All The Devils Are Here: Unmasking the Men Who Bankrupted the World (14 page)

There were a number of rationales behind J.P. Morgan’s push to create credit default swaps. The first had to do with the bank’s obsession with risk management. The one area where the bank’s modern risk management approach had not taken hold was commercial lending. Over the years, big corporate loans had become increasingly less profitable as corporations turned to other funding mechanisms, like commercial paper. More and more, companies were using banks for inexpensive lines of credit that they needed only in emergencies—which is precisely when a bank doesn’t want to extend credit. Yet banks were afraid to end these lines of credit because they didn’t want to alienate their big corporate customers, who used many of their other, more profitable services.

What’s more, although Basel may have viewed all commercial loans as equally risky, J.P. Morgan certainly did not. Was a loan to Walmart really as risky as a loan to Kmart? Yet the bank had no real way to distinguish the relative risk between the two. J.P. Morgan was reduced to making educated guesses. “We were extending credit,” says one member of the credit derivative team, “and nobody was putting a price on it.”

A tradable market for credit default swaps would change that. Traders buying and selling credit protection would allow the market to gauge the riskiness of a loan. If the cost of the credit default swap increased, that meant the chance of a default was rising; if it decreased, then the odds were decreasing. Even before a tradable market existed, J.P. Morgan’s quants began using credit default swaps internally, to put a price on the risk of its own commercial loans. The old-line commercial lenders hated it, but this was exactly the kind of approach to risk that Weatherstone favored.

And the second reason the bank wanted to make credit default swaps a reality? If a tradable market developed, J.P. Morgan would certainly be a dominant player. It stood to make a lot of money. Commercial loans represented the stodgy past; credit derivatives represented the turbocharged future.

As for capital requirements, there is no doubt, when talking to people who were there at the creation, that the J.P. Morgan team always understood the potential for credit default swaps to reduce the need for banks to hold capital. After all, if a bank pays a counterparty to accept the default risk of its loan portfolio, doesn’t that mean its credit risk has been reduced? And therefore, shouldn’t it get capital relief? If the government went along, every big
bank in the world would clamor to buy credit protection on its loan portfolio. The market wouldn’t just be big; it would be
huge
. But for that to happen, the Federal Reserve would have to agree that credit default swaps did indeed transfer default risk. And who could say when, or even if, that would happen?

In 1994, J.P. Morgan put together its first credit default swap. It came about as a result of the
Exxon Valdez
oil spill. The oil giant, facing the possibility of a $5 billion fine, drew down a $4.8 billion line of credit from J.P. Morgan. This put the bank in exactly the kind of position it didn’t want to be in. It couldn’t say no, because that would alienate Exxon. Yet the loan wasn’t going to make the bank much money, and it was going to tie up hundreds of millions of dollars in capital that would have to be placed in reserve.

The woman who came up with the idea of using a credit default swap to deal with this situation was Blythe Masters. Though she was not the head of the derivatives group, she was a key member of the team, a superb saleswoman who in later years would become the person most closely associated with J.P. Morgan’s entrée into swaps. After Exxon drew down its $4.8 billion line of credit, she convinced the European Bank for Reconstruction and Development (EBRD) in London to participate in a swap deal where it assumed the default risk for the loan, with J.P. Morgan paying it steady fees for doing so. The loan stayed on J.P. Morgan’s books.

Compared to what would come later, the deal was simplicity itself. J.P. Morgan was transferring the credit risk of a single loan to a single entity. Why was the EBRD willing to assume that credit risk? In truth, the reason was that the risk was minimal. Potential fine or no, Exxon was one of the strongest companies in the world, with 1994 revenues of close to $100 billion. It ranked third on the Fortune 500. Yet J.P. Morgan was going to pay the European bank substantial fees to assume the risk of an Exxon default. It seemed like free money.

And why was J.P. Morgan willing to pay those fees? Because even if it couldn’t reduce its government capital, it was still removing a risk it did not want to bear, one that was weighing down its commercial lending risk profile. It had its own internal capital requirements, which would be reduced with this swap deal. And besides, the Exxon deal served as proof of a concept, and might help convince the government that swap deals merited capital relief. But that was still a ways off.

Just like mortgage-backed securities in the 1980s, the derivatives business needed government help in order to really take off. For instance, the industry needed Congress to tweak the bankruptcy laws, so that derivatives contracts could be “netted out” in case of a default. Without that change, if a bankrupt company owed its counterparties $500 million in swap deals, while the counterparties owed the company $300 million, the derivatives dealers would have to stand in line for its $500 million—while paying the company the $300 million. After Congress passed the “netting out” provision, the counterparties would then be owed $200 million instead.

But the derivatives dealers also wanted something even more important from the government: they wanted regulators to keep their paws off their shiny new product. For J.P. Morgan, which had been one of the leading derivatives dealers long before it came up with credit default swaps, this was its top Washington priority.

The person who led the lobbying effort for the bank, Mark Brickell, could not have been better suited to this task. A tall, thin, mildly disheveled man, Brickell wasn’t like most Washington lobbyists. He wasn’t a hired gun. Rather, he was a true believer, both in the virtues of derivatives and in the need for government to leave them alone. Handed this role in 1986, Brickell embraced it with a gusto that would never abate; even in the wake of the financial crisis, Brickell insisted—against all observable evidence—that derivatives had not been a leading cause.

Brickell graduated from the University of Chicago in the early 1970s, where he had studied economics and become a convert to the fierce free-market ideology that dominated its faculty—an experience he would later describe as one of the formative experiences of his life. After attending Harvard Business School, he toyed with a career in politics before joining J.P. Morgan in 1976, where he stayed for the next quarter century.

It was the growing popularity of interest rate and currency swaps in the mid-1980s that first caused regulators to begin asking questions about them. In response, the big banks, which dominated the business, formed a lobbying group in 1985, called the Independent Swaps and Derivatives Association, or ISDA. Brickell, representing J.P. Morgan, joined the following year. In 1988, he became its chairman.

Not long after Brickell joined ISDA, the Commodity Futures Trading Commission, a relatively new agency, published a notice saying that it planned to examine whether derivatives qualified as futures. If the answer
was yes, then the CFTC would have regulatory authority over the swaps business. This was the first time anyone in government had raised such an idea—though it would hardly be the last. Over the course of the next decade, the question of whether derivatives should be regulated would arise regularly in Washington. Brickell’s job essentially was to beat it back.

Brickell made at least four central arguments. The first was that because the major derivatives dealers were banks, they were already regulated by federal bank supervisors. His second argument was that the derivatives business was a hothouse of innovation, making the financial world less risky, and regulation would stifle further innovations. A third was that derivative transactions took place only among the most sophisticated investors, who didn’t need the government looking over their shoulders. His final argument was that the market itself would impose the discipline needed to keep the growing business on the straight and narrow. Mistakes would lead to losses. Bad practices would cause other participants in the derivatives market to shun the offender. In making this argument, Brickell had a powerful ally in Alan Greenspan, who was also a believer in the power of market discipline—and a skeptic of regulation. It also didn’t hurt that he had been on the J.P. Morgan board before becoming Fed chairman.

What Brickell did not talk about—or, rather, what he consistently pooh-poohed—was the fear that, in dispersing risk so widely, derivatives were transferring risk from a single institution to the entire financial system. All that hedging of derivatives—the reflecting mirror syndrome—was creating an interconnectedness among financial institutions that hadn’t existed before. If one counterparty failed, what would happen to all the institutions holding its swap contracts? What would happen if the risks weren’t properly hedged? Who kept track of the exposures major financial institutions held in their derivatives books?

In addition, derivatives also created an enormous amount of unseen—and unaccounted for—potential debt. A credit default swap is really a kind of IOU—a promise to pay a very large sum of money if something bad happens. Most of the time that promise would never have to be kept. But sometimes it would—potentially costing an institution billions of dollars it wasn’t expecting to pay out.

To deflect Washington’s concerns, in the early 1990s Weatherstone chaired an international committee on derivatives that came up with a four-volume tome of best practices for derivatives. Brickell was his aide-de-camp on the
project. The report, entitled “Derivatives: Practices and Principles,” impressed the bank regulators so much that some of them tried to codify the report into regulatory language. Brickell, of course, pushed back.

Brickell took care of the Commodity Futures Trading Commission, meanwhile, by simply claiming that derivatives were not futures and were therefore outside the agency’s jurisdiction. If derivatives were ruled to be futures contracts, he said, the derivatives business would immediately be destroyed. Why? Because under the law, futures had to be traded on exchanges, and derivatives didn’t trade on an exchange. What’s more, the law said that any futures contracts that did not trade on an exchange were unenforceable. So if derivatives were declared futures, every derivative contract in the world would suddenly be worthless. Therefore they couldn’t be futures.

It was a circular argument, but it worked. Shortly after the CFTC first expressed its interest in derivatives, President George H. W. Bush appointed Wendy Gramm as the agency’s chairwoman. The wife of Senator Phil Gramm, the conservative Texas Republican, she had a PhD in economics and had been a high-level appointee at the Office of Management and Budget. After talking to Greenspan, the CFTC staff—and Brickell—Gramm ruled, in 1989, that derivatives were not futures. The
Wall Street Journal
ran an editorial with the headline “Swaps Saved.”

Gramm’s ruling did not put the issue to rest, however. On the contrary, prior to 1989 there were almost no congressional hearings about derivatives; over the next five years, there was a blizzard of them. Legislation to reauthorize the CFTC reopened the question of whether derivatives should be regulated like futures, leading to battles that went on for years. Court decisions that ruled that derivatives were, in fact, futures contracts had to be preempted by legislation. In 1992, the president of the New York Federal Reserve, Gerald Corrigan, made a widely noticed speech about the risks posed by derivatives. “High-tech banking and finance has its place, but it’s not all that it is cracked up to be,” he said in the speech. “I hope this sounds like a warning, because it is.” The following year, a derivatives scandal broke out when two big companies, Procter & Gamble and Gibson Greetings, lost tens of millions of dollars on swap deals. Both later sued the issuing bank, Bankers Trust, claiming they had been misled about the risks those deals posed. In Orange County, a county treasurer had boosted the county’s returns by using derivatives that Merrill Lynch had sold to him. When interest rates rose in 1994, the county lost so much money it had to file for bankruptcy.

Yet despite all the concern, the government never even came close to
regulating derivatives. Brickell was relentless in his advocacy, but he had help. Shortly after making his speech in 1992, Corrigan left the New York Fed and joined Goldman Sachs; he was soon testifying in favor of derivatives. And Greenspan, who had a godlike status in Washington, was adamant that derivatives should be left alone. “Remedial legislation relating to derivatives is neither necessary nor desirable,” he said at one congressional hearing. “We must not lose sight of the fact that risks in the financial markets are regulated by private parties.” In other words, market discipline would take care of everything.