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 second fund also got off to a running start, delivering cumulative returns of 4.4 percent in the first four months. At the start of 2007, though, things had begun to unravel. As the subprime mortgage market began to turn sour, the price of some mortgage securities and derivatives fell. That wasn’t supposed to happen—those products had been risk-proofed, according to the models—but the defaults had built up enough that the unthinkable had started to occur.

  The two funds tried to hedge themselves by purchasing protection against further mortgage defaults with ABX derivatives, but they did too little, too late. By February, investors had become so alarmed about the funds’ mounting losses that they demanded more than $200 million of their money back. Cioffi and Tannin tried to soothe them, arguing that the funds offered an “awesome opportunity” and that “we’re very comfortable with where we are.” In private, though, they were concerned. “I’m fearful of these markets,” Mr. Cioffi wrote in an email to a colleague on March 15, 2007, according to documents seized by the FBI. “It’s either a meltdown or the greatest buying opportunity ever, I’m leaning more towards the former.”

  In May, the two men admitted that the most highly leveraged fund had lost 6 percent in April alone. Then, soon after, they revised that estimated loss up to a staggering 19 percent. Investors were livid: how could Cioffi and Tannin have miscalculated the losses so badly? In reality, it was easy, because working out the “true” value of the assets held by the funds was fiendishly difficult. Some of the securities the funds held were traded in the open market, so their prices could be tracked, but most CDO products still weren’t being traded. If the funds were pursuing a “buy and hold” strategy, buying assets and retaining them until they expired (usually five years), the lack of price information might not have mattered. But these were hedge funds, and a widespread convention in the hedge fund world dictated that funds give their investors regular reports on the so-called mark-to-market value of their assets. Without that transparency, investors usually wouldn’t invest. The Bear Stearns funds, therefore, faced a big problem: how could they find “market prices” when a true market for their assets didn’t exist?

  Most funds resolved this dilemma by using models to take account of default patterns and the price of any such instruments that were being traded, and extrapolating from that data to create a price. Extrapolating in this manner was not difficult with corporate credit derivatives, since there were plenty of corporate debt instruments that did trade. The mortgage sector was more problematic. Mortgage derivatives had proliferated so fast, in such a short time, that it was hard to draw clear links between the price of underlying mortgage loans and linked CDOs. Trading in mortgage bonds, let alone mortgage derivatives, was sparse. The only obvious guide was the ABX index, which had been launched in early 2006. It provided a gauge of the value of the range of bonds in the CDOs—from BBB to AAA. So what many funds—including the Bear Stearns fund—did was look at the prices as given by ABX and then use that to deduce the prices of the bonds in their own CDOs. During 2006, that had cast a flattering glow on the fund, since the ABX trades were bullish. By the end of February 2007, though, the ABX index suggested that the price of BBB subprime mortgage-backed bonds had fallen to around 65 percent of face value. To put that another way, the cost of buying insurance via the ABX had risen so high that the prices made sense only if you thought the bonds commanded a mere 65 percent of their face value. The ABX ticked up again in March, but by June, the implied price of BBB bonds was sliding towards 60 percent of face value. Even the implied prices of A and AA instruments were starting to deteriorate.

  As Cioffi and Tannin factored those movements into their models, the impact was devastating. By early June, the value of the assets at the most leveraged fund was 23 percent down, while the older fund had suffered losses of 5 percent. Due to how highly leveraged the newest fund was, it was effectively bust, and the oldest fund teetered on the edge. BusinessWeek pointed to the trouble as “another illustration of the danger facing funds that rely heavily on borrowed money to make investment bets.”

  As the losses mounted, officials at J.P. Morgan’s headquarters at 270 Park Avenue pondered what they should do. When the two funds had used leverage to place their investment bets, they had done so by taking out large loans from banks, often on a short-term basis. J.P. Morgan had extended a hefty amount, alongside Barclays Capital, Merrill Lynch, Goldman Sachs, and others. The J.P. Morgan management was well aware of the risk involved, but the bank was also looking to expand its dealings with hedge funds. To reduce the risk, the bank had required that Bear put up plenty of high-quality collateral against the loans. By mid-June, Steven Black, cohead of the investment bank, was worrying whether the bank would be able to get its money back, and he sent a team to Bear’s Madison Avenue offices to assess the situation. Frantically, Bear officials tried to placate them, pleading, “Just stick with us, and it will all be fine—these are high-quality instruments!” But the J.P. Morgan risk managers insisted on seeing the accounts, and these suggested the funds were effectively bust.

  Black realized that J.P. Morgan needed to get its money back as fast as possible—or grab the collateral Bear had put up and sell it off. He called Warren Spector, the powerful and widely respected head of Bear’s investment bank, who had built the group’s debt markets operation—and was one of the few men at Bear who truly understood the full reach of this business. Spector struck a defiant pose: he suggested that J.P. Morgan was the only bank threatening to call in its loans. He also declared that the two hedge funds would soon recover their losses.

  Black was furious. He knew that Merrill Lynch and several of the other creditors were also threatening to call in their loans. So he called Alan Schwartz, another senior official at Bear Stearns, whom Black had known for years. Black said firmly: “We want our money back!” As the pressure mounted, Cioffi and the other officials at the Bear funds tried to get some money to repay the loans. They declared they would sell almost $4 billion of their most liquid assets, and Bear traders circulated a list of the securities on the block. It was not enough to placate the banks, though. As the days passed and Merrill Lynch failed to get its money back, Merrill officials told Bear they planned to sell about $400 million worth of Bear’s collateral in the open market. Most of that was complex, rarely traded instruments such as CDOs.

  That threat sent shock waves through the market. Nobody had ever tried to sell that many CDOs or mortgage bonds in public before. A fire sale of that kind threatened to produce something the CDO world had never seen before: “true,” undeniable market prices. In theory, that promised to be a very healthy, long-term development. After all, the bankers who had invented structured finance had always claimed to be upholding the virtues of free markets and rational pricing. They were supposed to like transparency. In actuality, though, the prospect of an open auction had terrifying short-term implications. Even at the best of times, forced sales hardly achieve good prices, and by mid-June, conditions in the mortgage market were getting worse by the day.

  On June 15, just as Merrill was issuing its fire-sale threat, Moody’s announced that it was cutting its ratings on 131 bonds linked to BBB-rated pieces of subprime debt and reviewing the ratings on 247 other bonds, all linked to mortgages issued in 2006. The move affected only $3 billion worth of bonds, a tiny proportion of all the $400 billion subprime-linked bonds sold in 2006. Nonetheless, it spooked investors so badly that the BBB tranche of the ABX tumbled to 60 percent of face value.

  Moody’s admitted that its experts were finding it hard to read the housing market trends. “[These mortgages] are defaulting at a rate materially higher than original expectations,” it observed. The mood was turning decidedly edgy. “Negative sentiment [is taking] a firm hold of the [subprime bond] market,” analysts at J.P. Morgan noted. Bankers feared that an auction of any of the CDO products would push prices lower still, and that would have ominous implications, not just for the Bear Stearns funds but for numerous other investmen
t groups and banks, too.

  After all, most of them were also marking the value of their CDOs using model prices; if a visibly lower “market” price emerged, almost anyone holding CDOs would need to record losses. Transparency would be a nasty shock. “If we end up seeing these assets sold at significantly distressed prices, it will likely cause other funds to have to reevaluate how effective and fair the values that they have been carrying these securities have been,” said Josh Rosner, a managing director at Graham Fisher, an investment research firm in New York.

  For several days, a game of brinkmanship played out. Merrill circulated a list of the CDOs and other securities it wanted to sell and invited bids from investors. J.P. Morgan and Goldman Sachs threatened to do the same. Frantically, Bear tried to dissuade them, pointing out that the banks would also suffer. Merrill Lynch and J.P. Morgan steadfastly insisted they wanted their money back. Eventually, as the tension mounted, a deal of sorts was cut. In late June, Bear Stearns publicly announced that it would provide $3.2 billion in emergency funds to the older of Cioffi’s two funds, to prop it up. The other fund would be liquidated. Bear also privately agreed with J.P. Morgan, Bank of America, Merrill Lynch, Goldman Sachs, and others that they could recoup their loans, and the banks dropped their fire-sale threat.

  Financiers with any investments linked to the mortgage market breathed a profound sigh of relief. The shock had been averted. Black and his colleagues at J.P. Morgan didn’t dare hope, though, that this was more than a temporary reprieve. Even with its lifeline from its mother bank, the remaining Bear fund looked sickly. Moreover, irrespective of the fate of the Bear fund, the drama had shown that a much wider structural threat was hanging over the system. What had doomed the Bear funds was that they were highly leveraged, exposed to long-term mortgage assets, and they had an investor base able to withdraw money at relatively short notice. In banking jargon, the Bear funds were thus plagued by a “maturity mismatch”: they bought long-term mortgage-linked assets that were hard to sell in a hurry, and they funded those purchases by raising short-term debt that could suddenly disappear. To make matters worse, the Bear funds were also expected to mark their assets to market on a regular basis—even though a market barely existed.

  In the case of Bear, that cocktail had proved poisonous almost as soon as the mortgage markets turned sour in early 2007, because the Bear funds held CDOs that were particularly vulnerable to a mortgage market downturn, and its investors and creditors had panicked at an early stage. However, Bear was in no way unique. On the contrary, the investment landscape was dotted with a host of funds that had used large quantities of leverage to invest in mortgage-linked assets and had the same maturity mismatch. Some of them had more patient investors or a better mix of assets. But the structural problem was widespread. And that begged a bigger question: could the problems at the Bear Stearns funds be treated as isolated? Or were they pointing to a problem that could erupt across the system as a whole? By late June, few bankers had a clear-cut answer. For their part, Dimon, Winters, and Black were starting to get worried. “This could turn nasty,” Black observed to colleagues.

  In mid-July, another shockwave hit. Winters was striding through Geneva International Airport on the way to a meeting when he received a phone call from an official at Deutsche Industriebank (IKB), a medium-sized lender based in Düsseldorf, Germany. The group was barely known outside its home country and had specialized in funding medium-sized manufacturing companies. What IKB had to say on that July day had nothing to do with industry, though: the bank was desperate for an emergency credit line, to cover what it described as a “temporary” funding problem. “We have a lot of safe securities, but investors are behaving strangely,” a bank official explained. “Will you help?”

  Winters was startled. The problem centered on a couple of investment vehicles run by IKB, known as Rhineland and Rhinebridge. The older of these, Rhineland, had been created five years earlier. Back then, IKB—like many other German banks—had been hunting for ways to diversify its business away from its core franchise of corporate lending because that was becoming unprofitable. So it had established Rhineland to invest in high-quality debt instruments, including mortgage-linked bonds. Rhineland was run as a SIV, which meant that it did not appear on IKB’s balance sheet. It funded itself by selling commercial paper notes to investors, including European pension funds and American public-sector investment bodies. Robbinsdale Area Schools district in a northwestern suburb of Minneapolis, for example, had bought Rhineland commercial paper. So did the Montana Board of Investments.

  Between 2002 and 2006, this strategy had delivered a fat stream of profits for IKB. In fact, it was so successful that in June 2007—or shortly before Winters received the phone call—IKB created a second SIV, which was Rhinebridge. Like the first SIV, this second entity enthusiastically bought debt instruments, including mortgage-linked CDOs. That made Western investment banks eager to court the IKB officials. At the ESF conference in Barcelona, for example, American brokers and City bankers swarmed around the Germans, in the hope of selling them more bonds.

  However, as Winters stood in Geneva International in July, it was clear that something had gone badly wrong with the IKB funds. He called his traders in London. “What’s going on?” he asked. “There’s something like a bank run starting in the commercial paper markets,” a trader replied.

  That news was alarming. Until that point, the commercial paper market had been deemed one of the safest, and dullest, corners of the financial world. It was where General Electric and other blue-chip giants raised the short-term funds that they needed for day-to-day operations. It was also where solid, risk-averse investors tended to put their cash as an alternative to placing their money on deposit at a bank. Corporate treasurers often bought commercial paper, since those notes tended to produce a return a fraction better than anything found in a bank account. Pension funds sometimes bought commercial paper, too. One of the biggest sources of demand for commercial paper, though, came from the giant $3 trillion money-market fund sector.

  These funds typically raised money from ordinary retail investors or companies, which tended to treat money-market funds as similar to a bank account: they placed cash there assuming they could always withdraw it, and on short notice. Precisely because money-market funds knew that investors might redeem their cash with little notice, such funds usually wanted to purchase only assets that had a short duration and were safe. Commercial paper fit the bill perfectly.

  The specific corner of the market where IKB raised funds was one subset of this world, a mutation known as the asset-backed commercial paper (ABCP) sphere. It took that name because the groups that issued short-term notes there backed them up with “assets,” such as mortgage bonds. The solid but dull investors who typically bought such notes usually knew little about how mortgage-backed CDOs worked, let alone about the inner workings of SIVs. They weren’t troubled much by that, though, because the notes carried high credit ratings, usually the triple-A or double-A level. Money-market fund managers buying the ABCP notes assumed they were as safe as anything that might be issued by corporate giants such as General Electric.

  But in mid-July, the pillar of faith in the ratings of those bonds started to crack, for several reasons. One was the dismal news about defaults emerging from the mortgage world. Another was the downgrades that the ratings agencies themselves were starting to make. In mid-July, Moody’s announced it was cutting its ratings on $5 billion of subprime mortgage bonds. Around the same time, Standard & Poor’s placed $7.3 billion in bonds on review for a downgrade. Then the saga of the Bear Stearns funds burst into the news. After the two funds collapsed, it emerged that many of the bonds and CDOs that had wreaked havoc at the fund had carried relatively high—not low—credit ratings. Investors in the ABCP market grew nervous.

  Few of them knew for sure whether the type of “mortgage-backed bonds” the Bear Stearns funds held were similar to those owned by IKB funds, say. Nor did investors know what the
price of a CDO “should” be. The financial chain that linked US households with CDO investors was so long and complex that it was hard for the experts—let alone a nonspecialist—to work out how defaults might impact cash flows on CDO investors at the other end of the chain. But the investors who bought ABCP paper bought it precisely because they were highly risk-averse. They could not tolerate uncertainty of any kind. So, as the rumors spread about Bear, they took the only step available to eliminate their risk: they stopped buying notes. “The problem is that people just don’t know quite what to trust, or not,” explained Donald Aiken, head of a large European money-market fund association. “Probably everything in most of those portfolios [behind commercial paper] is fine, but people don’t know for sure, and people don’t want to take the risk.”

  That buyers’ strike left IKB in a fix. In reality, the vast majority of the mortgage assets that the IKB funds held were not impaired, in terms of actual defaults on loans in those banks. However, most SIVs—like hedge funds—were required to provide regular updates on the value of the assets they held. Since the ABX was reporting drops in value, investors became utterly unwilling to buy notes issued by the IKB funds, leaving the funds desperate for cash. In theory, they had the right to call on IKB for a backup emergency loan to keep them afloat, but in practice, IKB didn’t have the resources to provide that money. The German bank had never laid aside significant capital reserves to cover for the possibility that the funds might need an emergency credit line. The idea that the ABCP market would shut down was deemed inconceivable. Moreover, the Basel regulatory rules did not require IKB to have that safety net, since the funds were off-balance-sheet SIVs. Thus, while the IKB funds held more than $20 billion in assets, the bank itself had a mere $16 billion in liquid assets on its books.