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 (4 page)

T
here was a critical juncture, around the time that Peter Hancock’s team seized on the idea of credit derivatives, when financial innovation might have followed a subtly different path. In the few years leading up to Hancock’s Boca off-site, regulators and many prominent banking experts grew concerned about the boom in derivatives and the proliferation of exotic new types. They fiercely debated whether regulations should be imposed.

Peter Hancock found himself at the heart of this debate. In 1991, three years before the Boca Raton meeting, he had received an unexpected summons from Morgan CEO Dennis Weatherstone. “Corrigan wants to talk to us about derivatives,” Weatherstone said, ordering Hancock to attend the meeting “since you can explain this stuff so well.” Hancock had distinctly mixed feelings about the invitation. E. Gerald Corrigan, then age fifty, was the seventh president of the New York Federal Reserve, a position to which he had been appointed in 1985. It was a powerful role, including the oversight of New York commercial banks, and Corrigan, a forceful, burly character with a gravelly voice, was not afraid to express his views bluntly.

By 1991, he had already worked at the Fed for a couple of decades, serving as special assistant for a period to the legendary Paul Volcker, and he had seen the financial system suffer through several business cycles and bouts of panic. He had cut his teeth handling the Herstatt Bank crisis of 1974, when the failure of a small German group had rocked the Euromarket, and had confronted the Latin American debt crisis, the
collapse of Continental Illinois National Bank, and the failure of Drexel Burnham Lambert. “I have seen it all before,” Corrigan was fond of growling. All that experience had left him uneasy about the tendency of bankers to sow havoc when left to their own devices.

The New York Fed’s vast granite headquarters was a five-minute stroll from the J.P. Morgan offices. Even so, Hancock had never passed through those intimidating steel doors. Bankers who worked on the commercial lending side of J.P. Morgan often chatted with central bankers, but central bankers and swaps traders had no such regular back-and-forth. As a result, Corrigan’s “invitation” left Hancock uneasy: what was the New York Fed planning to do with his beloved derivatives?

Corrigan himself was unsure. He had summoned Weatherstone and Hancock primarily because he was worried that he knew too little about derivatives, and he wanted to get more facts before deciding about possibly regulating them. J.P. Morgan was an obvious place to start, given its long-standing links with the Fed. Indeed, only a couple of years before, J.P. Morgan had hired the former executive vice president of the Fed, Steven Thieke, to act as its chief risk officer (one of the few cases where the bank hired from outside for a senior post).

For several hours, Corrigan grumpily peppered Weatherstone and Hancock with questions about the swaps world, and Hancock answered as best he could. He had the impression that Corrigan had only a modest knowledge of how derivatives worked. But, after all, why should that be a surprise? Almost nobody outside the teams of traders really understood the details. He left with the impression that while Corrigan was not automatically opposed to derivatives, he was not particularly thrilled with all of the innovation going on. What, Hancock wondered, would Corrigan do next?

Part of the problem with deciding what to do about derivatives regulation was that there was so little specific data available about the growth of the business. In the stock market, most trading takes place on public exchanges, such as the New York Stock Exchange or NASDAQ, which are tightly regulated to protect investors. Most commodities derivatives con
tracts also trade on regulated exchanges, such as the Chicago Mercantile Exchange, and are regulated by the US Commodities Futures Trading Commission. Some interest rate and currency derivatives were traded on exchanges too. Many others, though, were brokered privately between banks and clients in what are called “over-the-counter” deals, because the parties negotiate directly. What’s more, few regulations had been crafted to monitor and set guidelines for such OTC trades.

Since the dawn of modern finance, governments have been beset by the question of how much banking should be regulated. On the one hand, twentieth-century American and European governments have generally accepted that the business of finance should be exactly that, a
business
run privately in a profit-seeking manner. But finance is also not quite like other areas of commerce. Money is the lifeblood of the economy, and unless it circulates readily, the essential economic activities go into the equivalent of cardiac arrest. Finance serves a public utility function, and the question government regulators must wrestle with is to what degree private financiers should be allowed to seek a profit and to what degree they must be required to ensure that money flows safely.

In practice, during the twentieth century both American and European governments resolved the dilemma by keeping banking private but swaddling it in rules to ward against excesses. During the course of the century, those rules had expanded into what felt to bankers like a straitjacket of regulation. Some of the laws were national in nature, such as the Glass-Steagall Act in the United States, which separated commercial banking from investment banking. The Federal Reserve also imposed rules specifically on American commercial banks—with investment banks left outside its purview—including the stipulation that the total size of their liabilities could not exceed twenty times the size of their equity. If banks overexpanded their assets and failed to keep adequate reserve capital to cover potential losses, they were at risk of collapse, as had happened so spectacularly after the Crash of 1929. The regulations in London also imposed minimum reserve requirements.

On top of the national regulations, a set of international stipulations, known as the Basel Accord, had been agreed to by the Group of Ten nations, plus Luxembourg and Spain. A first set of agreements were
drawn up in 1988 in the picturesque Swiss mountain town of that name, under the management of the Basel Committee on Banking Supervision (BCBS), whose governing body is based at the Bank for International Settlements (BIS). The first set of rules, known as Basel I, imposed globally consistent standards for prudent banking, most notably by demanding that all banks maintain reserves equivalent to 8 percent of the value of their assets, adjusted for risk. These rules were expanded and modified for some years, with a revised version referred to as Basel II issued in 2004 but not yet agreed to by all parties.

By the early 1990s, regulators were dogged by the fact that many of these rules had been drafted
before
the explosion of derivatives innovation. They could be extended into the derivatives world to some extent; aspects of the Basel Accord set out, for example, levels of reserves that banks must hold if they were engaging in derivatives activity. But the urgent issue now was that the business had expanded so much, and in such complex ways, that regulators couldn’t get good estimates of the risks involved. The issue didn’t worry regulators too deeply at first. In the early 1980s, swaps deals accounted for so little of overall banking activity and were being done by such a relatively small and elite group of players that regulators regarded the sector as a sideshow. What traders did with their newfangled derivatives contracts seemed as peripheral to the “real” economy as the gambling in Las Vegas is. But, as the 1980s wore on and the business began to take off, some regulators became uneasy. They began to tweak the banking rules in a manner that forced banks to lay aside more capital against their derivatives business. That left bankers nervous. They feared that profits could drop if regulators became even more involved. In response to this, in 1985, a group of bankers working for Salomon Brothers, BNP Paribas, Goldman Sachs, J.P. Morgan, and others held a meeting in a smart Palm Beach hotel with a view to agreeing on standards for swaps deals. The idea was to hash out common legal guidelines for the deals. Out of that, they decided to create an industry body to represent the swaps world, subsequently known as the International Swaps and Derivatives Association, and one of the first things the ISDA did was to conduct a survey of the market. The published results
were startling. In 1987, ISDA reckoned the total volume of derivatives contracts was approximately $865 billion.

Shocked by that number, some Western government officials started to flex their muscles. In 1987, the Commodities Futures Trading Commission proposed to start regulating interest-rate and currency swaps in the same way it monitored the commodities derivatives world. That idea provoked horror from the banking world. The derivatives traders feared the CFTC would do a clumsy, heavy-handed job—not to mention that any existing derivatives contracts would be thrown into a legal limbo because the legislation the CFTC proposed stipulated that all deals not done on its exchange would be illegal.

ISDA leapt into action, sponsoring a lobbying campaign on Capitol Hill. Somewhat to their surprise they prevailed two years later when the CFTC backed down. That victory was just temporary, though. By the early 1990s, government scrutiny of derivatives was intensifying again, as the business continued to boom and a range of exotic new offerings were introduced. In truth, most regulators and central bankers still didn’t know in any detail how the swaps world worked. Its esoteric nature raised the troubling issue at the center of the regulatory dilemma: how could they allow this booming business to keep flourishing and still ensure that it didn’t end up jeopardizing the free flow of money around the “real” economy? Regulators didn’t want to stifle positive innovation, but they were growing leery. That was the impetus of Jerry Corrigan’s investigation of the business in the fall of 1991.

A few weeks after he had summoned Dennis Weatherstone and Peter Hancock to meet with him, in January 1992, Corrigan delivered a stern speech to the New York State Bankers Association. “Given the sheer size of the [derivatives] market,” he said, “I have to ask myself how it is possible that so many holders of fixed-or variable-rate obligations want to shift those obligations from one form to the other.” Translated from central bank jargon, this suggested that Corrigan was dubious about the banks’ motives for making these deals. “Off-balance-sheet activities have a role,” he continued, “but they must be managed and controlled carefully, and they must be understood by top management, as well as by
traders and rocket scientists,” he added. “I hope this sounds like a warning, because it is!”

Derivatives bankers were shocked. Corrigan seemed poised to institute regulation. Sure enough, a few weeks later it emerged that international regulators, led by Corrigan, were preparing to define how the Basel rules should be applied to market trading activities with more precision. Then, around the same time, Mark Brickell, a member of Hancock’s team, received a surprising overture from a Washington-based organization, the Group of Thirty. Brickell had joined J.P. Morgan straight out of Harvard Business School around the same time as Hancock and was a true believer in the wonders of swaps. Hancock had selected Brickell to act as his key point man in lobbying regulatory officials and politicians, who had been asking so much of late about the derivatives business. Brickell was ideally suited for the job. He was an intense man, with passionate libertarian views, who had entertained the idea of pursuing a career

in politics. Unlike most swaps traders, he therefore relished dealing with politicians, and he was so enthusiastic about lobbying that by 1992 he held the post of chairman of the ISDA. He was Hancock’s and the industry’s Rottweiler in fending off regulatory concerns.

The G30, it turned out, was planning to write a study of the derivatives world, and the caller told Brickell the group wanted J.P. Morgan to lead the process. It was clear that the report could be crucial for setting government policy. The G30 was a highly influential group of economists, academics, and bankers, set up in 1978 with funding from the Rockefeller Foundation, with a mission to promote better international financial cooperation. Paul Volcker led the group.

J.P. Morgan officials debated what to do. Inside the swaps group, the young traders were wary of collaborating on the study. At best, they feared it might result in J.P. Morgan sharing proprietary secrets; at worst, it would be leading to regulations that the bank would be seen as instrumental in instituting. “The whole project was fraught with peril for the swaps world,” Brickell later said. “There was a clear danger of having any recommendation codified as regulation.” Dennis Weatherstone never
theless insisted that the bank cooperate. As CEO, he was highly mindful of the bank’s legacy of public duty, and he suspected that Corrigan, and therefore the weight of the New York Fed, was behind the initiative.

Truth be told, Weatherstone was concerned about the risks of the swaps business. If the industry kept growing without controls, he feared the chances were good that excesses would lead to an implosion that would hurt not just other banks but J.P. Morgan, too. “If you are driving along the motorway in a smart Maserati and see an old car belching fumes,” he sternly told Hancock and his other young turks, “it’s no good just driving on. If that old car crashes, it could wipe out the Maserati, too.”

So Weatherstone agreed to chair the G30 report, and Hancock, Thieke, Brickell, and other J.P. Morgan bankers set to work on it with a host of representatives from other banks. Patrick de Saint-Aignan, a derivatives banker at Morgan Stanley, and David Brunner of Paribas coheaded the report; officials from HSBC, Swiss Bank, and Chase Manhattan also took part. Peter Cooke, a former Bank of England regulator offered advice; so did Merton Miller, the Nobel laureate and leading free-market economist from the University of Chicago. “We knew that we were setting the foundation for the derivatives world,” recalled Brickell.

The time had definitely come to do so. Between 1992 and 1993, the value of deals rose from $5.3 trillion to $8.5 trillion, according to ISDA data. What was more striking, however, was that deals were becoming more complex and were being sold to a wider range of customers. The initial customers for swaps had been large international corporations or banks, with sophisticated treasury departments and investment analysis, groups like Coca-Cola, IBM, and the World Bank. By 1992, small banks, midsized companies, pension funds, and many other asset managers were joining the market. And more and more of them were turning to derivatives not to control for future risks but to make big gambles and realize big returns.