All the Devils Are Here

by Bethany McLean; Joe Nocera

  The woman who came up with the idea of using a credit default swap to deal with this situation was Blythe Masters. Though she was not the head of the derivatives group, she was a key member of the team, a superb saleswoman who in later years would become the person most closely associated with J.P. Morgan’s entrée into swaps. After Exxon drew down its $4.8 billion line of credit, she convinced the European Bank for Reconstruction and Development (EBRD) in London to participate in a swap deal where it assumed the default risk for the loan, with J.P. Morgan paying it steady fees for doing so. The loan stayed on J.P. Morgan’s books.

  Compared to what would come later, the deal was simplicity itself. J.P. Morgan was transferring the credit risk of a single loan to a single entity. Why was the EBRD willing to assume that credit risk? In truth, the reason was that the risk was minimal. Potential fine or no, Exxon was one of the strongest companies in the world, with 1994 revenues of close to $100 billion. It ranked third on the Fortune 500. Yet J.P. Morgan was going to pay the European bank substantial fees to assume the risk of an Exxon default. It seemed like free money.

  And why was J.P. Morgan willing to pay those fees? Because even if it couldn’t reduce its government capital, it was still removing a risk it did not want to bear, one that was weighing down its commercial lending risk profile. It had its own internal capital requirements, which would be reduced with this swap deal. And besides, the Exxon deal served as proof of a concept, and might help convince the government that swap deals merited capital relief. But that was still a ways off.

  Just like mortgage-backed securities in the 1980s, the derivatives business needed government help in order to really take off. For instance, the industry needed Congress to tweak the bankruptcy laws, so that derivatives contracts could be “netted out” in case of a default. Without that change, if a bankrupt company owed its counterparties $500 million in swap deals, while the counterparties owed the company $300 million, the derivatives dealers would have to stand in line for its $500 million—while paying the company the $300 million. After Congress passed the “netting out” provision, the counterparties would then be owed $200 million instead.

  But the derivatives dealers also wanted something even more important from the government: they wanted regulators to keep their paws off their shiny new product. For J.P. Morgan, which had been one of the leading derivatives dealers long before it came up with credit default swaps, this was its top Washington priority.

  The person who led the lobbying effort for the bank, Mark Brickell, could not have been better suited to this task. A tall, thin, mildly disheveled man, Brickell wasn’t like most Washington lobbyists. He wasn’t a hired gun. Rather, he was a true believer, both in the virtues of derivatives and in the need for government to leave them alone. Handed this role in 1986, Brickell embraced it with a gusto that would never abate; even in the wake of the financial crisis, Brickell insisted—against all observable evidence—that derivatives had not been a leading cause.

  Brickell graduated from the University of Chicago in the early 1970s, where he had studied economics and become a convert to the fierce free-market ideology that dominated its faculty—an experience he would later describe as one of the formative experiences of his life. After attending Harvard Business School, he toyed with a career in politics before joining J.P. Morgan in 1976, where he stayed for the next quarter century.

  It was the growing popularity of interest rate and currency swaps in the mid-1980s that first caused regulators to begin asking questions about them. In response, the big banks, which dominated the business, formed a lobbying group in 1985, called the Independent Swaps and Derivatives Association, or ISDA. Brickell, representing J.P. Morgan, joined the following year. In 1988, he became its chairman.

  Not long after Brickell joined ISDA, the Commodity Futures Trading Commission, a relatively new agency, published a notice saying that it planned to examine whether derivatives qualified as futures. If the answer was yes, then the CFTC would have regulatory authority over the swaps business. This was the first time anyone in government had raised such an idea—though it would hardly be the last. Over the course of the next decade, the question of whether derivatives should be regulated would arise regularly in Washington. Brickell’s job essentially was to beat it back.

  Brickell made at least four central arguments. The first was that because the major derivatives dealers were banks, they were already regulated by federal bank supervisors. His second argument was that the derivatives business was a hothouse of innovation, making the financial world less risky, and regulation would stifle further innovations. A third was that derivative transactions took place only among the most sophisticated investors, who didn’t need the government looking over their shoulders. His final argument was that the market itself would impose the discipline needed to keep the growing business on the straight and narrow. Mistakes would lead to losses. Bad practices would cause other participants in the derivatives market to shun the offender. In making this argument, Brickell had a powerful ally in Alan Greenspan, who was also a believer in the power of market discipline—and a skeptic of regulation. It also didn’t hurt that he had been on the J.P. Morgan board before becoming Fed chairman.

  What Brickell did not talk about—or, rather, what he consistently poohpoohed—was the fear that, in dispersing risk so widely, derivatives were transferring risk from a single institution to the entire financial system. All that hedging of derivatives—the reflecting mirror syndrome—was creating an interconnectedness among financial institutions that hadn’t existed before. If one counterparty failed, what would happen to all the institutions holding its swap contracts? What would happen if the risks weren’t properly hedged? Who kept track of the exposures major financial institutions held in their derivatives books?

  In addition, derivatives also created an enormous amount of unseen—and unaccounted for—potential debt. A credit default swap is really a kind of IOU—a promise to pay a very large sum of money if something bad happens. Most of the time that promise would never have to be kept. But sometimes it would—potentially costing an institution billions of dollars it wasn’t expecting to pay out.

  To deflect Washington’s concerns, in the early 1990s Weatherstone chaired an international committee on derivatives that came up with a four-volume tome of best practices for derivatives. Brickell was his aide-de-camp on the project. The report, entitled “Derivatives: Practices and Principles,” impressed the bank regulators so much that some of them tried to codify the report into regulatory language. Brickell, of course, pushed back.

  Brickell took care of the Commodity Futures Trading Commission, meanwhile, by simply claiming that derivatives were not futures and were therefore outside the agency’s jurisdiction. If derivatives were ruled to be futures contracts, he said, the derivatives business would immediately be destroyed. Why? Because under the law, futures had to be traded on exchanges, and derivatives didn’t trade on an exchange. What’s more, the law said that any futures contracts that did not trade on an exchange were unenforceable. So if derivatives were declared futures, every derivative contract in the world would suddenly be worthless. Therefore they couldn’t be futures.

  It was a circular argument, but it worked. Shortly after the CFTC first expressed its interest in derivatives, President George H. W. Bush appointed Wendy Gramm as the agency’s chairwoman. The wife of Senator Phil Gramm, the conservative Texas Republican, she had a PhD in economics and had been a high-level appointee at the Office of Management and Budget. After talking to Greenspan, the CFTC staff—and Brickell—Gramm ruled, in 1989, that derivatives were not futures. The Wall Street Journal ran an editorial with the headline “Swaps Saved.”

  Gramm’s ruling did not put the issue to rest, however. On the contrary, prior to 1989 there were almost no congressional hearings about derivatives; over the next five years, there was a blizzard of them. Legislation to reauthorize the CFTC reopened the question of whether derivatives should be regulated like future
s, leading to battles that went on for years. Court decisions that ruled that derivatives were, in fact, futures contracts had to be preempted by legislation. In 1992, the president of the New York Federal Reserve, Gerald Corrigan, made a widely noticed speech about the risks posed by derivatives. “High-tech banking and finance has its place, but it’s not all that it is cracked up to be,” he said in the speech. “I hope this sounds like a warning, because it is.” The following year, a derivatives scandal broke out when two big companies, Procter & Gamble and Gibson Greetings, lost tens of millions of dollars on swap deals. Both later sued the issuing bank, Bankers Trust, claiming they had been misled about the risks those deals posed. In Orange County, a county treasurer had boosted the county’s returns by using derivatives that Merrill Lynch had sold to him. When interest rates rose in 1994, the county lost so much money it had to file for bankruptcy.

  Yet despite all the concern, the government never even came close to regulating derivatives. Brickell was relentless in his advocacy, but he had help. Shortly after making his speech in 1992, Corrigan left the New York Fed and joined Goldman Sachs; he was soon testifying in favor of derivatives. And Greenspan, who had a godlike status in Washington, was adamant that derivatives should be left alone. “Remedial legislation relating to derivatives is neither necessary nor desirable,” he said at one congressional hearing. “We must not lose sight of the fact that risks in the financial markets are regulated by private parties.” In other words, market discipline would take care of everything.

  In the spring of 1994, James Bothwell of the General Accounting Office—the same man who had been threatened with the loss of his job after he wrote a tough report about Fannie and Freddie—released a report on the dangers derivatives posed. Though Bothwell was not a derivatives expert, he had a PhD in economics from Berkeley and had been working on his investigation for two years. Corrigan’s 1992 speech had prompted five congressional committees to ask the GAO to look into derivatives. Bothwell and his team had surveyed fourteen major U.S. derivatives dealers—a fifteenth had refused to respond—and written a two-hundred-page report.

  The GAO’s report was far from a screed. “We were not against derivatives!” Bothwell says today. The report acknowledged how useful derivatives could be in managing risk. Still, Bothwell was stunned by what he had discovered. Brickell had consistently argued that since most derivatives dealers were banks, they were already regulated by the nation’s bank supervisors. But Bothwell quickly realized that securities firms and insurance companies were also diving into the derivatives business, and that the securities firms had set up separate derivatives affiliates to avoid SEC oversight. The insurance companies also set up separate subsidiaries, and state officials, who were in charge of regulating insurers, told the GAO that these new subsidiaries were outside their authority.

  The GAO team was also concerned by the see-no-evil attitude of the derivatives dealers. For instance, Bothwell’s team asked the firms whether they were conducting stress tests on their portfolios, to gauge how they would do under “abnormal market conditions.” Roughly one-third of the respondents said the question didn’t even apply to them.

  Most of all, the GAO was concerned about the elephant in the room: the possibility that derivatives posed systemic risk. Because the business was concentrated in a few hands, the failure of one dealer might “cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole,” the report said.

  Yet despite these concerns, the recommendations made by the GAO were hardly radical. “What we are pitching,” Cecile Trop, the assistant director of the GAO, told Congress, “is an early warning system that will help in anticipating and responding to a financial system crisis, should there ever be one. That doesn’t sound too onerous to us; it’s a prudent and reasonable kind of approach.”

  No sooner had the report been issued than the industry fired back. Immediately following its release, not one but six leading financial trade associations put out a joint statement that was nothing short of apocalyptic: “We are convinced that any legislation having these effects will harm the American economy.” ISDA issued a report about the GAO’s work, arguing that adopting the GAO’s suggestions would raise costs and reduce the availability of derivative products. It also said that the GAO had not proven that derivatives could create systemic risk. “The industry went after us and went after Congress to convince them that this was not a problem,” says Charles Bowsher, who was then the head of the GAO, and had been Bothwell’s only regulatory ally.

  A month after issuing his report, Bothwell appeared as a witness before the House agriculture committee to defend it. (The agriculture committees in the House and Senate have jurisdiction over the CFTC.) As he walked into the hearing room, he was stunned at the line of people, most of them lobbyists, waiting to get in. There were cameras everywhere.

  “What you see is that derivatives are growing up between the cracks in the regulatory system,” he testified. “No one really has the authority over that type of activity.”

  Two years earlier, when Bothwell had testified about Fannie Mae and Freddie Mac, the response from Congress had been brutal. This was worse. The GAO produces “consistently overblown conclusions which are embarrassingly undersupported by the evidence and replete with undue editorializing,” said Congressman Earl Pomeroy, a Democrat from North Dakota. “We have to be careful about excessive regulatory regulation,” said Wayne Allard, a Republican from Colorado.

  Then it was the regulators’ turn to testify. Not a single one—not the FDIC, the SEC, the Treasury, the Fed, the CFTC, nor even the Comptroller—would support Bothwell. Their general view was summed up by Darcy Bradbury, a deputy assistant secretary at Treasury: “As a general principle, there should be a demonstration that there has been, or will be, a failure of market discipline before the need for such broad Federal regulation is advanced.” When it was the industry’s turn to testify, Gay Evans, who had succeeded Brickell as chairman of ISDA, said, “The GAO proposals for legislation have been rejected by all the key U.S. financial regulators, including the Federal Reserve. Therefore, Mr. Chairman, swaps and privately negotiated derivatives play a key role in reducing, not increasing, risks.” Therefore?

  In a follow-up report issued in 1996, the GAO explained, in one clear sentence, why it thought differently about this issue than everyone else: “Past experience has shown that firms can develop serious problems before the marketplace knows about them.”

  There is one final piece to this story. That fifteenth company, the one that refused to participate in the GAO’s survey, was the insurance company American International Group, known on the Street simply by its acronym: AIG. “We got this call saying they couldn’t help us, but at some point they’d explain that,” Bowsher remembers. At that time, AIG was a relatively small player, with a derivatives desk one-third the size of Goldman Sachs’s, which was the biggest derivatives dealer among the investment banks. But the GAO team knew that AIG’s business was growing rapidly.

  After the report was complete, Bowsher and Bothwell made it a point to go talk to all the CEOs in person, AIG included. They set up an appointment with AIG’s chief executive, Hank Greenberg, and were summoned to his office on Wall Street, where they waited and waited in an anteroom. Bowsher wasn’t bothered by the wait—he was used to imperial CEOs—and during their meeting he found Greenberg both candid and smart. At least, unlike the others, Greenberg never said the GAO report was stupid. What he did say was that he hadn’t wanted to talk to them because he’d been having trouble with the person who ran his derivatives business. There had been big losses and a battle over control, but Greenberg had fixed all that. He’d “gotten rid of that person, and taken the losses,” Bowsher recalls him saying. And now, Greenberg said, derivatives weren’t something he had to worry about anymore.

  5

  A Nice Little BISTRO

  In 1994, the year of that meeting with B
owsher and Bothwell, Maurice R. “Hank” Greenberg was sixty-nine years old and had been the chief executive of AIG for a remarkable twenty-six years. Perhaps even more remarkable, despite his age and the length of his tenure, he showed no signs of slowing down. He had no succession plan, and zero interest in creating one. Two of his sons had become high-ranking executives at AIG and were often mentioned as potential successors. Both eventually left to run other insurance companies once they realized that Greenberg was never going to give them the keys to the kingdom. He was dominant, brilliant, irascible, short tempered, controlling, obsessive—and by far the most successful insurance executive of his era, and perhaps any era. Since 1968, when AIG’s founder, C. V. Starr, catapulted him over two higher-ranking executives to be the CEO, he had transformed Starr’s company—which had been founded in Shanghai nearly fifty years earlier—from a quirky, privately held firm into the largest insurance company in the world. It had a stock price that outpaced its competitors, a reputation for treading where others wouldn’t, and earnings growth so steady—topping $2 billion a year by the mid-1990s—that it was the envy of the industry. AIG wasn’t just Greenberg’s company; it was his creation, his baby, his sun and his moon and his stars. People sometimes joked that he planned to run it from the grave.

  The son of a taxi driver from the Bronx, Greenberg was as up-by-his-bootstraps as a twentieth-century New Yorker could be. He ran away from home at seventeen to fight in World War II, took part in the Normandy invasion, attended the University of Miami and New York Law School, got drafted to fight again in Korea, and finally wound up in the insurance industry when he complained about the man interviewing him for a job—to the man’s boss. In 1960, C. V. Starr lured Greenberg to AIG; two years later he put him in charge of AIG’s struggling U.S. operations, which he turned into a roaring success. Six years later, with Starr just months from death, he anointed Greenberg as his successor.