Feldstein was convinced that the models banks and funds used were miscalculating the true degree of default correlation in loan bundles, and he was convinced that eventually economic reality would hit. The true risk of the CDOs would then become clear, and prices would drop. “The models are great, but at the end of the day, in credit, anyone relying solely on them will lose,” Feldstein explained soon after he created his fund. “Those who are successful know this and overlay their own idiosyncratic views about risk, actual correlation among and between groups of credits, and other factors on any model they use.”
Ironically, however, such hedging on the market only further fueled the boom. After all, for every buyer in a market there must be a seller; a market in any commodity—be it equities, art, or synthetic CDOs—can operate only if there are parties on both sides of the trade. Feldstein and some others putting their money on the contrarian view helped to make a lively new business of trading in default swaps take off.
By 2005 there were more tools available to conduct such trading, too. In the early years, bankers who wanted to trade credit default swaps generally used only contracts that related to single names. From 2004 onward, though, indices of credit default swaps sprang up, known as “CDX” in the US and “iTraxx” in Europe. They tracked the cost of insuring against default on a basket of companies, offering a handy way for investors to evaluate trends in pricing, in the same way that the S&P 500 shows how the whole equity market is moving. They could also be traded as contracts in their own right.
The ABX index, which tracked the price of derivatives written against risky home equity loans, provided another way for investors to trade, after its launch in January 2006. Other mutations proliferated, too. The LCDX was an index of loan derivatives; the TABX tracked derivatives on mortgage tranches; CMBX was an index of derivatives on commercial mortgages. It was a veritable alphabet soup.
By 2006, bankers and investors were using all of these indices to trade as if their flashy computing models were infallible. Feldstein and his colleagues at BlueMountain just did not believe that they had assessed the true risks. To make the point, he and his colleagues placed an old-fashioned abacus in their office and labeled it “correlation calculator” as a black joke.
They also constructed an investment strategy to take advantage of the shortcomings of the banks’ models. To do this, they quietly constructed CDS portfolios that they traded with different investment banks and then used detective work to guess how each bank was modeling CDO risk. Then, like hackers tapping into a computer, they hunted for the flaws in those models, which they could exploit. It was not hard to find such weaknesses, since the models varied, sometimes in a haphazard manner. Sometimes the banks’ traders guessed what the geeks at BlueMountain were doing. They rarely complained, though. Individual bank traders did not usually have any personal incentive to worry about whether Feldstein was exploiting their models or not. They got paid according to their trading results, as measured by the internal models at the banks—and as long as those internal models produced flattering prices, those traders got fat bonuses.
In any case, few managers sitting at the top of the investment banks had much idea what their traders were doing, let alone whether or not the models were accurate. By 2005, very few men running investment banks had extensive experience in structuring and trading derivatives. The field was just too young to have produced many high-level leaders, and many derivatives experts were too cerebral to play the type of internal corporate political games needed to rise to the top at most banks. Bankers who had started their careers as corporate advisers or salesmen tended to be better at charming their superiors. One exception was Lloyd Blankfein, the CEO of Goldman Sachs; Anshu Jain, the co-CEO of Deutsche’s investment bank, was another. But Citigroup, Merrill Lynch, UBS, and numerous others were run by former bond and equity salesmen, lawyers, wealth managers, and commercial bankers. Such men had little instinctive interest in the technical details of managing risk. Moreover, the wider competitive climate provided an overwhelming incentive for them to focus on revenues above all else. If they didn’t deliver higher revenues, their company’s stock prices would be pummeled. “Banks now face the challenging task of sustaining their success in creating value,” Boston Consulting Group opined in a report on the industry’s performance. “Continuing to increase profitability remains important but becomes more and more difficult as profitability has already reached a new level.”
The antics of Goldman Sachs had a particularly significant impact on the psychology of many senior bankers. In 2002 and 2003, Goldman Sachs startled its rivals by delivering a hefty increase in profits. In 2004 that winning streak intensified when the brokerage raised its revenues by a third, to more than $16 billion—or more than any other player. That cranked up the pressure on other banks to deliver equally impressive growth. “We all got Goldman envy—it became like an obsession,” one European bank CEO later recalled.
So, as “Goldman envy” had spread, rivals had frantically embraced ideas for boosting profits that in retrospect would look like lunacy. What was worse, many even stepped up their sales of mortgage-based products after the housing market had begun to turn. Merrill Lynch, the home of the “thundering herd” of skilled salesmen in the equities world, was one such.
Back in 2003, the bank had appointed a new chief executive officer, Stanley O’Neal. He decided to bring Merrill into the securitization business with a vengeance, hiring teams of traders who were ordered to start cranking out masses of CDOs. By 2006, Merrill topped the league table in terms of underwriting CDOs, selling a total of $52 billion that year, up from $2 billion in 2001. (J.P. Morgan was in seventh place in 2006, selling a mere $22 billion.) The herd had crashed the party in style. But behind the scenes, Merrill was facing the same problem that worried Winters at J.P. Morgan: what to do with the super-senior debt?
Initially, Merrill solved the problem by buying insurance for its super-senior debt from AIG, just as Demchak’s team had done. However, in late 2005, AIG told Merrill it would no longer offer that service. One corner of the AIG empire was involved in extending mortgages, and AIG officials were getting alarmed about subprime risk. That left Merrill Lynch’s CDO desk with a big headache. But unlike at J.P. Morgan, that stumbling block was not enough to prompt Merrill Lynch to duck out of the game.
The CDO team decided to start keeping the risk on Merrill’s books, and a senior trader named Ranodeb Roy was appointed to manage it. As the super-senior quickly piled up, some of it was insured with monolines and some was buried on the books. Traders joked that if they could not protect themselves by handing the risk to a monoline, they would use the “Ronoline” instead. A few bank officials expressed unease. Jeffrey Kronthal, one senior manager, tried to impose a $3 billion to $4 billion limit on the amount of super-senior risk that the bank could take on. Also, in the summer of 2006, one trader protested when his colleagues created a $1.5 billion CDO deal called Octans and asked him to put almost $1 billion of that risk on the bank’s books. However, these protests were quickly squashed. The leaders of the CDO department—Harin de Silva and Osman Semerci—were determined to keep cutting deals. So was their boss, Dow Kim. In 2006, sales of the various CDO notes produced some $700 million worth of fees. Meanwhile, the retained super-senior rose by more than $5 billion each quarter.
Very few bankers inside Merrill Lynch had much idea what the CDO desk was doing. At Merrill, as with most Wall Street banks, departments competed viciously for resources and power, and the department that was most profitable usually had the most clout. As the CDO team posted more and more profits, it became increasingly difficult for other departments, or even the risk controllers, to interfere. O’Neal himself could have weighed in, but he was in no position to discuss the finer details of super-senior risk. The risk department did not even report directly to the board. O’Neal faced absolutely no regulatory pressure to manage the risk any better. Far from it. The main regulator of the brokerages was the SEC (Securities and
Exchange Commission), which had recently removed some of the old constraints.
Until 2004, the SEC had imposed controls on the amount of assets a brokerage could hold on its balance sheet relative to its core equity. In April of that year, however, the SEC’s five commissioners had decided—by a unanimous vote—to lift that so-called leverage ratio control. The ruling attracted almost no attention in the press at the time, since it seemed highly technical, but it had one very considerable consequence: it raised the competitive pressure on the brokerages even further. By 2005, it had become clear that a key reason why Goldman Sachs was producing such stellar earnings was that it had raised its leverage. Merrill Lynch and the others were therefore under intense pressure to follow suit, and, that being the case, the increased leverage of super-senior risk was tolerated.
The three other major brokerages—Bear Stearns, Morgan Stanley, and Lehman Brothers—also built up some super-senior exposure. Bear and Lehman had extensive experience in dealing with mortgage-backed bonds, and they prided themselves on running tight risk controls. As they each cranked up their CDO machines, they realized that super-senior risk was becoming like the toxic by-product of a chemical experiment or waste from a nuclear reactor. But they could find no good solution to the problem, and they weren’t willing to switch off their CDO machines.
Citigroup was also keen to continue to ramp up the output of its CDO machine, and as a commercial bank it had plentiful access to the “raw material” needed to create CDOs. Unlike the brokerages, though, Citi could not park unlimited quantities of super-senior on its balance sheet, since the US regulatory system did still impose a leverage limit on commercial banks; they were required to keep assets below twenty times the value of their equity. Citi decided to circumvent that rule by placing large volumes of its super-senior in an extensive network of SIVs and other off-balance-sheet vehicles that it created. The SIVs were not always eager to buy the risk, so Citi began throwing in a type of “buyback” sweetener: it promised that if the SIVs ever ran into problems with the super-senior notes, Citi itself would buy them back.
Citi’s CDO machine began running at such a frenetic speed that by 2007 it had extended such guarantees—which were internally nicknamed “liquidity puts”—on $25 billion of super-senior notes. It also held more than $10 billion of the notes on its own books. Almost none of the senior Citi managers knew about the liquidity puts, since Citi operated with a power structure that was even more fragmented and tribal than that at Merrill Lynch. And Chuck Prince, the CEO of Citi, was not a meddler, like Jamie Dimon. Prince had initially trained as a lawyer, and he delegated derivatives issues to others.
On the other side of the Atlantic, many banks were doing the same. The senior managers at Deutsche Bank, for the most part, did not let their traders put super-senior risk on the bank’s book. The German bank had a relatively tight system of internal controls and, just as Bill Winters had concluded, Anshu Jain, the cohead of the investment bank, considered that the paltry returns on super-senior simply didn’t compensate for the risks. However, other banks decided differently. The Royal Bank of Scotland aggressively grew its CDO business, and when some RBS employees expressed unease, they were naysayed. Early in the decade Ron den Braber, a statistical expert working in the CDO department, voiced worries that the bank’s models were significantly underpricing the risk attached to super-senior. He was subsequently encouraged to leave the bank. “I started saying things gently,” den Braber recalled, “in banks you don’t use the word ‘error,’ but what I was trying to say was important. The problem is that in banks, you have this kind of mentality, this groupthink, and people just keep going with what they know, and they don’t want to listen to bad news.”
Arguably, the most aggressive player of all in Europe was UBS. The Zurich-based group had built its business by acting as a dull but worthy commercial bank, with a formidable private banking franchise. However, during the 1990s merger craze the bank joined with Swiss Bank Corporation and PaineWebber, and it built an international capital markets operation. This was widely admired for its equity market skills, but UBS—like Merrill—did not have a good franchise handling debt. By 2004, Marcus Ospel, the CEO of UBS, was hungry for more. Even in Switzerland, “Goldman envy” was afoot. Like O’Neal at Merrill, Ospel was convinced that the fastest way for UBS to catch up was to expand its credit business. So the senior management took two striking steps.
First, they agreed to let a group of UBS’s powerful traders create an internal hedge fund, which would be run by John Costas, the former head of the investment bank of UBS. This started life in the summer of 2005, under the name of Dillon Read Capital Management. Second, in the autumn of 2005, the bank implemented a major review of its fixed-income business, hiring consultants from McKinsey and Oliver Wyman. On the advice of this review, the bank’s senior management decided to expand the securitization business.
On paper, UBS did not seem well placed to make the move. Though the bank’s asset management group had already been investing in American mortgage products for several years, it did not have its own mortgage-lending operation. To make matters worse, when Costas created the new hedge fund, he took 120 of the bank’s staff with him, including many of the firm’s fixed-income specialists. However, that did not deter UBS’s senior management. The bank hired new traders in London and New York and told them to build a CDO business as fast as possible. By late 2005, UBS was creeping up the securitization league tables.
When the super-senior problem reared its head, the bank first managed to sell the super-senior risk to outside investors. By the middle of the year, though, the bank had changed tack and was holding on to it instead. There was no regulatory constraint to doing that because the Swiss system that governed UBS followed the Basel Accord, and the Basel rules took a decidedly relaxed attitude towards assets with high credit ratings, such as super-senior risk. They stipulated that banks could use their own models to work out the risk and judge how much capital they needed to set aside.
The UBS risk department used the same fundamental system for modeling risk, based on the VaR and Gaussian copula techniques, that so many other banks had adopted, and its models implied that super-senior would never lose more than 2 percent of its value, even in a worst-case scenario. So the bank decided it needed to post only a sliver of capital. Then it went even further when its CDO traders stumbled on the realization that if they bought insurance from monolines against that 2 percent risk, the super-seniors became entirely risk-free. That effectively removed the need to post any capital at all. The bank could pile as much super-senior as it wanted onto its books, without constraint.
UBS also engaged in yet another means of squeezing more profit out of its CDO machine. The bank’s internal rules stipulated mark-to-market valuation, meaning that the value of assets held on the trading book had to be recorded at current “market” prices. It was still hard to get market prices for senior CDO notes, since they rarely traded, but what the CDO team started to do was to come up with estimates of what a CDO should be worth using their internal models. Then they would readjust those prices after a time, which, with the market still rising, invariably allowed them to report a profit. Those profits were small, but the overall CDO positions were so large that the money added up.
By 2007, the bank would be carrying $50 billion of super-senior assets on its books, most of which sat on the CDO trading desk. Occasionally, risk managers expressed surprise as the size of this mountain grew, but their concerns were dismissed. The conservative and bureaucratic UBS managers put great stock in the fact that the super-senior notes carried a triple-A tag. The result was that vast quantities of risk completely disappeared from the bank’s internal risk reports. “Frankly most of us had not even heard the word ‘super-senior’ until the summer of 2007,” recalled Peter Kurer, a member of UBS’s board. “We were just told by our risk people that these instruments are triple-A, like Treasury bonds. People did not ask too many questions.”
By mid-2
006, the pressure on Bill Winters’s team to make up ground on its rivals was intense. Each year, Oliver Wyman, a consultancy group, conducted an analysis of how all the banks were faring relative to each other. The consultancy would then release the results to the banks, in the hope that doing so would prompt them to buy Wyman’s services. J.P. Morgan did not usually succumb to that marketing pitch. When Dimon took over the bank, he had made it clear that he hated the idea of taking advice from management consultants. “Those consultants are a crock of shit!” he sometimes told his staff. To his mind, if a banker needed to take advice from consultants, then that banker was not doing his or her job.
However, the top managers at J.P. Morgan found that the reports often provided useful comparative intelligence. Blythe Masters had particular reason to pay attention to what Oliver Wyman said. By that stage, Masters had moved a long way from the credit derivatives team. After the JPMorgan Chase merger, she had been one of the few members of that group who had the patience and political skills to survive the infighting. She rocketed up the corporate hierarchy, being appointed chief financial officer of the investment bank in 2005, at the age of just thirty-four. It was a striking achievement, making her one of the most senior women on Wall Street. By 2005, some of her colleagues were whispering that Masters might possibly be heading for the very top.
As CFO, Masters was responsible for tracking how J.P. Morgan was faring relative to rivals and presenting that to outside analysts. So in the spring of 2006, she met with Nick Studer, one of the consultants at Oliver Wyman, to discuss Wyman’s “gap analysis” on how JPMorgan Chase had fared in 2005. This report essentially asked a clutch of banks to submit data on how their different divisions were performing, which the consultants then used to calculate how the banks looked relative to each other (on an anonymous basis). The 2005 scorecard made dismal reading for JPMorgan Chase. The bank was performing well in some areas, such as foreign exchange or interest-rate derivatives. However, in securitization, the bank’s underperformance was getting worse. Equities and commodities were weak, too. As a result, the total revenue gap between JPMorgan Chase’s investment bank and that of its rivals had surged to around $1.5 billion.
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 Page 16