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

  The key question for the team was, How could you bundle a whole host of loans together, extended to lots of different companies with different credit histories and business prospects, in a way that investors could feel confident about the level of risk they were taking on in buying a slice of the total? If investors couldn’t analyze the specific risk of default for all loans in the pool, one by one, as the EBRD could do in insuring Exxon’s default risk, how could they be assured? Their solution to that puzzle came by linking derivatives technology to a technique known as “securitization.” Experiments along those lines had already been bubbling for a couple of years at Swiss Bank Corporation, NatWest, and Chase Manhattan. The BISTRO plan essentially stole some of those ideas—but repackaged them with such crucial new twists that it transformed the field.

  The securitization concept that lay at the heart of this breakthrough was even older than the swaps idea. It had first cropped up in a significant manner back in the 1960s and 1970s, when some banks started selling off mortgage loans to outside investors in an effort to diversify their portfolios. Those who bought them could make a good profit in the mortgage business without needing all the infrastructure required to originate loans. It was a win-win.

  Making these sales was time-consuming, however, as investors wanted to scrutinize the details of the loans to guard against the risk of default. So bankers came up with the idea of bundling up large quantities of loans in packages. That would spread the risk of any problematic loans out over the whole bundle, so that if any borrowers with mortgages in the bundle did default, that loss would be covered by the profits made on the rest of the loans.

  Over time, bankers realized that they could use the cash flow from the mortgage payments being made on that bundle of loans to make a tidy extra profit. If they issued securities, such as bonds, they could back those securities with the cash flow from the mortgage payments—for example, making the regular payments to bondholders from that cash—and overall, they’d make money from both the mortgage payments and the sales of the securities. These became known as mortgage-backed securities—hence the term securitization—and the business boomed.

  Then, those trading in these securities got the crucial idea that Demchak’s team now jumped on. They realized that they could divide the securities they sold into several “tranches,” each with a different level of risk, and of return, for the investor. The highest risk and highest return were called “junior,” the middle level were called “mezzanine,” and the lowest risk and lowest return were called “senior.” The idea was that if defaults on any mortgages in the bundle did occur, those losses would be charged against the junior-level securities first. If losses were so high that they weren’t covered by the junior securities, then the mezzanine-level investors would take the additional hit.

  Those who invested in the senior-level securities would almost surely never suffer losses, because the chances of so many defaults happening at the same time were extremely slim. Just as in a flooding house, where the water floods the cellar first while the roof stays safe, losses from defaults would flood the junior and mezzanine levels—erasing those bondholders’ expected earnings—and the senior bonds would always be safe, except, that is, in the event of a truly major cataclysm. Due to their higher risk of loss, the junior and mezzanine notes paid proportionately higher returns, while, due to their extremely low risk, the senior notes paid quite low returns.

  The key attraction of this bundling, multitiered approach was that investors could choose the level of risk they wanted. And since investors were usually willing to pay a little more for the sheer convenience of someone else tailoring their level of risk, banks could often sell the complete set of notes for more than the total value of the mortgage loans. The concept was akin to a pizzeria that takes an $8 pizza, cuts it into eight pieces, and sells each piece for $1.25. Customers will sometimes pay more to buy just the amount and flavor they want, whether of pizza or of risk.

  In the 1980s, bankers took the idea that had been used to “slice and dice” mortgages and applied it to corporate bonds and loans. Demchak and his team, though, then took this a step further and applied it to credit derivatives. The idea was that, instead of grabbing a portfolio of different mortgages and selling investors a stake in it, they would instead sell a bundle of credit derivatives (CDS) contracts that insured somebody else against the risk of default. In financial terms this was equivalent to taking thirty different home insurance contracts, bundling them together, and persuading a bigger consortium of outside investors to underwrite the risk that losses might affect those thirty homes.

  As with the early mortgage bond deals, though, the investors who were underwriting that “insurance”—or that pool of CDS contracts—could choose their level of risk. Investors who wanted to roll the dice could agree to pay out the first wave of claims that might hit if, say, a few contracts went bad. Investors who wanted more safety might underwrite the mezzanine—or in-between—level of risk. That was similar to paying up on a collective insurance scheme when losses got bigger than, say, $5,000 but not higher than $100,000. The “safest” part of the scheme was the senior tier, where investors would be forced to pay the cost of defaults only after the claims—or losses—had become so widespread that all the other investors had been wiped out. There were thus different tranches of risk.

  To complete its scheme, the team also decided to borrow another trick from the domain of mortgage securitization. One widespread practice banks had engaged in was to create shell companies specifically for buying bundles of mortgages and selling the securities made from them. These companies were generally referred to as special purpose vehicles (SPVs), and they were usually located in offshore jurisdictions, such as the Cayman Islands and Bermuda, to ensure that they did not incur US tax. Demchak’s team decided to set up such an SPV to play the role that EBRD had filled in the Exxon swap. The shell company would “insure” J.P. Morgan for the risk of the entire bundle of loans, with Morgan paying a stream of fees to the SPV and the SPV agreeing to pay Morgan for any losses from defaults. Meanwhile, the SPV would turn around and sell smaller chunks of that risk to investors, in synthetically sliced-out junior, mezzanine, and senior notes.

  The really beautiful part of the scheme was that Demchak’s team calculated that the SPV would need to sell only a relatively small number of notes to outside investors in order to raise the money to insure all of that risk. Normally, the SPV would be expected to be “fully funded,” meaning that it would have to sell notes totaling the complete amount of risk that it was insuring. But the J.P. Morgan team reckoned full funding just wasn’t necessary; the number of defaults would be so low that so much capital wouldn’t ever be needed for covering losses.

  Demchak’s team furtively worked on putting that theory into practice. Right from the start, they decided to shoot for the stars. “Let’s do ten billion dollars!” Demchak and the J.P. Morgan team declared; he liked big, round numbers. The team identified 307 companies for which J.P. Morgan was carrying risk on its books that amounted to a total of $9.7 billion. Then they set up a shell company, and they calculated that the company would need to sell only $700 million of notes to cover any payouts to J.P. Morgan it might need to make—less than 8 percent of all the risk insured. This was akin to an insurance company offering insurance on a home worth $1 million, when it holds just $75,000 in its kitty.

  Just to be safe, though, Demchak decided that the SPV would invest the $700 million pot in AAA-rated Treasury bonds, so that if it were ever needed, there would be no doubt the money would be there. That ultrasafe investment plan would also help assure investors that the scheme was sound.

  The team then approached officials at Moody’s credit rating to get their stamp of approval, which would be needed to convince investors. For several months, Demchak’s team held intensive debates with the ratings agencies, just as bankers at NatWest, Swiss Bank Corporation, and Chase had previously done over their own earlier securitization schemes. Some ratin
gs officials worried that $700 million was not enough to insure the entire pot of $10 billion–odd loans, and suggested ways of potentially tweaking the scheme. The J.P. Morgan officials, though, pointed out that the ratings agencies’ own data indicated that the chance of any widespread default was laughably small. In essence, all that J.P. Morgan had done was to use the default models created by Moody’s—and take them to the logical extreme. So, finally, after much back-and-forth, they decided to accept J.P. Morgan’s arguments and out of the pool of $700 million in notes, two thirds were given the all-important AAA tag. The rest were stamped Ba2.

  In December 1997, just as most of the New York financial world was packing up for the Christmas holidays, Demchak’s team finally unveiled its creation. They had given it the ugly name “broad index secured trust offering,” shortened to BISTRO. With great hopes, the group set out to sell the notes. Some investors were dumbfounded. “It looks like a science experiment, with all those arrows!” one baffled fund manager quipped. Masters, however, was formidably good at marketing. Over and over again, she explained to potential investors how the scheme worked with a near-evangelical passion. She got results. Within a matter of days, the team had sold all the $700 million of notes. Indeed, the appetite was so strong that Masters concluded there was scope to conduct plenty more such deals.

  The team was jubilant. They felt they had stumbled on a financial version of the Holy Grail. At a stroke, they had managed to remove credit risk from the bank’s books on an enormous scale. That would immediately enable J.P. Morgan to relieve some of the pressure on its internal credit limits. The team also hoped that once regulators had a chance to examine the scheme, they would agree to let the bank reduce its capital reserves. But there were wider economic implications too, not just for J.P. Morgan but for the financial system as a whole.

  If it was now so easy to shift large volumes of credit risk off the bank’s books, banks would be able to truly fine-tune their loan portfolios. “Five years hence, commentators will look back to the birth of the credit derivatives market as a watershed development,” Masters earnestly declared. “Credit derivatives will fundamentally change the way banks price, manage, transact, originate, distribute, and account for risk.” She, like her colleagues, took it as self-evident that these “efficiency gains” from shifting risk this way could only lead to a better financial world, and they pleaded their case with an almost religious zeal.

  “When you heard these guys speak, you realized that they really believed this stuff,” Paula Froelich, a journalist from Dow Jones who had extensive contact with the BISTRO team during that period, recalled. “They thought they were the smartest guys on the planet. They had found this brilliant way to get around the [Basel] rules, to play around with all this risk. And they were just so proud of what they had done.”

  [ FOUR ]

  THE CUFFS COME OFF

  BISTRO-style CDS trades quickly took off. In early 1998, the J.P. Morgan swaps team conducted a second $10 billion deal, “insuring” another huge chunk of the bank’s loans and bonds. That success led the team to start marketing the service to others.

  Japanese banks were among the first to bite. By 1998, Japan was in the throes of a full-blown banking crisis that had left the largest banks desperate to find a way to reduce their risk. In the summer, the team cut a series of billion-dollar deals with lending institutions including Fuji, IKB, Daiwa, and Sanwa. Soon after, Masters arranged a BISTRO structure for Pittsburgh-based bank PNC. Demchak already knew that group well, since PNC was his hometown bank, and he had helped to restructure some troubled interest-rate derivatives deals that PNC had made in the early 1990s. A flurry of other American regional banks and European banks expressed interest. The European banks were usually reluctant to reveal the names of the companies whose loans were included in CDS deals; they feared they would lose customers if companies found out that their bank was buying insurance against its loan book risk. Undaunted, Demchak’s team tweaked the scheme again. In the early deals, they printed the names of the bonds and loans being covered. They later stopped printing the names of the companies whose loans were included in deals and marketed the tool as a way to maintain “client confidentiality” even while reshaping a bank’s balance sheet.

  Other banks did the same. In early 1998, Credit Suisse unveiled its own BISTRO-style CDS structure. So did BNP Paribas. More US and European banks quickly followed suit, triggering an explosion in credit derivatives activity. By December 1997, American banks had reported around $100 billion of such deals on their books. By the end of March 1998, that figure had grown to $148 billion in the US and was estimated to be about $300 billion globally, and J.P. Morgan alone accounted for $51 billion of that. The market for credit derivatives had grown overnight from a cottage industry into a bazaar where tens of billions of dollars of risk was changing hands.

  Demchak’s team was both stunned and thrilled. When they had first dreamed up the scheme, they hadn’t expected it to be a gold mine of profits. Their intent was to fine-tune a bank’s exposure to risk in order to free up credit limit constraints and reserve capital. But as the idea spread, the team started to hope that these deals might generate quite substantial revenues from clients through hefty fees. The status and reputation of those associated with creating BISTRO soared, both inside and outside the bank. Masters was promoted to be the head of credit derivatives marketing. Andrew Feldstein was put in charge of high-yield loans. Demchak was handed responsibility for the entire credit division. Hancock rose, too: he was named both chief financial officer and chief risk officer for the entire bank, a post that put him in the running for CEO when Sandy Warner retired.

  “The business opportunities created by credit derivatives, their relevance to clients, the size of the credit markets globally, and the gross in efficiencies in pricing and liquidity that exist are frankly staggering,” Masters said in a press interview in the summer of 1998. “The pace of change in the way banks manage credit risk has accelerated to a point where we can confidently predict credit risk management will be completely different in two years than it was even two years ago.”

  Demchak had decided at an early stage that Masters would be the perfect “face” to sell the idea to the outside world. Some of her colleagues resented that, pointing out that the true flashes of inspiration had come from Feldstein, Demchak, or Varikooty. Masters herself sometimes worried about the risks of being in the spotlight. But nobody could deny that she was a highly effective marketer. “Blythe Masters still looks more like a J.P. Morgan intern (which she was ten years ago) than the head of the credit derivatives marketing team,” one article said. “But it takes about a minute of conversation to learn that she possesses the knowledge and experience to lead the bank’s team…in overseeing the marketing of a $51 billion business.”

  At other banks, such success would have led to huge bonuses and pay packages, whereas J.P. Morgan paid the team relatively modestly. In 1998, they were handed a set of bonuses that were high by the standards of the rest of the bank but low by comparison to rivals’. Most took home at least $500,000 of pay that year, and many received more than $1 million. Headhunters swarmed around the group, offering to double, triple, or quadruple that compensation if they would move. “There would be all these cars with headhunters just hanging outside the door,” Demchak later remembered. “Some even turned up with contracts from other banks, ready to sign.”

  Almost nobody left; the team spirit was just too strong. By the summer of 1998, activity was so frenetic that the team was spending almost all their waking hours together, either hunched over their desks arranging deals or letting off steam at bars after long work hours. In other departments of the bank, there was a long-standing tradition that brokers would take traders out in the evenings to party. The credit derivatives group was so new that there was no such tradition, so the BISTRO group took themselves out, heading to Harry’s Bar or the Bull and Bear or Wall Street bars, or sometimes to Atlantic City for a wild night of gambling. O
n warm summer weekends they would head out to Long Island, where Masters and Demchak had each spent some of their swelling pay on beachfront houses. They were always together. “We just hung out 24/7. It was incredibly intense,” Terri Duhon later recalled. For some, the intensity took its toll on their family lives, prompting several divorces.

  Inside the office, the team increasingly developed its own subculture. When they had a moment free from arranging deals, they would stage contests on the trading floor to see who could throw a Frisbee or a baseball farthest before a computer screen was hit. Once, Masters declared she wanted to celebrate “bow tie” day, so the team arrived wearing cheap, colorful ties, to the astonishment of the rest of the bank.

  Pranks proliferated. One trader took to stripping down to his underwear “to let the air in” after all-night sessions arranging deals. A salesman started nicknaming all his clients after famous soccer players in the bank’s internal sales reports. When the regulators suddenly visited one day and demanded to see the team’s books, Demchak had to explain why “David Beckham” was buying BISTRO notes on a massive scale.

  Other divisions sometimes complained that the antics were getting out of hand, that Demchak was becoming “boorish” and the team was behaving like a frat house. Demchak brushed aside the complaints as sniping due to jealousy. He wasn’t worried; he knew his team was slavishly devoted to him, to Hancock, and, most important, to the mission of proving the revolutionary implications of credit derivatives. “Yes, it was a bit like a frat culture at times,” Demchak would later recall with a wistful smile. “But we had an amazing team spirit, it was just an amazing time. And, of course, we assumed it would last forever.”