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 (30 page)

The vitriol appalled her former colleagues. “They are picking on her because she is a woman, because she stands out,” one observed. “It’s a travesty of “justice.” Not a single one of us was involved in the transactions that later caused so much damage…all of this group are decent human beings.” Masters herself, though, tried to shrug it off. As she grew older, she had developed a sense of humor about the irony—and unpredictability—of life.

When she addressed a meeting of SIFMA in New York in late 2008, she referred to herself as “the woman who built financial weapons of mass destruction.” She knew the public was angry and wanted something to blame, and she could understand that. She was livid herself at how bankers had perverted her derivatives dream. Yet she—like Winters—continued to hope that somehow, something of the value of credit derivatives would be salvaged. “It’s probably safe to say that our industry image is at an all-time low,” she admitted with masterful
British understatement when she addressed the SIFMA conference. As ever, she cut a striking figure. In deference to the dark mood of the times, she wore a somber chocolate-brown suit instead of her usual jewel-toned hues.

“Some in the industry bristle at the suggestion that Wall Street or anyone could have predicted or should have avoided this meltdown,” she continued, “…many players had a role in creating this crisis, including lenders, borrowers, and regulators. But even if not
all
of the blame that will come should be directed towards our industry, there is unfortunately plenty of blame to go around…. What our industry needs is to rebuild our reputation,” she added, “and the first step is to acknowledge accountability and to own the responsibility for rebuilding a more systemically sustainable business model. Financial engineering was taken to a level of complexity which was unsustainable…. But it is important to distinguish between tools and their users. We need to remember that innovation has created tools for
managing
risk.”

She was keenly aware of the ultimate irony of the whole saga. “The events that have brought us here are a tragedy of unfolding proportions; it would be a greater tragedy if we failed to learn the lessons that they offer.”

In London, Tim Frost kept repositioning Cairn Capital. During the course of 2008, Cairn suffered more blows, as a clutch of CDOs linked to mortgage securities were declared to be in an “event of default.” Yet many other parts of the Cairn CDO empire that were connected with corporate credit continued to perform. And Frost was finding ways to draw benefits from all the bitter lessons he had learned. In the last two years, Cairn had developed an impressive sideline as an adviser to bankers or investors trying to restructure collapsed shadow banks. “We are still the only fund which has successfully managed to restructure a [SIV],” he said. “We have a lot of expertise to offer.” Cairn had snapped up the portfolios of many ruined CDOs at knockdown prices. In late 2008, the Bank of England quietly appointed Cairn an adviser. The fees on such advisory and restructuring work were paltry compared to what Frost had once hoped to earn from the hedge fund, but the Bank mandate was a stun
ning sign of just how successfully he and his colleagues had managed to find opportunity in adversity.

Terri Duhon’s consultancy business was enjoying a flurry of demand, as were advisory services run by Robert Reoch and Charles Pardue. As the full scale of the toxic shock became clear, policy makers and asset managers realized just how little they really knew about CDOs and other complex instruments, and they were frantic to find advisers who knew better and had clean hands. Such people seem in short supply.

Many of the “Morgan mafia” remained in close touch by email, trying to make sense of the unfolding drama. Many blamed the mortgage world. “The essential question is what in tarnation led market participants to overoriginate subprime mortgages at increasingly silly terms and then warp credit derivative technology into synthetic CDO of ABS when the [over]supply of real mortgages was insufficient to satisfy demand,” raged Feldstein. Some also recognized, though, that ideology was also to blame. “The economic models that Hancock and Merton and others upheld were right in a sense, but the problem is that they did not give enough emphasis to all the human issues, the regulatory structures, and things like that,” observed Masters. “The idea was that those issues were just noise in the models—but that is just dead-arsed wrong. We don’t live in that kind of world of perfect economic models.” For some, the congressional testimony of Alan Greenspan, the former chairman of the Federal Reserve, in the autumn of 2008, marked an intellectual turning point.

During the previous two decades, Greenspan had vehemently championed unfettered free-market competition and the argument that markets were not merely efficient but also self-correcting. However, when Greenspan appeared before Washington lawmakers on October 24, 2008, he admitted he was “in a state of shocked disbelief” and that he had made a “mistake” in believing that banks would do what was necessary to protect their shareholders and institutions. “[That was] a flaw in the model…that defines how the world works,” he declared. “I think Greenspan is quite right,” one of the former J.P. Morgan team observed shortly
after. “Now it is clear we need a
new
paradigm. But we haven’t found it yet, and frankly I don’t know where we will.”

Like many of the former J.P. Morgan team—and almost everybody else in the Western world—I am still trying to make sense of the last decade of grotesque financial mistakes. One compass that helps is the training I received when I did a PhD in social anthropology, before I became a journalist some fifteen years ago. Back in the 1990s, when I first started working as a financial reporter, I used to keep rather quiet about my “strange” academic background. At that time, it seemed that the only qualifications that commanded respect were degrees in orthodox economics or an MBA; the craft of social anthropology seemed far too “hippie” (as one banker caustically observed) to have any bearing on the high-rolling, quantitative world of finance.

These days, though, I realize that the finance world’s lack of interest in wider social matters cuts to the very heart of what has gone wrong. What social anthropology teaches its adherents is that nothing in society ever exists in a vacuum or in isolation. Holistic analysis that tries to link different parts of a social structure is crucial, be that in respect to wedding rituals or trading floors. Anthropology also instills a sense of skepticism about official rhetoric. In most societies, elites try to maintain their power not simply by garnering wealth, but also by dominating the mainstream ideologies, in terms of both what is said and what is
not
discussed. Social “silences” serve to maintain power structures, in ways that participants often barely understand themselves let alone plan.

That set of ideas might sound excessively abstract (or hippie). But they would seem to be sorely needed now. In recent years, regulators, bankers, politicians, investors, and journalists have all failed to employ truly holistic thought—to our collective cost. Bankers have treated their mathematical models as if they were an infallible guide to the future, failing to see that these models were based on a ridiculously limited set of data. A “silo” mentality has come to rule inside banks, leaving different departments competing for resources, with shockingly little wider vision or oversight. The regulators who were supposed to oversee the banks
have mirrored that silo pattern, too, in their own fragmented practices. Most pernicious of all, financiers have come to regard banking as a silo in its own right, detached from the rest of society. They have become like the inhabitants of Plato’s cave, who could see shadows of outside reality flickering on the walls but rarely encountered that reality themselves. The chain that linked a synthetic CDO of ABS, say, with a “real” person was so convoluted, it was almost impossible for anybody to fit it into a single cognitive map—be they anthropologist, economist, or credit whiz.

Yet the only thing that is more remarkable than this deadly state of affairs was that it went so unnoticed, for so long. For my part, I first crashed into the complex financial world back in early 2005, when I volunteered to start writing about credit for the
Financial Times.
By 2006, my team had become seriously alarmed by the trends and tried to point out the dangers. Yet it was a lonely endeavor. Most mainstream newspapers all but ignored the credit world until the summer of 2007. So did politicians and nonbankers. Credit was considered too “boring” or “technical” to be of interest to amateurs. It was a classic area of social silence. Insofar as any bankers ever reflected on that silence (which very few did), most assumed that it suited their purposes well. Freed from external scrutiny, financiers could do almost anything they wished. And locked in their little silos, almost nobody could see how the pieces fitted together as a whole or how overbloated finance had become.

Now, however, it is clear that this lack of holistic thought and debate has had devastating consequences. Regulators have realized, too late, that they were wrong to place so much blind faith in the creed of risk dispersion. Bank executives have been confronted with vast losses created by dysfunctional internal silos. Politicians are facing fiscal crisis as an economic boom crumbles to dust. Most tragic of all, millions of ordinary families, who never even knew that CDOs existed, far less dealt with them, have suffered shattering financial blows. They are understandably angry. So am I. It is a terrible, damning indictment of how twenty-first-century Western society works.

In pointing out the cultural issues, I do not mean to suggest that tangible macroeconomic issues were not crucial too. Excessively loose mon
etary policy stoked the credit bubble. So did savings imbalances and poor regulatory structures. Those tangible deficiencies must be addressed. Central bankers need to pay more attention to the behavior of finance when they set monetary policy. Regulators must monitor banks in a more holistic manner. Banks require bigger capital cushions. Financial products must become simpler and more transparent. Many recent innovations, such as mezzanine CDO of ABS, need to die. Others, though, could still be valuable. Nobody would try to ban all prescription drugs, or stop all nuclear processing, if some innovations malfunctioned. The basic idea that banks should disperse some of their credit risk, or insure against a bond or loan default, still seems valuable.

Yet what is also needed is a wider rethinking of the culture of finance. For too many years, bankers have treated “credit” as merely an isolated game of numbers. The roots of the word, though, come from the latin
credere,
meaning “to believe.” That is a concept centered on wider social relations, which financiers forget at their peril. For if there is one element, above all, that is now needed to restore sanity to banking, it is that policy makers, bankers, and politicians must adopt a more
holistic
vision of finance. In essence, what is needed is a return to the seemingly dull virtues of prudence, moderation, balance, and common sense.

Oddly enough, the symbol that J.P. Morgan inadvertently inherited from Chase Manhattan would seem an appropriate metaphor, the octagonal logo that harkened back to the wooden planks once hammered together to make water pipes. The rebranded J.P. Morgan has dropped the logo, which is perhaps a pity. In many ways the craft of finance isn’t so different from that of the water industry; both exist in order to push a commodity around the economy for the benefit of all. If those pipes are wildly inefficient, leaky, or costly, then everyone suffers. In the last two decades, as finance spun so out of control, it stopped being a servant of the economy but became its master. That must be reversed. Perhaps it is time to stamp an octagonal water symbol over the door of every modern bank as a reminder of the perils of forgetting that money is also vital fluid that must flow freely, and safely, throughout our fragile, interconnected world.

The primary sources for this book are extensive interviews with the main characters mentioned in this book, as well as numerous other people, over several years. Except where it is specifically mentioned, the quotes are drawn from author interviews or from author articles previously published in the
Financial Times
. I have also drawn heavily from financial stability reports by the Bank for International Settlements, International Monetary Fund, European Central Bank, and Bank of England, as well as the Capital Markets Monitors published by the Institute for International Finance. Studies conducted by the Counterparty Risk Management Group, the IIF, the Group of Thirty, and the Basel Committee have also been used, as well as a large array of media sources and reports by financial industry analysts.

The research also benefited from a large array of textbooks and popular literature on finance and the recent credit crunch, including (but not exclusively) Tavakoli, J.,
Structured Finance & Collateralized Debt Obligations
(John Wiley & Sons, 2003, 2008); Das, Satyajit,
Traders, Guns & Money
(Pearson, 2006); Morris, Charles,
The Trillion Dollar Meltdown
(Public Affairs, 2008); Bookstaber, Richard,
A Demon of Our Own Design
(Wiley, 2007); Bernstein, Peter,
Capital Ideas Evolving
(Wiley, 2007) and
Against the Gods
(Wiley, 1996); Rebonato, Riccardo,
The Plight of the Fortune Tellers
(Princeton University Press, 2007); Chernow, Ron,
The House of Morgan
(Grove Press, 2001); Lowenstein, Roger,
When Genius Failed
(Random House, 2001); Soros, George,
The New Paradigm for Financial Markets
(Public Affairs, 2008); Shiller, Robert J.,
The Subprime
Solution
(Princeton, 2008); Davies, Howard, and Green, David,
Global Financial Regulation
(Polity, 2008).

One: The Derivatives Dream

By 1994, the total notional value of derivatives contracts:
Loomis, J. Carol, “The Risk That Won’t Go Away,”
Fortune
(March 7, 1994).

Versions of derivatives trading have existed for centuries:
Dodd, Randall, “Backgrounder: Derivatives,”
Initiative for Policy Dialogue,
at http://www2.gsb.columbia.edu/ipd/j_derivatives.html; Davies, Roy, “Gambling on Derivatives,” at http://www.projects.ex.ac.uk/RDavies/arian/scandals/derivatives.html.

Salomon Brothers was one of the first:
Author interviews; see also Lowenstein, Roger,
When Genius Failed
(Random House, 2001).

But J.P. Morgan had always had a transcultural identity:
See Chernow, Ron,
The House of Morgan
(Grove, 2001).

A few months before the Boca off-site:
Loomis, J. Carol, “The Risk That Won’t Go Away.”

“I’ve known people who worked on the Manhattan Project”:
Philips, Matthew, “The Monster That Ate Wall Street,”
Newsweek
(October 6, 2008).

Two: Dancing Around the Regulators

Out of that, they decided to create an industry body:
“ISDA and Risk,” ISDA 20th Anniversary Report (March 2005).

“Given the sheer size of the [derivatives] market”:
Corrigan, E. Gerald, Speech to New York State Bankers Association dinner (January 1992).

So Weatherstone agreed to chair the G30 report:
ISDA 20th Anniversary Report, 30.

Felix Rohatyn, a legendary Wall Street figure:
Hansell, Saul, and Muehring, Kevin, “Why Derivatives Rattle the Regulators,”
Institutional Investor
(September 1992).

“I want to produce a guide by practitioners”:
ISDA 20th Anniversary Report, 30.

Brian Quinn, an executive director of the Bank of England, said the G30 report:
Gapper, John, “International Capital Markets—Bank Supervisor Calls for Tougher Futures Regulation,”
Financial Times
(September 29, 1993).

“If the market players continue forward in the spirit of the G30”:
J. Carter Beese, speech at ISDA Conference in Washington (November 3, 1993).

The company had made a deal with Bankers Trust:
Essentially in the first six months, P&G was to pay Bankers Trust a rate of CP (commercial paper) minus 75 basis points. After that, the rate would be set at a higher level, close to the floating rate. In return for this initial below-market rate, P&G faced grave uncertainties as to where rates might be six months out. Still, P&G had some insurance against a run-up, in the form of a six-month option to set the rate at any time. The goal of P&G’s treasury was to get the four and a half years’ money at CP-40. And if the interest rates kept falling, then P&G would have enjoyed large cost savings. For full details see: http://www.derivativesstrategy.com/magazine/archive/2000/1100fea3.asp.

in 1993, Citron’s investment pool delivered returns of 8.5 percent:
Lynch, David J., “Orange County: How It Happened: How Golden Touch Turned into Crisis,”
USA Today
(December 23, 1994).

“The question now is no longer whether regulatory or legislative changes will be made”:
Fillion, Roger, “GAO Portrays Derivatives as Fraught with Dangers,” Reuters News Service (May 19, 1994).

“Derivatives are perfectly legitimate tools to manage risk”:
Taylor, Andrew, “Critical Report Fuels Drive to Regulate Derivatives,”
Congressional Quarterly Weekly Report
(May 21, 1994).

“The head of Clinton’s new National Economic Council, Robert Rubin”:
Phillips, Kevin,
Arrogant Capital
(Little, Brown, 1994).

“When I say I don’t think legislation is needed”:
Lipin, Steve, and Raghavan, Anita, “GAO to Join Hot Debate on Derivatives,”
Wall Street Journal
(May 18, 1994), and Peltz, Michael, “Congress’s Lame Assault on Derivatives,”
Institutional Investor
(December 1, 1994).

Three: The Dream Team

“Funnily enough,” she told a reporter:
Fredrickson, Tom, “Blythe Masters, 34,”
Crain’s New York Business
(January 26, 2004).

Moreover, the credit derivatives concept did not seem:
For details of why Freund experimented with the idea, then dropped it, see Guill, Gene,
Bankers Trust and the Birth of Modern Risk Management,
Wharton Financial Institutions Center (November 2007), 30.

Sure enough, in August 1996, the Fed issued a statement:
see
Supervisory Guidance for Credit Derivatives
, Washington Federal Reserve (August 12, 1996), at http://www.federalreserve.gov/BOARDDOCS/SRLetters/1996/sr9617.htm.

Demchak’s team furtively worked:
For details of how this structure worked see “The J.P. Morgan Guide to Credit Derivatives,” Risk Publications, 1999. See also Das, Satyajit,
Credit Derivatives
(Wiley, 2005), for a very extensive discussion of the significance of BISTRO, in relation to the structures that proceeded, and the subsequent impact on the industry (322–344).

“Five years hence, commentators will look back”:
Credit Derivatives—Five Years Out,
DerivativesStrategy.com (July/August 1997), at http://www.derivativesstrategy.com/magazine/archive/1997/0797rtbl.asp.

Four: The Cuffs Come Off

BISTRO-style CDS trades quickly took off:
For general discussions of that, see Das, Satyajit,
Credit Derivatives.

“The pace of change in the way banks manage credit risk”:
Asarnow, Elliot,
The Journal of Lending and Credit Risk Management
(September 1998), 13.

“Blythe Masters still looks more like a J.P. Morgan intern”:
The Journal of Lending and Credit Risk Management,
8.

But they were also uneasy:
For a debate about the problems of fitting existing regulations to securitizations and the Fed and OCC response, see
Capital Interpretations, Synthetic Collateralized Loan Obligations,
November 15, 1999, at http://www.occ.treas.gov/ftp/bulletin/99-43a.pdf and
Supervisory Guidance for Credit
Derivatives,
Washington Federal Reserve, August 12, 1996, at http://www.federalreserve.gov/BOARDDOCS/SRLetters/1996/sr9617.htm.

Cassano happily agreed:
See details about this and comments from Cassano in Conference Call Transcript, AIG Financial Services Group presentation, Thomson StreetEvents (May 31, 2007), 23.

Capital reserves could be cut only:
See
Capital Interpretations, Synthetic Collateralized Loan Obligations
(November 15, 1999) at http://www.occ.treas.gov/ftp/bulletin/99-43a.pdf.

As the audience filed into the Cipriani:
“The J.P. Morgan Guide to Credit Derivatives,” Risk Publications, 1999.

Five: Merger Mania

The fate of hedge fund maverick Long-Term Capital Management:
For an excellent account of this see Lowenstein, Roger,
When Genius Failed
.

In 1999, the year after LTCM imploded:
The study in question was called “Improving Counterparty Risk Management Practices,” Counterparty Risk Management Policy Group (July 1999).

“The fact that the OTC markets function”:
Remarks by Chairman Alan Greenspan,
Financial Derivatives,
before the Futures Industry Association, Boca Raton, Florida (March 19, 1999).

“Congress nailed the door shut”:
Brickell, Mark, “Zero to $200 Trillion,” ISDA 20th Anniversary Report (March 2005), 25.

“Beyond that, the advantages are less compelling”:
Santoli, Michael, “Land of the Giants: Next in Line: How Would Chase Meld with Merrill? Time to Reunite the House of Morgan?”
Barron’s
(April 13, 1998).

The so-called noninterest income:
Michael, Nancy, “Banking’s Top Performers,”
ABA Banking Journal
(June 1, 2000). Data from SEC filings and the magazine’s calculations.

“From a standing start in 1980”:
Frank, Stephen E., “After Embracing Change, J.P. Morgan Is Struggling to Boost Its Bottom Line,”
Wall Street Journal
(May 27, 1998).

In 1999, the median ROE for the top one hundred banks was 18 percent:
Ibid.

As Clayton Rose, one of the senior J.P. Morgan bankers, observed:
Ibid.

But such has been the pace of change in global finance:
“Wall Street’s Old Order Changes New York Chase Manhattan’s Acquisition,”
The Economist
(September 16, 2000).

Indeed, in early 2001, a few months after the merger was completed, the bank was named “Derivatives House of the Year”:
Risk
magazine.

“I believe we handled everything with integrity”:
Chaffin, Joshua, “Companies and Finance: The Enron Collapse—J.P. Morgan Had Too Much Exposure, Says Chairman,”
Financial Times
(February 7, 2002).

“We did it according to accounting conventions”:
Television interview: William Harrison, chairman and CEO of JPMorgan Chase, discusses his firm’s involvement in the Enron scandal,
CNBC: Market Week with Maria Bartiromo
, CNBC (August 5, 2002).

“It’s unnerving how the bad news keeps piling up at J.P. Morgan”:
Timmons, Heather, and Palmeri, Christopher, “The Perils of J.P. Morgan,”
BusinessWeek
(January 21, 2002).

Or as the
Evening Standard
of London tartly declared:
Chambliss, Lauren, “How a Banking Giant Was Laid Low,”
Evening Standard
(October 16, 2002).

“Credit derivatives are a mechanism for transferring risk”:
Westlake, Melvyn, “Investment Banking—Surviving the Credit Crisis,”
The Banker
(May 1, 2002).

Six: Innovation Unleashed

“We can promote outstanding people quickly”:
Chambers, Alex, “How JP Morgan Survived the Loss of a Generation,”
Euromoney
(May 1, 2006).

“It is unlikely that the sector would have grown”:
Ibid.

In 2003,
Risk
magazine designated Deutsche Bank:
Awards.
Risk
magazine (January 2003) at http://www.risk.net//files/11/50/72/f115072/public/showPage.html?page=9109.

Pension funds were now targeting:
Hughes, Jennifer, Beales, Richard, and Tett, Gillian, “Investment—Even Governments Are Putting Money into Higher Yielding Instruments,”
Financial Times
(June 17, 2005).

“The product development now is incredibly fast”:
Katrien van Acoleyen, comments to ESF Conference in Nice (April 2005).

Remarkably, that meant that almost half of all mortgage-linked bonds:
BIS Annual Report
(June 2007), 146.

Each player had its own twist on modeling, after all:
Terri Duhon, comments to ESF and IMN conference in Nice (April 2005).

“People who are focused on ratings alone are prime fodder”:
Charles Pardue, comments to ESF and IMN conference in Nice (April 2005).