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

by Tett, Gillian

  In other areas of banking, or at other banks, her career might have been hobbled before she had really started. But derivatives was such a new field that it was easier to break the mold, and Peter Hancock was a staunch believer in meritocracy. He didn’t care what his team looked like or about their personal lives, as long as they were bright and collegiate. Above all they had to share his intellectual curiosity. “I suppose we created a place where people such as Masters could flourish,” he later commented. “I don’t think that would have happened at many other banks.”

  Masters was by no means the only woman in Hancock’s empire. Terri Duhon, a young female math whiz from a poor family in rural Louisiana, subsequently joined the IDM team. So did Betsy Gile, a cheery, no-nonsense woman who had previously worked in the lending business of J.P. Morgan. Another recruit, Romita Shetty, was an Indian-born credit expert who had started her career as an analyst at Standard & Poor’s rating agency. When Demchak first offered her a job in IDM, he gave her no actual job description. The team, he explained, was free-floating: members would work on different projects and with different colleagues as needed. She jumped at the chance. “What they were doing looked so exciting,” she later recalled.

  Just as Hancock had hoped, his collection of bright young bankers quickly started fermenting creative ideas in a range of types of derivatives business. Masters was part of a group told to pursue the credit derivatives idea, and she threw herself into the assignment. She could see fully well that it had revolutionary implications.

  From time immemorial, the worlds of business and finance have been beset with the problem of default risk, the danger that a borrower will not repay a loan or bond. Banks had long tried to minimize that problem in several ways. The most basic was to ensure that they made only wise lending decisions; hence J.P. Morgan’s strong emphasis on its training program. Diversifying a bank’s customer base was another technique, akin to diversifying a stock portfolio. Banks also sometimes clubbed together to make joint loans, thereby spreading the pain of defaults, and they imposed absolute limits on the amount of money that could be loaned to given sectors: only so much in housing, another amount in consumer credit, and so on. A rule might stipulate, for example, that each department could have no more than $10 million of loans to home builders. Nonetheless, history is littered with examples of banks that collapsed because they misjudged default risk or had too much exposure to a single sector or lender. The savings and loan debacle of the late 1980s and early 1990s was one case in point.

  Masters and the rest of the IDM team knew that in the world of swaps, techniques had been found to separate out, as a derivative product, parts of the risk attached to bonds—say, the risk that interest rates would rise and lead a bond’s value to fall. Derivatives traders had been able to sell that risk as a product to investors who were willing to bet that interest rates would not actually rise. The bondholder, with the bank acting as broker, was in effect able to sell the risk of the bond to another, less risk-averse investor. So what would happen, Masters asked herself, if the same principle were applied to the default risk associated with a loan? Doing so would overturn one of the fundamental rules of banking: that default risk is an inevitable liability of the business. If a technique could be developed to package default risk so that it could be traded, that would be an enormous boost for banking in general.

  For the first time in history, banks would be able to make loans without carrying all, or perhaps even any, of the risk involved themselves. That would, in turn, free up banks to make more loans, as they wouldn’t need to take losses if those loans defaulted. The derivatives buyers who had gambled on that risk would take the hit.

  Such derivatives could be especially useful for J.P. Morgan. By the early 1990s, the bank was facing a particularly pernicious set of financial headaches. The Basel I Accord of 1988 stipulated that all banks needed to hold capital reserves equivalent to 8 percent of the corporate loans on their books: $8 of spare funds for every $100 lent out. The rule applied to all corporate loans for all banks which were deemed to be investment grade by ratings agencies, irrespective of the precise risk attached to them. J.P. Morgan considered that extremely unfair. The bank concentrated on loans to high-quality corporate clients and foreign governments, and the default rate on those loans tended to be so low that keeping $8 of reserves for every $100 lent out seemed a complete waste of resources. Those loans were also not very profitable, because the riskier a loan, the more a bank can charge the client for it. This had seriously curbed the degree to which J.P. Morgan could grow its business.

  To make matters worse, those at the bank trying to boost profits faced a related internal headache, separate from the Basel rules. To combat the danger of default, the bank imposed rigorous internal credit limits on each department, keeping a tight rein on the exposure to risk. By 1994, Hancock’s derivatives group had expanded so fast that the net exposure it had incurred via swaps amounted to approximately $30 billion, and it was bumping up against its limit, finding itself hemmed in.

  If the bank could find a way to shift that credit risk off its books, both the “credit limit” headache and the “Basel” problem might disappear. That was a tantalizing prospect. “If we could make this idea work, this thing could be huge!” Demchak told his team.

  But could it be made to work? Over at Merrill Lynch, Connie Volstadt’s team had already been playing around with similar ideas for a year. And at Bankers Trust innovative traders named Peter Freund and John Crystal had actually cut a couple of deals using these concepts as early as 1991. That made Freund and Crystal the true “inventors” or pioneers of credit derivatives. However, perhaps ironically, Bankers Trust itself never tried to turn its brainchild into a large-scale business. The bank was beset with management upheaval at the time. Moreover, the credit derivatives concept did not seem sufficiently profitable, relative to other business lines, to tempt Bankers Trust traders to devote enough time and energy to create a mass-market credit derivatives business.

  Hancock’s group, though, operated with different incentives. At J.P. Morgan, generally pay was also tied to profits personally accounted for. But Hancock had impressed on the IDM bankers that they were supposed to chase ideas with long-term value, even at the expense of the quick buck. Moreover, the team knew that if they “cracked” the credit derivatives puzzle, they would solve a big problem for the bank, which would win them considerable acclaim, thereby boosting their careers. “They say necessity is the mother of invention,” Feldstein later said, smiling. “In the case of credit derivatives, we all knew there was a real need, a problem that had to be solved. So we all looked for ways to do that.”

  Blythe Masters fervently hunted for a way to make credit derivatives work, and eventually she spotted an opportunity at Exxon. In 1993, after Exxon was threatened with a $5 billion fine as a result of the Valdez oil tanker spill, the company had taken out a $4.8 billion credit line from J.P. Morgan and Barclays. When Exxon first asked for the credit line—which is a commitment to provide a loan, if needed—J.P. Morgan was reluctant to say no because Exxon was a long-standing client. The loan epitomized the twin problem of capital requirements and internal credit limits. Like so many of J.P. Morgan’s corporate loans, it would produce little, if any profit, yet would gobble up credit, pushing the limits, and would require a large amount of capital reserve. In theory, the bank could have dealt with that headache by selling the loan to a third party, since a market for selling such loans did exist. But that would have violated its commitment to client loyalty.

  Masters thought she could see a solution. In the autumn of 1994, she contacted officials at the European Bank for Reconstruction and Development (EBRD) in London to see if she could find a way to off-load the credit risk of the Exxon deal, but without selling the loan. The EBRD might be interested, she figured, because it had complementary needs; it had a large amount of credit available for extending to companies with high credit ratings. The bank was also eager to find ways to earn more money
on its investments, as it was rigorously restrained from high-risk activity, so generally earned low returns.

  Masters proposed that J.P. Morgan pay the EBRD a fee each year in exchange for the EBRD assuming the risk of the Exxon credit line, effectively insuring J.P. Morgan for the risk of the loan. If Exxon defaulted, the EBRD would be on the hook to compensate J.P. Morgan for the loss; but if Exxon did not default, then the EBRD would be making a good profit in fees. The EBRD might well be interested, Masters figured, because the chances that Exxon would default were so slim. True to the derivatives formula, the loan would not actually move from J.P. Morgan’s books to EBRD, so Morgan would be respecting its client relationship without eating up its internal credit lines.

  Andrew Donaldson, the EBRD’s director, liked the idea. He agreed that it was highly unlikely Exxon would default, and he was impressed by the steady stream of income from the fees. It was much higher than anything else he could earn on a highly rated bond or loan. “It seemed like a win-win situation,” Donaldson later recalled. Just as Salomon Brothers’ early interest-rate swaps deal between IBM and the World Bank had met two sets of needs, the Exxon deal was brilliantly transferring risk in a way that suited both parties.

  For several weeks, Masters made endless phone calls to London from New York as she and Donaldson—together with a phalanx of lawyers—worked out legal terms for the deal. In most sectors of finance, well-established rules governed deals. But the credit derivatives concept was so new that they had to be crafted on the fly; Masters was making history as she went. Nobody quite knew what the fees paid to the EBRD should be or even quite what to call this “product.” Eventually though, the deal was done, and it was dubbed a “credit default swap,” which, as the business spread, was shortened to CDS.

  Hancock and the team were jubilant. The Exxon deal showed that a substantial credit derivatives contract could be made to work. And it was not the only one. As Masters was cutting her deal with the EBRD, Robert Reoch, a British banker who worked on Winters’s team in London, cut a deal with Citibank asset management that transferred the risk attached to Belgian, Italian, and Swedish government bonds. However, it was one thing for a bank to arrange a few isolated deals; it was quite another to turn those deals into a full-blown business as lucrative as Hancock was aiming for. So, as 1995 got under way, the group went into overdrive to attack the key obstacles to making the concept fly on a large scale.

  One of those was convincing their internal commercial lending team, as well as regulators, that the concept was sound. This would open up a wide pool of loans on the bank’s books to use for making swaps. They also had to figure out a way to “industrialize” CDS deals, so that they could do many more of them much faster. One other key thing the team wanted to investigate was if, by removing the risk of its loans in this way, the bank would be allowed to lower its capital reserves. That was one of the most important potential payoffs, as a good deal of reserve cash would then be freed up for use in making profits. That was the dream: credit derivatives would allow J.P. Morgan—and in due course all other banks, too—to exquisitely fine-tune risk burdens, releasing banks from age-old constraints and freeing up vast amounts of capital, turbo-charging not only banking but the economy as a whole.

  Behind the scenes, Masters and Demchak started visiting US regulators. Two main institutions held responsibility for monitoring this activity: the US Federal Reserve, in New York and in Washington, and the Officer of the Comptroller of the Currency (OCC), in Washington. Neither of them had spent much time studying the idea of credit derivatives. After all, the concept had not even been invented when the Basel Accord, or any American financial rules, had been written. But that didn’t mean they wouldn’t weigh in with strict views if J.P. Morgan started doing lots of deals. Masters and Demchak posed the crucial question: if banks used credit derivatives to shift their default risk, would the regulators let them cut their capital reserves?

  The signs looked promising. At the start of the decade, regulators had grappled with the savings and loan disaster and had learned firsthand the dangers of banks concentrating loan risk, one of the big mistakes the S&Ls had made. Many regulators were consequently thrilled to learn that tools could be developed to disperse risk. Indeed, one senior American regulator was so enamored of the idea that when he heard about what Masters was doing, he telephoned her to learn more. “When I read the details, it seemed to me this was one of the best innovations I had ever seen. It was just a wonderful idea!” he later said.

  Sure enough, in August 1996, the Fed issued a statement suggesting that banks would be allowed to reduce capital reserves by using credit derivatives. Masters, Demchak, and Hancock were thrilled.

  Even as that battle was being waged, Demchak and others on the team threw themselves into an internal lobbying campaign to sell the concept to their colleagues, particularly the loan officers. In some respects, that proved harder than dealing with the regulators. During the late 1980s and early 1990s, the wild antics of the swaps team had provoked unease among the older members of the bank’s commercial lending arm. Those more traditional bankers now reacted with even more horror when Demchak declared he wanted to overhaul the way that commercial lending was done.

  To bolster his case, Demchak unveiled a flood of supportive data. It was drawn from a crucial new twist on the original VaR idea that Weatherstone had developed. During the early 1990s, the quantitative experts inside J.P. Morgan had refined their tools. The first version of VaR was concerned primarily with measuring market risk. However, by the mid-1990s, J.P. Morgan analysts were using similar ideas to analyze the risk of untraded loans, too, and then compare those numbers to the risks attached to bonds and other assets. The basic idea was to look at all the assets that a bank held on its books and work out which parts of the bank were producing good returns, relative to the risks—and which were not. The implications of this analysis looked alarming. By 1995 it seemed four fifths of the bank’s capital was tied up in activities that typically earned less than 10 basis points of return for the bank each year, meaning just 0.1 cent for each dollar used. Areas of the business that generated much higher profits, such as derivatives, were often short of capital. The bank’s capital simply wasn’t being used as profitably as it should be, let alone in a manner that would enable the bank to hit a self-imposed target of a 20 percent annual return on equity. “We have to change the way we do business!” Hancock declared over and over again, convinced that if the bank didn’t make this change, it faced a slow death.

  The harder Demchak and Hancock pressed the case for reform, though, the more recalcitrant some of the commercial loan officers became. They had spent their careers evaluating loan risks, and they still highly valued the merits of relying on relationships with firms and reputations, in addition to the math Demchak was relying on to produce his data. Demchak’s fervor didn’t help. Though he was most often easygoing, he found it hard to suffer fools. The more they refuted his arguments, the more biting Demchak’s comments became. “These guys are dinosaurs!” he wailed to his team in fury. The loan officers retaliated by dubbing Demchak “The Prince of Darkness,” because he seemed so intent on launching otherworldly schemes. Hancock was considered the king of these dark plans.

  For months, they were at an impasse. Finally, in July 1997, an unexpected twist broke the deadlock. In the middle of that year, a financial crisis erupted in Asia, and the commercial lending group suffered painful losses on loans across the region. That raised the pressure on the bank’s new CEO, Douglas A. “Sandy” Warner, who had replaced Weatherstone in 1995, to take some decisive action to improve the bank’s profits. It was becoming increasingly clear—just as Hancock and Demchak had long complained—that the bank’s level of profitability was lagging behind its rivals’, and these losses were a body blow. Warner decided to throw his weight behind the value of credit derivatives business.

  He gave Hancock responsibility for managing not just the fixed-income business, but the commercial lending de
partment, too. That was a radical move for staid J.P. Morgan, since almost no other Western bank had ever tried to combine lending, bonds, and derivatives into a single group before. Then Hancock handed responsibility for managing the loan book to Demchak. The Prince of Darkness was now in charge and able to remold the bank’s credit risk in line with all his dreams.

  However, one more obstacle still stood in the way of the team unleashing its revolution, and it was a daunting one. They still had to find a way to process a high volume of deals rapidly; to industrialize the CDS trade, transforming it from a cottage industry into a mass-production business.

  The crucial, last piece of the puzzle that fell into place went by the strange name “BISTRO” (although bankers would later give the idea an even stranger tag, “synthetic collateralized debt obligations”). This brainchild emerged from months of heated debate and experimentation. By the mid-1990s, Hancock’s group had two views of how to make credit derivatives work large-scale. In London, Bill Winters was inclined to try to create what bankers call a “liquid market” in credit derivatives. That would entail finding a way to make credit derivatives as easy for clients and investors to buy and sell as stocks, and might even require setting up an exchange. “Pile ’em high and sell ’em cheap!” Tim Frost, one of the young traders in Winters’s group, sometimes quipped. He was utterly convinced that a mass-market approach could be found for derivatives. He also had the “can do” spirit to drive that dream.

  Demchak’s team in New York, however, preferred to focus on a different idea for turbo-charging the market. That was, essentially, to bundle lots of deals together, pooling all of their risk, and then to create derivatives carved out of that whole pool, rather than swapping loan by loan.