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 (5 page)

The rush into derivatives was partly driven by aggressive marketing efforts by the banks and regulatory changes in the asset management world. Another factor that fueled the trend, though, was falling interest
rates. After Paul Volcker jacked up rates in 1979, inflation had tumbled. By 1983 it was running at 3.2 percent, down from 13.5 percent in 1981. The Fed was then able to trim short-term interest rates, which stimulates economic growth. In 1987, Alan Greenspan replaced Volcker as Fed chairman, and from 1989 onwards, he steadily reduced rates to fight a mild recession. That was good news for borrowers, and it also boosted bank profits, because when rates are low, banks can borrow money cheaply and lend it out to customers at higher rates, making easy returns. But falling rates made it harder for investment managers to earn decent returns by purchasing relatively risk-free government or corporate bonds. Those pay less when rates fall. Thus, while the absolute level of rate was still relatively high (at least, compared with what it would be a decade later), the direction prompted some bond investors to look for new tactics.

Merrill Lynch, Bankers Trust, Salomon Brothers, and J.P. Morgan itself suggested to their clients that they could use derivatives to boost their returns, and the banks invented a new wave of products to provide that service, with obscure names like “LIBOR squared,” “time trade,” and “inverse floaters.” Some federal agencies, such as Sallie Mae, the student loan provider, also began offering investment products that included derivatives. Most of these products produced high returns by employing two key features. They involved bets on the level to which interest rates would fall in the future, and with rates falling so dependably on Alan Greenspan’s watch, those bets produced easy money with what seemed like very little risk. Most of these deals also involved a concept that is central to the financial world, known as “leverage.” This essentially refers to the process of using investment techniques to dramatically magnify the force or direction of a market trend (just as a lever will increase the force of a machine). In practical terms, the word can be used in at least two ways in relation to derivatives. Sometimes investors employ large quantities of debt to increase their investment bets. For that reason, borrowing itself has often come to be called “leverage” in recent years. However, the economic structure of derivatives deals can also sometimes leave investors very sensitive to price swings, even without using large quantities of debt. Confusingly, that second pattern is also referred to as
“leverage.” In practice, though, these two different types of leverage tend to be intermingled. And the most important issue is that both types of leverage expose investors to more risk. If the bet goes right, the returns are huge; if it goes wrong, though, the losses are big, too. Using leverage in the derivatives world is thus the financial equivalent of a property developer who buys ten houses instead of five: owning more properties will leave that developer more exposed to losses and to gains if house prices rise or fall, particularly if the properties are financed with debt.

In 1992 and 1993, though, many investors thought it was worth taking those risks, by buying products with high leverage. “It was a type of crazy period,” recalls T. J. Lim, one of the early members of the J.P. Morgan swaps team, who worked with Connie Volstadt in the 1980s and decamped with him to Merrill Lynch. “The herd instinct was just amazing. Everyone was looking for yield. You could do almost anything you could dream of, and people would buy it. Every single week somebody would think of a new product.”

Some prescient warnings were issued. Allan Taylor, the Royal Bank of Canada chairman, said that derivatives were becoming like “a time bomb that could explode just like the Latin American debt crisis did,” threatening the world financial system. Felix Rohatyn, a legendary Wall Street figure who worked at Lazard Frères in corporate finance, far removed from derivatives, called derivatives “financial hydrogen bombs, built on personal computers by twenty-six-year-olds with MBAs.”

Those “twenty-six-year-olds” vehemently disagreed. The innovation frenzy showed exactly why derivatives were so powerful and why government control must be fought off. “The surest way to stifle innovation is to take current best practices and convert them into rigid requirements,” Brickell liked to say, paraphrasing Friedrich von Hayek, the libertarian Austrian economist and one of Brickell’s intellectual heroes. Indeed, if there was one thing that united swaps traders, aside from a fascination with deconstructing financial instruments, it was the belief in the efficiency, and superiority, of free markets.

Brickell took the free-market faith to the extreme. His intellectual heroes, in addition to Hayek, were economists Eugene F. Fama and Merton H. Miller, who had developed the Efficient Markets Hypothesis at
Chicago University in the 1960s and 1970s, which asserted that market prices were always “right.” They were the only true guide to what anything should be worth. “I am a great believer in the self-healing power of markets,” Brickell often said, with an intense, evangelical glint in his blue eyes. “Markets can correct excess far better than any government. Market discipline is the best form of discipline there is.”

Peter Hancock shared that view, though he rarely expressed it so forcefully in public. So did most other swaps traders. Of course, they knew perfectly well that financial markets were not truly free. On the contrary, the financial system was smothered in the government rules that had followed repeated crises. What made derivatives so thrilling for Brickell and other true believers was that they lay
outside
the purview of that legacy regulation. They allowed pioneering financiers to compete freely, unleashing their creativity, just as theory advocated.

This did not equate to a world with
no
rules, Brickell always liked to stress. On the contrary, the derivatives market could function only if the participants played according to a common law book. Indeed, crafting those legal guidelines had been a founding purpose of the ISDA. What made ISDA’s approach so different was that it asserted that rules were best designed
by the industry itself
and upheld by voluntary, mutual accord. Government bureaucrats should not be the sheriffs or high priests of this world; bankers and their lawyers were better informed, and they had strong incentives to comply. Like a hunter-gatherer tribe, all derivatives traders had an equal interest in upholding the norms. That was why any recommendation the G30 report might make about legislation to institute regulation was to be fought, argued Brickell, tooth and nail.

Another key factor that influenced how J.P. Morgan bankers and others viewed regulation was the development of an idea known as
value at risk,
or VaR. In previous decades, banks had taken an ad hoc attitude toward measuring risk. They extended loans to customers they liked, withheld them from those they did not, and tried to prevent their traders from engaging in any market activity that looked too risky, but without trying to quantify those dangers with precision. In the 1980s, though, Charles Sanford, an innovative financier at Bankers Trust, had developed
the industry’s first full-fledged system for measuring the level of credit and market risk, known as RAROC. That eventually prompted other bankers to start trying to measure risk not according to vague hunches but by using precise quantitative techniques.

Dennis Weatherstone, the Morgan CEO, played a crucial role in that wider industry trend. Having built his career on the volatile foreign exchange trading desks, not in the staid commercial arm of the bank, he was keenly aware of how risk could come back to bite you, if you did not prepare. The terrible stock market crash of 1987 hammered that point home again when all the banks suffered losses. So, in 1989—two years after that crash—Weatherstone introduced a near-revolutionary practice into J.P. Morgan known as the “4–15 report.” At 4:15 p.m. each day, after the markets closed, a report was sent to him that quantified the level of risk the bank was running in all areas of its business. Initially the report was crude, limited to painting an approximate picture of all the bank’s trading businesses. Weatherstone decided he wanted more, and he asked a team of quantitative experts to develop a technique that could measure how much money the bank stood to lose each day if the markets turned sour. It was the first time that any bank had ever done that, with the notable exception of Bankers Trust.

For several months the so-called quants played around with ideas until they coalesced around the concept of value at risk (VaR). They decided that the goal should be to work out how much money the bank could expect to lose, with a probability of 95 percent, on any given day. The 95 percent was an accommodation to the hard reality that there would always be some risk in the markets that the models wouldn’t be able to account for. Weatherstone and his quants reckoned there was little point in trying to run a business in a manner that would create obsessive worry about very worst-case scenarios. If a bank worried about those every day, it could barely afford to conduct business at all. What Weatherstone wanted to know was what levels of risk the bank was running in a bad-to-normal state of affairs, like a farmer who steels himself to expect periodic floods, snowstorms, and droughts but doesn’t worry about an asteroid impact that might bring on Armageddon. Hence the use of a 95 percent confidence level.

The system essentially worked by taking data from the previous few years and working out how much money the bank risked losing at any one time if markets turned sour. The key simplifying assumption on which the models rested was that the future was likely to look like the recent past. Dennis Weatherstone was well aware that this assumption might not always be correct. He knew it was only a rough approximation to reality. Models were only
tools
and could not be used without human intelligence, as he sternly lectured the J.P. Morgan staff. They were not the only way of measuring potential future losses. “We were all taught to think that models are useful, but that they also have limits,” Peter Hancock later recalled. “It is an obvious point, but it is also something people so often forget.”

Yet the beauty of VaR was that it allowed bankers to measure their risk with far more precision than ever before. A mind-boggling array of future dangers could be reduced to a single clear number, showing how much a bank stood to lose. The J.P. Morgan bankers assumed that would make it much easier for banks to control their risks, in relation to derivatives or anything else. That had a bigger implication: with tools such as VaR at their fingertips, banks now had both the incentive and the ability to navigate wisely in the derivatives world
without
the need for government interference. Or that, at least, was the argument that derivatives bankers liked to present.

On July 21, 1993, the long-awaited G30 report was finally unveiled. It was a hefty, three-volume tome. Right from the start, Dennis Weatherstone had insisted that the study be a serious, highly detailed guide. If the report could show that the industry already had a credible internal code of conduct, there should be less need for bureaucrats to impose rules. “This should not be a study that gathers dust on a shelf,” Weatherstone declared. “I want to produce a guide by practitioners that has so much useful, practical advice that it will be referred to for years to come.”

The G30 tome met that criterion in spades. The document started with some vague rhetoric that stressed the value of derivatives for the financial system as a whole. But it then laid out, in exhaustive detail, the
best norms for running the business. One section urged all banks to adopt VaR tools. Another demanded that banks’ senior managers learn in detail how derivatives products worked. Another section urged banks to use ISDA’s legal documents for cutting deals. The report also demanded that banks record the value of their derivatives activity each day, according to real-time market prices, following the principles of what’s become known as “mark-to-market.” This would bring consistency in valuations where before banks had been accounting the values of the derivatives deals in a host of ways. It also underscored the assumption that market prices were the “best” guide to value.

Equally important was what the G30 report did
not
say. The tome did not suggest the government should intervene in the market, in any way. Nor did it drop any hint that the derivatives world might benefit from a centralized clearing system, like that for commodities derivatives and the New York Stock Exchange, to settle its trades. These clearing systems not only recorded the volume of trades, providing a valuable barometer of activity that signaled signs of trouble, but also protected investors from the eventuality that the party on the other side of the trade—the counterparty—might fall through on a deal, leaving the trade in limbo. Without a clearinghouse, derivatives traders faced this so-called counterparty risk.

Brickell and the other members of ISDA were opposed to setting up a clearing system because they feared it would be the thin edge of a wedge of further regulations. They insisted that counterparty risk could be handled perfectly well by following the ISDA guidelines, posing some collateral against the risk of default, and just good smart trading. “The swap [market] framework is a model of market discipline,” Brickell argued. “Within it, every participant scrutinizes the reputation and credit quality of his counterparties and adjusts the flow of his business accordingly.”

As regulators and central bankers digested the weighty G30 report, a few commentators expressed concern that the report simply did not go far enough. Brian Quinn, an executive director of the Bank of England, said the G30 report “struck me as somewhat complacent” in regard to the risks posed by the derivatives world. But, just as Dennis Weather
stone had hoped, regulators generally appeared impressed by the detailed nature of the guidelines. “If the market players continue forward in the spirit of the G30 study, then regulators will have much less to do,” observed J. Carter Beese, a Securities and Exchange commissioner, in November 1993. Hancock, Brickell, and the rest of the swaps market heaved a sigh of relief.