Initially, arranging these deals was clumsy and time-consuming. Before a contract could be struck, two parties with matching needs had to be found. That alone could take weeks. On one of the first such deals, a swap between the Austrian government and Commerzbank, they spent an entire afternoon tapping out the details on a telex machine, spelling out all the future cash flows to their clients. As the 1980s wore on, though, the pace of business picked up. So did the profits.
The young traders in the group were thrilled with the increasing power and freedom they enjoyed. Few at the bank outside the swaps team itself knew how their trades worked, and the leader of the team, Connie Volstadt, widely recognized as one of the most brilliant minds in the derivatives world, was given great autonomy. Volstadt showed outright disdain for the Morgan Bank senior management and would reveal only the scantiest details about the team’s business. Indeed, the team members loved teasing those in the more hidebound departments. “We had this sense of being special, of being detached from everyone else, a little team that was very tightly bound together,” recalled Stott.
From time to time, the senior management would try to clip the swaps team’s wings. In 1986, Lewis Preston, then the chief executive of J.P. Morgan, flew to London and challenged the manner in which Volstadt was recording the value of deals. At the time, J.P. Morgan, along with every other bank, was unclear how to measure the worth of the swaps trades, as accounting guidelines were still being worked out. “You say your group has made a $400 million profit, but,” Preston challenged Volstadt, “it looks to me as if you have a $400 million loss!” Furious, Volstadt assigned a team of junior analysts and interns to reexamine every single paper ticket recording the deals, and when he proved his case, Preston backed down. The episode was indicative of the way the upper management viewed the swaps traders: as a bunch of unruly teenagers.
As Hancock watched the high-octane business of the swaps group from his humdrum perch in J.P. Morgan’s commercial banking team, he was fascinated and eager to join in. So in 1984, he joined the London bond group, and in 1986 he wangled his way to move across to New York, where the bank was expanding its derivatives operation. The J.P. Morgan managers had realized, to their utter delight, that there was no explicit provision in Glass-Steagall against trading in derivatives products.
Initially, Hancock’s role on the team was rather humble. He managed a small treasury team that used swaps to manage the bank’s on-balance-sheet assets and liabilities. But Hancock was articulate and opportunistic and soon found ways to make himself visible. After the 1987 stock market crash, interest rates fell and the bank suffered sizable unexplained losses in its derivatives books. Hancock was asked to explain to the bank’s senior management what had happened and ended up managing a small desk at headquarters that traded products known as “floors” and “caps.” Then, when the bank rebranded itself as J.P. Morgan in 1988, Hancock, a key sailor, organized a team that sailed round Manhattan with a vast J.P. Morgan logo on its sails. That garnered attention, particularly since Hancock’s team narrowly beat Goldman Sachs’s boat. He learned everything he could about how the derivatives world worked. He also impressed Dennis Weatherstone, CEO of the bank. Weatherstone was a legendary character. He hailed from working-class British stock, first joined the bank at age sixteen as a messenger boy in London, but later became a brilliant foreign exchange trader and eventually rose to the very top.
In 1988, a shock occurred that created Hancock’s opening. Connie Volstadt defected to work at Merrill Lynch, taking half a dozen of his team. It left the bank with a conundrum.
At other banks, the obvious way to fill the huge revenue hole left by Volstadt’s departure would have been to hire a new guru and build a new team from rival banks. But J.P. Morgan rarely hired outsiders into senior positions. The vast majority of its senior staff had come up through the ranks, giving the bank its insular culture, for good and ill. So the senior management initially appointed some of Volstadt’s junior team members to take over. Before long, it was clear they couldn’t fill his shoes, and Hancock saw his chance.
In 1990, at only thirty-two, he was considered too young to run a department. But he was good at navigating office politics. So, about a year after Volstadt left, Weatherstone announced that Hancock would lead the swaps team. “Sometimes in life you just get a huge break, and you just have to grab it and run with it,” Hancock later recalled. The would-be inventor now had a chance to let his penchant for invention run.
Over the next four years, Hancock rode the crest of the derivatives wave. When swaps had taken off, J.P. Morgan wasn’t at all viewed as an innovator; by 1994, its creative skills were as good as those of most rivals. Better still, the bank had advantages some rivals lacked. As a respected commercial lender, Morgan had access to a huge array of blue-chip companies and governments that were often eager to conduct derivatives deals. The bank was also one of the very few with a top-notch AAA credit rating, which reassured clients that the bank could stand by its trades. By the end of the 1980s, derivatives groups were no longer pairing only with other parties to make derivative deals, they also were using their own capital to make trades with clients on a huge scale. When clients cut deals with J.P. Morgan, the AAA rating assured them that the bank would always be around to fulfill its side of those deals.
As business boomed, the swaps department basked in the knowledge that it was producing an ever-increasing share of the bank’s profits. By the early 1990s, it accounted for almost half the bank’s trading revenues, and Hancock had been promoted to run not just the derivatives group but also the entire department it was part of, known as fixed income. He was considered a prime candidate for CEO.
A few months before the Boca off-site, a reporter from Fortune asked Hancock to explain how a complicated swap might work, and his response reaffirmed for her that derivatives traders were “like the spacecraft Galileo, heading for planet Jupiter.” “It would be something,” Hancock apparently said, “in which you get beyond binary risk and into a combination of risks, such as interest rates and currencies. Or take an oil company, which has risks of oil prices dropping and interest rates rising. To hedge, it could buy an oil price floor and an interest-rate cap.” But maybe, said Hancock, the company would like something a little cheaper: “In that case, we could do a contract that would pay out only if oil prices are low and interest rates are high at the same time.” The man who had once dreamed of being an inventor was in his element.
Yet down in Boca, Hancock was not in a celebratory mood. On the contrary, he knew that the derivatives sector was reaching a crucial point in its evolution and his team had to adjust. The essential problem was the phenomenon he described as the “curse of the innovation cycle.” In manufacturing or pharmaceuticals, patent laws ensure that a brilliant new product or idea is protected; competitors cannot simply steal that innovation. In banking, however, patents haven’t traditionally been an option. When financiers have a brilliant idea, nothing typically stops competitors from copying it right away, and before long they are putting downward pressure on profit margins.
The swaps business epitomized this problem. As soon as Salomon Brothers cut its first deal, other banks such as J.P. Morgan copied it, and the market exploded. The burst of activity had a vexing impact on profit margins. While the first wave of swaps deals had high margins, once copycats jumped in, competition brought fees down. For years, the issue hadn’t really worried Hancock because the volume of deals was growing so robustly. But he was unsure how long the volume could continue to explode, and he knew that if he wanted to keep his department cranking, he had to find a new way before long to do deals. He was feeling tremendous pressure to find the next Big Idea.
So while his team viewed the weekend as a lavish party, Hancock had a serious agenda. By bringing his young group together from all over the world, and pushing them into close quarters for forty-eight hours, he hoped he could spark the innovation flame.
On the Saturday morning, the group assembled in
a conference room a few feet from the sparkling blue sea for one in a series of meetings. How, Hancock asked, could they unleash a new wave of innovation in the derivatives business? Could bankers apply the principles to new areas? What about the insurance world? Or loans and credit?
The team was in little mood for mental gymnastics. Some were jetlagged and most were hung over. Bill Winters was nursing a badly swollen nose and wondering how he would explain it to his wife back home. “Frankly, I cannot remember much of our debate,” Bill Demchak, the team member who was Hancock’s de facto deputy, would later say with a sheepish laugh. All he could remember, he added, was that when he checked out of his hotel, his bill included charges for a smashed Jet Ski and a vast quantity of cheeseburgers. They had been charged to him, as a joke, by the rest of his team.
But Hancock’s intensity was impossible to resist. He strode around the room, chucking out ideas with his Planet Pluto energy, and soon enough the debate heated up. One key idea started to emerge: using derivatives to trade the risk linked to corporate bonds and loans. Commodity derivatives, a voice pointed out, let wheat farmers trade the risk of loss on their crops. Why not create a derivative that enabled banks to place bets on whether a loan or bond might default in the future? Defaults were the biggest source of risk in commercial lending, so banks might well be interested in placing bets with derivatives that would allow them to cover for losses, using derivatives as a form of insurance against defaults.
In truth, that was not a new idea. Three years earlier, the ever-inventive Bankers Trust had conducted the first pioneering deals along those lines. So had Connie Volstadt’s team at Merrill Lynch. But the notion hadn’t taken off because those trades didn’t appear particularly profitable. As the debate swirled around the room in Boca, though, Hancock and the others became excited about the concept. After all, they reasoned, the world was full of institutions—and not just banks—that were exposed to the risk of loan defaults. J.P. Morgan itself had a veritable mountain of loans on its books that were creating regulatory headaches. What would happen, they asked, if a derivative product of some kind could be crafted to protect against default risk—or to deliberately gamble on it? Would investors actually want to buy that product? Would regulators permit it to be sold? If so, what might it mean for the financial world if default risk—the risk most central to the traditional craft of banking—were turned into just another plaything for traders?
They had no idea that weekend how to answer those questions, but Hancock’s team was not used to taking no for an answer. They spent their days stretching their minds to the extremes, and they could see that the concept was potentially revolutionary. If you could really insure banks and other lenders against default risk, that might well unleash a great wave of capital into the economy. “I’ve known people who worked on the Manhattan Project—for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important,” Mark Brickell, one of the bankers on the J.P. Morgan swaps team, later recalled.
Recalling the Boca meeting, Hancock said, “The idea that we gave most emphasis to was using derivatives to manage the risk attached to the loan book of banks.” It was only many years later that the team realized the full implications of their ideas, known as credit derivatives. As with all derivatives, these tools were to offer a way of controlling risk, but they could also amplify it. It all depended on how they were used. The first of these results was what attracted Hancock and his team to the pursuit. It would be the second feature that would come to dominate the business a decade later, eventually leading to a worldwide financial catastrophe.
[ TWO ]
DANCING AROUND THE REGULATORS
There was a critical juncture, around the time that Peter Hancock’s team seized on the idea of credit derivatives, when financial innovation might have followed a subtly different path. In the few years leading up to Hancock’s Boca off-site, regulators and many prominent banking experts grew concerned about the boom in derivatives and the proliferation of exotic new types. They fiercely debated whether regulations should be imposed.
Peter Hancock found himself at the heart of this debate. In 1991, three years before the Boca Raton meeting, he had received an unexpected summons from Morgan CEO Dennis Weatherstone. “Corrigan wants to talk to us about derivatives,” Weatherstone said, ordering Hancock to attend the meeting “since you can explain this stuff so well.” Hancock had distinctly mixed feelings about the invitation. E. Gerald Corrigan, then age fifty, was the seventh president of the New York Federal Reserve, a position to which he had been appointed in 1985. It was a powerful role, including the oversight of New York commercial banks, and Corrigan, a forceful, burly character with a gravelly voice, was not afraid to express his views bluntly.
By 1991, he had already worked at the Fed for a couple of decades, serving as special assistant for a period to the legendary Paul Volcker, and he had seen the financial system suffer through several business cycles and bouts of panic. He had cut his teeth handling the Herstatt Bank crisis of 1974, when the failure of a small German group had rocked the Euromarket, and had confronted the Latin American debt crisis, the collapse of Continental Illinois National Bank, and the failure of Drexel Burnham Lambert. “I have seen it all before,” Corrigan was fond of growling. All that experience had left him uneasy about the tendency of bankers to sow havoc when left to their own devices.
The New York Fed’s vast granite headquarters was a five-minute stroll from the J.P. Morgan offices. Even so, Hancock had never passed through those intimidating steel doors. Bankers who worked on the commercial lending side of J.P. Morgan often chatted with central bankers, but central bankers and swaps traders had no such regular back-and-forth. As a result, Corrigan’s “invitation” left Hancock uneasy: what was the New York Fed planning to do with his beloved derivatives?
Corrigan himself was unsure. He had summoned Weatherstone and Hancock primarily because he was worried that he knew too little about derivatives, and he wanted to get more facts before deciding about possibly regulating them. J.P. Morgan was an obvious place to start, given its long-standing links with the Fed. Indeed, only a couple of years before, J.P. Morgan had hired the former executive vice president of the Fed, Steven Thieke, to act as its chief risk officer (one of the few cases where the bank hired from outside for a senior post).
For several hours, Corrigan grumpily peppered Weatherstone and Hancock with questions about the swaps world, and Hancock answered as best he could. He had the impression that Corrigan had only a modest knowledge of how derivatives worked. But, after all, why should that be a surprise? Almost nobody outside the teams of traders really understood the details. He left with the impression that while Corrigan was not automatically opposed to derivatives, he was not particularly thrilled with all of the innovation going on. What, Hancock wondered, would Corrigan do next?
Part of the problem with deciding what to do about derivatives regulation was that there was so little specific data available about the growth of the business. In the stock market, most trading takes place on public exchanges, such as the New York Stock Exchange or NASDAQ, which are tightly regulated to protect investors. Most commodities derivatives contracts also trade on regulated exchanges, such as the Chicago Mercantile Exchange, and are regulated by the US Commodities Futures Trading Commission. Some interest rate and currency derivatives were traded on exchanges too. Many others, though, were brokered privately between banks and clients in what are called “over-the-counter” deals, because the parties negotiate directly. What’s more, few regulations had been crafted to monitor and set guidelines for such OTC trades.
Since the dawn of modern finance, governments have been beset by the question of how much banking should be regulated. On the one hand, twentieth-century American and European governments have generally accepted that the business of finance should be exactly that, a business run privately in a profit-seeking manner. But finance is also not quite like other areas o
f commerce. Money is the lifeblood of the economy, and unless it circulates readily, the essential economic activities go into the equivalent of cardiac arrest. Finance serves a public utility function, and the question government regulators must wrestle with is to what degree private financiers should be allowed to seek a profit and to what degree they must be required to ensure that money flows safely.
In practice, during the twentieth century both American and European governments resolved the dilemma by keeping banking private but swaddling it in rules to ward against excesses. During the course of the century, those rules had expanded into what felt to bankers like a straitjacket of regulation. Some of the laws were national in nature, such as the Glass-Steagall Act in the United States, which separated commercial banking from investment banking. The Federal Reserve also imposed rules specifically on American commercial banks—with investment banks left outside its purview—including the stipulation that the total size of their liabilities could not exceed twenty times the size of their equity. If banks overexpanded their assets and failed to keep adequate reserve capital to cover potential losses, they were at risk of collapse, as had happened so spectacularly after the Crash of 1929. The regulations in London also imposed minimum reserve requirements.
On top of the national regulations, a set of international stipulations, known as the Basel Accord, had been agreed to by the Group of Ten nations, plus Luxembourg and Spain. A first set of agreements were drawn up in 1988 in the picturesque Swiss mountain town of that name, under the management of the Basel Committee on Banking Supervision (BCBS), whose governing body is based at the Bank for International Settlements (BIS). The first set of rules, known as Basel I, imposed globally consistent standards for prudent banking, most notably by demanding that all banks maintain reserves equivalent to 8 percent of the value of their assets, adjusted for risk. These rules were expanded and modified for some years, with a revised version referred to as Basel II issued in 2004 but not yet agreed to by all parties.
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 3
