Demchak’s razor-sharp mind dissected problems at lightning speed. A particular talent was lateral thought, pulling in ideas from other areas of banking. He was also a natural leader, and he instilled extreme loyalty among his staff. His colleagues often joked that if it were not for the practical Demchak, Hancock “would have stayed on Pluto.” He was the perfect man to implement his boss’s schemes.
Hancock installed another ambitious and driven banker in the London office of the team. Bill Winters, who had taken the breaking of his nose with such good cheer, also came from a relatively modest background by comparison to the Ivy League pedigrees of so many of the banking elite. He had studied at Colgate University in New York State, and joined the bank in the mid-1980s. He was blessed with good looks—female colleagues thought Winters looked a little like the actor George Clooney—but he preferred to stay out of the limelight. And whereas Demchak was given to explosions when confronting resistance, Winters was more flexible and tended to dance around problems, getting what he wanted with finesse. He was intensely hardworking.
Hancock first noticed Winters in the late 1980s, when he was working in the area of commodities derivatives. “We sent him down to Mexico and somehow—I still don’t know how—he persuaded the government to hedge half of its oil production and interest-rate exposure with us,” Hancock recalled. “There was no drama, he just did it. That is his style.” Hancock appointed him to run the European side of the derivatives team with the expectation that the “two Bills,” as their colleagues dubbed them, would work well together in tossing innovative ideas back and forth across the Atlantic.
Central to the swaps team’s quest now was to take the newfangled breed of financial products called derivatives into new terrain.
When bankers talk about derivatives, they delight in swathing the concept in complex jargon. That complexity makes the world of derivatives opaque, which serves bankers’ interests just fine. Opacity reduces scrutiny and confers power on the few with the ability to pierce the veil. But though derivatives have indeed become horribly complex, in actuality, they are as old as the idea of finance itself.
As the name implies, a derivative is, on the most basic level, nothing more than a contract whose value derives from some other asset, such as a bond, a stock, or a quantity of gold. Key to derivatives is that those who buy and sell them are each making a bet on the future value of that asset. Derivatives provide a way for investors either to protect themselves—for example, against a possible negative future price swing—or to make high-stakes bets on price swings for what might be huge payoffs. At the heart of the business is a dance with time.
Say that on a particular day, the pound-to-dollar exchange rate is such that one British pound buys $1.50. Someone who is making a trip from England to the US in six months and thinks the exchange rate may become less favorable might decide to make a contract to ensure that he can still buy dollars at that rate just before his trip. He might enter into an agreement to exchange 1,000 pounds with a bank in six months’ time, at $1.50, no matter what the actual exchange rate is by then. One way to arrange that deal would be to agree that the trade must happen, no matter what the actual rate of exchange is at the time, and that would be a future. A variation would be that the traveler agrees to pay a fee, say $25, to have the option to make the exchange at the $1.50 rate, which he would decide not to exercise if the rate actually became more favorable.
Versions of derivatives trading have existed for centuries. Rudimentary examples of futures and options contracts have been found on clay tablets from Mesopotamia dating to 1750 BC. In the twelfth and thirteenth centuries, English monasteries made futures deals with foreign merchants to sell wool up to twenty years in advance, and famously in seventeenth-century Holland, when tulip prices began to rise substantially, merchants frantically bought and sold tulip futures, leading to a bubble that ended in a spectacular crash.
The modern era of derivatives trading began when the Chicago Board of Trade was established in 1849, allowing for the buying and selling of futures and options on agricultural commodities. Wheat farmers might buy futures before harvest on the price their wheat would bring in, hoping to hedge against low prices in the event of a bumper crop. Speculators would take on the risk of the losses farmers feared in the hopes of big payoffs that all too often turned horribly bad.
In the late 1970s, a bold new era of derivatives innovation was inspired by a set of technological breakthroughs and increasing volatility in the financial markets. It brought derivatives from the world of commodities into the domain of finance. The post-WWII Bretton Woods system of credit and exchange controls, which had maintained relative stability in world markets, broke down, and the values of foreign currencies, which had been pegged to the dollar, became free-floating. That led to unpredictable swings in exchange rates. Oil price shocks then sparked a pernicious blend of recession and inflation in the US, with inflation eventually peaking at 13.2 percent in 1981. Shocked investors scurried to find ways to protect themselves from the devastating impact of the high interest rates—in the US the prime rate rose to a high of 20 percent in June 1981—and from relentless swings in exchange rate.
Historically, the best way to insulate against such volatility was to buy a diversified pool of assets. If, for example, a company with business in both the United States and Germany were concerned about swings in the dollar–to–deutsche mark rate, it could protect itself by holding equal quantities of both currencies. That way, either way the rate swung, the losses would be offset by equal gains. But an innovative way to protect against swings was to buy derivatives offering clients the right to purchase currencies at specific exchange rates in the future. Interest-rate futures and options burst onto the scene, allowing investors and bankers to gamble on the level of rates in the future.
Another hot area of the derivatives trade, which evolved shortly thereafter, was the highly creative business Peter Hancock’s team specialized in, known as “swaps.” In these deals, investment banks would find two parties with complementary needs in the financial markets and would broker an exchange between them to the benefit of both, earning the banks large fees.
Say, for example, two home owners each have a $500,000 10-year mortgage, but one has a floating-rate deal, while the other has a rate fixed at 8 percent. If the owner with the fixed rate thinks that rates are going to start to go down, while the other owner thinks they are likely to go up, then rather than each trying to get a new loan, they could agree that each quarter, during the life of their mortgages, they will swap their payments. The actual mortgage loans don’t change hands; they stay on the original banks’ books, making the deal what bankers call “synthetic.”
Salomon Brothers was one of the first banks to exploit the potential of derivatives swaps, brokering a pioneering deal between IBM and the World Bank in 1981. In 1979, David Swensen, a PhD from Yale who had recently started working on the Salomon Brothers trading desk, spotted that IBM needed to raise a good deal of cash in dollars and had substantial excess quantities of Swiss francs and deutsche marks from having sold bonds to raise funds in those currencies. Normally, IBM would have had to go to the currency market to buy dollars. Swensen realized, though, that IBM might instead be able to swap some of its francs and marks for dollars without actually having to sell them if some party could be found who could issue bonds in dollars to match IBM’s bonds in francs and marks.
The World Bank was a likely candidate, as it always needed cash in many currencies. As with the two home owners who write a contract to swap the terms of their mortgages, IBM and the World Bank could swap their bond earnings and their obligations to the bondholders without any bonds actually changing hands. In 1981, after two years of wrangling over the details of the deal, Salomon Brothers announced it had concluded the world’s first currency swap between IBM and the World Bank, worth $210 million for ten years.
This new form of trade quickly spread across Wall Street and the City of London, mutating into wildly co
mplex deals that seemed to give bankers godlike powers. With derivatives, they could take existing assets or contracts apart and write contracts that reassembled them in entirely new ways, earning huge fees.
Of course, making these deals still relied on bankers being able to find two parties who both believed they would benefit. In synthetic finance, just as in “real” markets, trades can occur only if there is a buyer for every seller. But given the growing globalization of banking and how many players in the world economy had complementary needs and different expectations about future market conditions, the bankers had a wealth of options. Some players needed deutsche marks, while others wanted dollars. Some wanted to protect against expected interest-rate increases, while others believed rates were likely to fall.
Players also had different motives for wanting to place bets on future asset prices. Some investors liked derivatives because they wanted to control risk, like the wheat farmers who preferred to lock in a profitable price. Others wanted to use them to make high-risk bets in the hope of making windfall profits. The crucial point about derivatives was that they could do two things: help investors reduce risk or create a good deal more risk. Everything depended on how they were used and on the motives and skills of those who traded in them.
By the time the J.P. Morgan swaps team gathered in Boca Raton in June of 1994, the total volume of interest-rate and currency derivatives in the world was estimated at $12 trillion, a sum larger than the American economy. “The speed at which the market grew just took everyone by surprise. It was quite remarkable,” recalled Peter Hancock, who had been a vital participant in the boom.
In many ways, Hancock’s career made him the perfect man to be at the center of that extraordinary innovation storm. He was born in 1958, into an upper-middle-class British family based in Hong Kong. Like many children from that background and generation, he was dispatched half a world away to a British boarding school, where he excelled at rugby and decided that his ambition was to be a great inventor. After spending many happy hours immersed in science books, he went to Oxford to study physics, but his plans were derailed when he was badly injured in a rugby game. Hancock was laid up in bed for some time, so couldn’t get to the physics laboratory, and he decided to switch to philosophy, politics, and economics. That he could study from his bed. By the time he graduated, he became intrigued about banking and the principles of free markets. “I decided that being an inventor would have to wait,” he recalled. He had decided he wanted a career that paid better than those in science did. It was a common decision for British graduates at the time. The City of London and Wall Street looked increasingly alluring.
On graduation, he applied for jobs at a range of international firms, hoping for a globe-trotting career. But when he was offered a job in the London branch of Morgan Guaranty Trust Company, or “The Morgan Bank,” later rebranded J.P. Morgan, he quickly accepted. It was an unusual choice for a British graduate. The City of London was dominated by British-owned banks, and though American groups had raised their presence in the City during the 1970s, those Wall Street institutions overwhelmingly recruited graduates from the United States.
But J.P. Morgan had always had a transcultural identity. Well known as one of the large Wall Street firms, its roots lay in the City of London, where American banker Junius Spencer Morgan took charge of the English brokerage George Peabody & Co. in 1864 and renamed it J.S. Morgan & Co. His son J. Pierpont Morgan worked at the firm for some years and was then dispatched to New York, where he formed a partnership with the wealthy Drexel family, Drexel, Morgan & Company, which after Anthony Drexel’s death was renamed J.P. Morgan. The American bank quickly swelled into a powerhouse, with J. Pierpont Morgan personally brokering many major deals, audaciously merging a number of steel companies he had bought to form U. S. Steel, and financing major concerns in railroads, shipping, coal mining, and other key industries. By the late nineteenth century, the group had become so preeminent that it appeared to wield as much power in the financial markets as the American government itself.
When crisis hit Wall Street in 1893, Morgan personally orchestrated a syndicate to provide the US Treasury with $65 billion in gold, keeping it solvent. In the Panic of 1907, when the New York Stock Exchange plunged to half of its value, Morgan put up vast sums of his personal fortune and rallied other leading bankers to do the same, shoring up the banking system.
In the years after the Second World War, the bank lost some of its preeminence. After the crash of 1929, a populist backlash against Wall Street led to the introduction of the Glass-Steagall Act, which forced banks to split off their capital markets operations—the trading of debt and equity securities—from their commercial banking businesses. The J.P. Morgan empire was required to fragment into separate entities, including Morgan Stanley, the US brokerage; Morgan Grenfell, a British brokerage; and J.P. Morgan, which was devoted to commercial banking. But the bank maintained an unusually close set of ties with both governments and powerful, blue-chip corporate clients, such as Coca-Cola and AT&T. The international heritage of the bank was also preserved, so much so that J.P. Morgan staff sometimes joked that joining the bank was akin to entering the diplomatic or British colonial service—albeit much better paid.
When Peter Hancock joined the bank, he was dispatched to New York to attend a yearlong training course, together with around four dozen other recruits, only half of whom were American. “It was an extraordinary experience. We had Chinese, Malaysians, French—you name it. And we were all housed together in one small building down on the Upper East Side of Manhattan,” Hancock recalled. The course itself, however, didn’t have much to satisfy Hancock’s penchant for invention.
The Commercial Bank Management Program, as it was called, was conducted in the bank’s historic headquarters at 23 Wall Street, right across the street from the Stock Exchange, in an imposing, column-fronted building where J. Pierpont Morgan himself had worked. The first half of the course was spent in a classroom, learning fundamental banking skills little different from the practices in J. Pierpont Morgan’s time; the nuts and bolts of assessing credit risk by reading a company’s balance sheet and analyzing its business. The goal was to drill into them how to measure the chance a company would default on a loan, the lifeblood of J.P. Morgan’s style of banking. For the second half of the training, the recruits acted as the junior analysts in actual deals.
The trainees were required to spend a good deal of time crunching corporate numbers. Only a few years earlier, those calculations had had to be done by hand. When they needed to look up bond prices, they consulted a voluminous book of tables. By the time Peter Hancock took the course, however, handheld calculators programmed with the power to use complex mathematics to assess corporate cash flows and measure risk were becoming the rage. A new technological elitism was taking hold, and the trainees were in the vanguard of a bold new breed of banker.
For the Morgan Bank trainees, though, the mathematics was stressed to be only part of what banking was about; social factors, such as client relationships and reputation, were also heavily emphasized. Back in 1933, during the height of the populist backlash against Wall Street, the son of J. Pierpont Morgan—J. P. “Jack” Morgan, Jr.—had been grilled by Congress about his ethos. He declared that the aim of his bank was to conduct “first-class business…in a first-class way.” Fifty years later, that mantra of Jack Morgan struck much of the banking world as quaint. Years of bold innovation had made high-risk trading and aggressive deal making the gold standard of the street, and a “kill or be killed” ethic prevailed.
At 23 Wall Street, though, the senior bankers still talked about banking as a noble craft, where long-term relationships and loyalty mattered, both in dealing with clients and inside the bank. While at other banks, the emphasis had turned to finding star players, offering them huge bonuses, and encouraging them to compete for preeminence, at the Morgan Bank the emphasis was on teamwork, employee loyalty, and long-term commitment to the bank.
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any of the staff had worked only at J.P. Morgan, and while the bank paid less than most of its rivals, the trade-off was greater job security. The young trainees in the training program were told solemnly that while the bank would tolerate “errors of judgment,” an “error of principle” was a firing offense. “First-class banking” remained the mantra.
Peter Hancock easily passed the course and was dispatched back to the London office, where he spent a couple of years analyzing the credit-worthiness of North Sea oil companies. That was considered a plum job, because the Norwegian and British oil industry was starting to boom. But Hancock was hungry for more. As he looked around the City, he could see the revolution in derivatives and swaps building, and he wanted in.
The Morgan Bank was considered too stodgy to be a pioneer in the business. Aggressive Salomon Brothers and iconoclastic Bankers Trust were the real innovators. But shortly after Salomon announced the big IBM–World Bank swap, J.P. Morgan started looking for ways to do more such deals.
Initially, the epicenter of experimentation was not J.P. Morgan’s New York headquarters but the London branch of a corporate offshoot known as Morgan Guaranty Limited (MGL). While the Glass-Steagall regulations prohibited the main New York bank from playing in the capital markets, Glass-Steagall didn’t apply overseas. London’s regulatory authorities took a more laissez-faire attitude, generally permitting banks to engage in a wider range of services. As a result, Morgan Guaranty had built up a good capital-markets business. In the 1960s talented trader Dennis Weatherstone led the development of a flourishing foreign exchange business, and in the 1970s the office moved into the world of sovereign and corporate bond issuance. Business boomed in part because American companies realized they could pay less tax by raising finance in London rather than in New York.
That booming corporate bond business created the opening for Morgan Guaranty to move into the swaps world, and from the early 1980s, the Morgan Bank started to offer its clients deals through its London branch that allowed them to take advantage of the swaps magic. “This was an example of a fantastic innovation which really served a client need. It really solved problems in a useful way,” Jakob Stott, one of the young bankers who was on the swaps team, recalled.
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 Page 2
