In the summer of 2004, Bill Winters had persuaded Dimon to unload a so-called structured investment vehicle (SIV) that had come onto the company’s balance sheet as part of the Bank One deal. (Despite his skill at micromanagement, Dimon had apparently not noticed this potentially explosive asset.) Essentially arbitrage vehicles that borrow short-term to finance investments in longer-term debt—including mortgage and bank securities—SIVs were, in times of easy credit, perfect fee generators for banks, which typically managed them for investors. Banks held these entities off their balance sheets, since they were not technically the owners of the assets themselves. But should credit ever become scarce, as it inevitably does in a slowing economy, they could be obligated to step in and cover losses.
Winters helped Dimon to realize that the fees didn’t offer a high enough return to offset the implied risk, and they unloaded the sole SIV, worth $8 billion, that sat on their books to the London-based bank Standard Chartered. “We sold it to someone who thought the best way to manage the risk was to take on twice as much of it. Scale is the answer every time except in the tail,” Winters later said, referring to how concentrated risks in SIVs worked out just fine until they instantaneously blew up in their sponsors’ faces. Citigroup, true to form, was moving in the other direction, piling into SIVs just as JPMorgan Chase pulled out. Winters also reduced the credit lines the bank was extending to other banks’ SIVs from $12 billion to $500 million.
With regard to structured products, Winters was no neophyte. He had been part of the J.P. Morgan team that had revolutionized credit derivatives in the late 1990s. The first innovation came to be known as a “credit default swap” (CDS). In looking for a way to reduce exposure to their client Exxon—which had recently tapped a multibillion-dollar credit line with the bank in anticipation of having to pay substantial fines for the Exxon Valdez’s oil spill—Winters’s colleague Blythe Masters had found another investor willing to insure the debt for the bank in exchange for an annual fee. In the process, J.P. Morgan was able to reduce its exposure to Exxon without having to sell the loan, thereby keeping client relations strong. (No corporate borrowers want to see their bank unloading their loans.) It was nothing short of revolutionary. What the J.P. Morgan team had done, writes Gillian Tett in Fool’s Gold, was to “overturn one of the fundamental rules of banking: that default risk is an inevitable liability of the business.”
The Federal Reserve later ruled that banks could reduce the required level of capital reserves by using credit derivatives. From that point, it was clear that there would be no shortage of buyers of CDS. Nearly every bank in existence had loans it would like to get off its books. There would surely be no shortage of sellers, either, whether these sellers were hedge funds making outright bets or insurance companies thinking their expertise in traditional forms of insurance could easily extend into the realm of credit.
To turbocharge the market for credit derivatives, the J.P. Morgan team eventually created a product called a broad index secured trust offering (BISTRO). Complex in its details and accounting, the product was nevertheless simple in essence—it aggregated the odds of default on a whole package of loans, not just on a single credit. Collateralized debt packages had long been around, but BISTRO represented a whole new segment—synthetic collateralized debt obligations (CDOs). Wall Street has an endless ability to slice and dice, though; and as soon as it was created, BISTRO was separated into various “tranches” that carried different levels of risk and return. Investors in the junior tranche would eat the first losses due to any defaults, and therefore earn the highest return. The mezzanine tranche came next, and after that was the senior tranche.
The credit rating agencies agreed that the different tranches deserved different credit ratings, and convinced themselves that even if a CDO was made up of low-rated credits, the senior tranche might actually have a higher rating than any of the individual loans. Even if every single credit in the CDO had a 30 percent risk of default, the thinking went, the odds that most of them would default at once were arguably infinitesimal. If you held the senior tranche, therefore, you were actually holding something whose probability of default was less than 30 percent. Thus, it had a higher rating.
Although both rating agencies and investment banks were pilloried in 2007 and 2008 for what was eventually reduced to a joke about filling a bag with crap and calling it gold, the intellectual argument behind the tranche ratings wasn’t dishonest or entirely flawed. It just failed to properly take into account the low-probability scenario in which most of the loans did default at once. And it’s not as if bankers weren’t aware of the possibility. Because J.P. Morgan had agreed to step in and guarantee BISTRO in the event that its funding was wiped out in some sort of über-default, they gave that risk its own name—super-senior. Better yet, they found a buyer of that risk (or, more precisely, a seller of insurance against it)—the insurance giant AIG. Joseph Cassano, head of a unit called AIG Financial Products, figured he was getting something for nothing with the transaction. It was like selling insurance against the end of the world. Why not take the money now, especially considering that if the end did come, you probably wouldn’t be around to have to pay the bill anyway? A decade later, AIG would pay a colossal price for Cassano’s cynicism.
(What Cassano and many others missed was the auto-synchronous relationship of many loans. Buy 12 different loans, and you’re pretty diversified. In principle, this is true. Unless, that is, those loans are all mortgages for houses sitting next to each other on a beach in Charleston, South Carolina. One strong hurricane, and the portfolio would be decimated. And the global real estate crisis hit like the mother of all hurricanes.)
Although the company occasionally kept a portion of that hived-off risk on its own books, the members of the BISTRO team considered themselves financial intermediaries as opposed to investors in the product itself. They saw it as a way to reduce their corporate lending risk, as opposed to taking on more. As the author of Fool’s Gold, Gillian Tett, pointed out in the Financial Times, however, Wall Street turned the product inside out. “As often occurs with Wall Street alchemy, a good idea started to be misused—and a product initially devised to insulate against risk soon morphed into a device that actually concentrated dangers.” Money was still cheap in the first half of the decade, and investors were clamoring for higher yields. Wall Street responded by creating newer flavors of synthetic CDOs that added leverage and delved into riskier asset classes, including subprime mortgages. The only conceivable problem for investment banks was that tranches for which they couldn’t find a buyer had to be held in inventory.
Demand for synthetic CDO product was so high that the yields on these newer, far riskier structures were pushed downward, raising doubts about whether the market was properly pricing the risk. That was especially the case, as a pioneer in collateralized mortgages, Lewis Ranieri, told The New Yorker in 2008, because by this point banks were lending to almost anyone who wanted to borrow, to buy whatever house they wanted, for no money down, no matter what their financial wherewithal. “They had created the perfect loan,” said Ranieri. “They didn’t know what the home was worth, they didn’t know what the borrower earned, and the borrower wasn’t putting any money into the purchase. The system had gone completely nuts.”
By late 2006, Winters had concluded that it was no longer worth the risk to underwrite or hold any such product on the company’s books. At the time, CDOs were yielding just 2 percentage points more than Treasuries. To hedge the CDO risk, JPMorgan Chase needed to buy credit default swaps, but the cost of those was rising. (In this, at least, the market was getting it right. Investors in CDOs might be taking too little yield, but sellers of insurance on those CDOs were starting to demand more money, even though it ultimately proved to be nowhere near enough.) Winters had no problem convincing Dimon of his concerns, and the bank began to pull back from all asset-backed CDO underwriting, while also selling the majority of subprime mortgages originated by the bank during the year. “I
’d love to say we saw what was coming,” Winters later said, referring to the housing collapse that crushed the value of these securities. “But that would be a lie. We just couldn’t see the return in them.”
Merrill Lynch’s CEO Stan O’Neal, among others, disagreed, and revved up his firm’s production of the complex securities. In 2006, Merrill underwrote $44 billion in CDOs, three times its 2004 output, collecting $700 million in fees. It created another $31 billion in 2007. O’Neal had personally intervened to set the company on this course, providing all the necessary capital to take the firm from fifteenth place in CDO underwriting in 2003 to first place in 2005. In mid-2006, he fired three executives who had warned that the firm was becoming dangerously overexposed in CDOs.
Wall Street firms issued $178 billion in mortgage- and asset-backed CDOs in 2005 and almost twice that in 2006. They effectively overstuffed the pipeline, and an increasing volume of the securities stayed in-house. At first, that didn’t worry executives such as O’Neal. The idea that Wall Street functioned merely as intermediary was officially out the window. Wall Street firms were acting like drug dealers who forgot the cardinal rule of the trade: don’t start taking the junk yourself. By mid-2007, Merrill owned more than $32 billion worth of CDOs.
In keeping only the highest-rated portions of the CDOs on their books, Wall Street executives looked at it as the perfect double-dip: fees for underwriting and profits from owning the least risky component of a package of debts—the probability that everything would default at once. Most of the stuff they kept on their books was AAA-rated, top-notch stuff, as good as the debt of Johnson & Johnson or General Electric. The world would have to come to an end before the strategy backfired. This was an echo of the flawed perspective at Long-Term Capital Management in the late 1990s. “The source of the trouble seemed so small, so laughably remote, as to be insignificant,” Roger Lowenstein wrote about LTCM in When Genius Failed. “But isn’t that always the way?”
Investment bankers were well compensated for ignoring the risks. Huge bonuses were paid from CDO deals, even though large pieces of these deals ended up sitting on the companies’ own balance sheets. It was a salesman’s nirvana. If no one wanted to buy the product you created, your own company would buy it from you, paying full commission.
Analysts responded by giving JPMorgan Chase what one insider calls “a world of shit for our fixed income revenues.” In 2006, the company was ranked nineteenth in asset-backed CDO issuance, well behind Citigroup, Merrill Lynch, Lehman Brothers, Bear Stearns, and UBS. Instead of wondering whether those other firms were being lazy with their own capital, chasing the so-called “carry trade” on CDOs, critics said that JPMorgan Chase was being too cautious. “One of the toughest jobs of the CEO is to look at all the stupid stuff other people are doing and to not do them,” says Bob Willumstad, Dimon’s longtime colleague at Travelers. “Maybe you’re the stupid one.”
But Dimon became more cautious yet. JPMorgan Chase had a reputation before he arrived for a tendency to get overexposed to Wall Street fads, such as telecom loans and technology private equity. He was determined not to repeat these mistakes by diving into the subprime and securitized debt fads. He remained vigilant about improving what he referred to as the “productivity” of the firm’s risk capital—more bang returned for every buck risked. He had already scaled back the firm’s proprietary trading activities in 2005, and he wasn’t about to reverse course and pile on risky assets less than a year later. “Everyone was trying to grow in products we didn’t want to grow in,” he later told a reporter. “So we let them have it.” Included among those products were so-called negative amortization and option adjustable-rate mortgages, which enticed undercapitalized home buyers to take on huge debts.
In October 2006, at a meeting with executives of the company’s retail bank, Dimon was told that subprime loans made by the retail bank were deteriorating dramatically. At the same time, the numbers showed an even greater deterioration among the loans made by competitors such as First Franklin (which Merrill Lynch had just bought) and Lehman Brothers. The credit card division, too, was seeing a decline in the quality of its own subprime lending. Dimon came to the conclusion that it was time to really dial back the subprime exposure. He called Billy King, then chief of securitized products. “I’ve seen it before,” he told King. “This stuff could go up in smoke.” Within weeks, the bank sold more than $12 billion in subprime mortgages it had originated. Dimon’s intuitive grasp, which his friend Jeremy Paul had seen in high school, was serving him in his role as CEO—while his managers handled their own patches, he monitored the bigger picture and realized that something was amiss.
In moving his bank out of the way of the oncoming subprime train, Dimon proved to be an exception to the great economist John Maynard Keynes’s cynical observation that a “sound banker … is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” Dimon would not be ruined along with his fellows.
If there’s one thing that even Dimon’s supporters will criticize him for, it’s that he willfully circumvents traditional chains of command, thereby complicating his managers’ relations with their own subordinates. He might ask 10 people for the same piece of information, just so he gets it as soon as possible. But his meddling is tolerated because of the results. In fact, some people see the meddling as one of his more valuable assets. “All the great CEOs that I’ve ever seen have this characteristic,” says his longtime adviser Bill Campbell. “They spend a lot of time at 50,000 feet, they spend significant time—although hopefully not too much—on the ground, and not much time in between. The 50,000 feet stuff is obviously incredibly important in terms of strategy and all that sort of stuff. The ground stuff is really important too. It helps the people that are on the ground because they believe they have a leader that understands them, can talk to them, can touch them, and understands their problems. But it also throws the middle management off because they go, ‘God, he knows that.’ Or ‘He knows her.’ It’s very good for middle management to have a leader that’s kind of bipolar in that way.”
JPMorgan Chase’s head of strategy, Jay Mandelbaum, points out another unique trait that has allowed Dimon to excel in the role of chief executive. When making decisions, he is extremely adept at looking at all the available information and quickly isolating the few issues that matter. “He won’t overanalyze a thing to death either,” says Mandelbaum. “At some point, you’ve got to go with your instincts.”
The company’s investment bank reported a 0.1 percent decline in profits in 2006, a year in which the likes of Goldman Sachs, Morgan Stanley, and Merrill Lynch reported 76 percent, 61 percent, and 44 percent increases in profit, respectively. Earnings at the top five independent investment banks, in fact, had tripled between 2002 and 2006, to more than $30 billion. And bonuses totaled $23.9 billion, more than $136,000 per employee. JPMorgan Chase’s historically volatile trading results had been tamed, but in other regards the analyst community was disappointed. “We entered 2007 thinking we were slipping,” recalls Winters. “We were missing a few things, that’s true; our commodity business was very small. But in retrospect it would become clear that we just weren’t booking a lot of revenues on business that would end up proving very expensive. If you could go back and take out of our competitors’ earnings what was later attributable to disasters, I think we probably did very well.”
• • •
While investors clamored for a big deal, Dimon actually shed assets, selling Brown & Co., the company’s deep discount brokerage business, to E*Trade for $1.6 billion, and selling its life insurance and annuity underwriting business to Protective Life Corporation. JPMorgan Chase did acquire 339 bank branches (and their associated commercial banking business) from the Bank of New York, but that wasn’t stuff to excite anyone.
“People are always saying I’m going to rush in somewhere and do a deal,” says a fru
strated Dimon. “But that’s not me. We did a lot of small little buys and sells, usually driven by the outline of the business, until Bear Stearns. I certainly don’t need to do a deal that adds some seventh leg to our business unless it has some strategic imperative.”
On a call with analysts in May, he tried, once again, to make explicit his view of acquisition opportunities. “There are three things that have to make sense,” he said. “And they are not in order of importance. One is the business logic. There should be clear business logic to it. The second is the price. Sometimes there is a price [at] which you cannot make it pay for shareholders. And the third is the ability to execute. [You have to be able to] see clearly getting done what you need to get done, whether it’s management or systems or marketing or culture or something like that. If those things make sense, you can then weigh and balance them. Meaning, if you have exceptional business logic and an easy ability to execute, you could pay a higher price. And conversely, if those things are a little more complex, you want a margin of error by getting a lower price.”
Of course, it doesn’t always take a splashy acquisition to make a pile of money. In the summer of 2006, Dimon, Black, and Winters made their most audacious play of the year when they snapped up a portfolio of disastrous bets on natural gas prices that had been made by Amaranth Advisors, a $9.2 billion hedge fund that was facing collapse if it couldn’t get the underwater trades off its books. On the weekend of September 16, Amaranth was desperately seeking a buyer for the trades. Goldman Sachs offered to do a deal for a portion of the total, but it demanded a $1.85 billion payment to relieve Amaranth of the positions.
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