall Street.

(Soundbite of laughter)

Prof. PARTNOY: Well, if you've made enough money on Wall Street, the one thing that you want is to make sure that it's safe. And I think one of the most interesting things that's happened to the Wall Street is that they threw up this boomerang of risk and it came back and sliced their heads off and that's not the way Wall Street used to work. Wall Street used to be the place where the smartest people were and the people who traded these complex instruments would never end up taking the risks associated with them.

But what happened with the subprime crisis was that whereas they used to toss this risk off their balance sheet, when they - they threw it off, it came back. And within these institutions they lost the ability to figure out whether something was risky or not. They ended up taking these really bad debts and the smart folks had left. They had gone to these hedge funds and the hedge funds have actually - the smart ones -have actually made a fair amount of money off of the crisis. The people who called it correctly, who bet against the subprime markets have made huge amounts of money because they saw this coming, and I think it's one of the ironies of the situation that we're in, that Wall Street actually cut it's own head off. They actually took on the risks that they previously had understood so well.

GROSS: So, is there anything good you have to say about credit default swaps? Like why regulate them? Should we get rid of them altogether? Should we just say that these are poison, let's just stop making them and selling them?

Prof. PARTNOY: No, absolutely not. We have to remember that derivatives are like fire or dynamite - they can be very dangerous, but they can be very useful as well, and credit default swaps can be an incredibly useful tool. If we had paid attention to credit default swaps, we would've seen a lot the problems early on because sophisticated people who are making side bets based on whether people will default are going to notice when people are more likely to default. And the prices in the credit default swap market are a very, very nice early warning indicator that we should take advantage of.

We shouldn't stamp out that market, we don't want these instruments to go away - and derivatives are not going to go away. Credit default swaps are not going to go away. We shouldn't want them to go away.

GROSS: What do you think of short selling? Do you think that that should remain legal? And I'll ask you to describe what it is before you answer the question.

Prof. PARTNOY: Short selling is essentially betting against stocks. There are different ways to do it, but the typical way is that you borrow a stock and you sell it and you make money when you buy it later at a lower price. Short sellers are incredibly important, and I think that they've been wrongly vilified in this crisis. I think if anything we need to subsidize short sellers. They're the heroes, they're the people who spot at many of these problems early on. When bankers complain about their stock prices going down because of short sellers, I think we all should raise a suspicious eyebrow. The reason the prices of these banks went down was because they had bought risky assets that went down in value.

The short sellers were people who had found out about this early on, who had dug into the details of their financial statements and had investigated the banks, almost like forensic accountants or financial journalists, finding all of these massive, massive risks. And everyone wants to blame someone and the fingers are pointing in all sorts of directions. And many people in Congress have said that the short sellers are some of the perpetrators, but I really think that's wrong headed. I think that, let's again take a step back and think about the role of short selling. Companies naturally are going to tell us positive information, right? If they have good news, we're going to hear about right away.

What about the bad news? Nobody talks about bad news. And we need somebody out there in the market who can play the function of trying to ferret out the bad news of going in and investigating. And people won't do that for free. Maybe a journalist will do it for a relatively small salary, but people in the financial markets aren't going to go out and find bad information about companies unless you pay them for it. So, I actually think that we should take a very light touch to short sellers and hedge funds. They are the heroes really. If we had paid attention to them a year or two ago, we would've understood that the banks were much riskier than - than the regulators imagined.

And I think that, as we're thinking through the regulatory structures, and I think the Obama administration understands this, that showing deference to markets and calling in these experts, the short sellers who really do understand these financial risks would be a wise move.

GROSS: So, are you glad that you left Wall Street when you did in the '90s?

Prof. PARTNOY: Well, it was incredibly stupid decision from a financial perspective because these industries boomed and I would've made huge amounts of money, I mean I did just fine, but from a financial perspective it was, it was dumb. But I've been able to since 1995 look at the industry from a big picture perspective and write about it freely. And I wouldn't have been able to do that - and I do feel for people who are in the industry, who know all these stories, who could tell them but they can't. When you talk to them privately, they'll tell you something off the record and they can't really speak their mind and the one thing I've been able to do over the last decade or so is to speak my mind.

And to have that freedom and that's something you really can't put a price on. So I am glad from that perspective that I've had that opportunity.

GROSS: And why can't people still working on Wall Street speak their mind?

Prof. PARTNOY: Well, they would be fired immediately if they spoke their mind. Even when they leave they need to sign confidentiality agreements so that their employers know that they won't speak their mind. You just don't, you can't do it, you don't shoot the golden goose. And particularly in a time like this when people are struggling on Wall Street and they're nervous about whether they'll keep their job or be able to get another job. This is the last time you would want to go out and out your firm. I think we will see a few people who have already made their bunch of money, who will come out now, who will talk about the problems. But most of the people are going to seal their lips.

GROSS: And you didn't have to sign a confidentiality agreement?

Prof. PARTNOY: Incredibly, no. I had my exit interview with Morgan Stanley and it was very cordial and I shook hands with the person who was giving me the exit interview and left and that was the end of it. If they had made me sign a confidentiality agreement I might not have been able to write "Fiasco". I would've encountered all kinds of problems with things that I've been saying or writing about. And fortunately I slipped through the cracks.

GROSS: Well, thank you so much for sharing some of what you know with us. Thank you.

Prof. PARTNOY: Thank you.

GROSS: Frank Partnoy's 1997 Wall Street memoir "Fiasco" has just been published in a new edition. And he has a new book coming out, called the "The Match King: The Financial Genius Behind A Century Of Wall Street Scandals". Partnoy is a professor at the University of San Diego School of Law. Coming up rock critic, Ken Tucker reviews the new solo album by Dan Auerbach, the Black Keys singer-guitarist.

This is FRESH AIR.

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