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

by Tett, Gillian

  By the early 1990s, regulators were dogged by the fact that many of these rules had been drafted before the explosion of derivatives innovation. They could be extended into the derivatives world to some extent; aspects of the Basel Accord set out, for example, levels of reserves that banks must hold if they were engaging in derivatives activity. But the urgent issue now was that the business had expanded so much, and in such complex ways, that regulators couldn’t get good estimates of the risks involved. The issue didn’t worry regulators too deeply at first. In the early 1980s, swaps deals accounted for so little of overall banking activity and were being done by such a relatively small and elite group of players that regulators regarded the sector as a sideshow. What traders did with their newfangled derivatives contracts seemed as peripheral to the “real” economy as the gambling in Las Vegas is. But, as the 1980s wore on and the business began to take off, some regulators became uneasy. They began to tweak the banking rules in a manner that forced banks to lay aside more capital against their derivatives business. That left bankers nervous. They feared that profits could drop if regulators became even more involved. In response to this, in 1985, a group of bankers working for Salomon Brothers, BNP Paribas, Goldman Sachs, J.P. Morgan, and others held a meeting in a smart Palm Beach hotel with a view to agreeing on standards for swaps deals. The idea was to hash out common legal guidelines for the deals. Out of that, they decided to create an industry body to represent the swaps world, subsequently known as the International Swaps and Derivatives Association, and one of the first things the ISDA did was to conduct a survey of the market. The published results were startling. In 1987, ISDA reckoned the total volume of derivatives contracts was approximately $865 billion.

  Shocked by that number, some Western government officials started to flex their muscles. In 1987, the Commodities Futures Trading Commission proposed to start regulating interest-rate and currency swaps in the same way it monitored the commodities derivatives world. That idea provoked horror from the banking world. The derivatives traders feared the CFTC would do a clumsy, heavy-handed job—not to mention that any existing derivatives contracts would be thrown into a legal limbo because the legislation the CFTC proposed stipulated that all deals not done on its exchange would be illegal.

  ISDA leapt into action, sponsoring a lobbying campaign on Capitol Hill. Somewhat to their surprise they prevailed two years later when the CFTC backed down. That victory was just temporary, though. By the early 1990s, government scrutiny of derivatives was intensifying again, as the business continued to boom and a range of exotic new offerings were introduced. In truth, most regulators and central bankers still didn’t know in any detail how the swaps world worked. Its esoteric nature raised the troubling issue at the center of the regulatory dilemma: how could they allow this booming business to keep flourishing and still ensure that it didn’t end up jeopardizing the free flow of money around the “real” economy? Regulators didn’t want to stifle positive innovation, but they were growing leery. That was the impetus of Jerry Corrigan’s investigation of the business in the fall of 1991.

  A few weeks after he had summoned Dennis Weatherstone and Peter Hancock to meet with him, in January 1992, Corrigan delivered a stern speech to the New York State Bankers Association. “Given the sheer size of the [derivatives] market,” he said, “I have to ask myself how it is possible that so many holders of fixed-or variable-rate obligations want to shift those obligations from one form to the other.” Translated from central bank jargon, this suggested that Corrigan was dubious about the banks’ motives for making these deals. “Off-balance-sheet activities have a role,” he continued, “but they must be managed and controlled carefully, and they must be understood by top management, as well as by traders and rocket scientists,” he added. “I hope this sounds like a warning, because it is!”

  Derivatives bankers were shocked. Corrigan seemed poised to institute regulation. Sure enough, a few weeks later it emerged that international regulators, led by Corrigan, were preparing to define how the Basel rules should be applied to market trading activities with more precision. Then, around the same time, Mark Brickell, a member of Hancock’s team, received a surprising overture from a Washington-based organization, the Group of Thirty. Brickell had joined J.P. Morgan straight out of Harvard Business School around the same time as Hancock and was a true believer in the wonders of swaps. Hancock had selected Brickell to act as his key point man in lobbying regulatory officials and politicians, who had been asking so much of late about the derivatives business. Brickell was ideally suited for the job. He was an intense man, with passionate libertarian views, who had entertained the idea of pursuing a career

  in politics. Unlike most swaps traders, he therefore relished dealing with politicians, and he was so enthusiastic about lobbying that by 1992 he held the post of chairman of the ISDA. He was Hancock’s and the industry’s Rottweiler in fending off regulatory concerns.

  The G30, it turned out, was planning to write a study of the derivatives world, and the caller told Brickell the group wanted J.P. Morgan to lead the process. It was clear that the report could be crucial for setting government policy. The G30 was a highly influential group of economists, academics, and bankers, set up in 1978 with funding from the Rockefeller Foundation, with a mission to promote better international financial cooperation. Paul Volcker led the group.

  J.P. Morgan officials debated what to do. Inside the swaps group, the young traders were wary of collaborating on the study. At best, they feared it might result in J.P. Morgan sharing proprietary secrets; at worst, it would be leading to regulations that the bank would be seen as instrumental in instituting. “The whole project was fraught with peril for the swaps world,” Brickell later said. “There was a clear danger of having any recommendation codified as regulation.” Dennis Weatherstone nevertheless insisted that the bank cooperate. As CEO, he was highly mindful of the bank’s legacy of public duty, and he suspected that Corrigan, and therefore the weight of the New York Fed, was behind the initiative.

  Truth be told, Weatherstone was concerned about the risks of the swaps business. If the industry kept growing without controls, he feared the chances were good that excesses would lead to an implosion that would hurt not just other banks but J.P. Morgan, too. “If you are driving along the motorway in a smart Maserati and see an old car belching fumes,” he sternly told Hancock and his other young turks, “it’s no good just driving on. If that old car crashes, it could wipe out the Maserati, too.”

  So Weatherstone agreed to chair the G30 report, and Hancock, Thieke, Brickell, and other J.P. Morgan bankers set to work on it with a host of representatives from other banks. Patrick de Saint-Aignan, a derivatives banker at Morgan Stanley, and David Brunner of Paribas coheaded the report; officials from HSBC, Swiss Bank, and Chase Manhattan also took part. Peter Cooke, a former Bank of England regulator offered advice; so did Merton Miller, the Nobel laureate and leading free-market economist from the University of Chicago. “We knew that we were setting the foundation for the derivatives world,” recalled Brickell.

  The time had definitely come to do so. Between 1992 and 1993, the value of deals rose from $5.3 trillion to $8.5 trillion, according to ISDA data. What was more striking, however, was that deals were becoming more complex and were being sold to a wider range of customers. The initial customers for swaps had been large international corporations or banks, with sophisticated treasury departments and investment analysis, groups like Coca-Cola, IBM, and the World Bank. By 1992, small banks, midsized companies, pension funds, and many other asset managers were joining the market. And more and more of them were turning to derivatives not to control for future risks but to make big gambles and realize big returns.

  The rush into derivatives was partly driven by aggressive marketing efforts by the banks and regulatory changes in the asset management world. Another factor that fueled the trend, though, was falling interest rates. After Paul Volcker jacked up rates in 1979, inflation had tumbled.
By 1983 it was running at 3.2 percent, down from 13.5 percent in 1981. The Fed was then able to trim short-term interest rates, which stimulates economic growth. In 1987, Alan Greenspan replaced Volcker as Fed chairman, and from 1989 onwards, he steadily reduced rates to fight a mild recession. That was good news for borrowers, and it also boosted bank profits, because when rates are low, banks can borrow money cheaply and lend it out to customers at higher rates, making easy returns. But falling rates made it harder for investment managers to earn decent returns by purchasing relatively risk-free government or corporate bonds. Those pay less when rates fall. Thus, while the absolute level of rate was still relatively high (at least, compared with what it would be a decade later), the direction prompted some bond investors to look for new tactics.

  Merrill Lynch, Bankers Trust, Salomon Brothers, and J.P. Morgan itself suggested to their clients that they could use derivatives to boost their returns, and the banks invented a new wave of products to provide that service, with obscure names like “LIBOR squared,” “time trade,” and “inverse floaters.” Some federal agencies, such as Sallie Mae, the student loan provider, also began offering investment products that included derivatives. Most of these products produced high returns by employing two key features. They involved bets on the level to which interest rates would fall in the future, and with rates falling so dependably on Alan Greenspan’s watch, those bets produced easy money with what seemed like very little risk. Most of these deals also involved a concept that is central to the financial world, known as “leverage.” This essentially refers to the process of using investment techniques to dramatically magnify the force or direction of a market trend (just as a lever will increase the force of a machine). In practical terms, the word can be used in at least two ways in relation to derivatives. Sometimes investors employ large quantities of debt to increase their investment bets. For that reason, borrowing itself has often come to be called “leverage” in recent years. However, the economic structure of derivatives deals can also sometimes leave investors very sensitive to price swings, even without using large quantities of debt. Confusingly, that second pattern is also referred to as “leverage.” In practice, though, these two different types of leverage tend to be intermingled. And the most important issue is that both types of leverage expose investors to more risk. If the bet goes right, the returns are huge; if it goes wrong, though, the losses are big, too. Using leverage in the derivatives world is thus the financial equivalent of a property developer who buys ten houses instead of five: owning more properties will leave that developer more exposed to losses and to gains if house prices rise or fall, particularly if the properties are financed with debt.

  In 1992 and 1993, though, many investors thought it was worth taking those risks, by buying products with high leverage. “It was a type of crazy period,” recalls T. J. Lim, one of the early members of the J.P. Morgan swaps team, who worked with Connie Volstadt in the 1980s and decamped with him to Merrill Lynch. “The herd instinct was just amazing. Everyone was looking for yield. You could do almost anything you could dream of, and people would buy it. Every single week somebody would think of a new product.”

  Some prescient warnings were issued. Allan Taylor, the Royal Bank of Canada chairman, said that derivatives were becoming like “a time bomb that could explode just like the Latin American debt crisis did,” threatening the world financial system. Felix Rohatyn, a legendary Wall Street figure who worked at Lazard Frères in corporate finance, far removed from derivatives, called derivatives “financial hydrogen bombs, built on personal computers by twenty-six-year-olds with MBAs.”

  Those “twenty-six-year-olds” vehemently disagreed. The innovation frenzy showed exactly why derivatives were so powerful and why government control must be fought off. “The surest way to stifle innovation is to take current best practices and convert them into rigid requirements,” Brickell liked to say, paraphrasing Friedrich von Hayek, the libertarian Austrian economist and one of Brickell’s intellectual heroes. Indeed, if there was one thing that united swaps traders, aside from a fascination with deconstructing financial instruments, it was the belief in the efficiency, and superiority, of free markets.

  Brickell took the free-market faith to the extreme. His intellectual heroes, in addition to Hayek, were economists Eugene F. Fama and Merton H. Miller, who had developed the Efficient Markets Hypothesis at Chicago University in the 1960s and 1970s, which asserted that market prices were always “right.” They were the only true guide to what anything should be worth. “I am a great believer in the self-healing power of markets,” Brickell often said, with an intense, evangelical glint in his blue eyes. “Markets can correct excess far better than any government. Market discipline is the best form of discipline there is.”

  Peter Hancock shared that view, though he rarely expressed it so forcefully in public. So did most other swaps traders. Of course, they knew perfectly well that financial markets were not truly free. On the contrary, the financial system was smothered in the government rules that had followed repeated crises. What made derivatives so thrilling for Brickell and other true believers was that they lay outside the purview of that legacy regulation. They allowed pioneering financiers to compete freely, unleashing their creativity, just as theory advocated.

  This did not equate to a world with no rules, Brickell always liked to stress. On the contrary, the derivatives market could function only if the participants played according to a common law book. Indeed, crafting those legal guidelines had been a founding purpose of the ISDA. What made ISDA’s approach so different was that it asserted that rules were best designed by the industry itself and upheld by voluntary, mutual accord. Government bureaucrats should not be the sheriffs or high priests of this world; bankers and their lawyers were better informed, and they had strong incentives to comply. Like a hunter-gatherer tribe, all derivatives traders had an equal interest in upholding the norms. That was why any recommendation the G30 report might make about legislation to institute regulation was to be fought, argued Brickell, tooth and nail.

  Another key factor that influenced how J.P. Morgan bankers and others viewed regulation was the development of an idea known as value at risk, or VaR. In previous decades, banks had taken an ad hoc attitude toward measuring risk. They extended loans to customers they liked, withheld them from those they did not, and tried to prevent their traders from engaging in any market activity that looked too risky, but without trying to quantify those dangers with precision. In the 1980s, though, Charles Sanford, an innovative financier at Bankers Trust, had developed the industry’s first full-fledged system for measuring the level of credit and market risk, known as RAROC. That eventually prompted other bankers to start trying to measure risk not according to vague hunches but by using precise quantitative techniques.

  Dennis Weatherstone, the Morgan CEO, played a crucial role in that wider industry trend. Having built his career on the volatile foreign exchange trading desks, not in the staid commercial arm of the bank, he was keenly aware of how risk could come back to bite you, if you did not prepare. The terrible stock market crash of 1987 hammered that point home again when all the banks suffered losses. So, in 1989—two years after that crash—Weatherstone introduced a near-revolutionary practice into J.P. Morgan known as the “4–15 report.” At 4:15 p.m. each day, after the markets closed, a report was sent to him that quantified the level of risk the bank was running in all areas of its business. Initially the report was crude, limited to painting an approximate picture of all the bank’s trading businesses. Weatherstone decided he wanted more, and he asked a team of quantitative experts to develop a technique that could measure how much money the bank stood to lose each day if the markets turned sour. It was the first time that any bank had ever done that, with the notable exception of Bankers Trust.

  For several months the so-called quants played around with ideas until they coalesced around the concept of value at risk (VaR). They decided that the goal should be to work out how much mo
ney the bank could expect to lose, with a probability of 95 percent, on any given day. The 95 percent was an accommodation to the hard reality that there would always be some risk in the markets that the models wouldn’t be able to account for. Weatherstone and his quants reckoned there was little point in trying to run a business in a manner that would create obsessive worry about very worst-case scenarios. If a bank worried about those every day, it could barely afford to conduct business at all. What Weatherstone wanted to know was what levels of risk the bank was running in a bad-to-normal state of affairs, like a farmer who steels himself to expect periodic floods, snowstorms, and droughts but doesn’t worry about an asteroid impact that might bring on Armageddon. Hence the use of a 95 percent confidence level.

  The system essentially worked by taking data from the previous few years and working out how much money the bank risked losing at any one time if markets turned sour. The key simplifying assumption on which the models rested was that the future was likely to look like the recent past. Dennis Weatherstone was well aware that this assumption might not always be correct. He knew it was only a rough approximation to reality. Models were only tools and could not be used without human intelligence, as he sternly lectured the J.P. Morgan staff. They were not the only way of measuring potential future losses. “We were all taught to think that models are useful, but that they also have limits,” Peter Hancock later recalled. “It is an obvious point, but it is also something people so often forget.”