Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (21 page)

In reality, some of those around the table suspected that the Basel measurements were far from perfect. By 2007, many international banks were using a reformed version of the original Basel Accord called Basel II that let banks use their internal systems when deciding how risky assets might be and thus how much capital was required. If the bank’s own models for judging the risk of, say, a CDO were wrong, then the Basel II system would not work and the dangers in the market might be considerable. Corrigan had spent enough time looking at various banks’ models to know that they were far from foolproof. Geithner’s
repeated warning that banks needed to pay more attention to the “tail risk” of fat tails indicated that he too was uneasy about the modeling. However, vague notions about invisible risk were not enough to force the G8 to act.

When Geithner had launched his campaign to clean up trading backlogs, he had been armed with alarming data. Similarly, when the Germans had launched their appeals for hedge fund regulation, they at least had a concrete disaster story to point to in LTCM. But in the case of the large banks, it was hard to point to any numbers that showed why anyone should be worried.

The meeting closed inconclusively. It was clear that the rest of the G8 did not support the German idea of clamping down on hedge funds, but it was also clear that nobody else around the table could articulate any better, proactive ideas about what they should do. As CEO of JPMorgan Chase, Jamie Dimon could impose policy shifts based on a gut feeling that the credit cycle was turning. Central bankers and regulators, by contrast, were trapped in vast bureaucratic machines. They were equipped only to fight the last war. Faced with a financial system that few people seemed to understand anymore, the G8 did nothing—other than hope that the losses appearing in the US subprime mortgage world would be absorbed quickly, just as the innovation evangelists presumed.

T
he sun slipped slowly down the cerulean Spanish sky. Next to the elegant Barcelona waterfront, hordes of vacationers strolled along the beach, enjoying the balmy summer air. A few stragglers could be heard screeching with laughter as they jumped into the sea. Above them, several hundred bankers stood on the elegant terrace of a futuristic, gleaming white hotel, staging a so-called champagne salute in celebration of the fact that investment banks had just enjoyed their most lucrative year in history. The date was June 11, 2007, and the occasion was the annual meeting of the European Securitisation Forum (ESF), the body devoted to promoting the art of securitization in Europe.

Champagne corks popped. Raucous laughter rang out. And as the light faded, a rock band struck up, playing cheesy covers. The band called itself “D’Leverage” and was composed of bankers from Barclays Capital, Credit Suisse, and others. The name was a joke. (“It’s meant to be funny—it’s
da
leverage, not
de
-leverage,” one of those watching explained.) They were slightly out of tune.

“It’s been an extraordinary year!” beamed Rick Watson, the man who ran the ESF, as the band struck up. Watson had every reason to be pleased. Back in the 1990s, Europe had no trade body like the ESF to champion securitization, and for years after the ESF sprang to life, its meetings attracted only a thousand bankers or so.

By the time of this gala, however, securitization had spread like wildfire in Europe, and more than five thousand attendees had turned up. The meeting carried a lofty title: “Global Asset Backed Securitization;
Towards a New Dawn!” An exuberant crowd included smooth-talking, white-toothed salesmen from large American banks, eagerly selling repackaged mortgage debt; self-deprecating British traders; and earnest, chain-smoking representatives from German insurance companies and banks. Their prey included asset managers from Italy, Spain, Germany, and Greece, often decked in elegant pastel colors. A silent gaggle of Chinese and Singaporeans circulated. It was rumored that they were furtively buying CDOs to find a home for foreign exchange reserves. A few regulators could also be spotted, conspicuous in looking generally dowdier than the bankers. Some of the biggest delegations, though, came from the three credit ratings agencies that were drawing fat profits from the CDO boom. Barcelona was the perfect opportunity to market their skills.

Long queues formed outside the bathrooms and around the coffee stations and computer terminals. Bankers jostled in the corridors on their way to sessions so full that they were forced to stand in the aisles or squat on the floor. Lively debate ensued about the American mortgage-backed bond market, the CDO sector, the SIVs, the state of the Spanish mortgage market, and the outlook for Russian ABS. There was even a high-profile debate on Islamic finance, in which investing must comply with the sharia ban on usury. Some hoped Islamic finance would be a hot new growth area for securitization. “What we are seeing right now in the securitization sector is an extraordinary burst of innovation,” Watson boasted.

But could the party last? Not everyone was convinced. In late May, just before the Barcelona conference, the prices of bonds and loans had suffered some drops, implying the credit market had reached a peak. “What has happened [in recent days] in the bond market suggests we could be at a turning point,” suggested Ganesh Rajendra, head of securitization research at Deutsche Bank. “There are some signs that the weather is changing,” echoed Alexander Batchvarov, a highly respected senior securitization analyst who worked at Merrill Lynch. “The market has been growing very fast—it doubled last year—we have to ask whether there will be such a fast pace of growth this year.”

Nobody doubted that
some
growth would occur. Most of the bankers
in Barcelona had never worked in the field when it wasn’t booming. The ESF organizers were so supremely confident about the future that they announced during the conference that the 2008 gathering would take place in Cannes, a bigger venue and considerably swankier, too. “We need more space. Next year’s conference will be even
bigger
,” Watson effused, as the champagne kept flowing and D’Leverage played on.

The very next day, on June 12, the news broke in New York that a crisis was erupting at a hedge fund with close links to Bear Stearns. “Hard hit by turmoil in the market for risky mortgages, a big hedge fund has fallen 23 percent from the start of the year through late April,” the
Wall Street Journal
reported. “The fund, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund, is widely exposed to subprime mortgages, or home loans to borrowers with weak credit histories.” The New York–based fund was run by two former Bear bankers, Ralph Cioffi and Matthew Tannin.

Initially, few details were reported about what exactly had gone wrong. What was clear, though, was that the fund had been hit by a toxic combination of bad mortgage bets and massive levels of leverage. Cioffi and Tannin had first set up shop back in October 2003, raising $925 million of investor money to create a fund called Bear Stearns High-Grade Structured Credit Strategies. They then borrowed heavily from banks to buy securities that were described in their marketing literature as “high-quality, floating rate, structured finance securities.” That included asset-backed bonds, CDOs, and bank loans, many of which had been created by Bear and most of which carried high credit ratings. In 2004, 2005, and 2006, as the credit markets boomed, the strategy produced fat profits, allowing the fund to produce annualized returns of between 13 percent and 40 percent. That success was so impressive that in the summer of 2006 the group created a second fund, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund. This version employed similar tactics but was more leveraged, sometimes as much as $20 for every dollar of investor equity.

The second fund also got off to a running start, delivering cumula
tive returns of 4.4 percent in the first four months. At the start of 2007, though, things had begun to unravel. As the subprime mortgage market began to turn sour, the price of some mortgage securities and derivatives fell. That wasn’t supposed to happen—those products had been risk-proofed, according to the models—but the defaults had built up enough that the unthinkable had started to occur.

The two funds tried to hedge themselves by purchasing protection against further mortgage defaults with ABX derivatives, but they did too little, too late. By February, investors had become so alarmed about the funds’ mounting losses that they demanded more than $200 million of their money back. Cioffi and Tannin tried to soothe them, arguing that the funds offered an “awesome opportunity” and that “we’re very comfortable with where we are.” In private, though, they were concerned. “I’m fearful of these markets,” Mr. Cioffi wrote in an email to a colleague on March 15, 2007, according to documents seized by the FBI. “It’s either a meltdown or the greatest buying opportunity ever, I’m leaning more towards the former.”

In May, the two men admitted that the most highly leveraged fund had lost 6 percent in April alone. Then, soon after, they revised that estimated loss up to a staggering 19 percent. Investors were livid: how could Cioffi and Tannin have miscalculated the losses so badly? In reality, it was easy, because working out the “true” value of the assets held by the funds was fiendishly difficult. Some of the securities the funds held were traded in the open market, so their prices could be tracked, but most CDO products still weren’t being traded. If the funds were pursuing a “buy and hold” strategy, buying assets and retaining them until they expired (usually five years), the lack of price information might not have mattered. But these were hedge funds, and a widespread convention in the hedge fund world dictated that funds give their investors regular reports on the so-called mark-to-market value of their assets. Without that transparency, investors usually wouldn’t invest. The Bear Stearns funds, therefore, faced a big problem: how could they find “market prices” when a true market for their assets didn’t exist?

Most funds resolved this dilemma by using models to take account of default patterns and the price of any such instruments that
were
being
traded, and extrapolating from that data to create a price. Extrapolating in this manner was not difficult with corporate credit derivatives, since there were plenty of corporate debt instruments that did trade. The mortgage sector was more problematic. Mortgage derivatives had proliferated so fast, in such a short time, that it was hard to draw clear links between the price of underlying mortgage loans and linked CDOs. Trading in mortgage bonds, let alone mortgage derivatives, was sparse. The only obvious guide was the ABX index, which had been launched in early 2006. It provided a gauge of the value of the range of bonds in the CDOs—from BBB to AAA. So what many funds—including the Bear Stearns fund—did was look at the prices as given by ABX and then use that to deduce the prices of the bonds in their own CDOs. During 2006, that had cast a flattering glow on the fund, since the ABX trades were bullish. By the end of February 2007, though, the ABX index suggested that the price of BBB subprime mortgage-backed bonds had fallen to around 65 percent of face value. To put that another way, the cost of buying insurance via the ABX had risen so high that the prices made sense only if you thought the bonds commanded a mere 65 percent of their face value. The ABX ticked up again in March, but by June, the implied price of BBB bonds was sliding towards 60 percent of face value. Even the implied prices of A and AA instruments were starting to deteriorate.

As Cioffi and Tannin factored those movements into their models, the impact was devastating. By early June, the value of the assets at the most leveraged fund was 23 percent down, while the older fund had suffered losses of 5 percent. Due to how highly leveraged the newest fund was, it was effectively bust, and the oldest fund teetered on the edge.
BusinessWeek
pointed to the trouble as “another illustration of the danger facing funds that rely heavily on borrowed money to make investment bets.”

As the losses mounted, officials at J.P. Morgan’s headquarters at 270 Park Avenue pondered what they should do. When the two funds had used leverage to place their investment bets, they had done so by taking out large loans from banks, often on a short-term basis. J.P. Morgan had extended a hefty amount, alongside Barclays Capital, Merrill Lynch, Goldman Sachs, and others. The J.P. Morgan management was well aware
of the risk involved, but the bank was also looking to expand its dealings with hedge funds. To reduce the risk, the bank had required that Bear put up plenty of high-quality collateral against the loans. By mid-June, Steven Black, cohead of the investment bank, was worrying whether the bank would be able to get its money back, and he sent a team to Bear’s Madison Avenue offices to assess the situation. Frantically, Bear officials tried to placate them, pleading, “Just stick with us, and it will all be fine—these are high-quality instruments!” But the J.P. Morgan risk managers insisted on seeing the accounts, and these suggested the funds were effectively bust.

Black realized that J.P. Morgan needed to get its money back as fast as possible—or grab the collateral Bear had put up and sell it off. He called Warren Spector, the powerful and widely respected head of Bear’s investment bank, who had built the group’s debt markets operation—and was one of the few men at Bear who truly understood the full reach of this business. Spector struck a defiant pose: he suggested that J.P. Morgan was the only bank threatening to call in its loans. He also declared that the two hedge funds would soon recover their losses.

Black was furious. He knew that Merrill Lynch and several of the other creditors were also threatening to call in their loans. So he called Alan Schwartz, another senior official at Bear Stearns, whom Black had known for years. Black said firmly: “We want our money back!” As the pressure mounted, Cioffi and the other officials at the Bear funds tried to get some money to repay the loans. They declared they would sell almost $4 billion of their most liquid assets, and Bear traders circulated a list of the securities on the block. It was not enough to placate the banks, though. As the days passed and Merrill Lynch failed to get its money back, Merrill officials told Bear they planned to sell about $400 million worth of Bear’s collateral in the open market. Most of that was complex, rarely traded instruments such as CDOs.

That threat sent shock waves through the market. Nobody had ever tried to sell that many CDOs or mortgage bonds in public before. A fire sale of that kind threatened to produce something the CDO world had never seen before: “true,” undeniable market prices. In theory, that promised to be a very healthy, long-term development. After all, the bankers
who had invented structured finance had always claimed to be upholding the virtues of free markets and rational pricing. They were supposed to like transparency. In actuality, though, the prospect of an open auction had terrifying short-term implications. Even at the best of times, forced sales hardly achieve good prices, and by mid-June, conditions in the mortgage market were getting worse by the day.

On June 15, just as Merrill was issuing its fire-sale threat, Moody’s announced that it was cutting its ratings on 131 bonds linked to BBB-rated pieces of subprime debt and reviewing the ratings on 247 other bonds, all linked to mortgages issued in 2006. The move affected only $3 billion worth of bonds, a tiny proportion of all the $400 billion subprime-linked bonds sold in 2006. Nonetheless, it spooked investors so badly that the BBB tranche of the ABX tumbled to 60 percent of face value.

Moody’s admitted that its experts were finding it hard to read the housing market trends. “[These mortgages] are defaulting at a rate materially higher than original expectations,” it observed. The mood was turning decidedly edgy. “Negative sentiment [is taking] a firm hold of the [subprime bond] market,” analysts at J.P. Morgan noted. Bankers feared that an auction of any of the CDO products would push prices lower still, and that would have ominous implications, not just for the Bear Stearns funds but for numerous other investment groups and banks, too.