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 (17 page)

The three other major brokerages—Bear Stearns, Morgan Stanley, and Lehman Brothers—also built up some super-senior exposure. Bear and Lehman had extensive experience in dealing with mortgage-backed
bonds, and they prided themselves on running tight risk controls. As they each cranked up their CDO machines, they realized that super-senior risk was becoming like the toxic by-product of a chemical experiment or waste from a nuclear reactor. But they could find no good solution to the problem, and they weren’t willing to switch off their CDO machines.

Citigroup was also keen to continue to ramp up the output of its CDO machine, and as a commercial bank it had plentiful access to the “raw material” needed to create CDOs. Unlike the brokerages, though, Citi could not park unlimited quantities of super-senior on its balance sheet, since the US regulatory system did still impose a leverage limit on commercial banks; they were required to keep assets below twenty times the value of their equity. Citi decided to circumvent that rule by placing large volumes of its super-senior in an extensive network of SIVs and other off-balance-sheet vehicles that it created. The SIVs were not always eager to buy the risk, so Citi began throwing in a type of “buyback” sweetener: it promised that if the SIVs ever ran into problems with the super-senior notes, Citi itself would buy them back.

Citi’s CDO machine began running at such a frenetic speed that by 2007 it had extended such guarantees—which were internally nicknamed “liquidity puts”—on $25 billion of super-senior notes. It also held more than $10 billion of the notes on its own books. Almost none of the senior Citi managers knew about the liquidity puts, since Citi operated with a power structure that was even more fragmented and tribal than that at Merrill Lynch. And Chuck Prince, the CEO of Citi, was not a meddler, like Jamie Dimon. Prince had initially trained as a lawyer, and he delegated derivatives issues to others.

On the other side of the Atlantic, many banks were doing the same. The senior managers at Deutsche Bank, for the most part, did
not
let their traders put super-senior risk on the bank’s book. The German bank had a relatively tight system of internal controls and, just as Bill Winters had concluded, Anshu Jain, the cohead of the investment bank, considered that the paltry returns on super-senior simply didn’t compensate for the risks. However, other banks decided differently. The Royal Bank of Scotland aggressively grew its CDO business, and when some RBS
employees expressed unease, they were naysayed. Early in the decade Ron den Braber, a statistical expert working in the CDO department, voiced worries that the bank’s models were significantly underpricing the risk attached to super-senior. He was subsequently encouraged to leave the bank. “I started saying things gently,” den Braber recalled, “in banks you don’t use the word ‘error,’ but what I was trying to say was important. The problem is that in banks, you have this kind of mentality, this groupthink, and people just keep going with what they know, and they don’t want to listen to bad news.”

Arguably, the most aggressive player of all in Europe was UBS. The Zurich-based group had built its business by acting as a dull but worthy commercial bank, with a formidable private banking franchise. However, during the 1990s merger craze the bank joined with Swiss Bank Corporation and PaineWebber, and it built an international capital markets operation. This was widely admired for its equity market skills, but UBS—like Merrill—did not have a good franchise handling debt. By 2004, Marcus Ospel, the CEO of UBS, was hungry for more. Even in Switzerland, “Goldman envy” was afoot. Like O’Neal at Merrill, Ospel was convinced that the fastest way for UBS to catch up was to expand its credit business. So the senior management took two striking steps.

First, they agreed to let a group of UBS’s powerful traders create an internal hedge fund, which would be run by John Costas, the former head of the investment bank of UBS. This started life in the summer of 2005, under the name of Dillon Read Capital Management. Second, in the autumn of 2005, the bank implemented a major review of its fixed-income business, hiring consultants from McKinsey and Oliver Wyman. On the advice of this review, the bank’s senior management decided to expand the securitization business.

On paper, UBS did not seem well placed to make the move. Though the bank’s asset management group had already been investing in American mortgage products for several years, it did not have its own mortgage-lending operation. To make matters worse, when Costas created the new hedge fund, he took 120 of the bank’s staff with him, including many of the firm’s fixed-income specialists. However, that did not deter UBS’s senior management. The bank hired new traders in London and
New York and told them to build a CDO business as fast as possible. By late 2005, UBS was creeping up the securitization league tables.

When the super-senior problem reared its head, the bank first managed to sell the super-senior risk to outside investors. By the middle of the year, though, the bank had changed tack and was holding on to it instead. There was no regulatory constraint to doing that because the Swiss system that governed UBS followed the Basel Accord, and the Basel rules took a decidedly relaxed attitude towards assets with high credit ratings, such as super-senior risk. They stipulated that banks could use their own models to work out the risk and judge how much capital they needed to set aside.

The UBS risk department used the same fundamental system for modeling risk, based on the VaR and Gaussian copula techniques, that so many other banks had adopted, and its models implied that super-senior would never lose more than 2 percent of its value, even in a worst-case scenario. So the bank decided it needed to post only a sliver of capital. Then it went even further when its CDO traders stumbled on the realization that if they bought insurance from monolines against that 2 percent risk, the super-seniors became entirely risk-free. That effectively removed the need to post any capital at all. The bank could pile as much super-senior as it wanted onto its books, without constraint.

UBS also engaged in yet another means of squeezing more profit out of its CDO machine. The bank’s internal rules stipulated mark-to-market valuation, meaning that the value of assets held on the trading book had to be recorded at current “market” prices. It was still hard to get market prices for senior CDO notes, since they rarely traded, but what the CDO team started to do was to come up with estimates of what a CDO
should
be worth using their internal models. Then they would readjust those prices after a time, which, with the market still rising, invariably allowed them to report a profit. Those profits were small, but the overall CDO positions were so large that the money added up.

By 2007, the bank would be carrying $50 billion of super-senior assets on its books, most of which sat on the CDO trading desk. Occasionally, risk managers expressed surprise as the size of this mountain grew, but their concerns were dismissed. The conservative and bureau
cratic UBS managers put great stock in the fact that the super-senior notes carried a triple-A tag. The result was that vast quantities of risk completely disappeared from the bank’s internal risk reports. “Frankly most of us had not even heard the word ‘super-senior’ until the summer of 2007,” recalled Peter Kurer, a member of UBS’s board. “We were just told by our risk people that these instruments are triple-A, like Treasury bonds. People did not ask too many questions.”

By mid-2006, the pressure on Bill Winters’s team to make up ground on its rivals was intense. Each year, Oliver Wyman, a consultancy group, conducted an analysis of how all the banks were faring relative to each other. The consultancy would then release the results to the banks, in the hope that doing so would prompt them to buy Wyman’s services. J.P. Morgan did not usually succumb to that marketing pitch. When Dimon took over the bank, he had made it clear that he hated the idea of taking advice from management consultants. “Those consultants are a crock of shit!” he sometimes told his staff. To his mind, if a banker needed to take advice from consultants, then that banker was not doing his or her job.

However, the top managers at J.P. Morgan found that the reports often provided useful comparative intelligence. Blythe Masters had particular reason to pay attention to what Oliver Wyman said. By that stage, Masters had moved a long way from the credit derivatives team. After the JPMorgan Chase merger, she had been one of the few members of that group who had the patience and political skills to survive the infighting. She rocketed up the corporate hierarchy, being appointed chief financial officer of the investment bank in 2005, at the age of just thirty-four. It was a striking achievement, making her one of the most senior women on Wall Street. By 2005, some of her colleagues were whispering that Masters might possibly be heading for the very top.

As CFO, Masters was responsible for tracking how J.P. Morgan was faring relative to rivals and presenting that to outside analysts. So in the spring of 2006, she met with Nick Studer, one of the consultants at Oliver Wyman, to discuss Wyman’s “gap analysis” on how JPMorgan Chase had
fared in 2005. This report essentially asked a clutch of banks to submit data on how their different divisions were performing, which the consultants then used to calculate how the banks looked relative to each other (on an anonymous basis). The 2005 scorecard made dismal reading for JPMorgan Chase. The bank was performing well in some areas, such as foreign exchange or interest-rate derivatives. However, in securitization, the bank’s underperformance was getting worse. Equities and commodities were weak, too. As a result, the total revenue gap between JPMorgan Chase’s investment bank and that of its rivals had surged to around $1.5 billion.

More than a billion dollars!
Masters was startled and baffled. She knew that it would not be easy to placate equity investors in the bank’s stock if they saw that. The year 2005 had been another record year for the banking world, with the largest investment banks collectively raising their revenues by 31 percent to $289 billion. In that time, however, JPMorgan Chase had produced only a modest rise. So what should the bank do? Was it time for the bank to revisit, once again, getting into the mortgage CDO and CDS game?

Once again, Winters asked his team to see if they could work out a way to make mortgage-linked CDOs pay, and Black did the same in New York. The message came back the same: there was no sensible way to get rid of super-senior risk. In fact, the problem of super-senior was getting more challenging by the day. As the CDO machine boomed in 2006, it was creating such an extraordinary demand for mortgage and corporate loans that the percentages banks could earn from those loans were falling still further. “This business just does not make sense,” Winters told his colleagues.

To Winters’s relief, Dimon backed him up. Dimon was a man with a ferocious grip on detail, but he was also willing to delegate decisions to men who could present arguments he respected. “On CDO of ABS, the reason we didn’t get in was due to the basic risk discipline of Winters and Black—they looked at it and just could not work out how to make the business profitable enough for the risks,” Dimon recalled. In addition, Dimon had the supreme self-confidence to take on analysts and consultants. Irrespective of whether investors were criticizing his strategy, he
was
not
going to turn J.P. Morgan into a pale version of Goldman Sachs, he told his colleagues. “One of the problems of being a CEO is the constant pressure on you to grow, grow, and grow. It is there the whole time,” Dimon recalled. “But if you are in the risk business, you can get into terrible trouble if you just keep growing. As Warren Buffett said, sometimes the best thing you can do is just go to the golf course and do absolutely nothing for a bit.”

Winters and Black duly sat on their hands. Yet they were each haunted by frustration. So was Masters. She had always prided herself on being a detail-orientated manager: when she ran a business, she liked to know every wrinkle about how it worked, to check it was done
right
. Back in the 1990s, that trait had prompted some colleagues to brand her a “control freak.” By 2006, most of those colleagues said that her style had mellowed. Like Demchak and others, she had learned lessons with the passage of time. At the age of thirty-six, she no longer acted as if she needed to win every fight; she had learned to dance flexibly around issues with maturity and a droll sense of humor. Some of her friends suspected the change also reflected a new sense of peace in her personal life. In the late 1990s she had gone through a divorce (like several others on the J.P. Morgan team). She had subsequently remarried, though, and by 2006 she was spending weekends with her new family on a horse farm she had acquired close to New York.

She had also become a beacon for other women at J.P. Morgan. By 2006 there were still precious few senior female executives on Wall Street, let alone with a teenage child. Masters felt almost as evangelical about promoting diversity as about propagating the derivatives creed. “In the world I operate in, I stand out for being a woman,” she admitted to womenworking2000.com, an online specialist publication. “I believe that a lot of the onus falls on people like myself to help get women into top positions—finding a mentor in her field is one of the most valuable things any young woman can do,” she added, noting that she always advised other women to “take yourself out of your comfort zone…women have to be more assertive than men are accustomed to them being!”

Masters hated leaving a mystery unsolved. She could understand why J.P. Morgan was lagging in commodities and equities. Her failure to
work out why the bank was falling behind in the credit world, though, felt like a personal blow. A decade earlier, she had helped to create the CDO business, and she had watched with pride as it so rapidly took off. Now it seemed to have mutated into a phenomenon she could no longer understand. “How are the other banks doing it? How are they making so much money?” she asked herself over and over again. She could not work it out.