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 (15 page)

When he arrived at Salomon Brothers in the late 1990s, he spent hours sitting on the trading desk, analyzing the bank’s positions. The Salomon Brothers traders initially tried to fob him off by giving him trading records that were presented with such extreme complexity that they were
extremely hard to follow. Dimon, though, waded through the data and eventually concluded that the books held only ten rather similar strategies. When he arrived at JPMorgan Chase he repeated the exercise, determined to get his head round the numbers; he was convinced that much of the complexity in the derivatives world was not just misleading but unnecessary. “People think I don’t understand this stuff, because I don’t have a trading background. But I understand it better than they think.”

Yet in one sense, Dimon was very different from the men and women who worked in the world of high finance: precisely because he had not built his career in that sphere, he was not overly impressed by the complexities or potential of high finance. He wasn’t antagonistic towards financial innovation, but he wasn’t reverential either. He believed that the only way to run a bank effectively was to regard it as a business—
nothing more or less
. The old J.P. Morgan bankers might have believed they were part of a quasi-noble financial guild, while the young derivatives Turks of the late twentieth century were driven by a belief that they were building a brave, new cyber finance world. Dimon took a purely pragmatic approach. To him, bankers were neither noble or Masters of the Universe. They were just businesspeople doing a job, pushing money around the economy as efficiently and effectively as they could. The point of a bank was simply to do that
business.

“Banking is a bit like running a small retail store,” Dimon sometimes said; he liked the analogy since he considered it to be one “that even my grandmother can understand.” “You gotta work out what kind of stuff your customers want. Then you gotta get the stock in, and sell it as quickly as you can, making a profit. If you get it wrong about the inventory, then you make a loss. That applies to trading bonds, or derivatives, or a retail store. It’s all about business.

“And,” he would add, “you
gotta
have good bookkeeping. You can’t have side books and back books, or whatever kinda books—you have to know where you stand with all your stock. I have always said that we have got to only have one set of books at JPMorgan Chase and be accurate and comprehensive.”

This no-nonsense approach shaped every aspect of Dimon’s strategy. Like any small shopkeeper who needs to keep track of his stock, Dimon
was obsessed with knowing every detail of his bank’s inventory. He wanted to know exactly how money was—or was not—moving through the bank, and he spent hours examining the IT systems and the trading books. Yet, like a small shopkeeper, Dimon also knew the critical importance of keeping staff and clients happy. He found it hard to tolerate bureaucracy or formality, and preferred to operate with a brash, informal, in-your-face air. “I always say to people: ‘Get to the point!’ ‘Say it upfront!’ I hate all this messing about,” he liked to say. On a whim, he would wander around the corridors, bouncing up to staff to pepper them with questions about their businesses and their deals, and then he’d ask about their families as well. He would also mentally file the details away, to be brought out at a later date. He showed little respect for traditional hierarchies. At other banks, investment bankers usually commanded far more status than retail bankers, and both were set well above the lowly “back office” staff involved in the logistics of running the bank. Dimon was acutely aware that all the bank’s groups were crucial for moving his financial “stock” around and making it pay. “How complex do you think it is to run a credit card business?” he sometimes liked to challenge his listeners, when the subject of financial innovation came up. “Let me tell you—it’s friggin’ complex! Getting to grips with credit cards is one of the most complicated challenges you get in banking.”

The same mentality shaped Dimon’s attitude towards risk. He didn’t view himself as particularly risk-averse. On the contrary, his career showed he could make bold bets, starting with his decision to join with Weill rather than go to Goldman Sachs. However, Dimon believed strongly that risks must be properly
managed,
and he went about the task with the same obsessive attention to detail that a small-business owner must pay to cash flow. Indeed, Dimon shared Dennis Weatherstone’s fascination with measuring and monitoring risk, and when he spoke about risk management, he often expressed sentiments that Hancock and other former J.P. Morgan bankers might have voiced. He was no fan of leaving the task to a dedicated risk department. One of his favorite phrases was “fortress balance sheet,” shorthand for the idea that a bank should always maintain a large reserve of spare capital in order to cope with unforeseen shocks. “We have got to have a fortress balance sheet!” he repeatedly
drilled into his staff. “No one has the right to not assume that the business cycle will turn! Every five years or so, you have got to assume that something bad will happen.”

Within weeks of his arrival at JPMorgan Chase, Dimon started putting his ideas into action. True to his word, he forced the London office to cut a new deal with its telephone suppliers. But that was just the start. As Dimon swept through the bank, peering into corners, he initiated a blitz of cost-cutting measures, and news of them spread through the organization at lightning speed. He declared that employees must start buying their own cell phones and banned the bank from paying for golf club memberships. As the measures spread, wild rumors swept through the bank about what else Dimon planned to do. One (false) story claimed that Dimon was monitoring which bankers were booking taxis and then running up bills by leaving them waiting idle. It was even whispered that Dimon was tracking the size of the hamburgers in the staff canteen, with a view to cutting those too.

Many of those stories were fallacious (Dimon never inspected the hamburgers). But they served his aims. As the stories spread, they evoked so much fear that bankers started cutting costs preemptively. In the first year, the bank’s operating committee—its most senior management group—implemented $3 billion of cost savings. That was reinvested elsewhere. The Chase retail bank branches were refurbished. The investment bank started recruiting staff to fill the gaps created by the exodus of former J.P. Morgan employees. Some $1.5 billion was spent on data centers and another $1 billion on technology at the investment bank.

The technology program was particularly close to Dimon’s heart. On his first trip to London, he made an unusual detour. Instead of heading first to the headquarters in the City of London, near the Barbican, he went straight to Bournemouth, a seaside town a hundred miles south of London, to the headquarters of the bank’s UK IT operations. There he convened a town hall and spent a couple of hours discussing the bank’s IT infrastructure.

The British IT specialists were astonished. In most banks, the sup
port staff were either patronized or completely ignored. Dimon was convinced, though, that there was no chance of making the merger at JPMorgan Chase work better if he couldn’t streamline the IT sector. Dimon was convinced that the infrastructure issues were far too important to outsource. Before his appointment, Harrison had struck a massive $5 billion IT outsourcing deal with IBM, one of the largest of its kind in the financial industry. By mid-September, Dimon had scrapped the contract and brought IT back in-house, where he could keep it right under his nose.

He also reorganized the human infrastructure. In the four years before Dimon had arrived, managers who worked for the separate parts of the JPMorgan Chase empire rarely interacted face-to-face; most cross-department communication was conducted by phone or email (or, all too often, not conducted at all). Soon after his arrival, Dimon created a new, dedicated managing directors’ dining room, to force the different department heads to meet face-to-face, over lunch several times a week. “You have to
talk
to people, look ’em in the eye!” he explained.

He also convened a meeting of the operating committee and demanded that everyone reveal exactly what the three hundred most senior employees were paid, by name—and in front of colleagues from other departments. That was revolutionary. At J.P. Morgan, as at almost every other bank, pay levels were a closely guarded secret. But Dimon was determined to break down the hierarchies of status. The new bank, Dimon insisted, should be a meritocracy: everybody would be judged purely by how he or she performed. To ram that home, he declared the end of employment contracts with special side deals. Instead, all employees would now have a single, basic contract. The only exception, Dimon declared with a rare flash of socialist principles, was health insurance, where the best-paid employees were ordered to pay a far higher set of medical premiums to subsidize the lowest paid. “There are no side deals in this company, no special deals,” Dimon said.

The result was a shifting of pay levels and status within the empire. The risk department benefited considerably. In Wall Street banks, the so-called compliance control and risk departments—the wings of the bank charged with checking that bankers obeyed the rules and with
monitoring the overall level of risk in the bank—usually commanded lower status and pay than the bankers. They also lacked power because they did not themselves generate revenues. Dimon raised the pay of the personnel monitoring risk so that it was even attractive enough to persuade some traders to move across into those functions. He also made it clear that the risk and compliance personnel carried real clout in the bank. Hordes of staff were placed in training courses organized by the risk department, and senior managers were told to attend risk meetings. Dimon insisted that the staff should think about risk in a truly holistic manner. It was not enough, he declared, to look at the dangers that might beset narrow “silos” of the bank or to simply subcontract risk management to one department. Nor could risk be reduced to a few mathematical models. Fifteen years earlier, when Dennis Weatherstone ran the bank, J.P. Morgan had invented the concept of VaR and then disseminated it to the rest of the industry. It was a notable legacy. However, Dimon had no intention of giving undue veneration to VaR. Dimon (like Weatherstone) deemed mathematical models to be useful tools, but only when they were treated as a compass, not an oracle. Models could not do your thinking for you. The only safe way to use VaR, or so Dimon believed, was alongside numerous other analytical tools—including the human brain.

By late 2004, speculation that Dimon was about to oust Harrison was rampant. “Yond Cassius has a lean and hungry look…such men are dangerous,” Brad Hintz, an analyst at Sanford C. Bernstein, observed, quoting Shakespeare. The prospect delighted many of the J.P. Morgan bankers, particularly the Heritage Morgan group. Though at first many of them were wary of Dimon, as the months passed, the unease was replaced by respect. On the surface, Dimon was hardly J.P. Morgan material. On weekends he sometimes wore sneakers to the office and cheerfully ate hamburgers and fries in the bank’s elite dining room. He had few qualms about saying “bullshit!” But personal style aside, Dimon’s banking philosophy jibed well with the ethos of the old J.P. Morgan.

Dimon had no interest in turning JPMorgan Chase into the equiva
lent of a hedge fund, or copying the aggressive trading tactics of brash Goldman Sachs, placing bets with the bank’s own money. He was keen to create a solid, balanced business. That was very much in keeping with the J.P. Morgan tradition. Even Dimon’s informality rang true to the old bank, where junior derivatives traders could cheerfully push their most senior boss into a swimming pool and break another’s nose without worrying about getting fired.

“In the old J.P. Morgan, people would ask about your families but forget to chat about the business. Dimon does both,” Jakob Stott, the London-based banker, observed. But Dimon had no illusions that he could ever create that same old feeling of family and fraternity in a bank as big as JPMorgan Chase. Nor did he want to. He was striving for a meritocracy, not a tradition-bound club where employees were retained for life, irrespective of how they performed.

Some of the employees inside JPMorgan Chase found this change of style unnerving. They grumbled that Dimon seemed so utterly sure of his opinions he could fall prey to hubris or overreach. A few muttered that the senior management was turning into “Jamie’s club,” full of employees deemed loyal to Dimon. Such sniping, though, was not widespread. To many Heritage Morgan bankers, the idea of blending Dimon’s ruthless discipline and energy with some of the old values of J.P. Morgan seemed very exciting.

The Heritage Morgan bankers started to think that if Dimon could instill his ruthless discipline while also respecting the values of the old J.P. Morgan, the result might just possibly be a powerful one. As Tony Best from the London office observed, “When we first met Dimon and he got obsessed with the telephones, we were all a bit shocked. But then we realized he was quite different from anything we had ever seen before, in a good way. He was almost like the leader we had always been waiting for in J.P. Morgan but never really got.”

As events would transpire, the J.P. Morgan Chase staff would have reason to be grateful that Dimon had arrived on the scene, holding true to his principles of risk management even as most of the rest of the banking world broke free from all bounds of rational discipline.

I
n late October 2004, Jamie Dimon and William Harrison reported results for the third quarter of that year, the first joint figures since the Bank One–JPMorgan Chase merger. They were dismal: profits in the third quarter were 13 percent below the level a year earlier (which in itself had been a bad period), due largely to losses on fixed-income trades. “Current results were below expectations, primarily due to weak trading results,” Harrison declared in his usual, courtly manner. Dimon was blunt. “They’re
terrible
results!” he declared. “Terrible!”

Some analysts hoped the results were an aberration, and that the wunderkind Dimon would soon turn the tide. But the next quarter’s results were weak too, leaving total 2004 earnings at just $4.5 billion, down from $6.7 billion the previous year. Return on equity was a mere 6 percent, in a year when the industry average rose to 15.5 percent. The results improved somewhat in the first quarter of 2005, but then deteriorated again in the spring. “You can almost hear JPMorgan Chase’s investors singing, ‘Why are we waiting, oh why are we waiting.’ Jamie Dimon’s flock of faithful is certainly being tested,” the
Financial Times
observed in August 2005. “His huge banking merger is not yet delivering what investors had hoped, and the stock price has not bounced back from the disappointing results of last month, in spite of trading conditions that many reckon are more propitious.”

Nervously, the bank’s staff wondered what Dimon would do. In early 2004, a former Bank of America executive named David Coulter had been running the investment bank. Just before Dimon arrived as the new
chief operating officer, Coulter was pushed out of that post. Control of the investment bank was handed to the two men who had been working as Coulter’s deputies: Steven Black, a former Citigroup banker who had worked with Dimon, and Bill Winters.

The Winters-Black partnership was approved by Dimon. But it struck many observers as odd; indeed, some of their staff started making bets about which of the two men would be forced out first. The coheads structure had thus far fueled vicious infighting and mistrust, and this solution seemed to promise more of the same. For one thing, Black had worked with Dimon during his Citigroup days and was in fact such a close ally that when Weill fired Dimon in late 1998, Black—or “Blackie,” as Dimon’s circle called him—resigned soon after. Meanwhile, Winters had no past ties with Dimon, and their temperaments were opposite; Dimon was famously extroverted, while Winters shunned the limelight. Outside the bank, few observers had ever even heard of Winters. In addition, Dimon had never shown any public passion for complex financial innovation, which was Winters’s strong suit. “I’ve got a rock star for a boss now!” Winters sometimes joked to colleagues. “But at least it takes the spotlight off the rest of us.”

Dimon was savvy enough, though, to appreciate that Winters had skills he needed. For one thing, Winters was running the bank’s non-US trading empire, which was generating half the profits of the entire investment bank. Winters was also a key link to the old derivatives heritage of J.P. Morgan. “Bill [Winters] has been around since the invention of seamless nylon stockings,” wrote Ian Kerr, a columnist on
EuroWeek.
“He knows where all the bodies are buried in that monster derivatives portfolio.”

J.P. Morgan executives vehemently denied that there were any such “monsters.” Yet Winters certainly knew more about the portfolio than almost anyone else. He was also intuitively good at sniffing for risk. That may have stemmed from his unusual life story. To his colleagues, Winters usually seemed like a classic all-American guy. He worked hard, but loved partying with his gang of fellow traders, too. In reality, though, his life before J.P. Morgan had been unusual. In his twenties, he had studied international relations at Colgate, hoping to become a diplomat. That
took him one summer to Croatia, where he fell in love with a local girl. He then moved to the Balkans for a couple of years, working in a beer-bottling factory under the old socialist system and learning to speak Croatian fluently. On returning to the United States with his new Croatian wife, he then applied for a job with J.P. Morgan since he needed to earn money. He then swiftly rose through the derivatives department, using his formidable wits and drive. But he never took the gilded banking ghetto for granted. In the early 1990s, a brutal war erupted in the Balkans that tipped Croatia into turmoil. That showed Winters in a profound sense that unthinkable things
can
sometimes occur in life. Systems can shatter. After that, he was never tempted to ignore seemingly “impossible” risks, in finance or anywhere else.

Winters rarely discussed any of that with colleagues. What they could see, though, was that he was pragmatic, understated, and culturally flexible. He understood the value of quietly forging canny, tactical alliances in order to survive. So did Black. As a result, and against expectations, Winters and Black managed to craft quite a good working relationship.

Shortly after Dimon announced their joint promotion, the two sat down, and Black said to Winters, “We’re big boys—we know that everyone is taking bets on which of us kills the other! Let’s show them that we can actually make this partnership work!” Winters said he was on board with that, and then, with a minimum of fuss, they agreed to rules of engagement. First, they agreed to keep their job descriptions deliberately flexible. The staff living in London tended to report first to Winters, while those in New York dealt first with Black, across a range of different sectors. The division of responsibilities was kept deliberately vague, however, to avoid the appearance that either might set out to build an autonomous empire. “Everyone reports to both of us. They all have a
first
port of call, but that port of call has got to be constantly changing,” Black said.

They also agreed that they needed to communicate frequently, even though Black was in the headquarters on Park Avenue and Winters was in London. “Making this work is really like making a marriage work. You have to think about communication,” Black later observed with a wry, knowing smile. “At the beginning, we were just too polite to each other.
But then we learnt to communicate better, as we went along. We just talked, talked, and talked.”

The task facing them was daunting. On paper, the wider business climate in 2004 should have been playing to all of J.P. Morgan’s strengths. The new decade was shaping up to be the Era of Credit, and credit was supposed to be J.P. Morgan’s strength. By late 2004, the bank could still claim a leading position in the trading of interest-rate derivatives, foreign exchange, and corporate loans, and a respectable operation in the arena of corporate bonds, too.

But the situation in securitization—or the selling of asset-backed securities—looked poor. When J.P. Morgan and Chase had merged, both sides believed the combined bank would dominate the securitization business. Chase was a leader in the business of lending money to low-rated companies (an activity known as leveraged finance) and repackaging those loans into bonds, while J.P. Morgan was a preeminent blue-chip lender and was skilled at bundling together pools of derivatives to create structures such as BISTRO. Chase also had extensive experience repackaging other forms of debt, such as mortgages, credit cards, and student loans, into asset-backed securities. But the dream of dominating the securitization market had not gone according to plan. In the fast-expanding asset-backed CDO and CDS business, J.P. Morgan was slipping behind other banks. The bank’s hesitance to get into the repackaging of mortgages was a key reason.

Uneasily, Winters and Black debated how to fight back. It was clear that securitization was not the
only
source of embarrassment. The bank was also weak in the commodities and equities spheres, since these had never been strengths of either of the merged banks. However, the weakness in securitization was more disconcerting because credit was supposed to be J.P. Morgan’s core competence. Or as
EuroWeek
tartly noted: “Given the profile of JPMorgan as an institution steeped in structured finance, it really is surprising that the bank [has] failed to hitch a ride on the great US remortgaging wave.” So Dimon decided to act.

As 2005 dawned, the word went out across the bank that JPMorgan Chase would get its act together in the credit world. “Securitization is a
priority!” Dimon declared to his staff, and there was one sector in particular in which the bank
really
needed to catch up: mortgage finance.

J.P. Morgan should have been able to raise its profile in the repackaging of mortgage debt quickly. Inside the vast, sprawling empire of JPMorgan Chase sat Chase Home Finance, one of America’s largest home loan mortgage originators. But though the volume of mortgages Chase had offered had surged as the housing boom took off, they were being sold to Lehman Brothers, Bear Stearns, and others for their mortgage CDO and CDS assembly lines. That was partly because the J.P. Morgan side had less experience with mortgage debt than with corporate loans, and was so leery about the risks involved with BISTRO-like products made from mortgages. Relations between the managers of Chase Home Finance and the J.P. Morgan side also played a role, though. The two groups barely communicated, epitomizing the in-fighting that still plagued the bank. “It felt like a state of war,” one banker inside Chase Home Finance later recalled.

Dimon was determined to change that; he had no patience for infighting and was determined to create a financial “production line” similar to those at the other banks, turning the mortgage loans being produced by Chase Home Finance into J.P. Morgan bonds in a single, seamless operation. Dimon installed a new team who were willing to work with the investment side. Those officials then hooked the two divisions together and created an integrated infrastructure that would allow all parts of the bank to handle the housing market. “It took us ages to build, but Dimon insisted we needed to get all the systems before doing anything,” Bill King, one of those involved in the integration project, later explained. “We produced something a bit like a Google machine of mortgages—you could track the public data in any way you wanted.”

By mid-2005, the production line was finally ready to be activated. But in 2006 Dimon started to get cold feet. By the end of 2005, the US housing market had been booming for several years. Between 1997 and late 2005, house prices rose more than 80 percent, according to the Case-
Schiller index, with particularly marked increases in California, Florida, Michigan, Colorado, the northeast corridor, and southwest markets. Some observers worried that the prices were driven by speculative mania, but most economists brushed off those concerns. “There is virtually no risk of a national housing price bubble based on the fundamental demand for housing and predictable economic factors,” David Lereah, the former chief economist of the National Association of Realtors, wrote in 2005, in a self-styled “antibubble” report. Onlookers “should [not] be concerned that home prices are rising faster than family income…. A general slowing in the rate of price growth can be expected, but in many areas inventory shortages will persist and home prices are likely to continue to rise above historic norms.” Or as Ben Bernanke, then chairman of the President’s Council of Economic Advisers, said in 2005: “House prices have risen nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgage rates, steady rates of household formation, and factors that limit the expansion of housing supply in some areas.”

When King and his colleagues scoured their Google-style mortgage database in early 2006, though, they spotted something odd: some of the data suggested that the pace of defaults on risky mortgages was starting to rise. That defied the normal economic rules. Mortgage defaults were thought to be triggered by sharp interest-rate increases or a slowdown in the economy (or both). Those had been the triggers in previous economic cycles, and those were the eventualities that had been factored into economists’ models evaluating the housing market. Neither was present in 2005. While in the spring of 2004, the Federal Reserve had started raising the short-term interest rate, jacking it up from a historic low of 1 percent to 4 percent by the end of 2005, there was still such voracious investor appetite for mortgage-backed bonds that mortgage lenders kept extending very cheap loans to households, confident they could sell those loans as CDO and CDS fodder. The economy was also growing strongly, with low jobless rates. So what was causing the default rate to rise?

Baffled, the mortgage group debated the issue, and Dimon became keenly interested. Over the course of several weeks, Bill King, who was a key driver of the creation of the mortgage pipeline, was summoned so often to meet with senior risk committees that colleagues asked whether he had been appointed a formal member of the groups. As far as King could tell, none of the other banks was responding to the odd pattern in defaults by switching off their mortgage production lines. On the contrary, Merrill Lynch, Bear Stearns, Citigroup, and others were speeding up their activity. So were mortgage lenders like Ameriquest and Countrywide. Yet King was growing more and more concerned.

Back in the 1990s, when brokers made loans to subprime borrowers, they conducted checks to ensure that borrowers would be able to pay off their loans. However, during the boom, lenders had become a good deal less fussy about demanding that borrowers prove they had the income to repay loans. They had even started offering “teaser” loans, with fantastically low initial rates—sometimes below 2.5 percent—that rose in stages to be quite high, often well above 10 percent. Many households taking out these loans could barely meet the “teaser” payments, let alone cope with higher rates once they started to kick in. Neither lenders nor borrowers worried much about the risk, because it was widely assumed that borrowers would simply refinance their loans at the end of their “teaser”-rate period. After all, households had refinanced with ease during the first five years of the decade, often doing so to cash in on some of the perceived equity they had earned due to the incredible rise in home prices. In 2005, American households extracted no less than $750 billion of funds against the value of their homes, compared to $106 billion a decade earlier, of which two thirds was spent on personal consumption, home improvements, and credit card debt. Lenders also assumed that if borrowers did face problems meeting their mortgage payments, they could simply sell their property, at a profit, and easily repay their loans.