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 (26 page)

By late 2007 the emails bouncing between their BlackBerries, though, were expressions of disbelief. Like Demchak, most of them were stunned that their super-senior brainchild had become such a rapacious scourge. “What kind of monster has been created here?” one of the former J.P. Morgan group wrote in a heartfelt email to another. “It’s like you’ve known a cute kid who then grew up and committed a horrible crime,” another member of the team commented. “All this just totally blows your mind.”

They simply hadn’t realized the degree of risk that was building up under all the acronyms. Over at BlueMountain, Feldstein had spotted at an early stage that banks were stockpiling super-senior holdings, and he had positioned his hedge fund to benefit when that pattern turned wrong. The strategy paid off handsomely, and in 2007, the three main funds at BlueMountain posted returns of 45, 34, and 9 percent, respectively. But Feldstein was the exception. Winters and Masters had never been able to understand why the other banks were so willing to keep
cranking up their CDO machines, and now that the truth had come out, they were profoundly shocked. They were also indignant and angry.

It was little comfort to them that the terrible mistakes of others put J.P. Morgan in a flattering light by comparison. As the losses piled up, confidence was crumbling so thoroughly that all banks were being hurt. A public backlash against all types of complex finance was building. “It feels like credit derivatives or CDOs have become a dirty word right now,” lamented Tim Frost.

Most of the former J.P. Morgan team considered pointing the finger at derivatives utterly unfair. “This crisis has
nothing
to do with innovation. It is about excesses in banking,” Winters observed. “Every four to five years there is a new excess in banking—you had the Asian crisis, then the internet bubble. The problem this time is extraordinary excess in the housing market.” Or as Terri Duhon said: “When car crashes happen, people don’t blame cars or stop driving them, they blame the drivers! Derivatives are the same—it’s not the tools at fault, but the people who used those tools.” Hancock was even more adamant. After he left J.P. Morgan back in 2000, he had created a consultancy group that advised governments and companies on how to use innovative financial products, such as derivatives, to their benefit. The other founding members of the group were Roberto Mendoza, another former J.P. Morgan banker, and Robert Merton, the Nobel Prize–winning economist who had helped to create the pathbreaking Black-Scholes formula that had played a crucial role in the development of derivatives. For seven long years, Hancock had extolled the virtues of financial innovation, often in the face of client skepticism. Even as the banking world reeled in shock in late 2007, he remained committed to the cause. “A lot of the problems in structured finance have not been due to too
much
innovation, but a failure to innovate sufficiently,” Hancock observed. “People have just taken the original BISTRO idea, say, added zeros, and done it over and over again without really thinking about the limits of diversification as a risk management tool. There is a big difference between using this structure for corporate loans, as we did at J.P. Morgan, and subprime mortgages!”

As the losses piled up, though, some members of the team realized
that certain assumptions that had driven them a decade before had been naive. Back in the 1990s the team had all believed, with near-evangelical fervor, that innovation would create a more robust and efficient financial world. Credit derivatives and CDOs, they assumed, would disperse risk. Now it turned out that the risks had not been dispersed at all, but concentrated and concealed. It was a terrible, horrible irony.

“Is there something we could have done to stop all this?” one of the group asked, as Merrill Lynch announced more losses. “It wasn’t our job to stop other banks being so stupid!” another shot back. “What about the regulators? Where were they?” With every new piece of bad news, their sense of shock and anger grew. So did their fears about a looming backlash.

O
n January 11, 2008, JPMorgan Chase burst into the news again. Andy Kuipers, chief executive of Northern Rock, announced that the bank was buying £2.2 billion of Northern Rock’s mortgage loans. “This is a relatively small transaction, representing around two percent of Northern Rock’s gross assets, but it is a positive development in the company’s ongoing strategic review,” Kuipers said, noting that the sale “will allow us to reduce the debt with the Bank of England.”

The significance of Northern Rock’s announcement, though, went well beyond Northern Rock’s fate. It signaled that JPMorgan Chase was flexing its muscles even as other major banks were furiously trying to shore themselves up. The price at which Bill Winters’s team in London had arranged to buy the Northern Rock mortgages was extremely favorable, and Winters regarded the deal as one of the sweetest the bank had done for some time. The reason the deal was so great, of course, was that there were precious few other bidders left in the market.

By the start of 2008, write-downs made by Western banks totaled more than $80 billion. To plug that gap, the banks had raised more than $60 billion in capital. JPMorgan Chase had not entirely avoided the pain; it had been caught holding on its books tens of billions of dollars of leveraged loans that tumbled in price. The bank also had a large direct exposure to the mortgage market, because it had expanded its home equity loan business back in 2005 and 2006. Tucked away in corners of the JPMorgan Chase empire, there were even a few super-senior firebombs: one corner of the bank department, for example, held a few loss-making mortgage CDOs on its books that Winters had not known about. As a
result, the bank recorded around $1.3 billion of write-downs in the fourth quarter of 2007, cutting net income for the investment bank to just $112 billion. But that loss seemed trivial compared to most of its competitors’.

What JPMorgan Chase did
not
have on its books were the vast piles of super-senior CDO of ABS assets, which were wreaking such havoc at Citi, UBS, and Merrill Lynch. Nor did it have a vast network of shadow banks or credit lines extended to them. It had also gone into the whole crisis with a stronger balance sheet—and a relatively low level of leverage—than most of its competitors, due to Dimon’s obsession with maintaining a “fortress balance sheet.”

During the previous seven years, J.P. Morgan staff had become accustomed to feeling like laggards; now suddenly they were stars. Most of the J.P. Morgan managers were reluctant to crow publicly, for fear of tempting fate. They also felt wary of taking credit for things they had
not
done. “We have made mistakes, too,” Winters stressed, whenever asked about the bank’s fortunes. “It is quite wrong to pretend otherwise.” There was also no denying, though, that the worse the crisis got, the more opportunities presented themselves. The really big question facing the JPMorgan Chase management was whether they should go further with their bottom fishing and purchase not just some cut-price loans but an entire
bank.
That seemed a natural step for Dimon. After all, he had shot to fame a decade earlier by embarking with Sandy Weill on one of the most extraordinary acquisition frenzies Wall Street had ever seen. Many analysts had assumed that Dimon would crank up acquisitions when he joined JPMorgan Chase, but he had confounded those predictions. During the credit boom, he believed the prices of other financial groups were grossly inflated. By 2008, though, the share prices of most banks had tumbled by more than 20 percent, one of the sharpest declines on record. Would that be enough to tempt him?

In February 2008, Steve Black told analysts that the bank was not actively pursuing mergers. “We were really not looking to buy anything [in early 2008]—truly,” Black later explained. “I mean, we had not ruled anything out, but we knew that we would only consider a deal if something was
extremely
cheap.” Yet Dimon was an opportunistic man. So as
the share prices of other banks kept falling, the JPMorgan Chase management kept scanning the horizon, shifting for opportunity.

On Thursday, March 13, Dimon was having a private dinner in a favorite Greek restaurant in New York with his parents, wife, and daughters to celebrate his fifty-second birthday. Suddenly his private cell phone rang. He was irritated. The cell phone in question was generally used only for family calls or office emergencies, and he had asked his staff to avoid disturbing him that night, unless crucial.

On the other end of the line was Dimon’s office. They told him that Gary Parr, a senior Lazard banker who was advising Bear, needed to talk urgently. So did Alan Schwartz, the Bear CEO. Their message was shocking: Bear was running so short of liquidity that it would be forced to file for bankruptcy without immediate aid. Would JPMorgan Chase extend that? Schwartz asked.

Dimon was stunned. He was well aware—as was all of Wall Street—that Bear was vulnerable because of the collapse of its two hedge funds back in June 2007. Dimon had even explored purchasing part of Bear’s operations then, but the brokerage had rebuffed those overtures. In the subsequent months, Bear had continued to forge a fiercely independent path, in keeping with its reputation as a scrappy, maverick player. Like most of its rivals, Bear told investors it would bolster its capital base, but in practice its efforts seemed halfhearted. It embarked on discussions with CITIC Securities, a Chinese entity, but never received anything more than a pledged equity swap worth $1 billion.

By late February, this “tough-it-out” strategy was making Bear’s investors and creditors increasingly nervous. Bear was known to be a big player in the field of mortgage debt, and it held a large pile of mortgage securities on its book. Throughout the winter of 2007, the Bear management repeatedly insisted that they were managing the risks of those assets well. Investors, though, were uneasy, because market conditions just kept getting worse.

In early January, the US government had published weak economic data. Then in mid-January, the credit ratings agencies started to down
grade their ratings of the giant monoline companies. That had alarming implications for the banks that had purchased monoline “insurance” to protect their CDO holdings. As investors digested the news, the equity and credit markets slid again, and though the Federal Reserve responded by cutting interest rates twice in late January, by a hefty total of 1.25 percentage points, market anxiety still ran high. Behind the scenes, banks were starting to feel so cash-constrained—and so nervous about the mortgage market—that they demanded that hedge funds begin posting more collateral when they took out loans. Many hedge funds could not comply with these tougher demands, which were known in the industry as “higher haircuts.” So many began selling their assets instead. As they did that, the prices of those assets fell, making the banks even more nervous about lending money to hedge funds. It was another pernicious feedback loop. Investors were spooked so badly that they started to withdraw from the markets to such an extent that “parts of the financial system [were becoming] dysfunctional, causing further financial retrenchment,” officials at the BIS noted.

Investors also intensely scrutinized any financial institutions that looked particularly vulnerable, and Bear Stearns was one. Bear’s real Achilles’ heel was its funding base. Because Bear was a brokerage, with no real commercial banking operations, it had no stable pool of bank deposits providing cash flow. Traditionally, Bear had raised most of its funding by issuing long-term bonds, but during the first seven years of the decade, it had become more reliant on the “repo,” or “repurchase,” market. This is a corner of finance where banks use assets they hold, such as mortgage-backed bonds, as collateral for borrowing money from other investors for a very short period, often just one or two days. All American brokerages used the repo market, which was one of the largest—but widely ignored—cogs of the American financial machine. Bear, however, tended to rely more on short-term repo funding than many of its peers, and it tended to post an unusually high proportion of mortgage-backed bonds as collateral.

As the financial woes intensified in early 2008, Bear found raising funds in the repo market increasingly difficult. This development went largely unnoticed by the wider financial community. The repo market—
like the commercial paper sector—had traditionally been widely ignored by journalists and regulators alike. A couple of hedge funds in New York did spot the problem, though, and quietly started to pull their assets from Bear. When that news leaked out, more funds reassessed their dealings with Bear. As unease spread, some investors asked Deutsche Bank, Credit Suisse, Goldman Sachs, and JPMorgan Chase to replace Bear Stearns as the counterparties to credit derivatives contracts they had written with Bear. This practice was well established in the markets and usually performed for reasons having nothing to do with the financial health of a counterparty, but as news of this flood of deal changes leaked out, it further fueled anxiety about Bear’s health.

The cost of buying insurance against a default by Bear, with credit default swaps, began to spiral upwards. A year earlier, the annual price of insuring $10 million of Bear bonds had been well under $100,000. By March 10, it was well over $600,000. Officials at Goldman Sachs and Credit Suisse circulated internal emails warning about the counterparty risk posed by Bear, and when news of those leaked out, investors became even more nervous. Then a large hedge fund called Renaissance Technologies pulled its accounts out of Bear, and a snowball of rumors of Bear’s demise was set in motion.

Frantically, the senior Bear managers hunted for ways to stop the leakage. On March 5, Bear’s cash holdings, on paper, topped $20 billion, and even on March 10 they were $18 billion, but by March 11, Bear’s funds had dropped to $10 billion. If Bear had been a commercial bank, it could have gone to the Federal Reserve for a loan, as the large commercial banks enjoy “lender of last resort facilities” and can always ask the Fed for funds in a crisis, as long as they have collateral. Banks do this either by participating in the regular “auctions” run by the Fed to pump liquidity into the system, or by using the so-called discount window, which provided additional funds in an emergency. Banks hated resorting to the second option, because it carried a stigma, but, facing a true crisis, at least they had the option, and in late 2007, the Fed had introduced a wave of new measures to make the move more attractive. Bear, however, had no access to the window.

On the evening of March 12, Bear’s lawyers called Timothy Geithner
at the New York Fed and asked what they should do. The question put Geithner on the spot, because he had no supervisory responsibility over the brokerages. That fell to the Securities and Exchange Commission. What’s more, the Fed had only relatively limited data about Bear’s business, and Geithner had no clear mandate to rescue Bear with a loan. He was a deeply pragmatic man, though, and he was keenly aware of how entwined Bear was with so many other firms, including the large banks. Back in 2005 Geithner had devoted considerable resources to studying the infrastructure of the credit derivatives world, and what he learned told him now that if Bear collapsed, the repercussions could reverberate all across the financial landscape. Though he had spent less time studying the repo market, he could also see that if Bear was to default on its repo contracts, that would prompt investors to panic.

“If Alan Schwartz [the Bear CEO] is worried, he had better call me,” Geithner told Bear’s lawyers. The next day Schwartz duly called Geithner. “So which institutions are you talking to?” Geithner asked. He badly hoped that Bear might be able to sell itself. A decade earlier, Geithner had worked in Tokyo, as financial attaché to the US Embassy, just as the Japanese banking crisis was getting under way. The Japanese had dealt with failing banks by persuading a stronger institution to step in, and Geithner hoped that such a shotgun marriage could save Bear.

Schwartz told Geithner that there were two possible suitors, JPMorgan Chase and Barclays Capital. “Better go back and get talking again!” Geithner said. He then asked his staff to check independently whether the two banks really were serious contenders. A few hours later, the answer came back from Barclays that it was not eager to conduct a deal. JPMorgan Chase, though, was a more serious option. It already knew Bear well, since it acted as its clearing bank, settling all of Bear’s trades. There were also good strategic reasons for Dimon to purchase Bear. For years, the JPMorgan Chase management had fretted that the bank was weak in the equity market and prime brokerage activities compared with rivals. Bear was strong in both. Discreetly, Fed officials encouraged Schwartz to talk to Dimon, prompting Schwartz to interrupt Dimon’s birthday dinner.

Dimon didn’t jump at the prospect immediately. “I can’t do that,” he
told Schwartz when the Bear CEO asked him to rescue the broker at once with a loan or a merger. He was extremely uneasy about what lay hidden deep inside Bear’s books. Having dodged so many bullets in relation to SIVs and CDOs, he didn’t want to jump headlong in front of a runaway train. Nor did he want to walk away from a potentially interesting deal. He played for time. He summoned Steve Black back from a holiday and ordered a large team of J.P. Morgan staff to go to Bear to start combing through its books.

The bankers arrived very late on Thursday night. Some had just climbed out of bed. Within an hour, they determined that the state of Bear’s finances was so dire that the brokerage might default within hours. Dimon and Geithner held off. On Friday morning JPMorgan Chase announced that it would extend a temporary loan to Bear, using funds that the Fed gave to JPMorgan Chase, “for an initial period of up to 28 days.” That loan, of around $30 billion, would stave off the risk of an immediate collapse, while enabling the Fed to channel more money to Bear without breaching its own rules. Then Morgan drafted in more staff to analyze the Bear accounts.

The pressure on them was intense. Initially, the Fed had suggested that Bear would have up to twenty-eight days to find a new buyer, but by Friday afternoon, that deadline was cut to three days. Geithner feared that the financial system would tip into crisis unless a deal was announced before the Asian markets opened on Monday morning, Sunday evening New York time. But Bear’s books were vast, with vast quantities of CDOs, as well as a plethora of complex credit derivatives deals. Getting a handle on what those were worth in just twenty-four hours was daunting.