It was probably inevitable that FP would one day get into credit derivatives. Part of its self-image, after all, came from its willingness to find the bleeding edge of the derivatives business, and get there before everyone else. By the late 1990s, nothing was more bleeding edge than credit derivatives.
In another sense, though, there was nothing inevitable about it at all. Savage, like Sosin, was a firm believer in having a deep, ongoing understanding of the risks FP took. It was a point of pride among FP’s executives that although they were derivatives traders, they were unusually careful ones. The problem for AIG when it began building deals around credit default swaps was that the risk models they used seemed to suggest that they came with virtually no risk at all. Which ultimately caused FP to let down its guard. The traders and executives didn’t do the constant calibrating, didn’t bring the skepticism, didn’t do the worst-case-scenario modeling or put on the hedges that they might have if they’d sensed danger lurking. Their internal models told them that there was a 99.85 percent chance that they would never have to pay out a penny. “The different nature of those trades from any other trades FP had done opened the door to all the problems that came about,” Savage told the Washington Post.
It was J.P. Morgan that lured AIG into the credit default swap business. The bank’s initial 1994 swap deal—the one that insured against an Exxon default—had gone off without a hitch. Since then, J.P. Morgan had done a handful of similar deals, while at the same time using credit default swaps internally to better evaluate its loan portfolio. In 1997, after the bank lost millions in bad loans during the Asian financial crisis, the credit derivatives team was put in charge of the bank’s commercial lending department, much to the horror of the old-time commercial lenders. They began using swaps to perform risk analysis on the loan portfolio. Credit default swaps were truly becoming central to the way the bank did business.
As for the regulators, once they began to understand what credit default swaps did, they warmed up to them. Bank regulators, it turned out, liked the idea of banks off-loading some of their default risk to other entities; in theory, it meant that banks were less likely to fail if they made bad loans. In fact, by 1996, the Federal Reserve agreed with J.P. Morgan that a bank should get some capital relief if it used credit derivatives. It put out a statement saying that if a bank used credit default swaps to move a borrower’s default risk off its balance sheet, it would be allowed it hold less capital.
What J.P. Morgan had not been able to create was a tradable market for credit default swaps. Such a market was important to the bank for several reasons. First, it would give the bank a new line of securities to create, market, and trade. Second, if a tradable market existed for credit derivatives, the market itself could be used to establish a company’s default risk. This would give J.P. Morgan a better way of measuring the risks in its own commercial loan portfolio, while also giving speculators the means to bet on the possibility of a company’s default, even if they had no economic interest in the company.
In the late 1990s, the bank—again, with Blythe Masters leading the way—found a way to create a credit product that investors loved. It did so by ingeniously combining credit derivatives with securitization. Instead of having a credit default swap reference a single company like Exxon, J.P. Morgan bundled together a large, diversified basket of credit derivatives that referenced hundreds of corporate credits. It was different from other kinds of securitizations in one critical way. Investors in mortgage-backed securities owned pieces of actual mortgages. But those who invested in J.P. Morgan’s invention didn’t own a piece of the actual corporate loans. Instead, they owned credit default swaps—the performance of which was determined by the performance of the underlying corporate credits. The credit default swaps referenced the actual loans, which were owned by others. Because securities like these were built out of credit derivatives rather than real assets, they came to be called synthetics.
Just as with mortgage-backed securities, synthetic securities were tranched, usually into three slices. The first, and smallest, was called the equity portion; it produced the heftiest return because it came with the most risk. In the event of a default, the equity holders would be the first to be wiped out. The second slice was called the mezzanine tranche; its holders would begin to lose money only after the equity holders had been completely wiped out. The third and largest tranche generated the smallest return, because it was supposed to carry only the tiniest of risks. Modern financial theory suggested that it would take a monstrous financial catastrophe for the defaults to eat through both the equity and the mezzanine tranches and hit the holders of the third tranche. After all, the credits were diversified, which was supposed to ensure a high degree of safety. J.P. Morgan’s models suggested that the possibility that defaults would hit the third tranche was so remote that no capital needed to be held against this final tranche. The bank called this tranche super-senior—so named because it was supposed to be safer than even the senior, triple-A tranche in a typical securitization.
The first such synthetic deal, which J.P. Morgan put together in 1997, was called the Broad Index Secured Trust Offering, or BISTRO. If the name made eyes glaze over, the intricacies of putting it together were even more mind-numbing. The swaps covered $9.7 billion worth of corporate credits spread out among some 307 companies, according to Fool’s Gold, Gillian Tett’s authoritative account of the creation of credit derivatives. Thanks to the diversification of the credits, J.P. Morgan calculated that only $700 million worth of notes would be required to ensure the entire $9.7 billion. So the bank set up a shell company—a so-called special purpose entity, or SPE—to which it would make insurance-like payments. The SPE, in turn, sold $700 million worth of notes to investors, beginning in December 1997. The payments from J.P. Morgan flowed through the shell company to the investors. After much wrangling, the big credit rating agencies agreed that there was very little risk in these securities and rated most of them triple-A. The BISTRO notes were quickly snapped up.
So where did AIG come in? As would so often be the case with credit derivatives, the issue had to do with capital requirements. Despite their enthusiasm for credit derivatives, bank regulators were leery about BISTRO, particularly that “riskless” super-senior tranche. Yes, it would take a genuine financial calamity to get to the point where the entire $700 million would be eaten up by defaults. But what it if happened? Who would be on the hook if there were so many defaults that they reached into the super-seniors, as mathematically improbable as that was? The answer was J.P. Morgan.
For the regulators, that’s all that mattered. The fact that J.P. Morgan was still theoretically on the hook in a worst-case scenario—as unlikely as it might be—meant that the bank had not completely eliminated the default risk on its portfolio. Therefore, the regulators concluded, banks that held the super-seniors got no capital relief—not unless they could truly find a way to off-load every last penny of the default risk.
Thus did J.P. Morgan begin looking for away to buy credit protection for the super-seniors, so it could show regulators that it had indeed gotten rid of that risk. And thus did it find FP, which was almost uniquely positioned to provide such protection. Because it was a derivatives dealer operating inside an insurance company, FP had no capital requirements. It was already doing a lot of derivatives business with J.P. Morgan. And the parent company’s triple-A rating meant that there could be no doubt—could there be?—that FP had the financial wherewithal to back up its promise to insure the super-seniors. In the BISTRO deal, J.P. Morgan bought credit protection from AIG, which took on the risk of a super-senior default. Not that anybody at AIG thought there was any risk; they were every bit as convinced as J.P. Morgan that this was a riskless transaction. “The models suggested that the risk was so remote that the fees were almost free money,” Tom Savage would later tell the Washington Post. “Just put it on your books and enjoy the money.”
Inside FP, the biggest proponent for getting involved in BISTR
O-type deals was not Savage, but one of his deputies, Joe Cassano, who had risen from the back office to become the chief operating officer of FP. Although he had come with Sosin from Drexel, he did not have a quant background; the son of a Brooklyn cop and a graduate of Brooklyn College, Cassano had learned the business by starting at the bottom and working his way up. It was Cassano who Blythe Masters first approached about getting involved in BISTRO, and it was Cassano who became the deal’s champion internally. The fees would likely be small—because the perceived risk was so low—but it was a business that FP could dominate, Cassano argued. (The fees would grow considerably over time.) If this structure proved popular, FP was likely to become the insurer of choice for everybody’s super-seniors, not just J.P. Morgan’s.
And the regulators? Once again, they eventually saw things exactly as J.P. Morgan had hoped they would. They ruled that when banks bought credit protection for their super-senior holdings, they could cut their capital requirements for the underlying credits by 80 percent. This became the rule that the Basel Committee embraced, and it was adopted by regulators around the world. Not surprisingly, every big bank in the world began clamoring for a chance to bundle their credit risk into BISTRO-like structures. The business took off, just as J.P. Morgan—and now AIG—had hoped it would.
Years later, by which time he was running FP—and not long before the first glimmers of the financial crisis could be seen on the horizon—Cassano spoke at an investment conference in which he boasted about being involved in that original BISTRO deal. “It was a watershed event in 1998 when J.P. Morgan came to us, who were somebody we worked with a great deal, and asked us to participate,” he said. “These trades were the precursors to what’s become the CDO market today.”
CDO stood for collateralized debt obligation, which is what that BISTRO-type structure was eventually called. By 2007, when Cassano made those remarks, Wall Street churned them out as if they were coming off an assembly line. There was, however, one giant difference between the early BISTRO deals and the CDOs of 2007. At the heart of the early BISTRO deals was corporate debt. But at the heart of the CDO market of 2007 was something far more dangerous: mortgages.
6
The Wizard of Fed
Inevitably, the nation’s first subprime boom ended badly. In its first iteration in the mid- to late-1990s, the subprime business had all the earmarks of a classic bubble. Subprime companies would go public and their stocks would skyrocket. Company founders got rich making loans to people who had never before been able to qualify for a mortgage. Shoddy business practices became the norm. Nobody seemed to care. Greed replaced fear, as it always does in a bubble. And then—poof!—it was over.
The first crack in the facade came when a crop of companies specializing in subprime auto lending went belly-up amid rising delinquency rates. That made investors nervous about securitizations based on any kind of subprime loans. Then, in the fall of 1998, came a financial crisis that ripped through Asia and so unsettled Wall Street that all the big banks and securities firms became momentarily cautious.
To compound matters, the subprime mortgage companies began taking unexpected write-downs. It had long been common industry practice for the subprime companies selling loans to Wall Street to keep what were called the residuals. These were the riskiest pieces of the securities, the ones that nobody else wanted; most of the time, they were the ones that came with the highest prepayment risk. Accounting rules required the companies to estimate the future value of the cash flows and book them as upfront profits, which they did very aggressively. But as more companies entered the business, they began to poach from each other by refinancing borrowers’ mortgages. More refinancings meant more people prepaying their mortgages—crushing the already overvalued residuals. As one subprime originator after another took big write-downs on their residuals, years of supposed profits were erased. Josh Rosner, who was then an analyst at Oppenheimer Securities, had played a hand in taking many of these companies public. “They were all liars,” he says now.
Spooked by the write-downs, Wall Street began to pull the plug on the subprime machine, withdrawing the warehouse loans that had been its lifeblood. One after another, the companies went bankrupt. Much of their supposed profit turned out to be illusory. One company, FirstPlus, had reported $86 million in earnings in the first nine months of 1997, but had eaten through $994 million in cash and had had to raise a stunning $1 billion in Wall Street financings, according to a presentation given by hedge fund manager Jim Chanos. Those were the kinds of “results” that can exist only in a bubble. In 2000, First Union shut down the Money Store, the subprime lender it had bought just two years earlier for $2.1 billion. “At the end of the day, we’re saying we made a bad acquisition,” First Union CEO G. Kennedy Thompson told the New York Times.
Along with the bankruptcies came a wave of lawsuits and complaints from consumer advocates, who accused the subprime industry of engaging in predatory lending. Customers, they said, had been gulled into taking on expensive mortgages—and paying exorbitant fees—by unscrupulous lenders. Many subprime refinancings replaced simple, affordable thirty-year fixed mortgages. “We and others were saying to the Fed, state legislators, anyone who would listen in D.C., that lending was getting out of control,” says Kevin Stein, the associate director of the California Reinvestment Coalition.
Even back then, there was a legitimate debate over who ultimately was more culpable: the lender or the borrower. After all, borrowers often wanted to get their hands on the money every bit as much as lenders wanted to give it to them. Not everyone was being gulled; many borrowers were using the rising values of their homes to live beyond their means. And there were plenty of speculators, betting that they could outrun their mortgage payments by flipping the house quickly. The line between predatory lending and get-rich-quick speculating—or a desperate desire for cash—was often difficult to discern.
But in the larger scheme of things, did it really matter who was at fault? The key point was this: A lot of people were getting loans they couldn’t pay back. Wasn’t that the real problem?
Prior to securitization, lenders had to care about the creditworthiness of borrowers. They held the loans on their books, and if a borrower defaulted, they took the hit. That’s why borrowers who didn’t have much money couldn’t get mortgages: lenders were afraid they would default. Securitization severed that critical link between borrower and lender. Once a lender sold a mortgage to Wall Street, repayment became someone else’s problem. The potential consequences of this shift were profound: sound loans are at the heart of a sound banking system. Unsound loans are the surest route to disaster. But at the time, almost no one seemed to realize that the wave of poorly underwritten loans that securitization seemed to encourage was a monstrous red flag.
The subprime business back then was still relatively small. The collapse of dozens of subprime companies didn’t remotely threaten the banking system. It didn’t have much of an effect on the housing market, either. But it was still significant. For the bank regulators charged with ensuring that the banking system remain sound, this was the canary-in-the-coal-mine moment, the signal that something was seriously wrong.
Or rather, it should have been.
In Alan Greenspan’s memoir, The Age of Turbulence, a five-hundred-plus-page tome published the year before the financial crisis, the phrases “subprime mortgage” and “predatory lending” don’t merit so much as a mention. Greenspan’s book is a triumphant account of his eighteen and a half years as Fed chairman—years during which, by his account, he put out economic crises, kept inflation under control, and deftly manipulated interest rates to ensure that the economy hummed and the markets rose. Before the financial crisis tarnished his reputation, Greenspan’s self-image—Fed chairman as economic Superman—was widely shared. Congressmen fell all over themselves to praise him when he made his semiannual appearances on Capitol Hill. His interest rate decisions were invariably lauded. Many economists viewed him as the greate
st Fed chairman ever, even greater than Paul Volcker, who had tamed the raging inflation of the 1970s. The small handful of favored journalists who had off-the-record access to Greenspan regurgitated his pronouncements as if they had been handed down by the Oracle of Delphi. To many people, Greenspan was the Oracle of Delphi.
Although the country was understandably fixated on Greenspan’s handling of monetary policy, the Fed had always had other roles, too. It had supervisory authority over the big bank holding companies. It was supposed to be the guardian of the “safety and soundness” of the banking system. It even had a Division of Consumer and Community Affairs, to look after the interests of bank customers. The Fed, in other words, was a regulator. Greenspan, however, was not.
As a young economist, Greenspan had come under the spell of Ayn Rand, the author of The Fountainhead and Atlas Shrugged, two of the most influential odes to capitalism ever written. The capitalism Rand believed in was “full, pure, unregulated, laissez-faire capitalism,” as she once put it, the kind that didn’t put regulatory roadblocks in the way of red-blooded entrepreneurs. Greenspan met Rand in the early 1950s, became part of her inner circle, and remained close to her until she died in 1982.
A conservative economist like Greenspan is always going to tilt against regulation. But Rand gave his leaning a philosophical underpinning and helped turn him into a true free-market absolutist. He came to believe that regulation always had unforeseen negative consequences, and that the market itself was far better at embracing the good and driving out the bad than any well-meaning government mandate. That’s what he meant by market discipline.
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