One clue to what had gone so terribly wrong at Citi could be found in the dry details of the technical statement that Citi issued that day and then filed with the Securities and Exchange Commission. The statement noted that Citi had $55 billion of exposure to the subprime market sitting on its books, of which $43 billion was in the form of super-senior risk attached to CDO of ABS. That was a staggeringly large number, made doubly shocking because it had never been highlighted in any report that Citi had previously issued. Out of the $43 billion, around $18 billion was linked to investment-grade and mezzanine CDO of ABS, which Citi had retained on its balance sheet, either because it was in the process of creating CDO or because it had nowhere else to park it as it cranked up its CDO machine back in 2006 and 2007.
Citi’s exposure to the strike in the commercial paper market was also staggering. Another $25 billion of the bank’s total exposure was “commercial paper principally secured by super-senior tranches of high-grade ABS CDOs,” Citi explained. Back in 2005 and 2006, when the CDO machine was booming, Citi had sold a large volume of super-senior liabilities to SIVs and conduits. To encourage buyers, the bank often had provided a sweetener, nicknamed a “liquidity put,” that guaranteed that if the shadow banks ever faced problems financing that debt, Citi would either take it back or provide financing. Before the summer of 2007, nobody in Citi had ever expected those liquidity puts to be exercised, but in July, when the money-market crisis exploded, the SIVs and conduits had duly handed the super-senior risk back to Citi. As a result, Citi’s super-senior exposure had more than doubled in just a few weeks.
By mid-October, after the ratings agencies had cut the ratings on CDOs and prices had fallen on the ABX, Citi’s management had come under pressure to revalue its CDO holdings, leading to the series of write-downs.
To most Citi executives, the bottom-line hit was as stunning as if an asteroid had smashed into the bank. On the day of the last announcement, Jamie Dimon bumped into a former senior colleague at Citi. “How did this happen?” Dimon asked as gently as he could. “We are not entirely sure ourselves,” the man replied. Dimon had no reason to doubt him. By 2007, Citi was operated as a vast empire of business silos, which tended to be so fragmented—and feuding—that they rarely interacted. As a result, few of the bankers outside the CDO silo knew the details of how the securitization machine worked, let alone of the existence of the liquidity puts. “Perhaps there were a dozen people in the bank who really understood all this before—I doubt it was more,” one senior Citi manager later recalled bitterly.
Investors were also shocked. Back in July, Citi had been on a roll, posting record profits and holding an extremely large capital cushion. Now the super-senior asteroid was blasting through that capital cushion, and Citi was looking befuddled.
More frightening still, Citi’s woes were hardly unique. In early October, Merrill Lynch unveiled a $5.5 billion write-down on its credit assets. Again, analysts weren’t unduly concerned at first. But in late October, Merrill raised the estimate to $8.4 billion, large enough to force Stan O’Neal, the hard-charging CEO of Merrill, to resign as well. Unlike Citi, Merrill’s problems didn’t stem from liquidity puts offered to SIVs. Most of Merrill’s super-senior woes arose from the CDO notes that Merrill had decided to retain on its own balance sheet. Merrill had assumed it would be protected from any losses on super-senior because it had insured so much of that risk with monoline insurance groups. But as the pain in the mortgage market intensified, monolines were reeling. Just as Bill Demchak had anticipated a decade before, the “insurance” monolines offered was starting to look chimerical. That was one reason why, under pressure from its auditors, Merrill had downgraded the value of its super-senior assets so dramatically.
The losses at UBS were arguably even more shocking. In early October, the bank had announced it was writing off approximately $3.4 billion in mortgage-linked losses. Investors were stunned, but they also congratulated the bank for having the courage to come clean. By late October, though, the bank was indicating to analysts that it would soon need to revise that loss up considerably, and in December it announced another $10 billion of write-downs. As with Merrill Lynch and Citi, the scourge was super-senior CDOs. Back at the start of 2005, the Swiss bank had barely held a single super-senior CDO note on its books. By early 2007, though, UBS had grown its CDO business at such a furious speed that it was holding $50 billion in super-senior notes.
By late November, the banking sector was barreling into a full-blown crisis. Bank share prices were tumbling at a startling rate. Since June alone, more than $240 billion had been wiped out of the market capitalization of the dozen largest Wall Street banks. The cost of purchasing protection against default was spiraling upwards. Worse still, it appeared that the banks no longer really trusted each other. The cost of borrowing funds in the interbank market was also rising. Banks were so nervous about the prospect of new shocks that they either were refusing to lend money to each other or were hoarding the cash they had for fear of what lay ahead.
Shocked, some bank executives tried to fight back. Behind the scenes, they asked regulators if they could suspend the mark-to-market accounting rules for a period. To them it seemed ridiculous that banks were being forced to record these vast, multibillion-dollar write-downs. There was precious little real-world evidence that the super-senior assets were actually impaired. Although mortgage default rates were rising at one end of the financial chain, most CDOs had not yet tipped into a formal event of default, and most investors holding senior CDO notes were still receiving their regular interest payments. Insofar as the value of CDOs was shrinking, those losses were theoretical. “This is mark-to-market accounting gone mad! If we stick to these principles we will end up destroying banks for no good reason at all,” complained a senior executive at one of the banks most badly afflicted by super-senior losses.
The regulators, though, showed absolutely no willingness to drop mark-to-market principles. Changing the accounting rules halfway through a bout of banking turmoil, they feared, was likely to make investors even more nervous, particularly given that Western bankers and regulators had championed “transparency” with such enthusiasm in previous years. The auditors of the banks were even less willing to take a lenient stance. A few short years earlier, the audit profession had suffered a brutal shock when the revered accounting firm Arthur Andersen went out of business due to accusations of being lax in auditing Enron. Auditors were adamant not to expose themselves to similar risks now. “We had seen what happened after Enron…that made [accountants] really scared,” one anguished senior accountant explained in October. “The banks really benefited from mark-to-market when the going was good, so to have them claim that we should drop mark-to-market accounting when the prices were falling, looked entirely self-serving…no auditor will willingly endorse that.”
The bigger the theoretical losses became, though, the more they started to have an impact on the “real” world, too. Six months earlier, regulators and investors alike had blithely assumed that American and European banks would be extremely well protected from any future turn in the credit cycle. In the first half of 2007, large Western banks had posted a record $425 billion in profits and wielded capital cushions that vastly exceeded the minimum levels required to comply with the Basel Accord. Global banks were estimated to hold core capital (known as tier one) of $3.4 trillion. That was why the Federal Reserve and others had been so confident that the banks would be able to absorb the $100 billion–odd hit that was expected to arise from the subprime sector. Moreover, precisely because banks had been slicing and dicing risk so enthusiastically, most regulators and investors had also assumed that banks would be exposed to only a tiny part of any credit losses. Risk was supposedly scattered throughout the system. But the more the subprime scourge hit the banks, the more wrongheaded all those assumptions started to seem.
When the regulators had celebrated the benefits of “risk dispersion,” they had assumed that the banks were selling almost all
of their CDO notes to other players. They had not realized that so much super-senior was piling up on some banks’ books, in a manner that left those banks exposed to entirely unexpected new concentrations of risk. Worse, as the super-senior losses mounted, they were so gigantic in scale that they were eating through the banks’ capital cushions—even though those reserves had appeared to be so impressively large just a few months before.
The SIV problem presented another headache. All through the turmoil of November, the bankers at JPMorgan had struggled to create a workable plan for the superfund to purchase troubled assets held by the SIVs. Behind the scenes, Bob Steel, the Treasury undersecretary, furtively urged them on. The US government had absolutely no desire to see SIVs collapse and embark on a fire sale of their assets. Nor did they want the “real” banks to bail out the SIVs, since that would consume even more of their scarce capital. Yet, as the three-way talks among JPMorgan, Citi, and Bank of America unfolded, the group found it impossible to agree on how to proceed. One key sticking point was that nobody was keen to take on the risk of providing big loans to the superfund. By early December the idea was a bust.
Inside JPMorgan, the death of the superfund angered officials. Having been forced to take part against their instincts, they had then devoted hours of management time trying to establish a plan, now all for nought. “If we were to bill the US Treasury for that wasted time, the bill would be huge!” one JPMorgan banker observed. For other banks, though, the implications were truly grave. Without a superfund to rescue it, Citi faced pressure to take even more SIV assets back onto its balance sheet. So did other large banks. That coupled with the super-senior write-offs had a chilling implication: a banking system, that had once appeared nearly impregnable looked as if it might actually run low of capital.
In late November, Timothy Geithner at the New York Fed placed surreptitious phone calls to some of the Wall Street banks. The gist of these calls was “Can you find more capital? You need to—now!” Frantically, Citi, Merrill, and other large banks looked for ways to plug the capital gap, no one even daring to hope that the government would step in. The debates about the superfund and the Northern Rock fiasco left no doubt that the UK and US governments hated the idea of using taxpayer funds to recapitalize the banks, and there seemed to be little chance of persuading Western investors to recapitalize the banks.
In mounting desperation, some bankers looked east for help. During the first seven years of the decade, China, Singapore, Korea, and the oil-rich countries of the Middle East had all built up large so-called sovereign wealth funds, huge investment funds dedicated to managing pools of government money. By 2007, such funds were estimated to control over $3 trillion of assets, though the precise tally was unknown because the funds were highly secretive. Traditionally, much of their cash had been invested in US Treasury bonds and other safe assets. The funds had shied away from taking direct stakes in American companies, partly because doing so tended to provoke nationalist ire. However, as the panic intensified on Wall Street and in the City of London, bankers laid aside that concern, and senior deal makers from Wall Street, London, and Zurich hopped onto planes in a frantic effort to persuade Asian and Middle Eastern funds to help.
Citi was the first to clinch a deal. In late November, the Abu Dhabi Investment Fund, the world’s biggest sovereign wealth fund, announced plans to inject $7.5 billion into the bank. Soon after, UBS raised $11 billion from the GIC fund of Singapore and Middle Eastern investors. Then Merrill Lynch raised $5 billion from a Chinese government fund, while Morgan Stanley garnered a similar sum from Singapore. It was an extraordinary turn of fortune. The Western banks had been the ones to bail out their emerging-market counterparts in the past. Humiliating as it may have been, though, bankers were too relieved to have found cash to engage in hand-wringing about the source. “Huge quantities of money from the emerging world—some $60 billion at the last count—are injecting a measure of stability into the developed world’s arteries,” observed analysts at HSBC in late 2007. Regulators were privately relieved as well. “If the banks are finding fresh sources of capital, then that is very good. They need to recapitalize, as swiftly as they can,” one of America’s most senior regulators observed in December 2007. “Once they have done that, the banking system can then move on. Or that is what we all hope.”
Yet while the capital raising looked impressively large, the losses that continued to mount at the banks were even bigger. As 2008 got under way, UBS, Merrill, and Citi all revealed more big write-downs on their holdings of credit assets, taking their collective total to $53 billion—just for those three banks. Super-senior write-downs accounted for a stunning two thirds of that figure. Gamely, the three all insisted that they were near the end of these write-downs. Nobody quite believed them, though. The essential problem was that the system was becoming trapped in a vicious spiral. The more that the banks revealed losses on super-senior assets—or any other credit assets—the more scared investors became, causing the prices of the assets to fall still further, which forced the banks to make more write-downs. It was a pernicious feedback loop.
As the losses mounted, the former members of the J.P. Morgan swaps team reeled in shock. A full decade had passed since Demchak’s acolytes had invented the seemingly innocuous concept of super-senior, back in the heady days when they were fervently chasing their credit derivatives dream. In the intervening years, they had scattered, but many still remained friends. They emailed regularly, and from time to time, some of them would meet for dinner, or visit each others’ vacation homes in Tuscany, the Hamptons, and other choice retreats. When Andrew Feldstein and Bill Demchak created a project to raise funds for Darfur refugees, Blythe Masters, Bill Winters, and many others rallied round with donations and support. Like any family, the group was also driven by petty rivalries, yet they almost never criticized each other to outsiders. A deep intellectual bond and remarkable sense of affection still linked most of them.
By late 2007 the emails bouncing between their BlackBerries, though, were expressions of disbelief. Like Demchak, most of them were stunned that their super-senior brainchild had become such a rapacious scourge. “What kind of monster has been created here?” one of the former J.P. Morgan group wrote in a heartfelt email to another. “It’s like you’ve known a cute kid who then grew up and committed a horrible crime,” another member of the team commented. “All this just totally blows your mind.”
They simply hadn’t realized the degree of risk that was building up under all the acronyms. Over at BlueMountain, Feldstein had spotted at an early stage that banks were stockpiling super-senior holdings, and he had positioned his hedge fund to benefit when that pattern turned wrong. The strategy paid off handsomely, and in 2007, the three main funds at BlueMountain posted returns of 45, 34, and 9 percent, respectively. But Feldstein was the exception. Winters and Masters had never been able to understand why the other banks were so willing to keep cranking up their CDO machines, and now that the truth had come out, they were profoundly shocked. They were also indignant and angry.
It was little comfort to them that the terrible mistakes of others put J.P. Morgan in a flattering light by comparison. As the losses piled up, confidence was crumbling so thoroughly that all banks were being hurt. A public backlash against all types of complex finance was building. “It feels like credit derivatives or CDOs have become a dirty word right now,” lamented Tim Frost.
Most of the former J.P. Morgan team considered pointing the finger at derivatives utterly unfair. “This crisis has nothing to do with innovation. It is about excesses in banking,” Winters observed. “Every four to five years there is a new excess in banking—you had the Asian crisis, then the internet bubble. The problem this time is extraordinary excess in the housing market.” Or as Terri Duhon said: “When car crashes happen, people don’t blame cars or stop driving them, they blame the drivers! Derivatives are the same—it’s not the tools at fault, but the people who used those tools.” Hancock was even more adaman
t. After he left J.P. Morgan back in 2000, he had created a consultancy group that advised governments and companies on how to use innovative financial products, such as derivatives, to their benefit. The other founding members of the group were Roberto Mendoza, another former J.P. Morgan banker, and Robert Merton, the Nobel Prize–winning economist who had helped to create the pathbreaking Black-Scholes formula that had played a crucial role in the development of derivatives. For seven long years, Hancock had extolled the virtues of financial innovation, often in the face of client skepticism. Even as the banking world reeled in shock in late 2007, he remained committed to the cause. “A lot of the problems in structured finance have not been due to too much innovation, but a failure to innovate sufficiently,” Hancock observed. “People have just taken the original BISTRO idea, say, added zeros, and done it over and over again without really thinking about the limits of diversification as a risk management tool. There is a big difference between using this structure for corporate loans, as we did at J.P. Morgan, and subprime mortgages!”
As the losses piled up, though, some members of the team realized that certain assumptions that had driven them a decade before had been naive. Back in the 1990s the team had all believed, with near-evangelical fervor, that innovation would create a more robust and efficient financial world. Credit derivatives and CDOs, they assumed, would disperse risk. Now it turned out that the risks had not been dispersed at all, but concentrated and concealed. It was a terrible, horrible irony.
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 24
