The stock market was taken by surprise, falling 186 points, or 1.4 percent, the day the bailout was announced. Still, not many took the funds’ troubles as a sign of a financial apocalypse. When JPMorgan Chase held its own second-quarter conference call on July 18, Bear’s financial services analyst David Hendler started a query with, “Just a question on …” but was interrupted by Dimon. “Actually, David, we have a few questions for you,” he joked. It was funny, albeit in a morbid sort of way. Although the losses were huge, Bear Stearns was still standing, and people like David Hendler still had jobs. As Bryan Burrough later pointed out in Vanity Fair, the firm thought it had survived a near-death experience.
By August, Bear was putting out fires left and right. On Friday, August 1, the firm held a conference call, trying to calm investors’ nerves about the collapsed funds. On August 5, the CEO of Bear Stearns, James Cayne, forced Spector to resign. (It later emerged that Spector had unilaterally authorized a late-game $25 million injection into Cioffi’s funds, without telling Cayne or the board. The discovery of this prompted Cayne to issue the death sentence.)
The stock market itself had stabilized, but the world of high finance had a new, much more ominous problem on its hands. The availability of short-term credit had dried up overnight. When France’s biggest bank, BNP Paribas, halted withdrawals of three funds on August 8, because it couldn’t “fairly” value their holdings, panic set in. Despite a $130 billion injection of funds into the market on August 10 by the European Central Bank, a credit crunch had begun in which no one entrusted his money to anyone else anymore, and the normally fluid overnight lending markets evaporated. The Latin root of “credit” is credere, “to believe.” Belief had been obliterated.
What comes next is common to all historical financial panics. Individuals who act rationally (i.e., they try to sell, in order to protect their own interests) have an aggregate effect that is ultimately irrational (i.e., with all sellers and no buyers, assets that do have an inherent value are nevertheless deemed worthless). In other words, if there’s no price at which someone will take something off your hands, its value is necessarilly zero. And if you’re a borrower who needs to sell something to pay back your debts, you’re in deep trouble.
“Credit is the air that financial markets breathe, and when the air is poisoned, there’s no place to hide,” writes Charles Morris in The Trillion Dollar Meltdown. The start of the credit problems prompted CNBC’s talking head Jim Cramer to unleash his now infamous rant beseeching the Federal Reserve to cut interest rates. Like Michael Lewis’s sarcastic column about Davos, it seems naive in retrospect. The market’s problems were far too complex to be solved by a mere rate cut. Morris was soon forced to change the title of his book to The Two Trillion Dollar Meltdown. (It may well have to be revised further.)
Although they were not desperate for capital, executives at Bear Stearns concluded that a vote of confidence from a prominent outside investor might quiet the critics. Over the next few months, they held discussions with the financier Henry Kravis of KKR, who considered ponying up a $2 billion cash infusion in exchange for 20 percent of the company. When the deal fell apart over conflict-of-interest issues, the company turned to several other possible investors, including the private equity firm J.C. Flowers, the hedge fund Fortress Investment Group, Berkshire Hathaway’s Warren Buffett, and Jamie Dimon.
That summer, after several quarters of being ignored by analysts, Dimon and his team were the toast of Wall Street, as it became increasingly clear that Dimon’s philosophy of the fortress balance sheet had positioned the firm to do just what he had promised—to be predator, not prey, when the environment got ugly. In a stark reversal, JPMorgan Chase was getting headlines for its strong positioning.
In October, the company announced $3.4 billion in quarterly profits, but also $1.64 billion in write-downs on its own credit exposure. The news sent JPMorgan Chase stock skidding nearly 10 percent. But only Goldman Sachs had fewer losses.
Had Bear been seeking to sell, say, its prime brokerage business, Dimon and his team would have been all ears. But swallowing the bank whole, including its vast subprime book, was not palatable. “We took a look and we weren’t interested,” Dimon recalls.
In September, news reports revealed that Bear’s shareholder Joseph Lewis had secretly been building a 7 percent stake in the firm, spending $860 million in the process. But that wasn’t a cash infusion; he’d bought the shares on the open market, a move that did nothing to alleviate the firm’s capital issues. In October, Bear announced a deal with the Chinese securities firm CITIC, in which the two companies agreed to invest $1 billion in each other. But investors saw the back-and-forth for what it was: an empty gesture. And then in November, all hell broke loose. The Wall Street Journal ran a front-page story about James Cayne, portraying him as a chronic dope smoker who spent more time playing in bridge tournaments than he did managing his floundering firm. (It had already been reported that he’d been playing golf the day the hedge funds were bailed out.)
Bear Stearns was now a symbol of risk management gone amuck, and on Wall Street, where reputation is everything, the Journal’s article spelled the end for Cayne, if not the entire firm. Bear hung around long enough to place second in Fortune magazine’s annual list of the most admired securities firms—behind Lehman Brothers—but it was now officially circling the drain. At the end of 2007, Bear Stearns reported $2.6 billion in write-downs, as well as its first-ever quarterly loss. Bear Stearns was the smallest firm of Wall Street’s giants, and the first to go down. But its problems were hardly Bear’s alone.
• • •
Citigroup’s former CEO Chuck Prince will go down in the annals of business as the guy who drove the once proud bank straight into a wall. (The Economist referred to him in May 2009 as “Citigroup’s former bumbler-in-chief.”) Never a verbose man, he will nonetheless also be remembered for what was one of the most ill-timed utterances by an executive in history. In July 2007, just before the world’s credit markets seized up, he spoke of Citigroup’s commitment to continue funding leveraged buyouts through the provision of so-called leveraged loans. “As long as the music is playing, you’ve got to get up and dance,” he told the Financial Times. “We’re still dancing.”
Less than a month later, the roof fell in on the dance hall, and Citigroup found itself stuck with $57 billion of leveraged loans on its books that it could no longer sell. And it was not alone. JPMorgan Chase, the longtime leader in the leveraged loan market, was sitting on $41 billion of its own. Eighteen months later, both banks were still writing down those loans, as investors’ appetite for highly leveraged companies failed to come back. (The exposures were large, but providing loans is the business of banks, and neither bank suffered much criticism for getting caught flat-footed by the swift and brutal change in investor sentiment.)
Citigroup, however, had a more serious vulnerability exposed by the freeze in credit. In his relentless quest for positive “operating leverage,” Chuck Prince had sponsored some $100 billion of SIVs as of the summer of 2007, making Citigroup by far the leading issuer in the $400 billion market. (Dimon, usually a stickler for detail, later admitted being taken off guard by the sheer size of the SIV market. He wasn’t the only one.)
Because SIVs earned a mere estimated 0.35 percent or so on their investments, which the sponsor had to split with the equity investors (equity investors, of course, were not in the SIV for just a 0.35 percent return—leverage gave them returns of 8 percent or so), Citigroup earned an estimated $175 million a year from its SIV business, despite potentially ruinous risks to both its balance sheet and its reputation. When the market for short-term borrowing disappeared, the SIVs were effectively insolvent, exposing the equity investors to a wipeout unless Citigroup stepped in to save them.
In October, Secretary of the Treasury Henry Paulson—the onetime chief of Goldman Sachs—floated the idea of creating a so-called “super-SIV” that would take the underperforming SIVs off the books of fir
ms whose balance sheets were buckling under this unexpected weight. JPMorgan Chase, Citigroup, and Bank of America would invest a total of $100 billion to create such a fund. Some CEOs might have balked at the notion of effectively bailing out their competitors, but Dimon was prepared to play the statesman. On a conference call with analysts in October, he talked of taking one for the team. “I think it’s clear that there may be asymmetric benefits to different parties in the super-SIV idea,” he said, “but it’s also clear that it may ameliorate some of the pressure on some of the markets that is taking place today. If the system is helped, we think that’s good for everybody. It’s perfectly reasonable that J.P. Morgan take part in something like that.”
The plan never got off the drawing board. After waffling for several weeks about whether or not it had any contractual obligation to provide liquidity or guarantees to the SIVs it said it merely “advised,” Citigroup finally buckled in December and agreed to take $58 billion worth of SIVs back onto its balance sheet, thereby obviating the need for the super-SIV. By that time, Chuck Prince was gone; he’d resigned in November, just a few weeks after the Wall Street Journal had run an article with the headline “J.P. Morgan’s Time to Grin.” Dimon, however, steadfastly refused to publicly celebrate Citigroup’s troubles.
“He’s smart enough to know that Citigroup has embarrassed themselves enough and he doesn’t need to gloat,” says one of Dimon’s former colleagues. Instead of dancing on the graves of Sandy Weill, Chuck Prince, and Citigroup, Dimon retreated from the press. JPMorgan Chase’s own results were nothing to brag about. At a conference in November, however, he stated, “SIVs don’t have a business purpose”—a clear swipe at Citigroup. In the company’s 2007 annual report, he elaborated on the subject. “There is one financial commandment that cannot be violated: Do not borrow short to invest long—particularly against illiquid, long-term assets.” “You know what sinks companies?” he asked an audience in late 2008. “Financing illiquid assets short.”
The Federal Reserve chief, Ben Bernanke, took Jim Cramer up on his advice and cut rates in September and October 2007. Although the equity and credit markets rallied in approval, that relief was short-lived. Third-quarter results from Wall Street firms were a debacle, with Citigroup and Merrill Lynch leading the parade of losers. Stan O’Neal, who had elbowed his way to the top of Merrill Lynch in 2002, led his firm down the same primrose path as Bear Stearns, particularly in its embrace of subprime CDOs. Citigroup’s earnings fell by 60 percent in the third quarter; Merrill’s results dropped from a $2.2 billion gain in the third quarter of 2006 to a $2.3 billion loss in the same period in 2007.
It began to dawn on the rest of the country that Wall Street firms had at some point ceased to focus on their original function—putting people with money together with people who need money—and had turned inward, becoming, in John Brooks’s words, “a mindless glutton methodically eating itself to paralysis and death.” Brooks wrote that in 1973. Thirty-five years later, it was the same story all over again.
When Warren Buffett decided to sell long-term put options on the S&P 500 index—essentially a bet that the market would be higher when the options expire between 2019 and 2027—he refused to post any collateral whatsoever against the positions. The banks would just have to take him at his word, and everybody did—except Dimon. “We stuck to our knitting, we lost the business, and we moved on,” he recalls. The last prominent investor to demand no collateral posting was John Meriwether of Long-Term Capital Management.
“I advise other companies’ CEOs, don’t fall into the trap where you go, ‘Where’s the growth? Where’s the growth? Where’s the growth?’” Jamie Dimon told Charlie Rose in early 2008. “They feel a tremendous pressure to grow. Well, sometimes you can’t grow. Sometimes you don’t want to grow. In certain businesses, growth means you either take on bad clients, excess risk, or too much leverage. Wall Street firms felt this pressure to grow, and they succumbed to it.”
The strategy of piling on leverage to juice returns had pervaded Wall Street’s executive suites. According to a study by the management consultancy Oliver Wyman, leverage appears to have driven almost half the growth in return on equity from 2003 through 2007. Ralph Cioffi of Bear Stearns wasn’t the only one putting his equity at risk by loading up on debt; all of Wall Street was in on the scheme.
Warren Buffett thinks Dimon separated himself from the pack by relying on his own judgment and not becoming slave to the software that tried to simplify all of banking into a mathematical equation. “Too many people overemphasize the power of these statistical models,” he says. “But not Jamie. The CEO of any of these firms has to be the chief risk officer. At Berkshire Hathaway, it’s my number one job. I have to be correlating the chance of an earthquake in California not only causing a big insurance loss, but also the effect on Wells Fargo’s earnings, or the availability of money tomorrow. Any big institution has a lot of risks that can be modeled reasonably well. Somebody at the top has to be thinking about that stuff every day. Jamie is the kind of guy you want to have running an institution like that. You have to have somebody that’s got a real fear in them of what can happen in markets. They have to know financial history. You can’t evaluate risk in sigmas.”
Another contributing factor was that money had been too cheap—nearly free—for too long. It is only logical that Wall Street chieftains, with limited liability in their roles as executives at public companies, and unlimited access to capital, would take on so much risk. They shared in the upside and were protected on the downside. Chuck Prince received a good-bye present of $39 million for nearly wrecking Citigroup. Stan O’Neal of Merrill Lynch received $162 million for gutting Merrill to the point at which it was forced into a shotgun marriage with Bank of America.
In 2007, JPMorgan Chase announced $3.1 billion in market-related write-downs, versus $20.8 billion at Citigroup. And JPMorgan Chase’s sales per employee, a measure of operating efficiency, were $349,000 in 2007, versus just $218,000 for Citigroup. The irony was hard to ignore. The promise of the so-called universal bank that had been the driving force behind the creation of Citigroup was being realized—but not at Citigroup. In March 2008, Weill issued something of a mea culpa, telling Fortune, “I get an ‘F’ for succession planning.”
In November 2007, Dimon hired Barry Zubrow, formerly a partner at Goldman Sachs, to be the firm’s new chief risk officer. Jon Corzine, the erstwhile Goldman CEO and current governor of New Jersey, had recommended his former colleague as someone who could talk to both the board and the company’s traders without alienating either of them. At the same time that his competitors’ risk-management processes were being revealed as woefully inadequate, Dimon was continuing to improve his own.
• • •
Although Dimon and his team were able to sidestep the subprime meltdown, they made a number of critical blunders of their own in the last days of the credit bubble. In home equity, the company ran with the pack, repeatedly loosening underwriting standards to keep market share. From a relatively conservative loan-to-value (LTV) ratio of 80 percent, Charlie Scharf and his team eased their standards to an LTV of 85 percent and then again to 90 percent. They also went along with so-called “no documentation” loans, in which the bank simply took borrowers at their word. In a remarkable display of cavalier lending, only 22 percent of home equity loans made by JPMorgan Chase in the first half of 2007 were supported by full documentation. That is not a figure any bank could be proud of. (Other banks went farther, issuing so-called NINJA loans—in which borrowers had “no income, no job, and no assets.”)
That explains why in 2007 the company wrote off $564 million in home equity loans, and added $1 billion to reserves. “We could have known and we should have known,” says Dimon. “Part of it was like the frog in boiling water, who doesn’t know it’s getting hot until it’s too late. But that’s no excuse. The fact is, it was bad underwriting. I’d like to write a letter to the next generation that says, ‘Even if you see home price
s go up 100 percent over five or 10 years, don’t go past 80 percent loan-to-value!’”
In the rush to add mortgage volume, the company also embraced the wholesale “channel” in which outside mortgage brokers made loans and passed them on to the company. This was an added dimension of risk; the company had little control over underwriting practices that went on outside its own walls. Although such loans accounted for only 33 percent of outstanding prime mortgages at the end of 2008, they accounted for a whopping 78 percent of losses. Dimon had written in the company’s 2006 annual report that the home equity division had maintained “its high underwriting standards.” He was wrong about that, at least as far as its wholesale business was concerned.
Dimon considers the decision to use mortgage brokers the biggest mistake of his career. After a speech at the Chamber of Commerce in March 2009 in which he said just that, the National Association of Mortgage Brokers released a statement calling it a “senseless” attack. The bank made other grave mistakes as well, such as aggressively chasing market share in jumbo mortgages and credit cards even as the economy had begun to shrink, leaving it with billions of dollars in future writedowns. Dimon’s vaunted ability to connect the dots failed him in these instances. The push to add market share in mortgages was successful—origination in the first quarter of 2008 increased 30 percent to $47 billion, doubling the company’s share from 5 to 10 percent—but it also cost the firm more than $500 million. “We were too early,” Dimon later said.
According to Scharf, he and his team made a serious miscalculation. “We didn’t think housing prices were going to go up forever,” he says. “We did say they could go down. But when we asked ‘What’s the worst it could be?’ we got that one totally wrong.” Dimon wrote in the company’s 2006 annual report that credit losses “could rise significantly, by as much as $5 billion over time.” He was off by several orders of magnitude.
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