Indeed, as bankers and investors processed the lessons from the internet crash, credit derivatives began to look more and more appealing. So, just as bankers in the early 1990s had responded to falling interest rates by producing more complex and leveraged derivatives products, they now began searching for a new round of more complex credit ideas.
Investor attention was also drawn to another sector. The real estate world—unlike the corporate sector—was relatively unscathed by the internet bust. On the contrary, the low interest rates Greenspan had instituted had given the housing market quite a boost, as mortgages became less and less expensive. Unbeknownst to the J.P. Morgan bankers, and against their better judgment, these two booming businesses of mortgages and derivatives were about to become fatefully intertwined.
PART 2
PERVERSION
[ SIX ]
INNOVATION UNLEASHED
The onset of the new decade unleashed a new era of credit. Alan Greenspan’s lowering of interest rates prompted an explosion of borrowing by both businesses and consumers. The boom was particularly pronounced in the housing market, as mortgages became ever more affordable. Even as the stock market tumbled, the credit market had kicked into overdrive, and it was becoming clear that the new action in investing was on the credit side of the business, not in equities.
In the early years of the decade, many banks threw themselves more aggressively into the credit derivatives business, which translated into greatly increased competition for the JPMorgan Chase team. It also opened up tantalizing opportunities for other employment even as the frustrations of the merger grew more dispiriting. The bank remained plagued by its Noah’s ark bureaucracy and vicious internal fights. Moreover, so many bad loans made to internet companies were plaguing the bank’s balance sheet that Demchak and his group could clearly see the bank was heading for a grim few years in which profits would be squeezed as political scandals mounted. “This is just no fun anymore,” Demchak remarked regularly to his colleagues.
Despite all the larger bank’s setbacks, though, and the growing frustrations, the team continued to rack up strong profits. In the middle of 2001, Demchak was told he would be promoted. In addition to running global credit, he was told, he would be given responsibility for derivatives and the commodities section, making him one of the most senior investment bankers in New York. But to the shock of his team, the very day after he was offered his new job, he tendered his resignation. “I just cannot do this anymore!” he declared. When the team heard the news, some of them cried, not only because Demchak was leaving but because they knew his departure also spelled the end of their remarkable run together. The team would never be the same without him.
Demchak was immediately approached by rival banks that were building their derivatives groups. Goldman Sachs was particularly persistent. But Demchak felt too exhausted and disenchanted to move right away to another bank. He also had no burning need to work; the value of stock held by managers of the J.P. Morgan side of the bank had surged with the merger. So for a while Demchak dreamed of dropping out of finance to fulfill a long-standing desire to train to become a boat builder. He traveled to the coast of Maine, finding it therapeutic to work with wood and traditional tools and to hang out with craftsmen who knew nothing about credit derivatives and cared less. In time, he persuaded some of them to decamp from Maine to the Hamptons, where Demchak had a house.
In due course, Demchak toyed with the idea of joining a hedge fund or a private equity group, but he decided he simply didn’t want to spend so much of his time staring at a computer screen again. Eventually, in 2002, he accepted an offer from PNC, the Pittsburgh-based lender, becoming vice chairman. Far from the glamour of Wall Street and the esoteric world of high finance, PNC afforded Demchak the chance to return to his Pittsburgh roots.
The offer was also alluring because the bank was badly in need of Demchak’s particular skills in managing risk. When the internet bubble burst, PNC had almost imploded from losses, and it desperately needed to remodel its balance sheet and credit portfolio to reduce its risk burden. That was music to Demchak’s ears. PNC’s balance sheet was tiny compared to J.P. Morgan’s, but it was large enough to offer plenty of challenge, and Demchak was being given the chance to apply all his theories about credit management just as he saw fit, with no internal bureaucratic fighting required. Managers at the Pittsburgh bank were hungry for his ideas on loan portfolio management, and Demchak was keen to get it right, third time around. The bruising fights from earlier years had taught him some painful lessons. By 2002 he was wiser when dealing with critics and less ideological in propounding his views. The former Prince of Darkness had matured. Better still, he was able to take a number of his beloved team with him. Krishna Varikooty was keen to follow him, for one. Back at JPMorgan Chase, once Demchak had decamped, the rest of his team quickly followed suit. Like pollen seeds, the former team scattered across the financial world, implanting their ideas into dozens of firms. Terri Duhon was lured away to ABN AMRO; while Betsy Gile, the credit manager, joined Deutsche Bank, where she helped to remodel the German bank’s credit portfolio. Romita Shetty, the Indian banker, went first to Royal Bank of Scotland and then to Lehman Brothers.
A number of the team either started or joined investment funds. Andrew Feldstein left to launch a hedge fund. Over in London, Tim Frost became a partner in the investment fund Cairn Capital. Jonathan Laredo, a credit analyst in London, joined another fund, called Solent, and Charles Pardue created Prytania, a consultancy and fund.
Hedge funds hadn’t played much in the credit sphere before, but the credit derivatives explosion was creating a host of new trading opportunities that they began to find attractive. “The good thing about the credit markets at the moment is that they are liquid enough to trade, but not so evolved that there are no [price] inefficiencies,” Feldstein observed after setting up his fund. Hedge funds thrive on exploiting such discrepancies in the market’s pricing of assets. “Hedge funds are becoming so big in the credit derivatives sphere now that it is fair to say that the torch of innovation is being passed from the banks to the funds,” observed Frost around the same time. “In many ways, funds are now more innovative than banks.”
Those members of the old team who stayed at the bank maintained a brave face. One of the loyalists was Blythe Masters, who was given control of credit policy after Demchak left. Another was Bill Winters, who continued to quietly run his trading empire in London. Tony Best and Jakob Stott, two former swaps traders who were allies of Winters, also stayed on. They tried to shrug off the exodus, denying that the bank was losing steam. “We can promote outstanding people quickly here. That is what supports the business when people decide to leave—these very smart young people coming through,” Best observed. But there was no denying that as the brain drain accelerated, morale sagged. Making matters worse, competition had turned so fierce that J.P. Morgan was no longer the undisputed king of the credit derivatives market.
Innovation was on fire around the financial world. “While J.P. Morgan has [been dealing] with these departures, the wider structured credit market has positively thrived as a result,” specialist financial magazine Euroweek reported. “It is unlikely that the sector would have grown at such a pace had it not been for the sheer number of ex-Morgan market participants that are now employed elsewhere.”
Goldman Sachs was quick out of the gate in developing a formidable credit derivatives business, and other leading brokerages, such as Morgan Stanley and Lehman Brothers, also joined the game with gusto. Most startling of all, jumping into the credit game was Deutsche Bank, which burst onto the scene from a standing start.
Traditionally, Deutsche was a large, stodgy commercial bank. But in the mid-1990s it formulated ambitious plans for becoming a major player in the international investment banking world. It hired teams of derivatives and bond traders from Merrill Lynch, acquired the operations of Bankers Trust, which had been at the forefront of derivatives innovation in the 1980s and ear
ly 1990s, and set out to build a preeminent platform in financial engineering in both New York and London. Derivatives were a prime focus. While the American bond and equity markets were so dominated by giant Wall Street banks that Deutsche would have had trouble breaking into that turf, the derivatives business was so new that it offered plenty of opportunity for outsiders.
Deutsche’s derivatives team hired many smart traders from other banks, including several from the J.P. Morgan team. Marcus Schüler, a highly visible salesman who had worked with Tim Frost in London, and Demchak acolyte Betsy Gile both moved to Deutsche. The bank then invested impressive resources to grab a big position in the commoditized business of trading CDS. It paid off quickly.
In 2003, Risk magazine designated Deutsche Bank the “Derivatives House of the Year,” knocking J.P. Morgan from that perch. Some Morgan staff started referring to Deutsche Bank as “enemy number one.”
Lehman Brothers, Citigroup, Bear Stearns, Credit Suisse, UBS, and Royal Bank of Scotland all also fiercely ratcheted up their derivatives operations. Not only was the competition demanding that they become more aggressive, but low yields on the more traditional credit investments were fueling the drive for higher returns. Yields on 10-year government bonds had dropped from 6 percent at the start of the decade to under 4 percent by 2002. Thirty years earlier, American pension funds had generally made easy money by investing in those bonds, which paid yields of around 9 percent a year while the funds were expected to deliver returns of only around 4 percent to 5 percent. Pension funds were now targeting higher returns even as the yield on bonds had fallen. Fund managers, and investors generally, were frantically looking for ways to boost profits, and that forced yet another turn of the innovation cycle. Banks devised a host of new tricks for offering investors better returns, which invariably revolved around creating products that employed more leverage, as well as more complexity and risk. The freewheeling experimentation centered on repackaging various credit into investment offerings, using either derivatives or bonds or a combination of the two.
By early 2001, the first generation of BISTRO deals had evolved into a class of standardized products widely referred to as “synthetic collateralized debt obligations.” A particularly popular variation on the BISTRO theme was known as “single-tranche CDOs.” These were essentially bundles of debt that were sold to a shell company, as with the BISTRO scheme, but then the company offered only one class of notes as opposed to junior, mezzanine, and senior. This meant that more of the risk of the loan bundles was retained on the shell company’s books, not just the super-senior risk.
In 2002 and 2003, single-tranche CDOs became all the rage. But insatiable investors quickly began demanding even better ways to juice up returns, so the banks produced a new twist on the CDO idea called a “CDO squared.” This was essentially a CDO of CDOs. In this scheme, rather than the shell company purchasing a bundle of loans, it would purchase pieces of debt issued by other CDOs and then issue new CDO notes. Typically, they would purchase only the riskiest notes from the other CDOs, because doing so allowed them to offer higher returns. Those investments were more dangerous for investors, but no matter. CDO squared offerings became wildly popular. “The product development now is incredibly fast,” observed Katrien van Acoleyen, an analyst from Standard & Poor’s. “People are trying to put all different types of underlying assets into these structures—asset-backed securities, emerging-market debt, or mortgages…now there are even people talking about creating a CDO cubed (or a CDO of CDOs of CDOs).” The crucial goal of all this complexity was to create more leverage and thus more potential return.
Around the turn of the century, Robert Reoch, one of the former J.P. Morgan derivatives bankers from Winters’s team in London, was standing in the canteen at Bank of America when he noticed a striking thing. Reoch had joined Bank of America a couple of years earlier. Like many others, it was eager to expand into the credit derivatives world. As Reoch stood in the lunch queue, while visiting the Chicago branch of the bank, he bumped into some bankers from the mortgage department. Until then the two groups had had only limited contact at BoA or anywhere else. Derivatives traders viewed themselves as a different breed of financial animal from financiers working in the mortgage world, and vice versa. When Reoch exchanged pleasantries with his mortgage colleagues at the canteen, though, he saw they were holding diagrams that looked akin to those he also used in relation to corporate credit derivatives. A “bingo moment” took place, as he later observed: both teams suddenly realized it made sense to collaborate with each other, since they were playing around with closely related concepts.
Similar intellectual collisions were quietly occurring all over the American financial world. Ever since the 1970s, bankers had used mortgages to create bonds or bundles of debt, later known as CDOs. By the dawn of the new decade, though, this activity became dramatically more intense and mingled with other fields of finance, including credit derivatives.
The American housing market had benefited hugely from the low interest rates Alan Greenspan was holding to, and the rapidly mounting piles of mortgage loans were fertile fodder for the CDO machine. This was especially true because so many of the new mortgages were relatively high risk, which allowed the banks to offer extremely attractive returns.
During the 1990s, CDOs had been constructed only out of “conforming” mortgages, meaning those that conformed to the high credit standards imposed by federal-government-backed housing giants Fannie Mae and Freddie Mac. That was in part because only a few lenders had been willing to extend mortgage loans to households that didn’t comply with the Fannie and Freddie standards. In the late 1990s, though, a swath of new mortgage lenders and brokers entered the field who specialized in offering “nonconforming” mortgages, more commonly called “subprime.” Loans were increasingly extended to borrowers with bad credit history. As more and more brokers jumped in, a free-for-all developed with the new players extending vast quantities of loans, on whatever terms they wished, without much government oversight, let alone control. In 2000, the amount of nonconforming mortgage bonds that were sold was tiny, running at a mere $80 billion, or less than a tenth of all mortgage bonds. By 2005, sales of nonconforming mortgage bonds hit $800 billion. Remarkably, that meant that almost half of all mortgage-linked bonds in America that year were based on subprime loans.
Precisely because subprime loans were risky, the home owners who took out such debt typically paid a higher rate of interest than prime borrowers did, and that meant that the “raw material” of subprime loans produced higher-returning CDOs than those built out of “prime” mortgages. For returns-hungry investors, subprime-mortgage-based CDOs were gold dust.
The only real constraint on the business was the need for brokers to find the cash to extend loans. In reality, though, that had become hardly a constraint at all. Brokers and banks alike no longer kept most of the mortgage loans they extended on their books any longer than a few days or even hours. Mortgage lending had become an assembly-line affair in which loans were made and then quickly reassembled into bonds immediately sold to investors. A bank or brokerage’s ability to extend a loan no longer depended on how much capital that institution held; the deciding factor was whether the loans could be sold on as bonds, and the demand for those was rapacious. In this way, the lending of the mortgages began to be driven by the demand of end investors, in what would prove to be a vicious cycle.
A fundamental danger of the mortgage CDO business was that there was no good information on what might happen to subprime mortgage defaults in a severe house price slump. As Terri Duhon and Krishna Varikooty had discovered when they tested the idea of bundling up mortgage loans to put into a BISTRO product, because the United States hadn’t experienced a nationwide housing crash for seventy years, data on default patterns was extremely scarce. Worse, it was virtually nonexistent for the riskier subprime sector, because subprime mortgages had represented such a small portion of the mortgage market before the turn of the century. Whi
le that information gap had worried the J.P. Morgan team enough back in 1999 to lead them to forgo BISTRO deals with mortgage debt, by the middle of the new decade most bankers were willing to ignore the risks and sell these investments on a massive scale.
Banks repackaged mortgage-based bonds in ever-more-creative ways. The best known product was a CDO of asset-backed securities, or CDO of ABS. This was usually (but not always) filled with mortgage-linked bonds. In a sense, then, CDOs of ABS were like CDOs of CDOs. They had an added layer of complexity to add more leverage. Within that field, another popular product was known as a “mezzanine CDO of ABS,” which took pools of subprime mortgage loans and used them as the basis for issuing bonds carrying different degrees of risk. The bankers would then take just the risky bonds, say those rated BBB, not A or AAA, and create a new CDO composed entirely from those BBB bonds. That CDO would then issue more notes that were also ranked according to different levels of risk. The scheme looked fiendishly complex on paper, but it essentially involved bankers repeatedly skimming off the riskiest portions of bundles, mixing them with yet more risk, and then skimming them yet again—all in the hope of high returns.
The schemes became more creative still when banks started creating these products not out of actual bundles of mortgage loans but out of derivatives made of mortgage loans. The idea was borrowed from the world of credit default swaps, and as with corporate-loan-based CDOs, these derivatives versions of CDOs enabled investors to place bets on whether mortgage bonds would default or not. These clever products were referred to as “synthetic CDO of ABS.” They would lead to a frenzy of speculation, all based upon the fundamental premise that the default risk of bundles of mortgages had been virtually erased by the process of bundling and then slicing them into tranches. If banks chose to hold more and more of the risk in these tranches on their own books, selling only the more popular tranches of notes, such as mezzanine, that was no worry because the risk had been so effectively dispersed that the chance the banks would ever take a hit from it seemed so remote as to be unfathomable.
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 11
