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 (22 page)

After all, most of them were also marking the value of their CDOs using model prices; if a visibly lower “market” price emerged, almost anyone holding CDOs would need to record losses. Transparency would be a nasty shock. “If we end up seeing these assets sold at significantly distressed prices, it will likely cause other funds to have to reevaluate how effective and fair the values that they have been carrying these securities have been,” said Josh Rosner, a managing director at Graham Fisher, an investment research firm in New York.

For several days, a game of brinkmanship played out. Merrill circulated a list of the CDOs and other securities it wanted to sell and invited bids from investors. J.P. Morgan and Goldman Sachs threatened to do the same. Frantically, Bear tried to dissuade them, pointing out that the banks would also suffer. Merrill Lynch and J.P. Morgan steadfastly
insisted they wanted their money back. Eventually, as the tension mounted, a deal of sorts was cut. In late June, Bear Stearns publicly announced that it would provide $3.2 billion in emergency funds to the older of Cioffi’s two funds, to prop it up. The other fund would be liquidated. Bear also privately agreed with J.P. Morgan, Bank of America, Merrill Lynch, Goldman Sachs, and others that they could recoup their loans, and the banks dropped their fire-sale threat.

Financiers with any investments linked to the mortgage market breathed a profound sigh of relief. The shock had been averted. Black and his colleagues at J.P. Morgan didn’t dare hope, though, that this was more than a temporary reprieve. Even with its lifeline from its mother bank, the remaining Bear fund looked sickly. Moreover, irrespective of the fate of the Bear fund, the drama had shown that a much wider structural threat was hanging over the system. What had doomed the Bear funds was that they were highly leveraged, exposed to long-term mortgage assets, and they had an investor base able to withdraw money at relatively short notice. In banking jargon, the Bear funds were thus plagued by a “maturity mismatch”: they bought long-term mortgage-linked assets that were hard to sell in a hurry, and they funded those purchases by raising short-term debt that could suddenly disappear. To make matters worse, the Bear funds were also expected to mark their assets to market on a regular basis—even though a market barely existed.

In the case of Bear, that cocktail had proved poisonous almost as soon as the mortgage markets turned sour in early 2007, because the Bear funds held CDOs that were particularly vulnerable to a mortgage market downturn, and its investors and creditors had panicked at an early stage. However, Bear was in no way unique. On the contrary, the investment landscape was dotted with a host of funds that had used large quantities of leverage to invest in mortgage-linked assets and had the same maturity mismatch. Some of them had more patient investors or a better mix of assets. But the structural problem was widespread. And that begged a bigger question: could the problems at the Bear Stearns funds be treated as isolated? Or were they pointing to a problem that could erupt across the system as a whole? By late June, few bankers had a
clear-cut answer. For their part, Dimon, Winters, and Black were starting to get worried. “This could turn nasty,” Black observed to colleagues.

In mid-July, another shockwave hit. Winters was striding through Geneva International Airport on the way to a meeting when he received a phone call from an official at Deutsche Industriebank (IKB), a medium-sized lender based in Düsseldorf, Germany. The group was barely known outside its home country and had specialized in funding medium-sized manufacturing companies. What IKB had to say on that July day had nothing to do with industry, though: the bank was desperate for an emergency credit line, to cover what it described as a “temporary” funding problem. “We have a lot of safe securities, but investors are behaving strangely,” a bank official explained. “Will you help?”

Winters was startled. The problem centered on a couple of investment vehicles run by IKB, known as Rhineland and Rhinebridge. The older of these, Rhineland, had been created five years earlier. Back then, IKB—like many other German banks—had been hunting for ways to diversify its business away from its core franchise of corporate lending because that was becoming unprofitable. So it had established Rhineland to invest in high-quality debt instruments, including mortgage-linked bonds. Rhineland was run as a SIV, which meant that it did not appear on IKB’s balance sheet. It funded itself by selling commercial paper notes to investors, including European pension funds and American public-sector investment bodies. Robbinsdale Area Schools district in a northwestern suburb of Minneapolis, for example, had bought Rhineland commercial paper. So did the Montana Board of Investments.

Between 2002 and 2006, this strategy had delivered a fat stream of profits for IKB. In fact, it was so successful that in June 2007—or shortly before Winters received the phone call—IKB created a second SIV, which was Rhinebridge. Like the first SIV, this second entity enthusiastically bought debt instruments, including mortgage-linked CDOs. That made Western investment banks eager to court the IKB officials. At the ESF conference in Barcelona, for example, American brokers and City
bankers swarmed around the Germans, in the hope of selling them more bonds.

However, as Winters stood in Geneva International in July, it was clear that something had gone badly wrong with the IKB funds. He called his traders in London. “What’s going on?” he asked. “There’s something like a bank run starting in the commercial paper markets,” a trader replied.

That news was alarming. Until that point, the commercial paper market had been deemed one of the safest, and dullest, corners of the financial world. It was where General Electric and other blue-chip giants raised the short-term funds that they needed for day-to-day operations. It was also where solid, risk-averse investors tended to put their cash as an alternative to placing their money on deposit at a bank. Corporate treasurers often bought commercial paper, since those notes tended to produce a return a fraction better than anything found in a bank account. Pension funds sometimes bought commercial paper, too. One of the biggest sources of demand for commercial paper, though, came from the giant $3 trillion money-market fund sector.

These funds typically raised money from ordinary retail investors or companies, which tended to treat money-market funds as similar to a bank account: they placed cash there assuming they could always withdraw it, and on short notice. Precisely because money-market funds knew that investors might redeem their cash with little notice, such funds usually wanted to purchase only assets that had a short duration and were safe. Commercial paper fit the bill perfectly.

The specific corner of the market where IKB raised funds was one subset of this world, a mutation known as the asset-backed commercial paper (ABCP) sphere. It took that name because the groups that issued short-term notes there backed them up with “assets,” such as mortgage bonds. The solid but dull investors who typically bought such notes usually knew little about how mortgage-backed CDOs worked, let alone about the inner workings of SIVs. They weren’t troubled much by that, though, because the notes carried high credit ratings, usually the triple-A or double-A level. Money-market fund managers buying the ABCP
notes assumed they were as safe as anything that might be issued by corporate giants such as General Electric.

But in mid-July, the pillar of faith in the ratings of those bonds started to crack, for several reasons. One was the dismal news about defaults emerging from the mortgage world. Another was the downgrades that the ratings agencies themselves were starting to make. In mid-July, Moody’s announced it was cutting its ratings on $5 billion of subprime mortgage bonds. Around the same time, Standard & Poor’s placed $7.3 billion in bonds on review for a downgrade. Then the saga of the Bear Stearns funds burst into the news. After the two funds collapsed, it emerged that many of the bonds and CDOs that had wreaked havoc at the fund had carried relatively
high
—not low—credit ratings. Investors in the ABCP market grew nervous.

Few of them knew for sure whether the type of “mortgage-backed bonds” the Bear Stearns funds held were similar to those owned by IKB funds, say. Nor did investors know what the price of a CDO “should” be. The financial chain that linked US households with CDO investors was so long and complex that it was hard for the experts—let alone a nonspecialist—to work out how defaults might impact cash flows on CDO investors at the other end of the chain. But the investors who bought ABCP paper bought it
precisely
because they were highly risk-averse. They could not tolerate uncertainty of any kind. So, as the rumors spread about Bear, they took the only step available to eliminate their risk: they stopped buying notes. “The problem is that people just don’t know quite what to trust, or not,” explained Donald Aiken, head of a large European money-market fund association. “Probably everything in most of those portfolios [behind commercial paper] is fine, but people don’t know for sure, and people don’t want to take the risk.”

That buyers’ strike left IKB in a fix. In reality, the vast majority of the mortgage assets that the IKB funds held were
not
impaired, in terms of actual defaults on loans in those banks. However, most SIVs—like hedge funds—were required to provide regular updates on the value of the assets they held. Since the ABX was reporting drops in value, investors became utterly unwilling to buy notes issued by the IKB funds, leaving
the funds desperate for cash. In theory, they had the right to call on IKB for a backup emergency loan to keep them afloat, but in practice, IKB didn’t have the resources to provide that money. The German bank had never laid aside significant capital reserves to cover for the possibility that the funds might need an emergency credit line. The idea that the ABCP market would shut down was deemed inconceivable. Moreover, the Basel regulatory rules did not require IKB to have that safety net, since the funds were off-balance-sheet SIVs. Thus, while the IKB funds held more than $20 billion in assets, the bank itself had a mere $16 billion in liquid assets on its books.

That was where J.P. Morgan came in. By mid-July, IKB was frantically calling other banks, seeking a loan to plug the gap. “Will you help?” the IKB officials asked Winters. Winters discussed the loan with his colleagues in London, as well as with Black in New York. He wanted to take the request seriously as IKB had traditionally been a good client. Winters had always been suspicious of SIVs, though, and the saga at IKB confirmed his doubts. As tactfully as he could, Winters said no.

For a few days, officials at IKB flailed around, trying to find new sources of funds. Eventually, the German government stepped in and forced a group of domestic banks to extend a 3.5-billion-euro lifeline to IKB. That enabled it to prop up its two SIVs. Once again, traders in the mortgage-backed bond markets heaved a sigh of relief. If the IKB funds had collapsed, they would have been forced to engage in a fire sale of assets, which would have pushed down CDO prices. The German rescue—once again—had averted that disaster.

Yet, as with the Bear bailout, the move seemed little more than a temporary reprieve. Across the financial system as a whole, tension was rising. Very few investors or bankers who worked outside the commercial paper market really understood what had gone wrong at IKB. Precisely because the commercial paper sector had been so slow-moving and dull in the past, it had been comprehensively ignored by journalists and regulators in the previous years. The fact that a buyers’ strike was under way in the ABCP sector was all but invisible to anybody outside that market. Yet the headlines about IKB showed that
something
was amiss, even if it was barely understood by anyone outside IKB.

Equity investors did not appear excessively alarmed. On July 20, the S&P 500 and FTSE, the main UK stock market index, both hit an all-time high. In the debt world, though, fear was spreading. By the end of July, the ABX was implying that the price of BBB mortgage bonds had tumbled to just 45 percent of their face value, while even AAA had fallen towards 95 percent. The models had assured that the triple-A tranches had an absolutely minuscule chance of ever losing value; but the ABX was now suggesting otherwise, and that was alarming. The market for corporate credit derivatives was also signaling alarm: by early August, the cost of insuring risky American and European corporate bonds against default had doubled in price, compared to its level in early July.

In early August, bankers linked to IKB called Winters again. They asked him for advice about what they should do with the mortgage securities on their books. “Sell your assets
now,
” Winters told them. “As much as you can!” It was a typical trader’s reaction: his years of working in markets had taught him that when crisis strikes, the people who sell first get the best price, if they can move ahead of a wave of forced sales. But the IKB officials rejected that idea. To them, the prices being signaled by the ABX just did not make sense. They could not believe that highly rated mortgage assets could be valued at significantly less than face value, at least not for long. They told Winters that they were going to wait it out until the markets returned to “normal.”

H
alf a world away in Tokyo, watching the IKB drama unfold, Hiroshi Nakaso, a senior official at the Bank of Japan was struck by déjà vu. Nakaso had never visited IKB and knew little about how SIVs worked. However, from his vantage point in Tokyo, he saw uncanny echoes with what he had observed almost a decade earlier. Back then, in the 1990s, the Japanese banking system had become overloaded with bad loans after a property bubble collapse, sparking a crisis. At the time, most American officials blamed the peculiarities of Japanese finance and criticized the Japanese government for its failure to tackle the woes at an early stage.

When Nakaso saw what was happening at IKB, it suddenly seemed as if Japan had not been so unique after all. The bailout deal that the German government had cobbled together to prop up IKB looked uncannily similar to measures the Japanese government had used to stave off a collapse of Japan’s banks. The investor psychology seemed dangerously similar, too. From a distance, Nakaso could sense that disorientation and panic were spreading, creating strange price swings. Investors were starting to lose faith. The shift was subtle, something almost none of the central bankers and regulators who worked in America and Europe had personally ever seen before. But to Nakaso it was profound. “I see striking similarities today with the early stages of our own financial crisis more than a decade ago,” he told some of his international contacts on August 2, 2007. “Probably we will have to be prepared for more events to
come…the crisis management skills of central banks and financial authorities will be truly tested [in the months ahead].”

Nakaso’s reaction was shared by other Japanese onlookers. When Nakaso’s counterparts in America or Europe heard such comments, though, most discounted them. They considered it fanciful, if not alarmist, to draw parallels between Japan’s woes and the troubles brewing in Western finance. By 2007, American and European financiers took it for granted that their financial system was vastly more sophisticated and efficient than that in Japan. There was also an overwhelming assumption in Washington—and in London—that any losses in the subprime world were unlikely to cause wider financial shock. In the spring of 2007, Henry Paulson, the US Treasury secretary, had told Congress that the subprime problem “appears to be contained.” Bernanke, the Federal Reserve governor, repeatedly echoed that line. “Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited,” Bernanke observed in a speech before the Federal Reserve of Chicago in May. “Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market; troubled lenders, for the most part, have not been institutions with federally insured deposits.”

In early July, after the collapse of the Bear Stearns funds, Bernanke changed his tune slightly. “Rising delinquencies and foreclosures are creating personal, economic, and social distress for many home owners and communities—problems that likely will get worse before they get better,” he testified to Congress on July 18, suggesting that subprime losses would be “in the order of around $50 billion to $100 billion.” He stressed, though, that the problem still seemed negligible given the size of the wider banking system. “It seems very far-fetched to make any parallels with Japan’s crisis. The key thing to remember is that these losses are not just held by American banks, as the bad loans were in Japan, but they are dispersed,” one senior American official observed shortly before Bernanke’s testimony. Or as Bill Dudley, a senior figure at the
New York Federal Reserve, told bankers in early summer, “This is a correction, but it is not dramatic in light of history…it could be over in a matter of weeks.”

As the summer of 2007 wore on, though, the panic in the commercial paper market steadily intensified. Before the summer, ABCP notes typically paid investors between 5 and 10 basis points more than the US overnight dollar borrowing rate. By the start of August, that was moving towards 100 basis points, making it absurdly expensive for SIVs to raise funds. Many could not sell notes, even at that exorbitant rate. An entire network of shadow banks was suddenly discovering that their lifeblood had been cut off. Meanwhile, the housing market took a decided turn for the worse.

On August 6, American Home Mortgage Investment Corporation filed for bankruptcy, having suffered substantial losses on its mortgage assets and finding it impossible to sell ABCP notes. “This is getting serious,” Winters thought. The SIVs alone were estimated to hold almost $400 billion of securities. In truth, only a third of those securities were thought to be directly linked to mortgages. But if the SIVs collapsed, that could spark fire sales of assets that would make the drama of the Bear Stearns funds seem trivial.

On the other side of London, at Cairn Capital, one of Winters’s former colleagues at J.P. Morgan, Tim Frost, was also alarmed—albeit for more personal reasons. By 2007, Frost had been working with Cairn for three years. In that period, it had expanded into a formidable operation, which employed more than one hundred staff and ran some $22 billion of assets spread between two dozen CDO-like structures and a hedge fund. It had moved from its initial, cramped office into swanky new headquarters in the posh neighborhood of Knightsbridge, with a fabulous view of London’s Hyde Park. The office was open plan and airy, and the walls showcased a revolving collection of quirky, cutting-edge art, including arresting portraits of shabby unemployed British miners. “It’s a warning of what happens if the returns are bad!” the Cairn staff joked to
clients. Not that they were: during 2005, 2006, and early 2007, Cairn produced steady profits in almost every corner of its sprawling empire. It enjoyed a high reputation among investors.

But by early August, ugly storm clouds were building. The problem was an SIV that Cairn had created back in January 2006, called Cairn High Grade Funding. Cairn had tried to run it in a relatively conservative fashion. Unlike some other SIV managers, Frost and his colleagues had been fussy in selecting their mortgage-backed bonds, trying to choose safe assets even when that meant earning lower returns. As a result, the fund had a higher proportion of triple-A assets than any other SIV, and Frost assumed that made the fund almost bulletproof.

Yet Cairn had an Achilles’ heel. Its SIV—like the IKB vehicle—funded itself in the commercial paper market, and it did not have a committed bank backup credit line. Many investors presumed that Barclays Capital would be obliged to help the SIV if it ran into crisis, since the British bank had played a central role in creating the fund back at the start of 2006. There was no
legal
commitment, though, for Barclays to help. Like so much else in the shadow banking world, that support was a matter of trust.

Until the summer of 2007, the Cairn managers saw little reason to worry about that state of affairs. The commercial paper market was so utterly calm that Cairn found it easy to raise funding. The execution was done by another company, known as QSR. “Quite honestly, [the] funding ordinarily never kept us awake at night,” David Littlewood, one of Frost’s partners, later explained. “[It] required very little maintenance apart from agreeing on a daily funding strategy with QSR.” In mid-July, however, QSR told Cairn that the commercial paper sector was freezing up. By late July, Cairn could sell notes only at the ruinously high cost of 100 basis points over the risk-free rate of borrowing.

Frantically, Frost and Littlewood tried to discuss with investors about what action Cairn could take. They were convinced that their fund was far better than those of rivals. But investors did not wish to hear about all the data that Cairn had to back that up. They were losing any ability to discriminate. Just like consumers who panic during a food poisoning
scare and stop buying all sausages or burgers overnight, ABCP investors had heard that some dodgy assets had got into the securitization chain—and since they could not tell exactly where the rot had ended up, they were boycotting
all
SIV notes.

Shocked, the Cairn partners debated what to do. Some investors wanted to sit tight and ride out what they believed would be a short-lived storm. That was what many other shadow banks, not to mention the IKB officials, appeared to be doing. But Frost—like his former boss Winters—had a trader’s instinct, honed from years trading risk at J.P. Morgan. He was convinced Cairn needed to act fast, to salvage whatever it could, rather than just pray that the markets would recover. His partners agreed.

At the beginning of August, the senior management of Cairn hunkered down in their Knightsbridge office, turning the largest conference room into a “war room.” Outside, tourists strolled through Hyde Park, licking ice cream cones and enjoying the summer sun. Inside, the Cairn managers frenetically worked the phones, desperately trying to work out what they could do with their crumbling SIV. It was far from clear. In the corporate world, there were well-established precedents for how to deal with bankruptcy. There were also clear rules about how to handle a failed bank. After all, over previous decades, regulators and bankers alike had seen plenty of banks collapse.

However, the problem with the SIVs was that nobody had worked out before what to do if they collapsed. They sat in a regulatory limbo since they were not covered by any regulatory rules, and there were no precedents for bankers, investors, or regulators to follow, either in relation to Cairn itself or to the system as a whole. “We are literally reading through our rule book, trying to work out what to do,” confessed one of Frost’s former J.P. Morgan colleagues who ran a rival SIV. In London, Düsseldorf, Frankfurt, and New York, the system was heading into uncharted territory.

On the morning of Thursday, August 9, 2007, the European Central Bank in Frankfurt posted a brief and dryly worded statement on its web
site. The gist was that the ECB would provide as much funding as banks might wish to borrow at a rate of 4 percent, in response to “tensions in the euro money markets…notwithstanding the normal supply of aggregate euro liquidity.”

Journalists and investors who read the bulletin were bewildered. Central banks normally pump money into financial markets almost by stealth, using long-standing devices such as auctions in which banks each bid for a preassigned pot of funds. The ECB, however, was offering the equivalent of an emergency blood transfusion. It seemed to perceive a crisis.

Two hours later, the ECB revealed that forty-nine banks in Europe had demanded—and received—a staggering 94 billion euros of cash, three times the normal level of demand. The last time the ECB had injected that much money into the markets was after the attack on the World Trade Center in 2001. But there was no such obvious disaster rocking the financial world now. The only specific new development that morning was that an asset management unit linked to BNP Paribas, a large French bank, had announced it was suspending three investment funds that held mortgage-linked bonds because a “complete evaporation of liquidity” made it impossible to value the mortgage assets. Yet that appeared small scale compared to what the ECB had done.

Frantically, journalists besieged the ECB’s press team with questions: “What has prompted the ECB to act?” The ECB staff struggled to cope. It was common practice at the ECB—in line with most financial institutions in continental Europe—to let its officials go on vacation for several weeks each summer. On August 9, Jean-Claude Trichet, the wily ECB president, was on a beach in northern France, and most senior officials were on vacation, too, including those who would normally run the press team.

“This is just a
fine-tuning
exercise,” a hapless junior press official was instructed to say, over and over again. More specifically, he added, the ECB had noticed in the days leading up to August 9 that the cost of borrowing money in the interbank market had jumped to a level of 4.7 percent, well above the rate officially set at 4 percent by the ECB. However, what neither the press officials—nor the senior ECB staff
themselves—appeared able to explain was
why
the borrowing rate was rising.

If the ECB’s move was supposed to calm markets, it disastrously backfired. Before August 9, most investors had not even realized that the cost of borrowing euros for banks was rising. The ECB’s actions, though, blazoned that news onto trading terminals and television screens around the world. Many of the traders and investors who saw the news had no idea what to think. The senior officials at many European banks and investment groups were also on vacation. Uneasily, their desk-bound colleagues dispatched emails to holiday destinations around the world. The gist of those messages was usually: “Something is really spooking the markets; but we don’t know
what
!”

On the other side of the Atlantic, officials at the New York Fed were spooked, too. Ever since the Bear Stearns funds had imploded in mid-June, central bankers from the largest Western nations had been holding regular telephone calls to discuss the strains building in the credit world and to swap information. In the preceding weeks, Fed officials had noted that conditions in the credit markets were becoming strained. The Fed had repeatedly discussed these tensions with the ECB, as well as with officials from the Bank of England, Bank of Japan, Central Bank of Canada, and the Swiss National Bank. However, the official mantra at the Fed, as at the Treasury, was that the mortgage problems were “contained.” US policy makers did not want to make any emergency move, since they feared that would do more harm than good. They were seriously irritated by what the ECB had done, particularly since the ECB had
not
notified the Fed about its intervention.

Fed officials debated how to respond. By the afternoon of August 9, New York time, some ten hours after the ECB posted its statement, almost every indicator tracked on the computer screens of the Fed signaled panic. The price of gold was rising, together with the price of US Treasury bonds, while the price of risky corporate bonds and mortgage-backed assets was tumbling. Investors were dumping anything that might contain default risk and heading for the safest assets around. Most ominously of all, the cost of borrowing dollars in the interbank market was also rising. That implied that banks and other key financial institutions
were reluctant to lend money to each other, either because they needed that cash or they did not trust each other—or both.