by Iain Martin
Hedge funds began as a way for wealthy investors to protect themselves against the risk of markets turning down or commodity prices rising. They evolved into mechanisms which could deliver returns superior to traditional banks or investment firms. The ‘hedge’ involves buying shares, or options on shares, and other financial instruments. Essentially, those in charge of the fund are taking positions, making well-informed bets on which shares, commodities or currencies will go up and which will go down. These bets are placed using the vast sums that clients have entrusted to them in the expectation of a much better profit than is available with run-of-the-mill investment firms or banks. They can also leverage themselves massively, using borrowed money to do it. They operate across all sorts of markets, carry a lot of risk and when they get it right make much bigger returns than conventional financial firms. The pioneers were mathematicians and scientists who realised that with the application of serious brainpower, and computing, it was possible to beat the market far more effectively than testosterone-fuelled traders dealing on the basis of instinct or feel for the market ever could.2 Hedge funds gradually expanded into so-called ‘alternative investment’ firms, making all sorts of trades and buying and selling anything that offered the prospect of a large return. The client pays a fat fee to be involved.
There are obviously considerable risks. Hedge funds do blow up if there are just a few misjudgements, and they are lightly regulated. In 1998 the implosion in the United States of the splendidly misnamed Long-Term Capital Management necessitated a $3.6bn rescue by Wall Street firms, at the instigation of the authorities, because the fear was that its failure would spread panic in the markets.3 Long-Term Capital Management was a Greenwich-based firm. For a while its failure shook the prevailing confidence that complex computerised models and innovative new financial products offered stability and ever-bigger profits. The moment of reflection was fleeting. The hedge funds – in Greenwich, in New York, in London and elsewhere – rapidly continued their lucrative work into the booming first decade of the new century. And no wonder. Get the calculations right, with the assistance of those computer models and the brightest graduates, and the hedge fund, and the client, could make money when markets rose and when they dipped. Generally being private partnerships, there was no pool of shareholders demanding a large slice of a hedge fund’s profits. Worker bees in successful firms could earn millions and those right at the top could make hundreds of millions of dollars – a year. In 2006, the average pay of the top twenty-five hedge fund managers was $363m according to the Institutional Investor’s Alpha report, and lower-paid managers on the list, those outside the top twenty-five, made $40m.4 A good proportion of that money washed ashore in Greenwich or nearby.
It was here, on the waterfront, that RBS did its business in a four-storey concrete block set in a landscaped park on Steamboat Road. RBS’s Greenwich Capital was not an exotic hedge fund. Its main business was more mundane, in the trading and underwriting of US Treasuries, government debt. Greenwich Capital also ‘securitised’ mortgages, creating asset-backed securities (ABS), in effect bonds made up of pools of mortgages assembled from lenders who wanted to transfer the risk of their loans and in the process generate more money that they could then use to lend even more. Yet even though they were not running a hedge fund – they were part of a regulated bank headquartered more than 3000 miles away in Edinburgh – the top managers at RBS in Greenwich were based in a town where the prevailing ethos among their friends was predominantly ‘hedgie’. Pay was soaring and property prices were rocketing on the back of financial innovation. Greenwich was an environment in which one might easily go a little crazy in an effort to make many millions and keep up with the neighbours.
‘People were making so much money and you could see in the eyes of the guys at Greenwich that they were hungry for as much of it as possible,’ says a once-frequent visitor to the building at Steamboat Road. RBS had originally intended to sell Greenwich Capital when it came as part of the purchase of NatWest in 2000. But after a quick inspection of the books, Iain Robertson, Johnny Cameron and Goodwin decided that it was a promising business worth keeping. The firm’s boss, Konrad ‘Chip’ Kruger, left and made himself even richer at a nearby hedge fund, naturally.5
Day-to-day control at Greenwich was handed to Jay Levine and Ben Carpenter in 2000, although Levine was very much seen as the senior partner in the relationship. He lived in Greenwich with his wife Tammy, and a colleague describes him as ‘smart and mathematical with a lot of friends who worked for hedge funds’. Another colleague says his gift with numbers was ‘exceptional, really something’. Finance was in Levine’s blood. His father, Howard, had been highly successful in the mortgage business and was best friends with Angelo Mozilo, the Bronxborn founder of Countrywide Financial credited later with a starring role in the sub-prime mortgage crisis.6 After graduating in economics from the University of California, Davis, Levine spent a year at the University of Leeds in England and then moved into banking. His reputation was made at Salomon Brothers, the investment bank. There his expertise was in devising innovative mortgage products of the kind that the financial newswire Bloomberg euphemistically described as extending ‘housing finance to a broader range of borrowers’. In the 1990s this was a rapidly growing industry, with President Bill Clinton’s administration looking for ways to increase home ownership to millions more Americans, a noble aim as long as borrowers can afford the payments.
In the excitement, checks on credit-worthiness were weakened and the amount the buyer needed to put down as a deposit was reduced to almost nothing. In any case, the mood of the era was for all kinds of financial deregulation. Lobbying from Wall Street and machinations by friendly politicians in Washington meant that the so-called Glass–Steagall Act had been chipped away at for years. It had been introduced in 1933, during the Great Depression, to keep retail, savings and mortgage institutions separate from investment banks, so that their risky trading on the markets did not again bring down the banks that consumers relied on. In the 1980s and 1990s the expanding finance industry had successfully eroded Glass–Steagall to the point that shortly before leaving office Bill Clinton signed its death warrant. Banks were extending into all manner of innovative activities, money was plentiful and credit was cheap. A long period of historically low interest rates spanned the presidencies of both Clinton and his successor George W. Bush. Cheap home loans were billed as an extension of the American dream. They also created an opportunity for profit – a lot of it – for those who ran hungry banks.
The RBS operation at Greenwich did not originate sub-prime mortgages. It did not directly offer loans to customers who wanted to buy a house and then wait while they paid it back in instalments over twenty-five years. However, it was moving beyond basic mortgage securitisation and into the market for collateralised debt obligations (CDOs), which had been developed on Wall Street in the late 1980s and then refined by a team from J. P. Morgan in the late 1990s.7 The architects of the CDO took existing mortgage securitisations (batches of Asset Backed Securities) and repackaged them into new structures. Investors liked CDOs because they provided a stream of income, based on the distant homebuyer making his or her repayments each month. At the top of the structure of a CDO sits a tranche that is labelled triple-A or even better, super-senior debt. This means that whoever holds such stuff is first in the queue for money. If there is a problem they get what income there is before those holding the lower-rated parts of the CDO. The idea was that this process helped spread risk, it being deemed highly unlikely that lots of homeowners would suddenly be unable to pay or that the value of their house would somehow collapse. A few might default, but the CDO was made up of so many loans that most of it was bound to be fine. It would require some sort of economic earthquake for it to really go bad. Meanwhile, investment bankers liked it because making and selling the CDOs created profit for the bank, a slice of which went into the pot for their bonuses. The banks could also buy, or put together themselves, products �
��hedging’ the risk of there being a problem in the future. And they could buy ‘mono-line’ insurance. Who could imagine such insurers failing?
At RBS it did not seem like that big a deal. After all, their CDOs were made up of other people’s loans. CDOs were not even deemed worthy of much detailed attention when Goodwin, Johnny Cameron, Jay Levine and several others did a half-day of presentation to analysts in London on 3 October 2005. It just seemed to be taken for granted by the executives that the amount of work the bank did in that area would grow. Cameron wasn’t entirely clear on the potential implications of the expansion into CDOs and Goodwin, say colleagues, certainly did not know how a CDO worked. That day an analyst asked near the end of the event why CDOs had only been mentioned once, briefly. Wasn’t this odd, when they were obviously fast-growing and perhaps risky? Brian Crowe, Cameron’s colleague, explained to the audience that it was complicated, and then didn’t answer the question properly. RBS was issuing CDOs and it would be a growth area in the next two or three years, he said. Others asked about whether the bank was more broadly taking too many risks on that side of the business. Goodwin was a model of reassurance: ‘Our appetite you would find pretty conservative if you were to define it – not wanting any undue excitement.’
There was about to be rather a lot of ‘undue excitement’. The message from Goodwin to Cameron had been clear when the RBS executive team had its annual trip away in early February 2006. The chief executive wanted growth, and the bank’s board concurred. GBM had grown its income by 30 per cent in 2005 with 24 per cent planned in 2006. For 2007 the target was another 25 per cent. The aim was for RBS to catch up quickly with its more established rivals, either banks such as Barclays that had big investment banking arms alongside their retail and commercial operations, or pure investment banks such as Goldman Sachs. ‘I want us to be bigger than J. P. Morgan,’ Goodwin told a fellow banker.
The board raised no objections, in fact quite the opposite. If the new RBS chairman had a concern it was about trying to get Goodwin to agree for the first time to undergo a proper annual appraisal and sign up to personal goals on how he ran the company. McKillop also wanted to bring a little order to the board and professionalise the working relationship between chief executive and chairman. Mathewson and Goodwin had actually had some stand-up rows when on their own, when Mathewson thought Goodwin was getting RBS a little too deep into investment banking or not listening to his advice, but it did not manifest itself in any concerted attempt to get Goodwin to change or ship out. ‘George was a terrible, terrible chairman who didn’t spot the danger in Fred’s way of working,’ says one of the longest-serving senior executives of that period. ‘That’s harsh,’ says another of their colleagues when this is put to him. ‘But George is quite emotional and scattergun.’ McKillop offered the chief executive support while attempting to get him to work more collaboratively with his executive team. He thought he was running a programme of Goodwin improvement.
Otherwise, at the June 2006 ‘off-site’, McKillop’s first such strategy session with the board and other senior executives, the mood was highly optimistic. There was very little discussion of the detail of the expansion of GBM and what little there was involved terms that seemed reassuring. ‘CDOs were never mentioned, it was much more general than that,’ says a participant. A member of the board adds: ‘Even the word securitisation sounded safe and reliable, as though it was something that you could trust, and the term structured credit sounds sensible too.’ McKillop agreed that the priority was growth. The investors he had visited wanted to know what RBS would do next, and Goodwin’s idea of building on parts of the business such as GBM that seemed to be doing well and recording healthy profits seemed perfectly reasonable. The instruction to GBM was unequivocal. On 21 June 2006, Brian Crowe emailed Cameron, Robertson and David Coleman, the group chief credit officer: ‘The board has been very bullish in the last twenty-four hours across all the GBM business in wanting to avoid the defensiveness in approach that we tend to adopt, and to be more aggressive and ambitious.’
Levine and Greenwich were already ahead of them. The boss of Greenwich was increasingly upbeat, ‘on a roll’ says a colleague. He had hosted a dinner for key staff and handed out T-shirts emblazoned with the words ‘Think Big’. They should be bold, they should not fear losses, the team were told. In March 2006, Levine moved to reorganise his team. Bob McGinnis, who ran the mortgage securitisation business, was stripped of his responsibilities. McGinnis and Levine were old colleagues. They had worked together at Salomon Brothers in the late 1980s, collaborating on what may even have been Wall Street’s first ever securitisation of sub-prime mortgages. McGinnis had joined Greenwich in 1997 and experienced the Royal Bank takeover when it bought NatWest.8 Greenwich had weathered the crisis in the markets when Long-Term Capital Management fell over in 1998. After the shock of 9/11 Greenwich had prospered, as most of its competition was based in lower Manhattan near the ruins of the World Trade Center and faced months of disruption. Now, after everything, Levine was effectively dumping him over lunch. ‘Why do you carry on working, Bob? You should stop,’ Levine told his colleague. ‘What’s it all for? Who are you going to leave all your money to?’ McGinnis was furious. He was getting a lecture on life and effectively being dispensed with. Levine said they might be able to find something for him, which came in a troubling form.
Shortly afterwards Levine wanted McGinnis and several others to meet Rick Caplan from Citigroup. Levine said Caplan had contacted him with a proposition. He could bring his team of twenty-five people from Citigroup and do what they had done there with CDOs. Last year they had made a $600m profit for the bank. McGinnis was incredulous. Greenwich already had someone good running their CDO desk, Fred Matera. Why would they bring someone in over his head?
After dinner, McGinnis and Levine discussed it. You know how Rick and his team made $600m for them last year, McGinnis said. Easy, his colleagues had simply stuffed $25bn or maybe $30bn of AAA bits of structured credit directly onto the Citigroup balance sheet. The CDOs pumped out profit for now, but the bank had all the risk on its balance sheet. ‘Come on, Jay, we don’t have that kind of appetite for risk at Greenwich, do we?’ Caplan had also given an unclear answer that unnerved McGinnis when he asked how much of that material on the Citigroup balance sheet was insured. Not a lot.
Bruce Jin, who had taken over as the head of risk at Greenwich, was also deeply concerned when he heard what was planned with the arrival of Caplan. He expressed his worries to colleagues at Greenwich, but Levine was determined. Caplan would move over to grow the CDO unit and be co-head with Matera, with the pair reporting to McGinnis. Caplan was hired in July and turned up in early September. Both Matera and McGinnis decided to make the best of it, if this was what was wanted. They would also do well financially if the arrangement worked out. A dozen, rather than twenty-five, new staff were hired. Going into the second half of 2006, the bonus-incentivised team was now twenty-five strong and working flat out. In 2005 RBS had issued eleven CDOs with a total value of $3.3bn, with Greenwich and London doing the work together. Now Greenwich had the appetite it could do a great deal more on its own. In less than a year, between July 2006 and May 2007, RBS Greenwich churned out fifteen CDOs worth $11.7bn on its own. The global CDO market doubled from 2004 to 2005 and then again from 2005 to 2006 and in a booming market for these products RBS was also doubling its market share.
It sometimes took months to put together CDOs as the various loans were assembled in what the traders termed the warehouse, a virtual storeroom where they sat ticking over on the books of RBS. The presumption in London on the part of Brian Crowe and his team was that the CDOs were supposed to be made and then sold on as quickly as possible: ‘That’s what you do in a markets business. You sell,’ says one of Crowe’s executives. ‘On our behalf they had built a very good CDO origination machine but not a distribution machine.’ In other words, Caplan and Matera’s team retained bits of the CDOs and they started to build up on the bank’
s balance sheet.
‘I really don’t think Jay was a bad person,’ reflects one of his colleagues in London. By the height of the boom Jay Levine was certainly becoming a very rich person. In three years – 2004, 2005 and 2006 – he was paid in the region of £40m. Visitors from London and Edinburgh to Steamboat Road found the atmosphere ‘buzzy’, ‘entrepreneurial’, ‘non-stuffy’ and ‘go go go’. ‘Jay and his people were very American and great at making you feel welcome. It was all smiles and “Hey, what’s going on with you guys?”’ On 29 June 2006, in another indication of how committed both Levine and his bosses back in London were to the growth of the North American operation, the turf was cut on a new $400m headquarters in Stamford, a few miles from Greenwich. This development wasn’t on quite the same scale as the RBS mother ship opened in Scotland by Goodwin. Stamford was more a ‘mini-Gogarburn’. Local dignitaries, including Governor Jodi Rell, a Republican, turned out for the ceremony to launch the development, which was being built just off the Connecticut Turnpike on a 500,000-square-foot plot a few miles from Steamboat Road. In the new building the 700 or so staff moving from the Greenwich facility just down the road would be joined by 550 relocating from New York. The plan was to hire another 600 staff by the time it opened for business as the RBS Americas head office in 2009.
Who was monitoring all of this? Levine and the business based in Greenwich reported to Crowe, as chief executive of GBM, and to Cameron – who was chairman of GBM. For all the terminology of investment and banking, the various parts of Cameron’s division earned him and some of his staff such substantial rewards in several simple ways. They helped large companies or entrepreneurs borrow, either by loaning them money or arranging the financing of their debt through bond issues. In the case of leveraged finance, RBS might take a share in a company that was borrowing money to do a deal or embark on a major project. Other specialised teams traded currencies (foreign exchange); other groups sold derivatives and futures that allow companies to hedge against risks such as the price of a basic commodity shifting.
