Notwithstanding those moves, the volume of leveraged loans on J.P. Morgan’s books continued to rise, and in early summer it hit $32 billion. Dimon, Winters, and Black decided to go further and implement a series of so-called macroeconomic hedges. Traders were instructed to short the equity markets, betting that stocks would fall, and to take out derivatives contracts betting that corporate and mortgage defaults would rise. Bets were also made that long-term interest rates would rise. If an economic crunch hurt the value of the leveraged loan pile, the bank would offset those losses with these hedges. “The fact is that every five years or so, something bad happens. Nobody ever has a right to not expect the credit cycle to turn!” Dimon kept saying. It was an observation driven as much by gut feeling as by any hardheaded analysis. To Dimon that gut feeling was a reason to act.
Unknown to Winters, some of his former J.P. Morgan teammates were reaching similar conclusions. The cautious attitude towards risk instilled by the J.P. Morgan training seemed to have become imprinted in their DNA. As Bill Demchak at PNC in Pittsburgh tracked the credit boom throughout 2006, he became deeply alarmed. Late that year, during a regular earnings update with equity market analysts, he declared that PNC was embarking on a radical new policy to shed credit risk from its balance sheet, either by selling loans or by insuring them with credit derivatives as insurance. By the standards of what almost all other regional banks in America were doing at the time—expanding their loan exposure as the markets boomed—the decision was extraordinary. Demchak, though, remembered only too well the devastation of Chase’s portfolio after the internet bubble burst, and he was determined to save PNC from that fate. Then his team went further and put into place a series of macrohedges. Ironically, they were similar to what Winters was doing half a world away. Demchak had never been a close friend of Winters, and some of Demchak’s friends were angry that Winters had not done more to protect Demchak in the merger years. A friend of Demchak’s later said, “I think Winters was quite pleased to see Demchak leave, in some ways, because it boosted his career.” Yet, irrespective of their personal differences, one thing linked them: neither Demchak nor Winters liked taking uncontrolled risks.
Andrew Feldstein was also battening down the hatches at BlueMountain Capital, the hedge fund he had started. He had been expecting a turn in the credit cycle since 2005 and had designed his fund’s whole investing strategy around what he believed were price distortions in the credit markets. Having spotted early on the degree to which banks were abusing their CDO machines, in relation to the treatment of super-senior risk and much else, he had placed hefty bets on a downturn in the CDO market.
He hadn’t always called the shots right. His bearish stance on the credit markets had cost him considerable earnings during 2005 as the markets continued to boom. “I called the turning point too early,” he later observed, with a wry smile.
Yet Feldstein was more convinced than ever that something would give in the credit world. Unlike Masters and Winters, he had close dealings with the CDO trading desks of numerous banks, and he had spent hours analyzing their trades. He had no way of knowing exactly how much super-senior risk the banks were piling onto their balance sheets. That was a closely guarded secret, even within the banks. Yet he could see that it was rising at some banks, and he was convinced the situation was precarious.
So he also took short positions in the market on the banks he believed were holding the biggest super-senior piles. He also shorted the super-senior tranches held by the banks and the mezzanine tranches that banks were selling to customers using prices that were distorted by credit ratings. “In an ideal world, I would like to think that markets are rational and efficient. And in my own career I have tried to promote that,” Feldstein liked to say. “But until that ideal world arrives, we will also continue to trade.”
From time to time, Feldstein tried to tell some of his old colleagues about the scale of super-senior risk he thought was piling up on the banks’ books, but his warnings were met with skepticism. When he dropped hints to Winters about the distortion of model prices, Winters brushed the word off. After all, BlueMountain was in the business of trying to make profits from the shortcomings of the investment banks, so Winters was wary of Feldstein’s motives.
Feldstein also explained more explicitly to Demchak that numerous banks were keeping piles of super-senior liabilities on their balance sheets. Demchak and Feldstein were friends, and Demchak was a director of BlueMountain. Even so, Demchak found it impossible to believe that the banks could be ignoring the risk controls he took for granted, or that the brilliant mechanism he’d been involved with creating had become so perverted. “Andrew told me what he thought the banks were doing with their super-senior risk, but I kind of ignored it,” Demchak later said, with a dry, despairing chuckle. “I just couldn’t believe it. Most of us could not.”
By early 2007, most Western policy makers were convinced that the credit cycle had become so extreme that it would inevitably turn soon, leading to ripple effects well beyond the American housing market. But they were at a loss to judge how that might play out. So much of the financial activity of the boom was out of their sight or control. Since 2004, the Fed had been steadily raising interest rates, along with the Bank of England, in a deliberate effort to prick the bubble. The European Central Bank had belatedly followed suit. Yet these moves hadn’t worked. Instead of rising, the cost of borrowing had stubbornly continued to fall in many corners of the market. In the US government bond sphere, yields on 10-year Treasuries even tumbled below short-term bond yields, creating a bizarre pattern known as an “inverted yield curve.” Alan Greenspan dubbed the situation a “conundrum.” There were other puzzles, too. In previous decades, the price of assets had been volatile when surprises hit the markets, be they an oil price shock, a rate rise, or a swing in the housing market. However, as Basel’s BIS noted at the time, the “striking feature of financial market behavior” in the twenty-first century was “the low level of price volatility over a wide range of financial assets and markets.” The prices of almost all assets were rising, while the cost of borrowing was flat or falling. One troubling result, policy makers feared, was an increasing correlation among the prices of many different asset classes, which would mean that a downturn would also be widespread.
Most policy makers and bankers had never seen such eerily calm markets in their careers, and they were uncertain and divided about what—if anything—they should do. At one end of the intellectual spectrum stood senior American officials, who mostly assumed that the pattern was benign. In January 2006, Ben Bernanke, an esteemed academic economist, took over at the Fed from Greenspan. Earlier in the decade, Bernanke had coined the phrase “the Great Moderation” to describe the new twenty-first-century atmosphere of calm. Both he and Greenspan seemed to think that this “moderation” had arisen because central bankers had successfully crushed inflation and because there was a savings surplus in Asia. Essentially, the argument was that Asian countries were using their foreign exchange reserves to buy US Treasuries and keep rates low.
Greenspan and Bernanke were also both keenly aware, though, that credit prices could not keep rising indefinitely. “Extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets,” Greenspan noted in 2005. However, Bernanke and his predecessor also hoped that any “attendant price fall” would not lead to a financial shock, because the blow would be softened by financial innovation. Back in the 1980s, the savings and loan crisis had devastated some banks because they were not able to shed credit risk. By 2007, though, the dominant creed at the Washington Fed and US Treasury was that credit risk had been so widely dispersed, via credit derivatives and CDOs, that any blows would be absorbed.
The innovation evangelists seemed to have history on their side. During the first seven years of the twenty-first century, the financial system had been rocked by repeated shocks, including the attack on the World Trade Center, th
e collapse of Enron, the implosion of the internet bubble, and then the collapse of a $9 billion hedge fund called Amaranth Advisors in 2006. Yet on each occasion, the system had bounced back fast. Fed officials appeared confident that the same pattern would apply to any losses that might arise from subprime mortgages or any other shock to the system. So did many international commentators. “The dispersion of credit risk by banks to a broader and more diverse set of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient,” the IMF declared in its 2006 annual report. Such dispersion, it added, would help to “mitigate and absorb shocks to the financial system” with the result that “improved resilience may be seen in fewer bank failures and more consistent credit provision.”
Not quite everybody, though, adhered to this creed. At the other end of the intellectual spectrum stood officials at the BIS (Bank for International Settlements) in Basel. The BIS was known as the “central bankers’ bank” because it provided a forum for central bankers to meet and exchange ideas. The BIS was in rather a peculiar structural position in the global banking world, since it had no direct responsibility to voters and politicians but was privy to many central banking secrets. That gave it some freedom of thought, and from 2003 onwards its officials started expressing views quite different from those of the Fed. One of the first clashes occurred on August 30, 2003, at a conference of economists in Jackson Hole, Wyoming. Bill White and Claudio Borio, the two most senior economists at the BIS, presented a paper warning that not all financial innovation was good: “The changes in the financial and monetary regime [in the past twenty years] may have potentially increased the scope for financial imbalances to grow during expansionary phases…making it more vulnerable to boom and bust cycles,” Borio, a somewhat impish Italian man, declared. “In those expansions in which the imbalances did develop, they would both reflect and contribute to distortions in the real economy [thereby undermining the sustainability of the expansion. By the same token] they could sow the seeds of headwinds and financial stress during the subsequent downswing.”
The audience was dominated by American economists, including both Bernanke and Greenspan, and they were unimpressed. “People thought Bill [White] was just being alarmist,” one senior American policy maker later recalled. Subsequently, Roger Ferguson, the deputy chairman of the Federal Reserve, harangued the two men for being unnecessarily “gloomy.” Fed officials also pressured them to water down the tone of the reports that the BIS published. White and Borio complied to some extent, and from then on kept their dissent mostly out of public view. After all, the Federal Reserve was a major shareholder of the BIS. “There was a lot of opposition to what we were saying,” White later recalled. Alan Greenspan commanded such formidable respect and power that he was often dubbed “the Maestro,” he knew, and American academics were powerful, too. Confronting that was hard, even for the BIS.
White and Borio, though, became steadily more alarmed. By early 2007, they had become convinced that a key reason for the “conundrum” Greenspan had identified was that financial institutions had become so highly leveraged in ways policy makers could not see. Far from being the salvation, innovation might be creating new problems, they feared, and they impressed those concerns on their colleagues. “What worries me is what might happen if—or when—the system starts to de-leverage,” Malcolm Knight, managing director of the BIS, observed in the spring of 2007. Or as White defiantly wrote in the conclusion to the 2007 BIS annual report: “It would clearly be undesirable, even if it were possible, to roll back the changes that have occurred over the last few decades…nevertheless, more skepticism might be expressed about some of the purported benefits of having new players, new instruments, and new business models, in particular the ‘originate and distribute’ approach which has become so widespread. These developments have clear benefits, but they may also have side effects, with associated costs.”
Other Western central bankers and regulators tended to have views that fell somewhere between these two extremes. At the European Central Bank, in Frankfurt, Jean-Claude Trichet appeared sympathetic to the view of the BIS. “We are currently seeing elements in global financial markets which are not necessarily stable,” he observed in January 2007 at the annual meeting of financiers and global leaders in the Swiss mountain resort of Davos. “There is now such creativity of new and very sophisticated financial instruments—that we don’t know fully where the risks are located. We are trying to understand what is going on, but it is a big, big challenge,” he added, with a Gallic shrug. He pointed to the “low level of rates, spreads, and risk premiums” as factors that could trigger a potentially violent “repricing” of assets.
British regulators seemed even more ambivalent. Back in 1997, the UK government had stripped the Bank of England of its responsibility for supervising banks, handing that to a new institution, the Financial Services Authority (FSA). The Bank remained in charge, however, of maintaining overall financial stability. London was a crucial player in the credit sphere. More than half of all credit default swaps were thought to be traded in the UK, and many of the shadow banks were headquartered there. But the British central bankers found it fiendishly hard to track what was going on, let alone interest anyone else. The Bank was dominated by macroeconomists, not market experts, and few politicians—let alone journalists—were interested in the credit world. For several years, Paul Tucker, head of markets at the Bank, doggedly plodded on, trying to piece together what was occurring. By the spring of 2007, his detective work had left him shocked by the scale of change under way and uneasy about what it might mean. “[We are in] the age of what I call Vehicular Finance,” he remarked. “The key intermediaries are no longer just banks, securities dealers, insurance companies, mutual funds and pension funds. They include hedge funds, of course, but also collateralized debt obligations, specialist monoline financial guarantors, credit derivative product companies, structured investment vehicles, commercial paper conduits, leverage buyout funds—and on and on. These vehicles can fit together like Russian dolls.”
The FSA was too busy supervising individual banks to reflect on what this “Russian doll” interconnectedness might mean for the system as a whole. Mervyn King, governor of the Bank of England, seemed uninterested, too. A former economics professor, King assumed that the modern esoteric creations of the credit world had little to do with the working of the “real” economy. Tucker worried that the “vehicular finance” could turn dangerous, but he had no power to force the banks to reform their ways. In any case he wasn’t at all sure how dangerous the situation was. “Over the last year, the world has enjoyed a further period of monetary and financial stability,” he said in the spring of 2007. “Against that background, banks and dealers have posted fairly remarkable profits, accumulating more capital resources. Over the coming decade, some currently observable imbalances will plausibly work their way through the system. In ten years’ time, we may therefore…be better informed on whether the changes in the structure of our financial markets help or hinder the preservation of stability.”
The position of Timothy Geithner, the youthful president of the New York Federal Reserve, was more ambivalent still. Unlike the men running the Fed and the Bank of England, Geithner had no background in academic economics. He arrived at his post in October 2003, aged just forty-two, after a career in the Treasury. Free from rigid economic dogmas, he was a deeply pragmatic man who sometimes observed that his aim in life was merely to do “the least bad job possible.” Like almost every other American policy maker and official, Geithner believed that in an ideal world, banking should be based on the principles of free-market competition. In the real world, though, he recognized that governments sometimes needed to jump in. In his eyes, the financial system was often plagued with what he called “collective action problems”—or cases when the banks were so busy pursuing their own interests in a competitive and greedy fashion that they failed to rati
onally consider long-term outcomes.
Competitive forces, in other words, did not always produce efficient or safe results, Geithner believed. That view was different from Greenspan’s faith in laissez-faire finance. Geithner’s approach was much closer to that of the former New York Fed president Jerry Corrigan. That was no coincidence, as after Geithner arrived at his post, he took to calling Corrigan regularly for advice, along with other experienced financiers. Corrigan was only too happy to play the avuncular adviser. He and Geithner not only shared similar attitudes to the markets, but both had a “geeky” fascination with the technical details of market infrastructure. “I guess you could say Corrigan and Geithner are in the same church pew. Greenspan is not,” observed one senior American official who knew them all well.
The ever-pragmatic Geithner was careful never to express any public sentiment that might dissent from Greenspan’s views. Compared to Greenspan, Geithner was not just younger, but he also commanded far less clout and respect. As the decade wore on, though, he became privately uneasy about some of the trends in the credit world. From 2005 onwards, he started to call on bankers to prepare for so-called “fat tails,” a statistical term for extremely negative events that occur more often than the normal bell curve statistical models the banks’ risk assessment relied on so much implied. He commented in the spring of 2006: “A number of fundamental changes in the US financial system over the past twenty-five years appear to have rendered it able to withstand the stress of a broader array of shocks than was the case in the past. [But] confidence in the overall resilience of the financial system needs to be tempered by the realization that there is much we still do not know about the likely sources and consequences of future stress to the system…[and]…The proliferation of new forms of derivatives and structured financial products has changed the nature of leverage in the financial system. The addition of leverage imbedded in financial instruments to balance-sheet leverage has made this source of potential risk harder to assess.”
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 18
