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 (27 page)

All through Saturday, the JPMorgan Chase bankers frenetically combed through Bear’s records. Every few minutes, they relayed their findings over to Winters in London, until he determined he needed to be in New York and hopped a flight Sunday morning. As Winters was landing, Dimon and Black were giving Geithner their verdict: there were too many black holes in Bear’s books to cut a deal. Winters agreed. “It just would not be prudent to proceed,” he told his colleagues.

Geithner frantically tried to allay their concerns. By Sunday morning, the situation was dire. The repo market investors who had lent
money to Bear included some powerful state-backed Asian institutions, and they were now threatening to pull their loans to
all
American brokers if Bear defaulted on its contracts. That would likely set off a terrible chain reaction. Geithner became more determined than ever to have a deal in place by the time Asian markets opened later that night.

Fed officials feverishly tossed ideas around. Eight years earlier, the large private equity group J.C. Flowers—which had also been considering making an offer to Bear but decided against that—had bought a troubled Japanese institution called Long-Term Credit Bank, which had murky black holes on its books. The Japanese government had facilitated the deal by offering J.C. Flowers a quasi insurance policy that promised to compensate Flowers if the dicey loans at LTCB turned bad.

In the case of Bear, Geithner and the other Fed officials knew it would be impossible to replicate that deal exactly. But what if the Fed ring-fenced, or isolated, some of the most troubled assets on Bear’s balance sheet, meaning that the Fed would guarantee JPMorgan Chase that it would cover losses on those assets? Dimon, Winters, and Black tossed the idea around and told Geithner that if they could buy Bear cheaply enough, they might cut that deal. Geithner duly consulted with Ben Bernanke and Hank Paulson about the tricky matter of an appropriate price for Bear, and returned to Dimon with a proposal: If JPMorgan Chase bought Bear for $2 a share, the Fed would take $30 billion of Bear’s assets and place them into a special, ring-fenced vehicle. If those ring-fenced assets lost value, JP Morgan would take the first hit, up to $1 billion. After that, the Fed was on the hook.

The price was startling. Dimon was famous for cutting deals on the cheap, but even he had never expected to see a price quite
that
low. At the start of the weekend, a price of around $8 to $10 a share had been floated in the discussions between JPMorgan Chase, Bear, the Fed, and the Treasury. By Sunday, the JPMorgan Chase side was pushing for a price nearer $4. Paulson, though, cut that in half. He seemed determined to avoid giving any impression that the government was bailing out Bear—or its shareholders. At the close of trade on Friday, the share price of Bear Stearns had been around $18 a share, and the previous October it had been trading around $131. At just $2 a share, the offer now valued Bear at
just $250 million, considerably less than just the bank’s building at 383 Madison Avenue was worth. Ironically, J.P. Morgan had been planning to move its headquarters from midtown to downtown Manhattan. If it purchased Bear and its building, it would have enough space to stay in Midtown. “Frankly, we could probably raise the funds to do this deal just by doing a whip-round inside the company and getting contributions from everyone who hates the idea of having to commute downtown,” one senior J.P. Morgan banker joked to his colleagues.

Shortly before Asian markets opened on Monday morning—or Sunday night in New York—the deal was struck. The Fed also announced plans to extend its liquidity provisions to all the twenty primary dealers that buy Treasury securities from it, meaning that it was agreeing to provide a safety net for the brokerages, comparable to that for the commercial banks. It was the first time it had employed that measure since the Great Depression.

As news of the deal broke, employees at Bear reacted with fury, stunned at the bargain-basement price. Most of them had large proportions of their wealth tied up in Bear shares, which had now evaporated, and adding salt to the wound was the fact that if the Fed had announced its extension of funds to brokers only a week earlier, Bear wouldn’t have faced collapse. A two-dollar bill was taped to the front door of their headquarters on Madison Avenue as a potent symbol of their disgust.

Most observers outside Bear, though, reckoned that Geithner and Dimon had pulled off a stunning coup. While on Monday morning, the stock market gyrated, as investors tried to make sense of the deal and traded particularly heavily in the shares of Lehman Brothers and Merrill Lynch, since they shared many of Bear’s vulnerabilities, by Tuesday anxiety was ebbing. The cost of borrowing funds in the interbank sector dropped, as did the price of insuring banks and companies against the risk of default. The credit markets rallied. Not only had the deal removed the immediate threat of a Bear collapse, it had shown investors that the government was willing to forcefully intervene and that was starting to shore up market confidence. Then on Tuesday afternoon, further evi
dence emerged of the government’s readiness to act. The Federal Reserve slashed the prime rate another 75 basis points, its sixth cut since September, taking it down to 2.25 percent, from 5.25 percent a year before. “We had been on the brink of the biggest financial meltdown this country had ever seen, but I think the Fed has now turned the psychology around,” said David Jones, chief economist at DMJ Advisors. “The Fed is saying it is ready to supply all the emergency credit banks need to get us out of this crisis.” Echoing the general sense of jubilation, Mark Zandi, chief economist at Moody’s noted, that “[The Fed] was slow to react to events last summer and fall, but starting this year they have been very creative.”

Inside JPMorgan Chase, though, reactions to the deal were less jubilant. During the first few months of the credit turmoil, the bank had largely escaped the media spotlight, because investors and journalists were focusing on the banks posting large losses. The Bear deal pushed JPMorgan Chase into the glare. Jamie Dimon’s face splashed onto magazine covers and headlines extolled him as the “Wunderkind!” and “The Contender.” Some pundits delighted in pointing out that Dimon’s feats now seemed to be eclipsing even those of his former boss Sandy Weill. Other commentators reached even further back into the past and drew parallels between Dimon and the mighty J. Pierpont Morgan. The bank’s press team tried to damp down the hype. “Nobody here wants to be put on a pedestal and then just get knocked down,” one JPMorgan Chase spokesman commented. The fascination with Dimon, though, would not die away. “With that one jaw-dropping deal [to purchase Bear], Dimon, like the bank’s namesake before him, has become a principal player in the biggest financial drama of his age,” enthused the
New York Times.
“Like J. Pierpont Morgan, he is capitalizing on the fear and panic that can grip the markets to expand his storied banking empire.”

In reality though, Winters, Black, and Dimon knew all too well that the “storied empire” was facing severe challenges. In the days after the Bear deals, the headaches mounted at an alarming rate. One problem revolved around the contract they had cut with the Fed. When JPMorgan’s lawyers combed through the paperwork that they had hastily signed on Sunday, March 16, they realized that the fine print could potentially
expose JPMorgan Chase to more risks than it had anticipated. Alarmed, the JPMorgan team pressed to renegotiate the deal in the following week. The Fed agreed, but as a quid pro quo it suggested that the price of the deal should be raised to $10 a share. That offered a tiny crumb of comfort to Bear shareholders, but it also removed some of the financial cushion in the deal for JPMorgan Chase. On Sunday, March 16, Dimon had thought he was acquiring the bank with a cushion of about $5 billion between the sale price and the book value of its assets. By April that cushion was evaporating. It later disappeared entirely.

There were other disturbing blows. In the months before Bear had collapsed, the broker had acquired a large number of credit derivatives contracts that were designed to protect it from a downturn in the credit markets. Ironically, in the week after the Bear deal was announced, those contracts produced big losses because of the sharp rally in the credit markets. Then Winters discovered that Bear was taking another set of unanticipated losses linked to a hedge fund. He was also apprised of large backlogs of unconfirmed credit derivatives trades sitting in Bear’s back offices. Worst of all, in many cases the Bear management had not made any provisions against possible losses on its derivatives deals.

Cultural differences also came to the fore. The day the merger was struck, the logistics team at JPMorgan Chase ran cables between the two banks to hook up the IT systems. Since their two headquarters were only two blocks apart, that seemed an easy process, but it soon transpired that the computer networks were incompatible. Mixing the human cultures was more difficult. Bear was a scrappy, aggressive bank, where employees were highly competitive with one another and “ate what they killed,” earning bonuses on the revenues they generated. To the JPMorgan Chase staff, the Bear employees seemed dangerously freewheeling; to the Bear staff, JPMorgan Chase felt oppressively dull, if not bureaucratic. In an effort to bridge the gap, Dimon, Winters, and Black conducted a series of town halls, and the Bear employees were taken aback. JPMorgan Chase had made regular town halls a point of pride, but the senior executives at Bear were not at all used to taking questions from junior staff. Some Bear staff liked the idea, but others considered it patronizing. “This is like the Boy Scouts taking over the mob,” some of the JPMorgan staff joked to
each other. Nobody was particularly surprised when JPMorgan executives indicated in early April that apart from large numbers of Bear staff in the equities and prime brokerage sectors, who would be retained, only a handful of Bear managers would stay on.

Even as the Bear deal calmed the markets, the drama of Bear’s collapse sent a chilling message about the vulnerabilities that now plagued the wider system. No longer could the activities outside the regulated commercial banking system be considered so “small” that they were not vital to the flow of capital through the larger economy. By 2007, the New York Fed calculated that the combined assets of all the SIVs and similar vehicles came to $2.2 trillion, while hedge funds controlled another $1.8 trillion, and the five brokers had $4 trillion on their balance sheets. The five commercial bank holding companies—the piece of the system that Geithner oversaw—held just $6 trillion total, while banks as a whole had $10 trillion in assets. More important than mere size, though, was that the shadow banks and brokers were so deeply interconnected with commercial banks through a fiendishly complex web of trades. Quite apart from whether they were “too
big
to fail,” they were too
interconnected
to ignore.

One source of the interlinkages was the repo world. Another came from credit derivatives. The credit derivatives sector had exploded at such a pace that there was more than $60 trillion in outstanding CDS trades sitting in the market as a whole. In a strict economic sense, the risk embodied in those contracts was much smaller, at “just” $14 trillion, since many of the deals offset each other. Banks would buy bonds while also buying protection on those bonds, meaning that the net exposure was canceled out. But that would still leave a vast pool of potential counterparty risk if parties to a trade failed.

Back in 1994, the derivatives world had backed away from the idea of alleviating this counterparty risk with a centralized exchange. Instead, they had argued that it was better for each player in the market to use legal contracts and self-discipline to make the system safe. But these bilateral tools had not prevented a panic during the Bear drama. As the
broker ailed, investors had been terrified when they realized the logistical challenges that would arise from any failure, particularly since it was hard to determine how many contracts had even been written. The CDS market had turned into a vast, opaque spider web of deals in which banks, shadow banks, and brokers alike had become dangerously ensnared, interlinked by fear.

I
n the weeks after the Bear collapse, equity markets rallied; the drama seemed almost cathartic, like a ritual sacrifice in which Bear had been slaughtered to atone for the follies of Wall Street. Some commentators argued that the forceful interventions by the New York Fed and the Treasury showed that the system was not repeating the key mistake of Japan’s banking crisis, covering up its rot. The drama was also spurring wide debate about what had gone wrong.

Only a few days after Bear Stearns collapsed, Timothy Geithner had urged Jerry Corrigan, his predecessor at the New York Fed, to organize a “voluntary” Wall Street report on how complex finance could be made less risky. Corrigan was only too happy to oblige. Corrigan had already overseen two earlier studies, one on the lessons from the implosion of Long-Term Capital Management, and the second, in 2005, just as the credit bubble was getting under way, on the state of complex finance. Corrigan was convinced that his third report, though, would be the most important. “We need to ask some important rhetorical questions—like, Why did everyone miss the boat?” Corrigan observed. “I am still mystified by that—that is the big issue. Yes, we knew that risk was mispriced, but we did not see what was coming! I don’t think anyone really did.”

Corrigan asked Andrew Feldstein to help him write the section on reforms needed for credit derivatives. Outside Wall Street, Feldstein’s five-year-old fund, BlueMountain, was little known; however, by 2008 the fund’s credit derivatives book was bigger than that of many banks, which gave Feldstein huge clout in the sector.

Also in the spring of 2008, the Institute for International Finance, a Washington-based think tank, corralled one hundred senior bankers to write a report on the credit dramas. This report argued that the system had to change, that it was time to go back to basics, to revert to a simpler, more transparent, and more “honest” style of banking. “There really is an overriding responsibility for the industry to get its act together now,” observed Charles Dallara, head of the IIF. The IIF had no powers to force banks to clean up their acts, but most of its recommendations were subsequently adopted by the Basel committee of international supervisors, a body that did have the power to set new rules. In late spring, at meetings of the Group of Eight finance ministers, the Basel committee issued its own report, and though it stopped short of recommending a complete rethink of the Basel Accord, as some analysts had hoped for, it did call on banks to lay aside much bigger reserves, to focus more on liquidity issues, and to be far more discriminating in their use of credit ratings.

Even after the turmoil and losses, though, other voices objected strenuously to reform proposals. Mark Brickell, who had lobbied so vigorously in the 1990s against regulation of derivatives on behalf of the International Swaps and Derivatives Association, spoke on April 16, 2008, at the ISDA’s annual meeting.

As Brickell stood at the podium in the ballroom of the Vienna Hilton, history weighed on him. ISDA had gathered in the same city two decades earlier, and Brickell considered that symbolically appropriate. Vienna was the home of the great free-market economist Friedrich von Hayek, Brickell’s hero. “[Twenty years ago] we set out to design a business guided by market discipline because we believed that it should be an even better guide to good behavior than regulatory proscription,” he observed. “The credit crunch gives good evidence that market discipline has guided the derivatives business better than regulation has steered housing finance.”

Brickell remained as opposed as ever to the idea that governments should intervene. “Hayek [the Viennese economist] believed that markets would create a rhythm of their own, that they are self-healing. That is something we all should remember and honor today,” he told the audi
ence. “When governments arrive to help, there is always a price to be paid that often takes the form of greater regulation.”

Not all attendees agreed that government scrutiny was wrong. The conference had started with a keynote speech from Paul Calello, the head of the investment bank of Credit Suisse, who had warned, “We cannot expect ‘business as usual.’ There will be new regulation, and there
should
be; voluntary efforts are not enough. This new phenomenon of ‘too interconnected to fail’ is now a permanent part of the financial system.” Some of the ISDA officials were furious, believing Calello had let them down.

In early August, Corrigan himself weighed in with his report, which urged banks to overhaul their risk management systems, to create a more standardized and transparent set of financial tools, and to move credit derivatives trading onto a centralized clearing platform. And he urged that these things be done within a matter of months. “Costly as these reforms will be, those costs will be minuscule compared to the hundreds of billions of dollars of write-downs experienced by financial institutions in recent months to say nothing of the economic dislocations and distortions triggered by the crisis,” Corrigan wrote in a covering letter to Henry Paulson. “[The banking industry] needs a renewed commitment to collective discipline in the spirit of elevated financial statesmanship that recognizes that there are circumstances in which individual institutions must be prepared to put aside specific interests in the name of the common interest.” Corrigan lamented that there appeared to be precious few such bankers left.

Corrigan’s urgency was well placed. In the weeks after the Bear–JPMorgan Chase deal, the LIBOR rate, the key “litmus test” of borrowing costs, had fallen, but it was creeping back up again by midsummer. Policy makers were alarmed and confused about what was going on. More trouble seemed imminent.

One issue was that, as the problem came to be described, the tremors on Wall Street were now reverberating on Main Street. Banks buckling
under their vast losses were slashing loans not just to hedge funds now, but to all sorts of companies. The crucial question now was one of timing: would the banks recover before the credit crunch threw the economy into recession? Solemnly, Paul Tucker, head of markets at the Bank of England, warned that “We face a race [against time]” to see whether “financial conditions…stabilise before macroeconomic slowdown, here and abroad, raises loan defaults.”

The signs didn’t look good for recovery at the banks that quickly; the losses just continued to mount. By April, the total loss in the estimated prices of mortgage-linked CDOs and other securities had reached almost $400 billion, a dramatically larger figure than any of the earlier predicted subprime losses, which prompted the International Monetary Fund to estimate that the total “losses” from the credit crisis could reach $1 trillion. Though some argued that those ABX-based prices had fallen too far, that argument offered little reassurance to investors. Even if prices seemed absurdly low relative to fundamentals, there were simply no buyers for super-senior assets. “The real problem is the lack of any buyers for the AAA debt,” explained Rick Watson, head of the European Securitisation Forum. “That is the biggest issue dogging the market.”

What was now driving the price of super-senior risk was not so much “hard” economic data, which could be plugged into models, but investor fear, which economists had long ignored in their modeling. In this new world, the “quants” were at sea. It was a terrifying, disorienting landscape, and the banking community was about to suffer a gut-wrenching case of vertigo.

Steve Black was scheduled to play a golf match on Saturday, September 13, with some key JPMorgan Chase clients. On Friday morning he called the club to say he was unsure if he would play. Six months after the drama of the Bear Stearns deal, he sensed that more trouble and uncertainty were about to strike. On September 7, the Federal Reserve had put the two state-backed mortgage giants, Fannie Mae and Freddie Mac, under “conservatorship,” a move tantamount to nationalization. By the sum
mer, confidence that they would be able to weather the storm of mortgage defaults and the credit crunch had started to slip. The housing market was continuing to deteriorate fast, and the default rate on prime mortgages started to rise. Like the shadow banks and brokers, Fannie and Freddie had been operating with very high levels of assets relative to their equity.

The move on September 7 temporarily calmed markets, but it also stoked more uncertainty about long-term prospects. As the implications of the conservatorship sank in, many investors realized they had suffered big losses. In addition, a host of CDS written on bonds that had been issued by the two giants defaulted. The state of the housing market was looking ever more dire, as was the fate of prices of mortgage-linked securities. By August, average US house prices were 20 percent below their level two years before. The ABX was also continuing to slide. A new cycle of fear was gaining traction, and investors warily scanned the banking landscape for warning signs of new failures.

In early September, Lehman Brothers came into the crosshairs. During the Bear crisis, Lehman’s share price had slumped because investors assumed that if Bear collapsed, Lehman would go next. Lehman had also drawn a large portion of its funding from the short-term repo markets and had large exposure to both the residential mortgage bond sector and commercial real estate. When the Fed rescued Bear, Lehman’s share price rebounded, and when the Fed then announced it would extend funding to all brokerages, some bankers joked that the Fed’s announcement should be called the “Save Lehman Act 2008.”

In June, the firm shocked observers by announcing a $2.8 billion loss in its second-quarter results, though it swiftly raised $6 billion of capital to shore up its base. Rumors began circulating, though, that the bank was understating the scale of its bad loans. Analysts thought Lehman should allay those concerns by raising more capital or merging, but Lehman CEO Richard Fuld refused to do either. Fuld was a fiercely independent character who hated the idea of selling out, and though Lehman executives discussed selling a stake in the company to investors,
including the Korean Development Bank, by early September no deal was in the works.

Lehman was bleeding funding by then, and on Wednesday, September 10, Fuld made one last, desperate roll of the dice. The company declared plans to sell its asset management operations and spin out almost $30 billion of its mortgage assets into a separate, ring-fenced vehicle. But when bankers at other institutions looked into the details of what Lehman was up to, they spotted a troubling detail. The small print of Lehman’s announcement suggested that it was using valuation estimates for its troubled assets much higher than those of other banks. Confidence in the bank crumbled. “What about the rest of the bank’s numbers? Can we trust those?” bankers started to ask.

The price of buying protection against a Lehman default using credit derivatives rocketed, and investors in the repo market stopped dealing with the bank. In an eerie replay of Bear’s collapse, hedge funds moved their money out of the bank, and investors started to assign the credit derivatives contracts they had previously written with Lehman Brothers to other banks.

By Tuesday the 9th, Black was becoming alarmed about the risks this posed to JPMorgan Chase. Morgan was the broker’s clearer, which meant it would be exposed to losses if Lehman suddenly collapsed. To protect itself, Black called Fuld and told him that he wanted Lehman to post an additional $5 billion of collateral. Black promised to work with the broker so that they did not need to find the funds from their capital. Even so, Fuld balked. Eventually Black agreed to accept $3 billion.

By Friday, Black was still hoping that Lehman would make it through. After procrastination, he eventually called the golf club and agreed to play the next day, as planned. A few minutes later, Dimon burst into his room. “Guess what? We have got to go down to the Fed to discuss Lehmans.” At 6:00 p.m., Dimon, Black, and more than two dozen other Wall Street dignitaries—with the notable exception of Lehman Brothers—assembled in a large conference room in the Fed headquarters.

Once the bankers were assembled, Geithner cut to the chase. Leh
man, he declared, was on the brink of collapse, but the government had no appetite to save it with taxpayer funds. Was anyone willing to buy the broker? Or could the banks club together, as they had with LTCM?

Nobody in the room was keen.

When LTCM imploded in 1998, the hole in the fund was around $4 billion. Most of the banks that participated in the rescue thus needed to produce “only” $250 million or so. The hole in Lehman’s books was estimated to be well over $40 billion, implying that any rescue would require each bank to produce several billion dollars each. Many of those sitting in the Fed room could not produce that type of cash, even if they had wanted to. They desperately needed more capital themselves.

“But I assume we are going to talk about AIG [too],” Steve Black interjected. Geithner looked irritated; the meeting, he explained, had been called to discuss a solution to the
Lehman
problem. AIG would have to wait.

During the previous year, the health of the mighty AIG insurance group had attracted less attention from investors or journalists than that of the big banks. But Black knew that AIG was sitting on a vast position in super-senior risk that was ravaging its balance sheet. What he wanted to know was what did the Fed—or any of the other banks—plan to do about
that
? Without a solution, he feared that AIG could collapse, creating an even bigger shock.

Vikram Pandit, the man who had replaced Charles Prince as Citi CEO, echoed Black’s concern. “He’s right. We need to talk about AIG!” Geithner looked even more irritated. It was bad enough trying to cope with one financial crisis; battling two simultaneously looked almost impossible. He wanted to find a solution to Lehman Brothers first, and he pushed on. “There is no political will for a federal bailout,” Mr. Geithner said. “Come back in the morning and be prepared to do something.”

The next day, more than two dozen senior officials from the main Wall Street and European banks and brokers assembled at the Fed. Calello
from Credit Suisse was there. As he arrived at the Fed, he was struck by the historical irony: almost exactly a decade before, Calello had rushed down to the Fed on the weekend to discuss the fate of the Long-Term Capital Management hedge fund. This time, Calello noted, there were far more European bankers assembling for crisis talks in relation to Lehman. It was a powerful sign of how closely integrated the London and New York markets had become. “Why didn’t we learn the lessons from before?” Calello asked himself.