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 subsequent months, Duhon heard on the grapevine that other banks were starting to do CDS deals with mortgage debt, and she wondered how the other banks had coped with the data uncertainties that so worried her and Varikooty. Had they found a better way to track the correlation issue? Did they have more experience with dealing with mortgages? She had no way of finding out. Because the CDS market was unregulated, the details of deals weren’t available, and she had no good intel sources at the other banks. Like most of those working on Demchak’s team, she had spent her entire career at J.P. Morgan.

  The team did only one more BISTRO deal with mortgage debt, a few months later, worth $10 billion. Then it dropped the line of development altogether. Years later, Duhon was stunned when she learned of the staggering volume of mortgage-based CDS deals the rest of the banking world had gone on to do.

  Five years after the Boca Raton event, the J.P. Morgan derivatives team hosted a conference for its clients, at Wall Street’s Cipriani ballroom. The venue was one of the most prestigious and elegant in the financial district, a cavernous room with a classical domed ceiling, glittering chandeliers, and a marble floor the size of several tennis courts. Before the event, some of the J.P. Morgan team had worried whether they could attract enough clients to fill the grand space. Blythe Masters was determined, however, to bring in a good crowd. Soon after joining Demchak’s team, she had persuaded the group to start pooling details about all their potential customers, and she had created a list jokingly referred to as “MOAD”—as in the “Mother of All Databases”—which she and her colleagues now tirelessly worked. So many clients responded that the event was standing room only.

  By October 1999, the official volume of credit derivatives deals in the market was estimated at $229 billion, six times the level just two years earlier. J.P. Morgan alone accounted for almost half of the total. The bank had not just kick-started the business; it virtually was the market. The J.P. Morgan clients, investors, and rivals packed into the Cipriani ballroom that day were eager to find out what the young derivatives Turks were planning next.

  As the audience filed into the Cipriani, they were given a hefty, seventy-three-page tome decorated with a blurred picture of orange and white squares on a black background, not unlike a piece of artwork by Mark Rothko. Next to that was the title The J.P. Morgan Guide to Credit Derivatives, and inside the book, which Demchak’s team sometimes referred to, with only a faint sense of irony, as the “bible,” pages of dense text set out in exhaustive detail exactly how credit derivatives worked and the rationale behind their creation. “Until recently, credit remained the major component of business risk for which no tailored risk-management products existed,” the book solemnly declared. But now, it added, there was banking salvation. “By separating specific aspects of credit risk from other risks,” it continued, “credit derivatives allow even the most illiquid credit exposures to be transferred to the most efficient holders of that risk.”

  Later sections of the book explained in exhaustive detail how the risk attached to credit derivatives could be calculated and the approach that regulators and lawyers typically adopted when evaluating these instruments. It also described how J.P. Morgan’s VaR risk assessment models worked. By the end of 1999, the bank had handed out 15,000 copies of those models to clients, for free. From some perspectives, distributing research tools in this manner did not make much business sense. Rivals laughed that once again it was a sign of just how uncommercial J.P. Morgan could sometimes be. But Hancock and his colleagues reckoned there was a bigger game to be played. If they could convert everyone else to adopt the same quantitative creed, they might adopt the derivatives gospel, too—or so the hope went.

  There were two issues the “bible” notably did not discuss in any detail. One was the headaches posed by super-senior risk. The only reference to that occurred toward the back of the book, in a turgid paragraph that essentially stated that super-senior was so exceedingly safe that it could be held on a bank’s balance sheet with just a tiny sliver of reserves. Of course, J.P. Morgan itself had decided to offload its own mountain of super-senior risk to insurers such as AIG. But the team made no mention of that in the bible. No mention was made, either, of the team’s unease about making BISTRO deals out of mortgage debt.

  On that glorious, triumphant day in the Cipriani, the team saw no reason to trumpet caution. As far as they were concerned, BISTRO-style CDS was a wonderful invention, which had not just turbo-charged their careers but was also liberating the banking system from age-old constraints. Only many years later would they come to realize that the BISTRO creation would evolve to produce some very perverted offspring.

  [ FIVE ]

  MERGER MANIA

  By late 1999, the J.P. Morgan derivatives team was hardly alone in believing credit derivatives were key to building a brave new banking world, but the role it would play was eclipsed for many years by other forces at work. As the advent of the twenty-first century loomed, the wider financial and corporate world was in a state of ferment. The internet inaugurated a technological revolution that was producing transformations in business and the global economy as profound as the discovery of electricity or building of the railroads. At a stroke, investors and businesses all over the world could find new trading partners and tap into once-remote pools of capital, and competition became ever more intense. At the same time, free-market ideology was winning minds over more and more of the globe. Innovation, competition, efficiency, and deregulation were the rage, not just in finance but in other spheres, too. Pundits, politicians, bankers, and bureaucrats alike argued that globalization was inevitable and to be embraced, the product of the increasingly unfettered forces of a new and improved capitalism.

  The dot-com bubble blew up to staggering proportions as it became fashionable to believe that the internet was rewriting the fundamentals of business and a mantra of “growth over profits” took hold. Start-ups spent astonishing amounts of venture capital in the quest to “get large or get lost.”

  In the mid-1990s, the tech-heavy NASDAQ was trading around 800. On March 10, 2000, it hit a peak of 5,048.62. That same month Cisco, the manufacturer of so much internet-related technology, briefly became the most valuable company in the world, with a $500 billion market capitalization. Such technology-driven euphoria had not been seen since the railroad boom of the 1840s or the automobile boom of the 1920s.

  Accompanying the globalization boom was regulatory change. The walls erected to separate spheres of banking started to crumble. J.P. Morgan’s Dennis Weatherstone was a leading advocate of the loosening. In 1989, he had persuaded the US government to let J.P. Morgan enter bond underwriting, one of the mainstays of investment banking, and one year later the bank was allowed to begin underwriting equities, too. Pressure built for other banks to break through these barriers, and a wave of consolidation in the banking world was unleashed in both the US and Europe. Sandy Weill, the freewheeling financier, embarked on a bold plan to merge Citibank with financial services powerhouse Travelers Group, which had previously bought the hard-charging brokerage Salomon Brothers, to create a financial behemoth called Citigroup. The brokerage Morgan Stanley acquired Dean Witter, creating a merged retail and institutional securities giant. By the late 1990s, the last remaining pieces of the Glass-Steagall Act looked like quaint relics, and Wall Street successfully lobbied for their final demise. On November 12, 1999, President Bill Clinton signed a bill repealing the last of the Depression-era rules.

  The repeal of Glass-Steagall legitimized the concept of combining commercial and investment banking to construct “one-stop shopping” empires, and many more mergers quickly followed, not just across different sectors of finance but across national borders, too. The formerly stodgy German commercial lender Deutsche Bank announced that it was purchasing the freewheeling Bankers Trust. Deutsche also hired a large chunk of Merrill Lynch’s former trading group, tasking them with creating a derivatives business. Credit Suisse, the once-dull Swiss group, grabbed DLJ,
another American broker. The industry was rapidly adjusting to a new reality that banks needed to be big and offer a full range of services in order to compete at all.

  As institutions merged, financial activity broke through long-standing barriers. The art of trading corporate bonds had always been siloed off from the business of extending loans and underwriting equities. Now investors began hopping across assets classes, not to mention national borders, with abandon. Aggressive and high-risk hedge funds exploded onto the scene, some growing so large that they were competing in earnest with the new banking behemoths. The financial world was becoming “flat,” morphing into one seething, interlinked arena for increasingly free and fierce competition.

  Those playing in this twenty-first-century domain of unfettered cyberfinance knew these changes carried risks. The fate of hedge fund maverick Long-Term Capital Management was a deeply troubling cautionary tale. LTCM, which had been created in 1994, epitomized the new era of finance. It was run by a group of academics and traders who ardently believed in libertarian economics and who were dedicated to the cause of using computing power and mathematical skills to hunt for trading opportunities all over the world. Robert Merton, a Nobel laureate and one of the partners in LTCM, was a friend of Peter Hancock, and he—like the J.P. Morgan team—passionately believed in the liberating power of derivatives. LTCM grew to a staggering size and earned astonishing returns by using computing power to make big-ticket bets on spreads in the pricing of assets in all corners of the global markets. But the fund spectacularly imploded when the global markets experienced an intense panic following a financial crisis in Russia in 1998. Ironically, a key reason for this panic was that computer models had made markets and investors so closely integrated that they were behaving in a manner not factored into the hedge fund’s models. The saga was a stark reminder that innovation can carry with it nasty revenge effects.

  As spectacular as LTCM’s collapse was, it put no brakes on the push for innovation. In 1999, the year after LTCM imploded, Jerry Corrigan, the former New York Fed governor, organized a group of senior Wall Street and European bankers to write a report on the lessons from the debacle. They concluded that banks needed to overhaul their dealings with hedge funds, keep much better control of their financial risks, report any large or concentrated exposure to clients, and pay more attention to the dangers posed by excessive leverage and debt. The study did not, however, suggest that the government should step in to curb or control the flurry of innovation and competition. Sentiment was still moving in entirely the opposite direction.

  Fed Chairman Alan Greenspan had long been a champion of free-market principles, and by 1999 he was a leading voice against regulation of the credit derivatives world. “By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives,” Greenspan declared in a March 1999 speech. He was speaking at a banking conference in Boca Raton, ironically—and perhaps appropriately—the very same hotel where the J.P. Morgan bankers had concocted the idea of making credit derivatives a viable business. “The fact that the OTC markets function quite effectively without the benefits of [CFTC regulation] provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives [than exists under the CFTC],” Greenspan continued. “These new financial instruments…enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it. This unbundling improves the ability of the market to engender a set of product and asset prices far more calibrated to the value preferences of consumers…and enables entrepreneurs to finely allocate real capital facilities to produce those goods and services most valued by consumers, a process that has undoubtedly improved national productivity growth and standards of living.” What that piece of central banking jargon essentially meant was that Greenspan believed derivatives were making markets more efficient.

  In the late 1990s officials at the Commodities Futures Trading Commission once again suggested that it might be a good idea for that body to exert its authority over the credit derivatives world. The idea was again quashed. In 2000, Washington lawmakers approved the Commodities Futures Modernization Act, which specifically stressed that “swaps” were not futures or securities, and thus could not be controlled by the CFTC, or the SEC, or any other single regulator. “Congress nailed the door shut in 2000 [on unified regulation], with the passage of the Commodities Futures Modernization Act,” observed ISDA lobbyist Mark Brickell. The derivatives sector was jubilant.

  Those were heady days in the banking world at large, but at J.P. Morgan, business had started lagging. The swaps group was booming, but other parts of the bank had failed to keep up with the ever-more-muscular competition. In the spring of 2000, the bank staged a meeting for all its managing directors in the Sheraton Hotel, just off New York’s Times Square. The meeting was billed as a chance for the senior and middle management to discuss the bank’s strategy for the future. Holding forums to air out issues was another tradition the bank prided itself on. At the start of the meeting the crowd was asked to vote anonymously, using handheld electronic devices—a nod to the computing revolution—on whether the bank was heading in the right direction. The results from the cyberpoll were grim: the vast majority were not happy with how the bank was doing and were unclear about what the future strategy was.

  As the pace of change had heated up in the prior years in the financial system generally, the senior managers at J.P. Morgan had found themselves dogged by a terrible, and bitter, irony. In some respects, the bank’s managers were thrilled by the wider revolution afoot in the financial world. Hancock and his acolytes had harnessed the power of computing to create their derivatives innovations. The bank had also lobbied for years to repeal the hated Glass-Steagall Act. But now J.P. Morgan was becoming as much a victim as a beneficiary of these changes. During the late 1990s, the internet boom delivered a stunning stream of revenues for Merrill Lynch, Morgan Stanley, Citigroup, Chase Manhattan, and other banks able to arrange initial public offerings for dot-com start-ups or trade shares. J.P. Morgan, though, had missed out on much of that boom. It was weak in the arena of equity market underwriting, and it had not thrown itself into financing risky start-ups, sticking with its tradition of providing funding to established blue-chip groups. In 1998, in a token effort to show it too was “cool” and could play the IT game, the management established a project dubbed “lab Morgan,” overseen by Nick Rohatyn, a rising J.P. Morgan banker (and the son of Felix Rohatyn, a prominent Wall Street financier). Housed in a loftlike office at the group’s headquarters on 60 Wall Street, with exposed brick walls and pipework, it was the bank’s attempt to show it could be hip and play in the world of cyberfinance. Investors were unimpressed.

  J.P. Morgan had also become dangerously small by comparison to the new breed of behemoths. By late 1999, Citigroup wielded $716 billion in assets. J.P. Morgan, with $260 billion, was a third the size. Sandy Warner, the new J.P. Morgan CEO, airily brushed aside comparisons. “I don’t think bigness is a strategy [for Morgan]. There needs to be a certain scale. Beyond that, the advantages are less compelling and can even be diminishing,” he had declared at the bank’s annual meeting the year Weill announced his Citigroup merger plans. Instead of aiming for size, J.P. Morgan management stated, it would focus on profitable “smart” niches. That strategy had its own rewards. During the 1980s and early 1990s, Dennis Weatherstone had battled to reshape the bank’s business away from commercial lending to investment banking, and by 1999 that had been implemented to an impressive degree. The so-called noninterest income part of the bank’s business, meaning activities outside lending, produced four fifths of the bank’s revenues, considerably more than at any other large American commercial bank. More striking still, the bank was starting to feature in industry league tables tracking the investment banking world. It tended to rank around number six in terms of merger and acquisitions business; in American bond underwriting, i
t was in the top three; in derivatives, it was usually at or near the top.

  However, J.P. Morgan’s problem was that the world around it was moving faster. As the Wall Street Journal had observed in 1998, “From a standing start in 1980, Morgan is now on the cusp of the bulge bracket of the world’s six top investment banks…increasingly, however, the biggest profits aren’t going to a bulge bracket of six banks but to a super-bulge of three firms—Merrill Lynch, Morgan Stanley Dean Witter, and Goldman Sachs.” Worse, the type of investment banking business that J.P. Morgan was focusing on, with its heavy emphasis on derivatives, wasn’t producing the staggering profits being made from the internet boom.

  Between 1997 and 1999, the level of return on equity at J.P. Morgan rose from 13 percent to 17 percent, which should have been impressive. But that looked feeble compared to most of its peers. In 1999, the median ROE for the top one hundred banks was 18 percent, and Bank of New York had a ROE of 34 percent, while Chase Manhattan, Merrill Lynch, and Goldman Sachs all produced figures well over 20 percent. Investors took note. Between the start of 1997 and early 2000, the share price of Merrill Lynch and Citigroup roughly trebled. J.P. Morgan’s share price didn’t even double. “There just isn’t any sense that the management knows what it is doing anymore,” one managing director reflected as she sat in the Sheraton conference room.

  After the results of the poll were displayed, Peter Hancock leapt onto the stage. As CFO, it was his job to explain the management strategy, and with his trademark intensity, he attempted to reassure the audience. Outside the halls of J.P. Morgan, speculation was rife that the bank would soon be forced into a merger, as so many of its rivals had been. The J.P. Morgan management was resisting strongly, and Hancock sketched out its alternative vision for revitalizing the bank, maintaining its hallowed role as an independent player. Morgan would continue harnessing the power of financial innovation, such as derivatives, to make itself into a sharp, focused investment bank that could continually serve its clients with new products.