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

  More than a billion dollars! Masters was startled and baffled. She knew that it would not be easy to placate equity investors in the bank’s stock if they saw that. The year 2005 had been another record year for the banking world, with the largest investment banks collectively raising their revenues by 31 percent to $289 billion. In that time, however, JPMorgan Chase had produced only a modest rise. So what should the bank do? Was it time for the bank to revisit, once again, getting into the mortgage CDO and CDS game?

  Once again, Winters asked his team to see if they could work out a way to make mortgage-linked CDOs pay, and Black did the same in New York. The message came back the same: there was no sensible way to get rid of super-senior risk. In fact, the problem of super-senior was getting more challenging by the day. As the CDO machine boomed in 2006, it was creating such an extraordinary demand for mortgage and corporate loans that the percentages banks could earn from those loans were falling still further. “This business just does not make sense,” Winters told his colleagues.

  To Winters’s relief, Dimon backed him up. Dimon was a man with a ferocious grip on detail, but he was also willing to delegate decisions to men who could present arguments he respected. “On CDO of ABS, the reason we didn’t get in was due to the basic risk discipline of Winters and Black—they looked at it and just could not work out how to make the business profitable enough for the risks,” Dimon recalled. In addition, Dimon had the supreme self-confidence to take on analysts and consultants. Irrespective of whether investors were criticizing his strategy, he was not going to turn J.P. Morgan into a pale version of Goldman Sachs, he told his colleagues. “One of the problems of being a CEO is the constant pressure on you to grow, grow, and grow. It is there the whole time,” Dimon recalled. “But if you are in the risk business, you can get into terrible trouble if you just keep growing. As Warren Buffett said, sometimes the best thing you can do is just go to the golf course and do absolutely nothing for a bit.”

  Winters and Black duly sat on their hands. Yet they were each haunted by frustration. So was Masters. She had always prided herself on being a detail-orientated manager: when she ran a business, she liked to know every wrinkle about how it worked, to check it was done right. Back in the 1990s, that trait had prompted some colleagues to brand her a “control freak.” By 2006, most of those colleagues said that her style had mellowed. Like Demchak and others, she had learned lessons with the passage of time. At the age of thirty-six, she no longer acted as if she needed to win every fight; she had learned to dance flexibly around issues with maturity and a droll sense of humor. Some of her friends suspected the change also reflected a new sense of peace in her personal life. In the late 1990s she had gone through a divorce (like several others on the J.P. Morgan team). She had subsequently remarried, though, and by 2006 she was spending weekends with her new family on a horse farm she had acquired close to New York.

  She had also become a beacon for other women at J.P. Morgan. By 2006 there were still precious few senior female executives on Wall Street, let alone with a teenage child. Masters felt almost as evangelical about promoting diversity as about propagating the derivatives creed. “In the world I operate in, I stand out for being a woman,” she admitted to womenworking2000.com, an online specialist publication. “I believe that a lot of the onus falls on people like myself to help get women into top positions—finding a mentor in her field is one of the most valuable things any young woman can do,” she added, noting that she always advised other women to “take yourself out of your comfort zone…women have to be more assertive than men are accustomed to them being!”

  Masters hated leaving a mystery unsolved. She could understand why J.P. Morgan was lagging in commodities and equities. Her failure to work out why the bank was falling behind in the credit world, though, felt like a personal blow. A decade earlier, she had helped to create the CDO business, and she had watched with pride as it so rapidly took off. Now it seemed to have mutated into a phenomenon she could no longer understand. “How are the other banks doing it? How are they making so much money?” she asked herself over and over again. She could not work it out.

  Like Winters, she was so steeped in the ways of J.P. Morgan that it never occured to her that the other banks might simply ignore all the risk controls J.P. Morgan had adhered to. That they might do so was simply outside her cognitive map, as was also true for Winters. “Am I proud of this [failure to guess]? No! Perhaps we should have realized what was going on,” Winters would later say, in a defensive tone. “Maybe it seems hard to believe, but we didn’t really understand. Or not until the very end, and by then it was all too late.”

  [ TEN ]

  TREMORS

  In October 2006, Bill King, the man Jamie Dimon had charged with working out J.P. Morgan’s mortgage pipeline, traveled to Rwanda to participate in a project to help local coffee farmers develop their businesses. One day, after visiting the coffee plantations, he returned to his hotel to discover that Jamie Dimon was on the other end of a crackling phone line. “Billy, I really want you to watch out for subprime,” Dimon said. “We need to sell a lot of our positions. I’ve seen it before. This stuff could go up in smoke!”

  King was not particularly surprised by the intervention. After all, Dimon was a hands-on manager with strong knowledge of the market, who had no qualms about disturbing his employees’ holidays if he considered a matter urgent. And by the autumn of 2006, Dimon thought the housing sector was becoming just that.

  In the spring of 2006, national house prices had started to slide. “A housing crisis approaches,” a column in Barron’s magazine boldly declared by August, pointing out that the median price of new homes had dropped almost 3 percent in the previous eight months, while sales of new homes had fallen 10 percent, leaving new home inventories at record levels. “The national median price of housing will probably fall by close to 30 percent in the next three years [based on] simple reversion to the mean,” it added, meaning that the fast-rising home prices of the past few years were the result of a bubble. The predictions of doom were derided by the housing and mortgage industry, with David Lereah, chief economist of the National Association of Realtors, declaring that a “soft landing” for the market was in sight. Home builders, though, started to slash their forecasts. “Builders that built speculative homes are trying to move them by offering large incentives and discounts, and some anxious buyers are canceling contracts for homes already being built,” observed Robert Toll, CEO of luxury home builder Toll Brothers, after its stock crashed 50 percent for the year by August. Forbes magazine tartly observed: “When even Toll Brothers, the high-end builder, suffers cancelations, you know the real estate boom is over.”

  On October 6, home builder Kara Homes, known for their construction of “McMansions,” filed for bankruptcy protection, less than a month after reporting that the company had enjoyed the “two most profitable quarters in the history of our company.” The delinquency rate on subprime mortgages rose from 12 percent to 14 percent.

  Troublesome as they were, these signs of housing strain did nothing to stop the mortgage-based CDO machine. Between October and December 2006 alone, banks issued a record $130 billion worth of CDOs, double the level a year before, and 40 percent of those were created from asset-backed securities consisting primarily of subprime mortgages. That brought the total sales of cash CDOs to $470 billion for the year. Issuance of derivatives-based CDOs was even higher. One particularly fast area of growth was so-called mezzanine structured finance CDOs, or instruments created from the riskiest pieces of risky ABS. Some $32.5 billion of those were sold in 2006, four times as much as in 2005. Meanwhile, most Wall Street banks were so intent on continuing to grow the business that in the summer and autumn of 2006, Merrill Lynch, Morgan Stanley, and Bear Stearns each acquired stakes in midsize mortgage lenders.

  By stark contrast, Jamie Dimon was seriously worried. As the winter of 2006 loomed, Dimon held a series of meetings to discuss the mortgage outlook. Should JPMorgan Chas
e stop mortgage lending? Should the bankers try to hedge it even more? Or was it time to be more aggressive and actively bet on a housing crash—as some hedge funds were doing? The brainstorming was intense and continued for weeks. Dimon was reluctant to slash mortgage activity too violently, given that the US retail lending market was a key part of JPMorgan Chase’s business franchise and one that Dimon himself had previously targeted for growth. Nor was he keen to make an overt punt that the housing boom was about to crash.

  Over at Deutsche Bank, a group of traders were already taking that tack. As far back as October 2005, Karen Weaver, an analyst on Deutsche’s New York team, wrote a hard-hitting report warning of a future mortgage crunch. After that, Greg Lippman, head of the mortgage trading desk, started betting a crash would occur by purchasing ABX contracts that bet on a downturn. Those produced a loss in early 2006 because CDOs were still booming, but Lippman was so convinced that a crash loomed in 2007 that the Deutsche Bank team nevertheless boldly increased its trading bet.

  Goldman Sachs was also rolling the dice. During 2005 and most of 2006, the bank had adopted a bullish trading stance towards the mortgage world, believing the house bubble had further to run. At the end of 2006, though, managers decided that conditions were changing. In one of the big, bold gambits that had made the brokerage so famous, the Goldman traders sold their mortgage positions, sometimes at a loss, and then adopted a bearish stance, using large quantities of the company’s own money to benefit from a crash. “We could tell that the markets were getting overheated, so we took a position in the ABX and other ways,” one senior Goldman trader recalled.

  Some of the senior J.P. Morgan managers thought their bank should do the same. In December, Ownit and Sebring, two mortgage brokerages, collapsed, suggesting that housing conditions were turning worse. Even so, Dimon was still reluctant to make aggressive trading bets. That flew in the face of J.P. Morgan tradition and style. “We are not Goldman Sachs,” he told his staff. So the bank concentrated on less dramatic ways of protecting itself. For the second time, Chase Home Finance was told to raise its underwriting standards and to sell its mortgages on as fast as it could. The investment bank was also told to keep purchasing CDS contracts to gain protection against mortgage defaults.

  By early 2007, the cost of buying that protection was starting to rise, as more and more bad housing news tumbled out. In late February, HSBC, the British bank, admitted that mortgage defaults were rising sharply at Household Finance, a Charlotte-based subprime lender it owned. Chillingly, the bank revealed that the behavior of these defaults was defying the bank’s economic models. New Century Financial, another housing lender, issued a similar statement. By late February it had become quite expensive to buy protection against default risk on the BBB portions of CDOs—so costly, in fact, that the price of insurance made sense only if you believed those mortgage bonds were worth just 70 cents on the dollar.

  Yet even amid the unease, the J.P. Morgan bankers continued to find players willing to write those insurance contracts. “There were plenty of people on the other side of the trade, which made it easier for us,” Winters later recalled. Some banks were convinced that the decline in valuations on the ABX was extreme, and they figured they could make an easy profit by selling protection that they wouldn’t ever have to pass on. Analysts at Bear Stearns claimed that the “true” price of BBB tranches should be 90 cents on the dollar, not 70 cents as they were trading on the ABX. “It’s time to buy the index,” Gyan Sinha, Bear Stearns’s respected mortgage analyst, said. “The market has overreacted.” Other institutions continued to write protection against mortgage default because there was so much momentum behind the CDO machine that it had almost left them on “autopilot.” They had to keep finding CDS contracts to create CDOs, to keep their investors happy and keep earning fees.

  One of the banks that remained bullish about the market was Merrill Lynch. As spring approached, it kept frenetically creating CDOs, in fact, at an accelerating pace. Though the J.P. Morgan bankers were relieved that others were willing to sell them default protection, they were also rather baffled. Did Merrill Lynch, they wondered, know something that they did not? Was it trying to prop up the market? From the outside, Merrill appeared to be on quite a roll. Its 2006 results were the best it had ever produced, with net earnings running at $7.5 billion, up a staggering 49 percent for the year. Meanwhile, the senior management appeared to be in a cautiously upbeat mood. “Investment banks have had no choice but to build their risk-taking capabilities,” Dow Kim, cohead of global and the man behind much of the broker’s CDO boom, told a specialist publication in early 2007. “Clients want more liquidity and capital from their sell-side providers and that trend will continue. We have been very disciplined and have ramped up only in line with our overall growth. We are responding to the new business environment, but we have picked our spots—and a lot of our risk emanates directly from our client business.”

  Merrill’s upbeat tone was echoed by many across the market. When Boston Consulting Group published its regular capital-markets report on 2006, it noted that investment bank revenues overall had surged by 33 percent to $289 billion, while profits had jumped 38 percent to $90 billion. The report did not point out that those heady profits had been achieved only by the banks’ leveraging their assets to unprecedented degrees. In 2001, Merrill Lynch’s leverage ratio had stood at just 16 times. By 2007, it was 32 times. The ratio at Goldman Sachs stood at 25, Morgan Stanley at 33, Bear Stearns at 33, and Lehman Brothers at 29—all of which were sharply higher, too. However, in the new twenty-first-century finance, very few analysts bothered to pay any attention to these numbers. They were fixated on the data about revenues and profits. “The outlook for 2007 is positive…due to favorable economic and market conditions,” Boston Consulting Group declared, echoing the consensus view. It predicted that investment bank revenues would hit $335 billion in 2007, yet another sharp increase.

  By the late spring of 2007, Winters and Black were becoming increasingly worried. Their unease revolved about far more than the mortgage world. In the first six years of the decade, the business of repackaging corporate loans and derivatives had also boomed. In 2006 alone, bankers sold $105.8 billion in CDOs made out of risky corporate loans, double the previous year and seven times the volume at the start of the decade. They also sold $35.6 billion in CDOs built from corporate credit derivatives, ten times the amount sold in 2001. That had prompted manic demand for the raw material needed to build these CDOs, namely loans, bonds, and derivatives. As a result, the borrowing costs for companies were tumbling to record lows.

  Mainstream companies generally did not respond to the cheap finance by loading up their balance sheets with debt. Memories were too fresh of what had happened in the internet bubble, when companies had collapsed under their debt burdens. Private equity companies, though, had no qualms about grabbing every cheap debt deal on offer. They were like the corporate equivalent of subprime mortgage borrowers. Buyout groups needed debt to fund their acquisitions and had every incentive to raise as much finance as they could as cheaply as possible. Bankers were only too keen to arrange for that, since doing so provided the perfect raw material out of which they could build corporate CDOs.

  By the spring of 2007, the leveraged finance party had become so intense that buyout groups were being offered finance on terms that seemed ridiculously lax. Not only were interest rates ultralow, but bankers were also loosening the legal covenants for these deals, giving borrowers an even more generous ride. Like mortgage borrowers, buyout groups gleefully refinanced to cut their borrowing costs. They also loaded up with debt to pay themselves fat bonuses. Unsurprisingly, the buyout deals got bigger, too. In 2006, there were $753 billion in leveraged buyouts, half of which were conducted in the United States, seven times the level seen four years before. The mania was so intense that a host of giant corporations were gobbled up, including Equity Office Properties, Alliance Boots, TXU, and HCA (Hospital Corporation of America).

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bsp; That trend left J.P. Morgan in a fix. It did not want to turn its back on the corporate lending world, which was supposed to be its core franchise. Many of the largest private equity groups were long-standing clients of J.P. Morgan, and Winters and Black didn’t want them going elsewhere. They also knew that rivals were more than ready to grab any business they could. Over at Citigroup, CEO Chuck Prince was flamboyant about his eagerness to extend leveraged loans. “As long as the music is still playing, we are still dancing—and the music is still playing,” he told the Financial Times in the summer.

  Yet Winters and Black feared that sooner or later some of the buyout groups would end up defaulting on their deals. If that occurred while the debt was still on J.P. Morgan’s books, in the process of being repackaged, it would leave the bank at risk. That “warehouse” period typically lasted for several weeks, at least. Dimon was also concerned. So, as with mortgages, they embarked on an initiative to trim risk. They did not clamp down on corporate lending altogether. When the total volume of the bank’s leveraged loan deals hit $27 billion in the late spring, though, they ordered their desks to start raising underwriting standards. Then they turned down a few deals, even ones involving powerful private equity firms. A deal to finance a leveraged buyout of Boots, a UK retail store, was nodded through; so was one involving TXU. Deals to finance the buyout of First Data and Archstone, though, were rejected. “We took ourselves out of five of the ten big private equity deals that spring,” Black later said. “But that means we were in five of those deals, which we regret.”