The Tinkerers

by Alec Foege

  J. P. Morgan needed to do something to rein in that risk. It also needed capital to divert to more profitable enterprises. But terminating loans with its longtime customers was not an option. In a business built on relationships, the bank couldn’t afford to burn any bridges.

  This is where Hancock and one of his bright young analysts came in. The deputy’s name was William Demchak, and he was a tinkerer if ever there was one.

  When it came to cooking up the formula for credit derivatives, Peter Hancock was the big thinker and Bill Demchak was the technician. Hancock asked Demchak to run Investor Derivatives Marketing. He wanted Demchak to pull together a team to make his vision a reality. The motley derivatives bunch was spread among J. P. Morgan’s London and New York offices, and included a British graduate of the London School of Economics as well as a New York trader and a woman who had grown up in rural Louisiana but later studied math at the Massachusetts Institute of Technology on scholarship.

  However, Demchak’s key colleague on the project, known at Morgan at the time as the Credit Transformation, was Blythe Masters, a young, middle-class blond British woman armed with an economics degree from Cambridge University and a penchant for horses. Masters had started on the commodities desk in J. P. Morgan’s London office, but after attending the Boca Raton gathering, sensed an opportunity. Still in her midtwenties and married with a young child, Masters nonetheless moved to New York to participate in what she viewed as the opportunity of a lifetime.

  Masters later recalled that the environment at J. P. Morgan derivatives group at the time was a unique one. Instead of the alpha dog, testosterone-fueled i-banking culture of lore, Hancock and Demchak encouraged teamwork over individual achievement. While Masters had no trouble generating a constant stream of ideas for the project, she favored the collegial environment her superiors fostered, one where innovation was emphasized over personal gains, though making money was still the primary driver. It was a rare crucible for the kind of financial tinkering that happens only once a generation, if that.

  Masters rapidly became something of a proselytizer for credit derivatives. She would give talks to her colleagues about their potential virtues; she enjoyed debating the finer points of credit derivatives strategy. Her passion for brainstorming rained down on the group. When Exxon faced the possibility of $5 billion in fines due to the Valdez oil spill in 1993, the fossil fuel giant opened a $4.8 billion line of credit with J. P. Morgan and Barclays. In fall 1994, Masters convinced the European Bank for Reconstruction and Development (EBRD) that she could dispose of the credit risk associated with the Exxon loan without actually selling off the loan, which would have offended Exxon, a longtime Morgan customer.

  In August 1996, the Federal Reserve indicated it would permit banks to carry lower reserve funds if they employed credit derivatives to offset their loan risk, providing further incentive for a bank such as J. P. Morgan to push the limit in terms of ingenuity. And ingenuity was what Demchak and his team in New York were after.

  Together, Demchak and Masters arrived at the big breakthrough. The key idea was to combine credit derivatives with the securitization process and create a new product that allowed the risk associated with a group of loans to be sold to another party as a bond. The name of the new product was BISTRO, for broad index secured trust offering. The point was to scrub the bank’s balance sheet of the risk associated with particular loans. This was done by gathering a bunch of commercial loans together and then dicing them up into tranches, or baskets, that separated the loans from their risk. This was made possible by the fact that the loans were all pooled together and categorized by their levels of risk and return.

  Demchak, an expert in structured finance, organized the loans in such a way that the resulting investment was not tied to specific loans, which made the resultant product an attractive one to investors wary about being tied down to specific real estate properties. Then the repackaged risk was sold to a shell company called a special purpose vehicle, or SPV, which in turn issued the bonds that were sold to investors. On paper and on computer screens, these new products made perfect sense, at least in concept. Without realizing it, Demchak and his team had found a solution to an age-old problem in finance: how to increase returns while minimizing risk.

  Demchak and Masters spent much of 1997 convincing regulators and the ratings agencies that BISTRO was airtight. For the bankers at J. P. Morgan, plenty was at stake—approval of BISTRO was a big win for the bank. Whereas banks were ordinarily limited by international banking rules in the amounts they could lend, BISTRO freed up their capital. Normally, they needed to have a certain percentage of their loans in reserves to protect themselves from excessive defaults. But since BISTRO eliminated the bank’s risk of default by selling it to outside parties, they no longer needed to hold the reserves typically required.

  Launched in December 1997, BISTRO was an instant hit, selling out in just two weeks. Investors were happy to bet on the risk of loan default as long as the price of the bonds appeared cheap as compared to the amount of risk they were shouldering. The biggest customers were other banks and insurance companies, which allowed J. P. Morgan to offload $9.7 billion in credit risk, freeing up capital for other activities and drastically reducing its debt profile.

  Of course, the credit risk had only disappeared purely in accounting terms. After all, it was not as if J. P. Morgan stopped extending loans to businesses at this point. If anything, it increased the debt flow since it now had fewer restrictions on how it allocated capital. Furthermore, the whole process did little to question the process of whom the bank lent money to and whether those companies were likely to default.

  Indeed, had the tale of BISTRO ended here, the financial brilliance and ingenuity of Bill Demchak, Blythe Masters, and their colleagues likely would have been uncontested. After all, their jobs were to find new ways to make money for their employer and their customers. And the credit default swaps were just another innovative way of doing that.

  I find it difficult to argue that the creation of BISTRO was anything but a classic tale of American tinkering. Think about it: it matches all the criteria, point for point. There was a big problem that needed solving (an excess of credit risk) and a passionate team of wizards eager to apply the tools that existed at hand to create something new. And it benefited the common good, at least at first.

  BISTRO “was the most sublime piece of financial engineering that was ever developed. It was breathtaking in terms of beauty and elegance,” Satyajit Das, an authority on derivatives and risk management, told Portfolio. com’s Jesse Eisinger a decade later. But “in many ways,” Das acknowledged, “J. P. Morgan created Frankenstein’s monster.”

  Oddly enough, BISTRO may be one the best examples of the deeply probing tinkering of the sort that I described earlier in this book, despite the unfortunate end result it produced. Tinkering, these days, does not demand purity of purpose. Frankly, the benefits of tinkering are rarely as clear-cut as they were as recently as a century ago. In the throes of the industrial revolution, it seemed every new technological innovation was revelatory and essential to the betterment of mankind. Few could convincingly contest the value of the lightbulb or the phonograph or the automobile, for that matter, since each added a dimension to human existence so dramatic and game changing. But many of those technological itches have been scratched in the passing decades.

  Furthermore, the industrial age has brought upon us the detrimental after-effects of all that great tinkering. Pollution and landfill and global warming slowly suffocate our better visions of ourselves and remind us that human ingenuity will always fall just short of solving our mortal predicament.

  But as far as American tinkering goes, the CDS market fit the traditional story arc. Against the odds, a group of bright and resourceful innovators convinced others to reassess their notion of risk. This is not to say that making money wasn’t a factor in this font of financial wizardry. For many involved, of course, it was the guiding factor. But that sh
ouldn’t necessarily detract from the brilliance of tinkering that filled the investment needs of two consenting parties.

  The rise of collateralized debt obligations, or CDOs, however—kind of the McNuggets version of the CDS market—showed what tinkering unfettered by a societal purpose can do. In the wake of the bursting Internet bubble of 2000, the early BISTRO deals offered hope that there was still money to be made in the conceptual ether. As J. P. Morgan prospered from its newly concocted innovations, other financial institutions began to funnel their resources into the credit derivatives market. Goldman Sachs, Morgan Stanley, and Lehman Brothers were the earliest converts; even the tradition-bound Deutsche Bank built itself a credit derivatives operation, viewing it as an opportunity to break into the American markets in a way that stock and bond offerings didn’t.

  Part of the problem with the credit default swap gambit was that the tinkering continued well after the benefits had tapered off, at least to most people in the society at large. Otherwise, let’s face it: credit derivatives, as originally devised and implemented by Bill Demchak and Blythe Masters, ultimately served to benefit both banks and consumers. Indeed, they still do.

  Hedging is a tried and true investment strategy that ultimately protects nearly all investors making bets on a narrow group of investments that may collapse when that sector of the economy collapses. Both sides involved in a credit default swap want something that the other has, but neither wants to sell the credit asset underlying the trade. Many perfectly legitimate entities invest in CDSs: lenders, customers, anyone who seeks to protect themselves from the unimaginable, mainly a failure of borrowers of all stripes to pay their debts.

  A 2009 survey done by the International Swaps and Derivatives Association revealed that 94 percent of the five hundred largest global companies employ derivatives, while more than 70 percent of the US-based nonbank corporations use interest rate or currency derivatives. Among US-based banking firms, all do interest rate and currency swaps, while 88 percent participate in credit default swaps.

  However, the promiscuousness of the ideas that produced this situation suggests that not all tinkering is created equal. Much like in the physical world, virtual tinkering can get lost in the weeds. Ultimately, physical tinkering must produce a material thing, an object that ultimately must survive on its own merits. Virtual tinkering is not held to the same standard, by dint of the fact that a physical product is not mandatory. And yet the accountability that is a given in the material world is difficult to apply in the virtual one.

  It’s no surprise that in the aftermath of the CDO implosion, many white-collar workers, including those working in finance, began to question the value of their contribution to society. Around this time, when layoffs at Wall Street firms had reached an all-time peak, many former bank executives took stock of their self-worth, and the appeal of working with one’s hands suddenly came back into vogue.

  The timing couldn’t have been better for a new wave of physical tinkerers, who had been practicing their craft away from the limelight, hoping someday to be appreciated.

  CHAPTER 7

  THE TINKERER ARCHETYPE IS REBORN

  THERE MAY NO LONGER BE SUCH A THING as the lone, humble inventor in the United States, but the very existence of Australian-born transplant Saul Griffith at least challenges the premise that individual tinkering genius cannot flourish in our soil. Raised in Sydney and educated in material sciences at the University of South Wales with a master’s degree from the University of Sydney, he arrived in America on a scholarship to the Massachusetts Institute of Technology in 2004, where he earned a PhD in programmable assembly and self-replicating machines, which sounds confusing until you learn about some of the things Griffith has spent his time doing since then. Through pondering some big issues, he has come up with an astonishing number of clever technological innovations—from a kite that tows boats to an electricity-assisted adult cargo tricycle to cheap insulation inspired by origami. The best known, perhaps, is the one that helped win him the $30,000 Lemelson-MIT Student Prize in 2004: a small desktop machine that allows an operator with little training to make a cheap pair of eyeglass lenses on demand. Griffith’s motivating idea was to make glasses more affordable for people in impoverished countries. His brilliant solution worked. What he didn’t realize, however, was that once an expensive lens factory is built, the cost of manufacturing and shipping a pair of eyeglasses only costs a few dollars.

  Still, Griffith remained a solid idea-generating force at MIT. As a student, Griffith invented a portable electric generator that a user swings around his head to produce energy, a concept he adapted from an Aboriginal musical instrument called a bullroarer. Another device created three-dimensional chocolate objects from digital renditions. In 2007, he was awarded a MacArthur Foundation “genius grant,” which was accompanied by a $500,000 prize. Griffith, in his typically thrifty style, sunk the bulk of his winnings back into his business enterprises. Many of these have sprung out of the inventors workshop, known as Squid Labs, that he established in California with a group of friends, some of whom he met at MIT. In its three years of existence, Squid Labs operated out of a warehouse in Emeryville under the slogan “We’re not a think tank, we’re a do tank.”

  A free-form ramshackle business incubator of sorts, Squid Labs produced a flurry of start-ups, including Howtoons, a website stocked with cartoons meant to teach children how to build things; Instructables, a clearinghouse of low-priced plans for a wide range of do-it-yourself projects; MonkeyLectric, a manufacturer of artistically striking lighting products for bicycles; and Makani Power, which designs airborne wind turbines meant to capture the energy from high-altitude winds unreachable by turbines mounted on towers.

  Each of these creations inspired or anticipated an innovative mini-movement of its own, and together they confirmed Griffith’s powers as a tinkering futurist. Spanning from practical to fantastical, they also harness a bit of the cocky, quicksilver energy that seems to be lacking in the work of many of today’s innovators.

  Griffith’s journey to the United States was originally fueled by his interest in environmentally beneficial innovation. This is not surprising when considering that Australia is regarded as ground zero of the earth’s global-warming time bomb, a cauldron of weather extremes exacerbated by an economy deeply dependent on coal as both a leading source of energy and the country’s main export. At Squid Labs, he devised something they called electronically sensed rope that includes built-in sensors and conductive fibers that adjust the flexibility of the rope based on the amount of weight it is supporting. Squid also developed a power source for the One Laptop per Child nonprofit that provides children in developing countries with affordable computers. And all of Griffith’s endeavors seem to be imbued with a twisted sense of humor one doesn’t expect from such a prodigious innovator: one do-it-yourself project on Instructables.com includes step-by-step directions to construct a computer mouse (hardware) out of a real dead mouse carcass (referred to on the site as wetware).

  Growing up in Sydney as the son of a textile engineer and university professor and his wife, an artist and weaver, Griffith’s earliest memories of tinkering involve weaving machines and large manual looms that have more to do with the past than the future of innovation. Both his father and mother had at-home studios, so Griffith’s childhood was filled with taking apart lots of different kinds of machines and putting them back together. “It was just a culture of ‘don’t be scared of any machine,’” he told me during an extended conversation we had via Skype. “I grew up around machines that weighed two or three tons, and I wasn’t afraid to play with them.”

  An early project of his own creation was constructing a grappling hook like the ones used by Spider-Man and Batman. That single task occupied the whole of one summer. Griffith said he spent each day trying every piece of string and every piece of metal in the house “until something would stick when I threw it up on the roof of the house.”

  There was also a tradition
in his family of making Christmas and birthday presents. Typically, they’d be either crafts projects or art projects, or else they’d be more practical items such as coat racks or camera tripods.

  Griffith’s fascination with his mother’s weaving and knitting looms led to an interest in computers, more specifically the electronic computerization of printmaking. One of his first big mechanical endeavors was helping his father electrify one of his mother’s nineteenth-century lithographic presses. “That was probably one of the first times I was exposed to real engineering, with tolerances and measurements and selecting the right motors and gears,” he said.

  But perhaps more critical to Griffith’s development than the exposure to so many objects to tinker with, however, was the seamless connection these experiences made between the arts and science. “I think there’s such an artificial division between the arts and the sciences, it’s hard for me to understand,” he said. “The best scientists I know are all good writers or good artists.”

  After working in various capacities for Australia’s largest steel and aluminum producers after graduation, Griffith realized that there wasn’t much else in the way of inventing going on in his native country unless it involved a better way of getting iron ore out of the ground. While living in Zimbabwe with a girlfriend, he read an article in Wired magazine about the decade–long quest to develop an electronic book. Fired up by the notion of all the natural resources and energy e-books would save, he became determined to be a part of the development process. “I had been working on projects in municipal solid waste treatment, and I was aware of how much we threw out in landfill was newsprint—52 percent or 54 percent in 1997. I’ve always had environmentalist leanings and that seemed like a terrible thing to do, and if you could eliminate newsprint with the electronic book, that would be perfect.”