His listeners were unmoved. At the end of the meeting, another electronic vote was conducted, and the proportion in the crowd who believed in the bank’s strategy had not risen at all. Most of the staff—the junior staff at least—shared Hancock’s belief in the power of financial innovation. But they also knew that the rest of Wall Street was making much higher returns from the internet and financial merger boom than J.P. Morgan was producing with derivatives, and the senior managers came across as increasingly out of touch.
Privately, Hancock shared the frustration. By 2000, he had concluded that the only way the bank could really keep up with the competition was to take truly radical action. He thought that should be to focus extremely aggressively on a few, dedicated niches, such as derivatives, rather than conducting mergers in order to compete in the “one-stop-shopping” game. The future for J.P. Morgan, he believed, lay in being a boutique. But his was a minority view, and it led him into conflict with others in the core management team, affectionately known within the bank as the “House Arrest Group,” so called because CEO Sandy Warner was ardent about mandatory attendance at the group’s monthly gatherings.
All through 1999 and 2000, the HAG, as it was known, heatedly debated what course the bank should take. Members were split between sitting tight or pursuing a merger. By early summer, discussions were so intense that gossip was swirling around the bank that Warner had fallen out with Hancock. Some rumors even suggested Hancock was about to launch a palace coup, but Hancock denied that.
Then, abruptly, in the summer of 2000 Hancock resigned. The circumstances of his departure were murky. What was crystal clear, though, was that he was bitterly disappointed by the management’s indecision. And, after devoting the two decades of his career to the derivatives dream and the cause of J.P. Morgan, he was heartbroken by the bank’s relative decline.
The bank tried to keep his departure secret, hoping to quell mounting speculation about J.P. Morgan’s fate. For a period, Hancock simply disappeared from view, working out his notice largely from home. Meanwhile, behind the scenes, CEO Sandy Warner opened merger discussions with Goldman Sachs. The bank had already held highly secretive talks with Goldman a few years earlier, as well as informal discussions with Citibank, Deutsche Bank, Chase Manhattan, Morgan Stanley, and others. None of those prior overtures had come to anything, because of the senior management’s reluctance to lose their independence. After floating a merger deal by Warner, Sandy Weill of Citibank joked that the discussions made him “think of yogurt” because the J.P. Morgan officials were so obsessed with their “culture.” The 2000 talks with Goldman Sachs were no more fruitful; Goldman was beset by its own internal disputes about strategy. Officials were also appalled by the price J.P. Morgan claimed it was worth. “There was still this incredible arrogance and elitism at Morgan,” one of the parties later recalled.
The HAG committee slumped back into indecision. Then, in mid-August, when Warner was on vacation with his family in northern Michigan, he received a call from William B. Harrison, CEO of Chase Manhattan. Chase Manhattan was large and had a long history on the American financial scene. On paper, the two institutions had complementary strengths. J.P. Morgan had a blue-chip client list and derivatives expertise; Chase Manhattan had a mass-market customer base and was highly skilled at cutting deals. Chase was also formidable in some derivatives spheres. Combining those strengths would create an investment banking giant. Based on their 1999 results, the combined balance sheets had $660 billion in assets and more than $36 billion in stockholder equity. In asset terms, that was playing near the same ballpark as behemoth Citigroup.
The two banks, however, were very different animals. Chase Manhattan had emerged from a motley collection of banks bashed together in a series of mergers. The oldest piece of this mishmash was the Bank of the Manhattan Company, established in 1799, which began life as a water carrier serving New York, later branching into finance. In 1955, Bank of Manhattan purchased Chase, to form Chase Manhattan, and that entity emerged as a prestigious player in the 1970s and 1980s, under the leadership of David Rockefeller, the banking scion. But after it was weakened by real estate losses, it was purchased by Chemical Bank in 1996. The combined entity then bought Hambrecht & Quist in 1999, a San Francisco–based specialist in high-tech finance. That turbulent corporate history left the bank without a strong identity or cohesive culture. To compensate, the bank was run along highly bureaucratic lines, but intense infighting had created a dog-eat-dog environment. That was the antithesis of J.P. Morgan, where most of its staff had spent their entire careers immersed in the inward-looking Morgan culture. As Clayton Rose, one of the senior J.P. Morgan bankers, observed in the late 1990s, “When I joined this firm, you could shoot a gun and not hit a single mid-career hire.”
The cultural differences had led to widely divergent strategic imperatives. J.P. Morgan had been emphasizing the shedding of risk, using derivatives to remove a massive volume of it from the bank’s books, diversifying its exposures, and freeing up capital resources. Doing so had taken years and cost the bank a fair share of profits, since J.P. Morgan sometimes had to pay more in fees to those who assumed that risk than it made back from the savings in capital requirements. Meanwhile, Chase had spent the 1990s moving in precisely the opposite direction, taking on more and more concentrated risk to boost its profits. Most notably, from the mid-1990s onwards, the company had rushed to offer funding to a host of dot-com companies, as well as established groups that were perceived to be “innovative.” WorldCom was a key client. So was Enron.
Chase had made a merger overture to the J.P. Morgan leadership three years earlier, but had been abruptly rebuffed. By the summer of 2000, though, the tables had turned. Chase’s earnings from its internet investments and financing of a swath of fast-growing companies in the telecommunications and energy spheres had generated such a stream of profits that its share price had surged, even as J.P. Morgan had underperformed. Harrison, the CEO of Chase, was a courtly southerner and former commercial lender who had no pretensions to being a brilliant Wall Street intellect, but he was tenacious. At six-four, he was a former basketball star who had played for the University of North Carolina Tar Heels, where he had earned a reputation for dogged determination. By 2000, Harrison had conducted multiple bank mergers, and he knew he was in the driver’s seat.
On September 13, Chase Manhattan announced plans to purchase J.P. Morgan for an amount in shares that was worth slightly more than $30 billion, one of the largest deals ever recorded in the financial world. At a bound, J.P. Morgan had joined the great consolidation game.
The deal was presented to the outside world as a “merger,” for tax reasons as much as any desire to preserve J.P. Morgan’s dignity. In deference to the “merger” label, Harrison and Warner were named coheads of the bank, and representatives from each side were appointed as joint leaders of almost every department. It was dubbed the “Noah’s ark” strategy inside the bank, because leadership was going to be “two by two.” Immediately, however, it became clear that the “merger” label was a fiction: in every sense, Harrison—and Chase—had the upper hand. Or as the Economist observed: “HOW are the mighty fallen! J.P. Morgan, once the dominant financial power in America, and arguably the world, swallowed up by Chase Manhattan, a big, old—but not terribly distinguished—rival. Even five years ago, that J.P. Morgan’s blue-blooded bank should taint its aristocratic culture by merging with any other institution would have seemed inconceivable. But such has been the pace of change in global finance that nothing seems unthinkable anymore.”
The branding of the new bank was humiliating to the J.P. Morgan staff. The bank had taken enormous pride in sporting the name of its founder, J. Pierpont Morgan, and insisted on using periods to separate the “J” and “P” to signify that the name referred to a legendary man. Harrison knew the “Morgan” franchise had enormous brand value, so he agreed to the name going first, but in the name of the overall bank, JPMorgan Chase, the periods were dropped. Th
e investment bank, though, would go by J.P. Morgan. The bank also adopted the Chase logo, an octagon that harkened back to the wooden planks nailed together to create water pipes by the old Manhattan water group. The J.P. Morgan team considered that logo—and its associations with the lowly water business—unbearably tacky.
As they reeled in shock, Hancock’s former acolytes tried to work out what the merger meant for their derivatives dreams. On paper, most of them seemed well placed to flourish. Mindful of the need to hang on to J.P. Morgan’s derivatives skills, Harrison had agreed to put the innovation stars into seemingly plum positions. Demchak was named a cohead of credit; Masters was a cohead of asset-backed securities; Feldstein was named head of the global credit portfolio. In London, Bill Winters was named cohead of fixed income, and Tim Frost was appointed cohead of European credit. Technically, that gave them all positions as good as in the old J.P. Morgan bank, but now in a firm that was a true powerhouse.
These developments might have been appealing. Chase Manhattan had always had a formidable sales force, covering numerous corners of the financial world that J.P. Morgan had never managed to reach. It also had its own pool of creative financiers, including some in the CDO world. And, of course, the combined bank now had the advantage of vast size. The combined bank was estimated to control about half of the market for interest-rate swaps, a potentially formidable platform. Indeed, in early 2001, a few months after the merger was completed, the bank was named “Derivatives House of the Year.”
Yet, as the J.P. Morgan swaps alums tried to adjust to the Chase influence, it was impossible to recapture the thrill of their early achievements. The fraternal spirit had dissipated, as had the fun, in the new dog-eat-dog atmosphere. Chase also had a different approach altogether to managing risk. The senior managers at Chase had always been wary of derivatives risk, but they had neither tried to shed credit risk on any large scale nor worried about excessive concentrations of credit risk. On the contrary, to boost profits the bank had heavily weighted its loan book to fast-growing sectors, such as the internet, with few controls.
From his perch as the new cohead of global credit, Demchak tried to convince the Chase side of the value of shedding risk, as his team had so successfully managed for J.P. Morgan. So did Feldstein. When they got a look at the Chase Manhattan portfolio, they became adamant. They were shocked by the concentrations of risk, and asked for the power to radically remodel the loan portfolio. The former Chase officials, however, dragged their feet. Those concentrated credit risks had earned the bank extremely fat profits in the internet boom, and the bank’s share price had soared, enabling it to purchase J.P. Morgan. The Chase officials saw no reason to copy a strategy J.P. Morgan had ridden with such a notable lack of commercial success.
To Demchak the business of remodeling the loan book was not just a good idea, it was an article of faith. He found the stance of the Chase bankers utterly infuriating, and he didn’t bother to conceal his disdain. “I can’t believe they’re running the bank like this!” he would wail to his colleagues, as his battle over the loan book grew more and more intense. His mission seemed hopeless until a dramatic turn of events.
On December 2, 2001, the American energy group Enron filed for bankruptcy. The news stunned the markets and corporate world. Enron had been a poster child for innovation and free-market competition. It employed 22,000, had reported revenues of $101 billion in 2000, and had been named as “America’s most innovative company” by Fortune magazine for six years in a row. However, in the autumn of 2001, it emerged that those stunning profits had been a mirage; the company had used creative accounting tricks to inflate its results, seemingly with the knowledge of its banks and accountants. When those schemes came to light, confidence in Enron collapsed, and the company filed for what was then the largest bankruptcy in American corporate history.
The news delivered a shocking blow to JPMorgan Chase. During the 1990s, Chase had developed a tight relationship with Enron, lending the company vast sums, underwriting its bonds, and creating a series of structured financial products and schemes in collaboration with the company, including some of those with which Enron had inflated its results. Just two months before Enron’s implosion, co-CEO Harrison had gone out of his way to tell bankers and journalists in the City of London just how “proud” he felt that Enron was a key client. Now Harrison found himself vehemently denying that the bank had engaged in any wrongdoing. “I believe we handled everything with integrity, but we had too much exposure,” he told employees in a speech broadcast over the company’s internal voice-mail system in early 2002.
The bank’s losses from Enron’s failure were initially estimated to be $900 million, but that number doubled as the scale of damage became clear.
Irrespective of Harrison’s denials, it swiftly became clear that former Chase employees not only had created some of the controversial Enron schemes, but also had done so knowing they were distorting the energy giant’s balance sheet. A structure known as “Mahonia” was a case in point. In 1995, Chase created an off-balance-sheet vehicle bearing that name as a tool to channel funds to Enron, and the bank subsequently used it to conceal up to $8.5 billion of debt in its accounts. Technically, the Mahonia structure was legal. “We did it according to accounting conventions and rules. It was transparent. It was on our balance sheet, and to our best knowledge, it was on Enron’s balance sheet,” Harrison said. However, US lawmakers dubbed Mahonia one of a collection of “shame trades” and railed against both Enron and its two main banks, JPMorgan Chase and Citigroup. When it emerged that two banks had earned around $200 million in fees creating such structures, the anger became intense.
Then even worse carnage struck. In the second half of 2000, the internet bubble started to burst. After reaching 5000 in March 2000, the NASDAQ quickly plummeted to 3000, and a vast swath of dot-coms went bust. In January 2001, the fiber-optic network operator Global Crossing, a client of Chase Manhattan, filed for bankruptcy protection, with debts of $12.4 billion. In July 2002, the telecom giant WorldCom imploded under $32 billion of debt. JPMorgan Chase had underwritten bonds for WorldCom and took another big hit. What was worse, by mid-2002, lawsuits in relation to WorldCom, Enron, and Global Crossing were flooding into the bank. Unsurprisingly, the bank’s share price slumped to less than half the level when the merger was struck. “It’s unnerving how the bad news keeps piling up at J.P. Morgan,” observed BusinessWeek. Or as the Evening Standard of London tartly declared: “Name a scandal-plagued US company in the headlines and one bank keeps showing up behind the scenes: JPMorgan Chase.”
Demchak, Feldstein, and the other so-called Heritage Morgan bankers were furious at the scale of mismanagement. Time and again, Demchak had warned of the need to diversify the risk from Chase loans, and that advice had been roundly rejected. He could take scant comfort now in knowing he had been proven right.
Demchak and his former J.P. Morgan colleagues mused about the bitter irony of it all. If they had just managed to stay independent for a few more months, the share price of Chase would have crashed. Events would have turned out quite differently. They felt as if the fates were laughing at them. But even as they reeled from the carnage, the innovation cycle was about to heat up again, and with the wonders of dot-coms soundly repudiated, attention would turn anew to the marvelous potential of credit derivatives and other forms of financial innovation.
On January 3, 2001, the US Federal Reserve suddenly announced a 50-basis-point cut in interest rates, reducing them to 6 percent. That news stunned the markets almost as much as the internet collapse. In the prior eight years, Alan Greenspan had made a virtue out of running monetary policy in a calm, controlled manner, decreasing rates steadily but slowly at just 25 basis points a shot. This gradualist approach was said to mitigate volatility.
Greenspan was convinced, though, that the collapse of the internet bubble required a forceful response. Back in late 1989 and 1990, when the US economy had suffered a similar downturn, he had stuck to measured
, slow rate cuts, and they had turned out to be too little, too late. The economy had sunk into a recession. He was determined to avoid that mistake this time around.
A few weeks after that first dramatic rate cut, Greenspan reduced rates again, and in the following months, he kept steadily cutting. When the attack on the World Trade Center sent the markets into a tailspin, he cut rates even further. By 2003, the prime rate was just 1 percent, its lowest level for many decades.
The policy worked, and worries of a recession abated, though the crash had wiped out $5 trillion in the market value of technology companies between March 2000 and October 2002. By 2003, the mainstream economy was rebounding. In stark contrast to the bursting of the savings and loan bubble, no European or American institution actually collapsed from its losses. Greenspan and other policy makers partly attributed that to the fact that so many banks were using credit derivatives to spread their risk around. Unsurprisingly, the J.P. Morgan bankers agreed. “Credit derivatives are a mechanism for transferring risk efficiently around the system,” Tim Frost cheerfully told journalists, noting that defaulted loans that would have knocked a hole in a bank’s balance sheet ten years ago were “now hits that we have spread around the system, and represent tiny blips on the balance sheets of hundreds of financial institutions.”
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 10
