Yet the beauty of VaR was that it allowed bankers to measure their risk with far more precision than ever before. A mind-boggling array of future dangers could be reduced to a single clear number, showing how much a bank stood to lose. The J.P. Morgan bankers assumed that would make it much easier for banks to control their risks, in relation to derivatives or anything else. That had a bigger implication: with tools such as VaR at their fingertips, banks now had both the incentive and the ability to navigate wisely in the derivatives world without the need for government interference. Or that, at least, was the argument that derivatives bankers liked to present.
On July 21, 1993, the long-awaited G30 report was finally unveiled. It was a hefty, three-volume tome. Right from the start, Dennis Weatherstone had insisted that the study be a serious, highly detailed guide. If the report could show that the industry already had a credible internal code of conduct, there should be less need for bureaucrats to impose rules. “This should not be a study that gathers dust on a shelf,” Weatherstone declared. “I want to produce a guide by practitioners that has so much useful, practical advice that it will be referred to for years to come.”
The G30 tome met that criterion in spades. The document started with some vague rhetoric that stressed the value of derivatives for the financial system as a whole. But it then laid out, in exhaustive detail, the best norms for running the business. One section urged all banks to adopt VaR tools. Another demanded that banks’ senior managers learn in detail how derivatives products worked. Another section urged banks to use ISDA’s legal documents for cutting deals. The report also demanded that banks record the value of their derivatives activity each day, according to real-time market prices, following the principles of what’s become known as “mark-to-market.” This would bring consistency in valuations where before banks had been accounting the values of the derivatives deals in a host of ways. It also underscored the assumption that market prices were the “best” guide to value.
Equally important was what the G30 report did not say. The tome did not suggest the government should intervene in the market, in any way. Nor did it drop any hint that the derivatives world might benefit from a centralized clearing system, like that for commodities derivatives and the New York Stock Exchange, to settle its trades. These clearing systems not only recorded the volume of trades, providing a valuable barometer of activity that signaled signs of trouble, but also protected investors from the eventuality that the party on the other side of the trade—the counterparty—might fall through on a deal, leaving the trade in limbo. Without a clearinghouse, derivatives traders faced this so-called counterparty risk.
Brickell and the other members of ISDA were opposed to setting up a clearing system because they feared it would be the thin edge of a wedge of further regulations. They insisted that counterparty risk could be handled perfectly well by following the ISDA guidelines, posing some collateral against the risk of default, and just good smart trading. “The swap [market] framework is a model of market discipline,” Brickell argued. “Within it, every participant scrutinizes the reputation and credit quality of his counterparties and adjusts the flow of his business accordingly.”
As regulators and central bankers digested the weighty G30 report, a few commentators expressed concern that the report simply did not go far enough. Brian Quinn, an executive director of the Bank of England, said the G30 report “struck me as somewhat complacent” in regard to the risks posed by the derivatives world. But, just as Dennis Weatherstone had hoped, regulators generally appeared impressed by the detailed nature of the guidelines. “If the market players continue forward in the spirit of the G30 study, then regulators will have much less to do,” observed J. Carter Beese, a Securities and Exchange commissioner, in November 1993. Hancock, Brickell, and the rest of the swaps market heaved a sigh of relief.
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 re
ally 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 introducing 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.
[ THREE ]
THE DREAM TEAM
In 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 e
conomics 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.”
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 5
