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

  He also convened a meeting of the operating committee and demanded that everyone reveal exactly what the three hundred most senior employees were paid, by name—and in front of colleagues from other departments. That was revolutionary. At J.P. Morgan, as at almost every other bank, pay levels were a closely guarded secret. But Dimon was determined to break down the hierarchies of status. The new bank, Dimon insisted, should be a meritocracy: everybody would be judged purely by how he or she performed. To ram that home, he declared the end of employment contracts with special side deals. Instead, all employees would now have a single, basic contract. The only exception, Dimon declared with a rare flash of socialist principles, was health insurance, where the best-paid employees were ordered to pay a far higher set of medical premiums to subsidize the lowest paid. “There are no side deals in this company, no special deals,” Dimon said.

  The result was a shifting of pay levels and status within the empire. The risk department benefited considerably. In Wall Street banks, the so-called compliance control and risk departments—the wings of the bank charged with checking that bankers obeyed the rules and with monitoring the overall level of risk in the bank—usually commanded lower status and pay than the bankers. They also lacked power because they did not themselves generate revenues. Dimon raised the pay of the personnel monitoring risk so that it was even attractive enough to persuade some traders to move across into those functions. He also made it clear that the risk and compliance personnel carried real clout in the bank. Hordes of staff were placed in training courses organized by the risk department, and senior managers were told to attend risk meetings. Dimon insisted that the staff should think about risk in a truly holistic manner. It was not enough, he declared, to look at the dangers that might beset narrow “silos” of the bank or to simply subcontract risk management to one department. Nor could risk be reduced to a few mathematical models. Fifteen years earlier, when Dennis Weatherstone ran the bank, J.P. Morgan had invented the concept of VaR and then disseminated it to the rest of the industry. It was a notable legacy. However, Dimon had no intention of giving undue veneration to VaR. Dimon (like Weatherstone) deemed mathematical models to be useful tools, but only when they were treated as a compass, not an oracle. Models could not do your thinking for you. The only safe way to use VaR, or so Dimon believed, was alongside numerous other analytical tools—including the human brain.

  By late 2004, speculation that Dimon was about to oust Harrison was rampant. “Yond Cassius has a lean and hungry look…such men are dangerous,” Brad Hintz, an analyst at Sanford C. Bernstein, observed, quoting Shakespeare. The prospect delighted many of the J.P. Morgan bankers, particularly the Heritage Morgan group. Though at first many of them were wary of Dimon, as the months passed, the unease was replaced by respect. On the surface, Dimon was hardly J.P. Morgan material. On weekends he sometimes wore sneakers to the office and cheerfully ate hamburgers and fries in the bank’s elite dining room. He had few qualms about saying “bullshit!” But personal style aside, Dimon’s banking philosophy jibed well with the ethos of the old J.P. Morgan.

  Dimon had no interest in turning JPMorgan Chase into the equivalent of a hedge fund, or copying the aggressive trading tactics of brash Goldman Sachs, placing bets with the bank’s own money. He was keen to create a solid, balanced business. That was very much in keeping with the J.P. Morgan tradition. Even Dimon’s informality rang true to the old bank, where junior derivatives traders could cheerfully push their most senior boss into a swimming pool and break another’s nose without worrying about getting fired.

  “In the old J.P. Morgan, people would ask about your families but forget to chat about the business. Dimon does both,” Jakob Stott, the London-based banker, observed. But Dimon had no illusions that he could ever create that same old feeling of family and fraternity in a bank as big as JPMorgan Chase. Nor did he want to. He was striving for a meritocracy, not a tradition-bound club where employees were retained for life, irrespective of how they performed.

  Some of the employees inside JPMorgan Chase found this change of style unnerving. They grumbled that Dimon seemed so utterly sure of his opinions he could fall prey to hubris or overreach. A few muttered that the senior management was turning into “Jamie’s club,” full of employees deemed loyal to Dimon. Such sniping, though, was not widespread. To many Heritage Morgan bankers, the idea of blending Dimon’s ruthless discipline and energy with some of the old values of J.P. Morgan seemed very exciting.

  The Heritage Morgan bankers started to think that if Dimon could instill his ruthless discipline while also respecting the values of the old J.P. Morgan, the result might just possibly be a powerful one. As Tony Best from the London office observed, “When we first met Dimon and he got obsessed with the telephones, we were all a bit shocked. But then we realized he was quite different from anything we had ever seen before, in a good way. He was almost like the leader we had always been waiting for in J.P. Morgan but never really got.”

  As events would transpire, the J.P. Morgan Chase staff would have reason to be grateful that Dimon had arrived on the scene, holding true to his principles of risk management even as most of the rest of the banking world broke free from all bounds of rational discipline.

  [ EIGHT ]

  RISKY BUSINESS

  In late October 2004, Jamie Dimon and William Harrison reported results for the third quarter of that year, the first joint figures since the Bank One–JPMorgan Chase merger. They were dismal: profits in the third quarter were 13 percent below the level a year earlier (which in itself had been a bad period), due largely to losses on fixed-income trades. “Current results were below expectations, primarily due to weak trading results,” Harrison declared in his usual, courtly manner. Dimon was blunt. “They’re terrible results!” he declared. “Terrible!”

  Some analysts hoped the results were an aberration, and that the wunderkind Dimon would soon turn the tide. But the next quarter’s results were weak too, leaving total 2004 earnings at just $4.5 billion, down from $6.7 billion the previous year. Return on equity was a mere 6 percent, in a year when the industry average rose to 15.5 percent. The results improved somewhat in the first quarter of 2005, but then deteriorated again in the spring. “You can almost hear JPMorgan Chase’s investors singing, ‘Why are we waiting, oh why are we waiting.’ Jamie Dimon’s flock of faithful is certainly being tested,” the Financial Times observed in August 2005. “His huge banking merger is not yet delivering what investors had hoped, and the stock price has not bounced back from the disappointing results of last month, in spite of trading conditions that many reckon are more propitious.”

  Nervously, the bank’s staff wondered what Dimon would do. In early 2004, a former Bank of America executive named David Coulter had been running the investment bank. Just before Dimon arrived as the new chief operating officer, Coulter was pushed out of that post. Control of the investment bank was handed to the two men who had been working as Coulter’s deputies: Steven Black, a former Citigroup banker who had worked with Dimon, and Bill Winters.

  The Winters-Black partnership was approved by Dimon. But it struck many observers as odd; indeed, some of their staff started making bets about which of the two men would be forced out first. The coheads structure had thus far fueled vicious infighting and mistrust, and this solution seemed to promise more of the same. For one thing, Black had worked with Dimon during his Citigroup days and was in fact such a close ally that when Weill fired Dimon in late 1998, Black—or “Blackie,” as Dimon’s circle called him—resigned soon after. Meanwhile, Winters had no past ties with Dimon, and their temperaments were opposite; Dimon was famously extroverted, while Winters shunned the limelight. Outside the bank, few observers had ever even heard of Winters. In addition, Dimon had never shown any public passion for complex financial innovation, which was Winters’s strong suit. “I’ve got a rock star for a boss now!” Winters sometimes joked to colleagues. “But at least it takes the spotlight off the rest of us.”

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nbsp; Dimon was savvy enough, though, to appreciate that Winters had skills he needed. For one thing, Winters was running the bank’s non-US trading empire, which was generating half the profits of the entire investment bank. Winters was also a key link to the old derivatives heritage of J.P. Morgan. “Bill [Winters] has been around since the invention of seamless nylon stockings,” wrote Ian Kerr, a columnist on EuroWeek. “He knows where all the bodies are buried in that monster derivatives portfolio.”

  J.P. Morgan executives vehemently denied that there were any such “monsters.” Yet Winters certainly knew more about the portfolio than almost anyone else. He was also intuitively good at sniffing for risk. That may have stemmed from his unusual life story. To his colleagues, Winters usually seemed like a classic all-American guy. He worked hard, but loved partying with his gang of fellow traders, too. In reality, though, his life before J.P. Morgan had been unusual. In his twenties, he had studied international relations at Colgate, hoping to become a diplomat. That took him one summer to Croatia, where he fell in love with a local girl. He then moved to the Balkans for a couple of years, working in a beer-bottling factory under the old socialist system and learning to speak Croatian fluently. On returning to the United States with his new Croatian wife, he then applied for a job with J.P. Morgan since he needed to earn money. He then swiftly rose through the derivatives department, using his formidable wits and drive. But he never took the gilded banking ghetto for granted. In the early 1990s, a brutal war erupted in the Balkans that tipped Croatia into turmoil. That showed Winters in a profound sense that unthinkable things can sometimes occur in life. Systems can shatter. After that, he was never tempted to ignore seemingly “impossible” risks, in finance or anywhere else.

  Winters rarely discussed any of that with colleagues. What they could see, though, was that he was pragmatic, understated, and culturally flexible. He understood the value of quietly forging canny, tactical alliances in order to survive. So did Black. As a result, and against expectations, Winters and Black managed to craft quite a good working relationship.

  Shortly after Dimon announced their joint promotion, the two sat down, and Black said to Winters, “We’re big boys—we know that everyone is taking bets on which of us kills the other! Let’s show them that we can actually make this partnership work!” Winters said he was on board with that, and then, with a minimum of fuss, they agreed to rules of engagement. First, they agreed to keep their job descriptions deliberately flexible. The staff living in London tended to report first to Winters, while those in New York dealt first with Black, across a range of different sectors. The division of responsibilities was kept deliberately vague, however, to avoid the appearance that either might set out to build an autonomous empire. “Everyone reports to both of us. They all have a first port of call, but that port of call has got to be constantly changing,” Black said.

  They also agreed that they needed to communicate frequently, even though Black was in the headquarters on Park Avenue and Winters was in London. “Making this work is really like making a marriage work. You have to think about communication,” Black later observed with a wry, knowing smile. “At the beginning, we were just too polite to each other. But then we learnt to communicate better, as we went along. We just talked, talked, and talked.”

  The task facing them was daunting. On paper, the wider business climate in 2004 should have been playing to all of J.P. Morgan’s strengths. The new decade was shaping up to be the Era of Credit, and credit was supposed to be J.P. Morgan’s strength. By late 2004, the bank could still claim a leading position in the trading of interest-rate derivatives, foreign exchange, and corporate loans, and a respectable operation in the arena of corporate bonds, too.

  But the situation in securitization—or the selling of asset-backed securities—looked poor. When J.P. Morgan and Chase had merged, both sides believed the combined bank would dominate the securitization business. Chase was a leader in the business of lending money to low-rated companies (an activity known as leveraged finance) and repackaging those loans into bonds, while J.P. Morgan was a preeminent blue-chip lender and was skilled at bundling together pools of derivatives to create structures such as BISTRO. Chase also had extensive experience repackaging other forms of debt, such as mortgages, credit cards, and student loans, into asset-backed securities. But the dream of dominating the securitization market had not gone according to plan. In the fast-expanding asset-backed CDO and CDS business, J.P. Morgan was slipping behind other banks. The bank’s hesitance to get into the repackaging of mortgages was a key reason.

  Uneasily, Winters and Black debated how to fight back. It was clear that securitization was not the only source of embarrassment. The bank was also weak in the commodities and equities spheres, since these had never been strengths of either of the merged banks. However, the weakness in securitization was more disconcerting because credit was supposed to be J.P. Morgan’s core competence. Or as EuroWeek tartly noted: “Given the profile of JPMorgan as an institution steeped in structured finance, it really is surprising that the bank [has] failed to hitch a ride on the great US remortgaging wave.” So Dimon decided to act.

  As 2005 dawned, the word went out across the bank that JPMorgan Chase would get its act together in the credit world. “Securitization is a priority!” Dimon declared to his staff, and there was one sector in particular in which the bank really needed to catch up: mortgage finance.

  J.P. Morgan should have been able to raise its profile in the repackaging of mortgage debt quickly. Inside the vast, sprawling empire of JPMorgan Chase sat Chase Home Finance, one of America’s largest home loan mortgage originators. But though the volume of mortgages Chase had offered had surged as the housing boom took off, they were being sold to Lehman Brothers, Bear Stearns, and others for their mortgage CDO and CDS assembly lines. That was partly because the J.P. Morgan side had less experience with mortgage debt than with corporate loans, and was so leery about the risks involved with BISTRO-like products made from mortgages. Relations between the managers of Chase Home Finance and the J.P. Morgan side also played a role, though. The two groups barely communicated, epitomizing the in-fighting that still plagued the bank. “It felt like a state of war,” one banker inside Chase Home Finance later recalled.

  Dimon was determined to change that; he had no patience for infighting and was determined to create a financial “production line” similar to those at the other banks, turning the mortgage loans being produced by Chase Home Finance into J.P. Morgan bonds in a single, seamless operation. Dimon installed a new team who were willing to work with the investment side. Those officials then hooked the two divisions together and created an integrated infrastructure that would allow all parts of the bank to handle the housing market. “It took us ages to build, but Dimon insisted we needed to get all the systems before doing anything,” Bill King, one of those involved in the integration project, later explained. “We produced something a bit like a Google machine of mortgages—you could track the public data in any way you wanted.”

  By mid-2005, the production line was finally ready to be activated. But in 2006 Dimon started to get cold feet. By the end of 2005, the US housing market had been booming for several years. Between 1997 and late 2005, house prices rose more than 80 percent, according to the Case-Schiller index, with particularly marked increases in California, Florida, Michigan, Colorado, the northeast corridor, and southwest markets. Some observers worried that the prices were driven by speculative mania, but most economists brushed off those concerns. “There is virtually no risk of a national housing price bubble based on the fundamental demand for housing and predictable economic factors,” David Lereah, the former chief economist of the National Association of Realtors, wrote in 2005, in a self-styled “antibubble” report. Onlookers “should [not] be concerned that home prices are rising faster than family income…. A general slowing in the rate of price growth can be expected, but in many areas inventory shortages will persist and home prices are likely to continu
e to rise above historic norms.” Or as Ben Bernanke, then chairman of the President’s Council of Economic Advisers, said in 2005: “House prices have risen nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgage rates, steady rates of household formation, and factors that limit the expansion of housing supply in some areas.”

  When King and his colleagues scoured their Google-style mortgage database in early 2006, though, they spotted something odd: some of the data suggested that the pace of defaults on risky mortgages was starting to rise. That defied the normal economic rules. Mortgage defaults were thought to be triggered by sharp interest-rate increases or a slowdown in the economy (or both). Those had been the triggers in previous economic cycles, and those were the eventualities that had been factored into economists’ models evaluating the housing market. Neither was present in 2005. While in the spring of 2004, the Federal Reserve had started raising the short-term interest rate, jacking it up from a historic low of 1 percent to 4 percent by the end of 2005, there was still such voracious investor appetite for mortgage-backed bonds that mortgage lenders kept extending very cheap loans to households, confident they could sell those loans as CDO and CDS fodder. The economy was also growing strongly, with low jobless rates. So what was causing the default rate to rise?