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 (6 page)

Then disaster struck. By early 1994, Fed chair Alan Greenspan was starting to fear that the US economy was overheating after several years of loose monetary policy. On February 4, 1994, he suddenly raised the federal funds rates by 25 basis points from 3 to 3.25 percent. The move, which came amid other unexpected economic data, stunned the markets, triggering a sharp fall in bond prices. It also caused carnage in the derivatives world. So many of the derivatives deals made in 1992 and 1993 were premised on rates continuing to fall, and with the sudden hike, these deals produced enormous losses.

An early victim was Procter & Gamble. The company had made a deal with Bankers Trust, with a face value of $200 million, that promised to reduce its medium-term financing costs, but only if interest rates kept falling. With the rate increase, the company was forced instead to book a pretax $157 million loss. Then more shocks emerged. Gibson Greetings, a medium-sized card company, announced a loss of $23 million; the Mead Corporation, another small American company, revealed similar losses; and Paine Webber, the asset management group, posted a loss of a whopping $268 million. A $600 million fund linked to Askin Capital Management collapsed. Orange County, the California municipality, suffered the biggest loss of all. In the early 1990s, Robert Citron, county treasurer, had decided to boost the municipality’s investment returns by purchasing inverse floater products from Merrill Lynch. Initially, the tactic was successful; in 1993, Citron’s investment pool delivered returns of 8.5 percent, against the state average of 4.7 percent. Orange County, as so many other derivatives users had begun to do, had borrowed heavily to place these bets, greatly leveraging its core assets, and its losses totaled more than $2 billion. The municipality was forced to file for bankruptcy.

These shocking losses prompted investor and public fury. Procter & Gamble sued Bankers Trust, and Orange County sued Merrill Lynch.
Meanwhile, the mainstream American and British media unleashed a torrent of criticism.
Adam Smith’s Money World
declared that derivatives might be the financial equivalent of the next space shuttle disaster.
Fortune
published a cover with the word “derivatives” on the jaws of a giant, terrifying alligator. “Financial derivatives are tightening their grip on the global economy,” the article ominously warned, “and nobody knows how to control them.”

Shortly thereafter, the General Accounting Office issued a highly critical 196-page study on the state of the derivatives world, with conclusions diametrically opposed to those of the G30 report. Derivatives trading, it declared, was marked by “significant gaps and weaknesses” in risk management that created a wider systemic risk. Indeed, the dangers were so high, it argued, that derivatives might even end up producing a debacle as bad as the savings and loan shock. There was an “immediate need” for Congress to step in, Charles Bowsher, head of the GAO, urged.

Democrats and Republicans swiftly responded, and by the summer of 1994, no fewer than four bills proposing regulations had been submitted to Congress. “The GAO and I see eye-to-eye on the need for increased disclosure, for improved supervision, and for stronger international coordination of derivatives regulation,” declared Texas Democrat Henry Gonzalez, who was chairing the banking panel and backing one bill. Edward Markey, a Massachusetts Democrat who was chairing a congressional panel overseeing the securities markets, warned, “The question now is no longer whether regulatory or legislative changes will be made…but what form such changes should take.”

Derivatives traders were horrified. J.P. Morgan itself weathered the scandals moderately well. The losses at Procter & Gamble badly damaged the standing of Bankers Trust. Merrill Lynch’s image was badly wounded by the Orange County scandal. While some of J.P. Morgan’s clients also suffered losses, they were less visible than those of other groups. That partly reflected luck. The team had also shied away from some dangerous schemes.

Before Orange County had cut its disastrous deal with Merrill Lynch, for example, the municipality had approached J.P. Morgan asking to cut a similar trade. Bill Demchak, then one of the young salesmen on the
derivatives desk, flew out to meet the treasurer of the municipality and quickly concluded that the Orange County officials had no idea how derivatives really worked. “Under no circumstances should we deal with this client!” he declared.

At the time, such caution had cost Hancock’s team hefty fees and reinforced the take among its rivals that the bank was stodgy. “The reality was that we just did not chase the last dollar—we were less commercial in that respect,” Hancock later said. By the summer of 1994, the bank was relieved to have dodged the Orange County scandal. As rivals writhed, J.P. Morgan swooped in. “We got a lot of business after those scandals, restructuring deals that had gone wrong, because we were one of the banks that clients still trusted,” Demchak recalled.

Hancock knew that it would be essentially meaningless for J.P. Morgan to grab a bigger slice of the derivatives pie, however, if the business were going to be strangled by regulations. So, behind the scenes, Brickell and other ISDA officials furiously leapt into lobbying action, determined to block the bills before Congress. Brickell paid a frenetic series of visits to Republican and Democratic congressmen. He also relentlessly called journalists, trying to persuade them to stop writing about derivatives in such a negative light. He then met with regulators around the world, preaching the gospel that the industry was perfectly capable of cleaning up its act on its own, using the G30 report as its template.

History was not on their side: on almost every occasion during the previous hundred-odd years, lawmakers had responded to financial scandal by producing a new set of government rules. Yet Brickell was a zealot; in his eyes, the battle in Washington was not about mere business, it was an ideological fight of the highest order.

The sheer intensity of his lobbying mission irritated many. Christopher Whalen, a director at Whalen Co., a Washington lobbying firm, observed at the time: “ISDA came to Washington telling everyone they’re stupid. Their message was that everything is okay [in derivatives]—a blanket statement, boom. That strategy has convinced everybody in Washington that they have something to hide.” Or as an aide to Edward Markey said: “There is a disconnect in terms of a lack of understanding between many market participants of how the policy-making process
works…. The combination of arrogance and defensiveness is never one that works very well in Congress…[their attitude] was basically: ‘How dare anybody question the functioning of this market! How presumptuous!’”

But Brickell was relentless, and as the weeks passed, against expectations, his campaign turned the tide. One reason was that the Clinton administration was receptive. Before Clinton entered the White House, in 1992, he had taken an anti–Wall Street stance. Once ensconced, faced with the formidable lobbying power of Wall Street, the Clinton camp shifted view. “Derivatives are perfectly legitimate tools to manage risk,” Treasury Secretary Lloyd Bentsen said in a May 1994 speech to securities dealers. “Derivatives are not a dirty word. We need to be careful about interfering in markets in too heavy-handed a way. Right now our principal emphasis is on making sure existing regulatory authority is fully reviewed and implemented.”

Or as Kevin Phillips, the historian, noted in a book at that time: “Even before the man from Arkansas was inaugurated, it was clear that strategists from the financial sector, more than most other Washington lobbyists, had managed the Bush-to-Clinton transition without missing a stroke. Well-connected Democratic financiers stepped easily into the alligator loafers of departing Republicans. The accusatory rhetoric of the campaign dried up. The head of Clinton’s new National Economic Council, Robert Rubin, turned out to have spent the 1980s as an arbitrageur for Goldman Sachs.”

The tenacious campaign being waged by ISDA also chimed with the views of Alan Greenspan. A staunch believer in free markets, he cautioned against the bills proposed. “Legislation directed at derivatives is no substitute for broader reform, and, absent broader reform, could actually increase risks in the US financial system by creating a regulatory regime that is itself ineffective and that diminishes the effectiveness of market discipline,” Greenspan admonished Congress in the early summer of 1994.

Even Jerry Corrigan appeared to have accepted ISDA’s stance. Corrigan had left the New York Fed in 1993 and moved to Goldman Sachs as an adviser. From that vantage point, he also had reservations about intro
ducing government rules. “Derivatives are like NFL quarterbacks: they get more credit and more blame than they deserve,” he said in a congressional hearing. “When I say I don’t think legislation is needed, I’m not saying that I’m satisfied with the status quo. But the things that need to be done can be done under existing legislative authority.”

By end of 1994, the ISDA campaign had been so brilliantly effective that all four of the antiderivatives bills in Congress were shelved. Henry Gonzalez, the sponsor of one of them, commented in his colorful Texan style about the effort, “It’s been like a coyote out in the brush country baying to the moon at midnight. Only the poor ranchers waking up would know that was the coyote, as far as being heard.” It was an extraordinary victory for ISDA—one of the most startling triumphs for a Wall Street lobbying campaign in the twentieth century.

This battle set the terms for the derivatives innovation frenzy that followed over the next dozen years. Self-policing had won the day. That was to make all the difference. Peter Hancock’s team was about to conceive a way to make the idea of credit derivatives work, and in the absence of regulatory oversight, the eventual innovation frenzy would later fuel a boom beyond all bounds of rational constraint—or self-discipline.

I
n the weeks following the swaps team’s Boca Raton off-site, stories of the weekend’s escapades ripped around the bank. To the team members themselves, the tales were a source of pride and of furtive bonding. The stories added luster to the aura around them, and the swaps desk was now considered as edgy as would ever be possible at staid J.P. Morgan.

Immediately upon returning, the team threw itself into crafting ways to make the idea of credit derivatives work. As far as Peter Hancock was concerned, this was an innovation battle that he personally needed to wage on two fronts. He needed to produce some brilliant ideas that would take finance to a new frontier, and he needed to devise a social organization that would unleash his team’s innovative juices.

Hancock had shrewdly selected Bill Winters and Bill Demchak to lead the effort, and they set right to work building their teams. One of Winters’s smart hires was Tim Frost, an ambitious young derivatives trader who hailed from the English town of Nottingham and had never quite lost that region’s flat vowels in his accent. Another important addition was Tony Best, a smooth, skilled salesman with a cut-glass British accent who had worked in swaps since the 1980s. Over in New York, Demchak hired a laconic, redheaded banker from New Orleans named Charles Pardue, who quickly proved his talents. Another key hire was Andrew Feldstein, an earnest former lawyer who was introverted but exceedingly bright, who also had a penchant for lateral thought. “Andrew and I have the same kind of mind,” Demchak liked to say. “He is someone
I can sit around for hours with, tossing around problems, picking things apart and then trying to reassemble them.”

In keeping with J.P. Morgan’s international tradition, Demchak also recruited a clutch of non-Americans to his cause, some of whom were officially placed in the IDM team, while others were merely affiliated. One of those was Krishna Varikooty, a diligent young Indian, who was a talented mathematical modeler. Demchak would come to respect Varikooty deeply, impressed not only by his quantitative skills but also by his strong ethics and stubborn stance when fighting for something he believed to be right. “Krishna is like my conscience!” Demchak liked to joke. A particularly notable hire was Blythe Masters, a young British woman. She was a pretty blonde with a slim frame and porcelain face, who spoke with a so-called BBC accent. She had grown up in Kent, a corner of southern Britain so verdant that it’s dubbed “the garden of England,” where she studied at a prestigious private school and developed an abiding passion for horseback riding. From an early age, she displayed a stubborn, driven streak, which helped her to win a coveted place to study economics at Cambridge University.

Before entering college, she did an internship at J.P. Morgan, and the experience changed the course of her life. By chance, she was placed on the bank’s derivatives team in London during the summer of 1987, when Connie Volstadt’s team was reexamining its books to resolve the accounting dispute about the $400 million loss it had been accused of. Masters, who was drafted to help track down old trades, became fascinated with derivatives. “I think these products appealed to me because I had a quantitative background,” she later explained, “but they are also so creative.”

While her contemporaries spent their summer holidays during college cavorting on the beaches of Thailand or InterRailing around Europe, Masters returned each year to work at J.P. Morgan’s London office. “When she was at university she wasn’t weird or anything—she was up for a laugh,” one of her college friends recalled. “But you always knew she was ambitious.” Immediately after graduation, in 1991, Masters joined J.P. Morgan’s commodities desk, first in London and later in New York. But then her life took an unorthodox twist.

She started dating a fellow banker, became pregnant at twenty-three, and married. Some colleagues expected her to leave the bank, but she insisted she was committed to her career. Years later, when she had become a prominent spokesperson for the J.P. Morgan derivatives group, interviewed regularly by journalists, she was reluctant to discuss the events. “Nobody ever asks
men
about their families or their decision to have children!” she would point out to colleagues. “Why should anyone care about mine?”

She knew only too well, though, that she would need to demonstrate extraordinary devotion to her job if she were to be taken seriously. When she went to the hospital to have her baby, she slipped a tiny device to track market prices into her handbag, though she ended up barely using it. “Funnily enough,” she told a reporter, with British sarcasm, “it turned out that being a mother was somewhat more time-consuming than I thought.”

In other areas of banking, or at other banks, her career might have been hobbled before she had really started. But derivatives was such a new field that it was easier to break the mold, and Peter Hancock was a staunch believer in meritocracy. He didn’t care what his team looked like or about their personal lives, as long as they were bright and collegiate. Above all they had to share his intellectual curiosity. “I suppose we created a place where people such as Masters could flourish,” he later commented. “I don’t think that would have happened at many other banks.”

Masters was by no means the only woman in Hancock’s empire. Terri Duhon, a young female math whiz from a poor family in rural Louisiana, subsequently joined the IDM team. So did Betsy Gile, a cheery, no-nonsense woman who had previously worked in the lending business of J.P. Morgan. Another recruit, Romita Shetty, was an Indian-born credit expert who had started her career as an analyst at Standard & Poor’s rating agency. When Demchak first offered her a job in IDM, he gave her no actual job description. The team, he explained, was free-floating: members would work on different projects and with different colleagues as needed. She jumped at the chance. “What they were doing looked so exciting,” she later recalled.

Just as Hancock had hoped, his collection of bright young bankers quickly started fermenting creative ideas in a range of types of derivatives business. Masters was part of a group told to pursue the credit derivatives idea, and she threw herself into the assignment. She could see fully well that it had revolutionary implications.

From time immemorial, the worlds of business and finance have been beset with the problem of default risk, the danger that a borrower will not repay a loan or bond. Banks had long tried to minimize that problem in several ways. The most basic was to ensure that they made only wise lending decisions; hence J.P. Morgan’s strong emphasis on its training program. Diversifying a bank’s customer base was another technique, akin to diversifying a stock portfolio. Banks also sometimes clubbed together to make joint loans, thereby spreading the pain of defaults, and they imposed absolute limits on the amount of money that could be loaned to given sectors: only so much in housing, another amount in consumer credit, and so on. A rule might stipulate, for example, that each department could have no more than $10 million of loans to home builders. Nonetheless, history is littered with examples of banks that collapsed because they misjudged default risk or had too much exposure to a single sector or lender. The savings and loan debacle of the late 1980s and early 1990s was one case in point.

Masters and the rest of the IDM team knew that in the world of swaps, techniques had been found to separate out, as a derivative product, parts of the risk attached to bonds—say, the risk that interest rates would rise and lead a bond’s value to fall. Derivatives traders had been able to sell that risk as a product to investors who were willing to bet that interest rates would not actually rise. The bondholder, with the bank acting as broker, was in effect able to sell the risk of the bond to another, less risk-averse investor. So what would happen, Masters asked herself, if the same principle were applied to the default risk associated with a loan? Doing so would overturn one of the fundamental rules of banking: that default risk is an inevitable liability of the business. If a technique could
be developed to package default risk so that it could be traded, that would be an enormous boost for banking in general.

For the first time in history, banks would be able to make loans without carrying all, or perhaps even any, of the risk involved themselves. That would, in turn, free up banks to make
more
loans, as they wouldn’t need to take losses if those loans defaulted. The derivatives buyers who had gambled on that risk would take the hit.

Such derivatives could be especially useful for J.P. Morgan. By the early 1990s, the bank was facing a particularly pernicious set of financial headaches. The Basel I Accord of 1988 stipulated that all banks needed to hold capital reserves equivalent to 8 percent of the corporate loans on their books: $8 of spare funds for every $100 lent out. The rule applied to all corporate loans for all banks which were deemed to be investment grade by ratings agencies, irrespective of the precise risk attached to them. J.P. Morgan considered that extremely unfair. The bank concentrated on loans to high-quality corporate clients and foreign governments, and the default rate on those loans tended to be so low that keeping $8 of reserves for every $100 lent out seemed a complete waste of resources. Those loans were also not very profitable, because the riskier a loan, the more a bank can charge the client for it. This had seriously curbed the degree to which J.P. Morgan could grow its business.

To make matters worse, those at the bank trying to boost profits faced a related internal headache, separate from the Basel rules. To combat the danger of default, the bank imposed rigorous internal credit limits on each department, keeping a tight rein on the exposure to risk. By 1994, Hancock’s derivatives group had expanded so fast that the net exposure it had incurred via swaps amounted to approximately $30 billion, and it was bumping up against its limit, finding itself hemmed in.

If the bank could find a way to shift that credit risk off its books, both the “credit limit” headache and the “Basel” problem might disappear. That was a tantalizing prospect. “If we could make this idea work, this thing could be huge!” Demchak told his team.

But
could
it be made to work? Over at Merrill Lynch, Connie Volstadt’s team had already been playing around with similar ideas for a
year. And at Bankers Trust innovative traders named Peter Freund and John Crystal had actually cut a couple of deals using these concepts as early as 1991. That made Freund and Crystal the true “inventors” or pioneers of credit derivatives. However, perhaps ironically, Bankers Trust itself never tried to turn its brainchild into a large-scale business. The bank was beset with management upheaval at the time. Moreover, the credit derivatives concept did not seem sufficiently profitable, relative to other business lines, to tempt Bankers Trust traders to devote enough time and energy to create a mass-market credit derivatives business.

Hancock’s group, though, operated with different incentives. At J.P. Morgan, generally pay was also tied to profits personally accounted for. But Hancock had impressed on the IDM bankers that they were supposed to chase ideas with long-term value, even at the expense of the quick buck. Moreover, the team knew that if they “cracked” the credit derivatives puzzle, they would solve a big problem for the bank, which would win them considerable acclaim, thereby boosting their careers. “They say necessity is the mother of invention,” Feldstein later said, smiling. “In the case of credit derivatives, we all knew there was a real need, a problem that had to be solved. So we all looked for ways to do that.”

Blythe Masters fervently hunted for a way to make credit derivatives work, and eventually she spotted an opportunity at Exxon. In 1993, after Exxon was threatened with a $5 billion fine as a result of the
Valdez
oil tanker spill, the company had taken out a $4.8 billion credit line from J.P. Morgan and Barclays. When Exxon first asked for the credit line—which is a commitment to provide a loan, if needed—J.P. Morgan was reluctant to say no because Exxon was a long-standing client. The loan epitomized the twin problem of capital requirements and internal credit limits. Like so many of J.P. Morgan’s corporate loans, it would produce little, if any profit, yet would gobble up credit, pushing the limits, and would require a large amount of capital reserve. In theory, the bank could have dealt with that headache by selling the loan to a third party, since a market for
selling such loans did exist. But that would have violated its commitment to client loyalty.

Masters thought she could see a solution. In the autumn of 1994, she contacted officials at the European Bank for Reconstruction and Development (EBRD) in London to see if she could find a way to off-load the credit risk of the Exxon deal, but
without
selling the loan. The EBRD might be interested, she figured, because it had complementary needs; it had a large amount of credit available for extending to companies with high credit ratings. The bank was also eager to find ways to earn more money on its investments, as it was rigorously restrained from high-risk activity, so generally earned low returns.

Masters proposed that J.P. Morgan pay the EBRD a fee each year in exchange for the EBRD assuming the risk of the Exxon credit line, effectively insuring J.P. Morgan for the risk of the loan. If Exxon defaulted, the EBRD would be on the hook to compensate J.P. Morgan for the loss; but if Exxon did not default, then the EBRD would be making a good profit in fees. The EBRD might well be interested, Masters figured, because the chances that Exxon would default were so slim. True to the derivatives formula, the loan would not actually move from J.P. Morgan’s books to EBRD, so Morgan would be respecting its client relationship without eating up its internal credit lines.

Andrew Donaldson, the EBRD’s director, liked the idea. He agreed that it was highly unlikely Exxon would default, and he was impressed by the steady stream of income from the fees. It was much higher than anything else he could earn on a highly rated bond or loan. “It seemed like a win-win situation,” Donaldson later recalled. Just as Salomon Brothers’ early interest-rate swaps deal between IBM and the World Bank had met two sets of needs, the Exxon deal was brilliantly transferring risk in a way that suited both parties.