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 (8 page)

To complete its scheme, the team also decided to borrow another trick from the domain of mortgage securitization. One widespread practice banks had engaged in was to create shell companies specifically for buying bundles of mortgages and selling the securities made from them. These companies were generally referred to as special purpose vehicles (SPVs), and they were usually located in offshore jurisdictions, such as the Cayman Islands and Bermuda, to ensure that they did not incur US tax. Demchak’s team decided to set up such an SPV to play the role that EBRD had filled in the Exxon swap. The shell company would “insure” J.P. Morgan for the risk of the entire bundle of loans, with Morgan paying a stream of fees to the SPV and the SPV agreeing to pay Morgan for any losses from defaults. Meanwhile, the SPV would turn around and sell smaller chunks of that risk to investors, in synthetically sliced-out junior, mezzanine, and senior notes.

The really beautiful part of the scheme was that Demchak’s team calculated that the SPV would need to sell only a relatively small number of notes to outside investors in order to raise the money to insure all of that risk. Normally, the SPV would be expected to be “fully funded,” meaning that it would have to sell notes totaling the complete amount of risk that it was insuring. But the J.P. Morgan team reckoned full funding just wasn’t necessary; the number of defaults would be so low that so much capital wouldn’t ever be needed for covering losses.

Demchak’s team furtively worked on putting that theory into practice. Right from the start, they decided to shoot for the stars. “Let’s do ten billion dollars!” Demchak and the J.P. Morgan team declared; he liked big, round numbers. The team identified 307 companies for which
J.P. Morgan was carrying risk on its books that amounted to a total of $9.7 billion. Then they set up a shell company, and they calculated that the company would need to sell only $700 million of notes to cover any payouts to J.P. Morgan it might need to make—less than 8 percent of all the risk insured. This was akin to an insurance company offering insurance on a home worth $1 million, when it holds just $75,000 in its kitty.

Just to be safe, though, Demchak decided that the SPV would invest the $700 million pot in AAA-rated Treasury bonds, so that if it were ever needed, there would be no doubt the money would be there. That ultrasafe investment plan would also help assure investors that the scheme was sound.

The team then approached officials at Moody’s credit rating to get their stamp of approval, which would be needed to convince investors. For several months, Demchak’s team held intensive debates with the ratings agencies, just as bankers at NatWest, Swiss Bank Corporation, and Chase had previously done over their own earlier securitization schemes. Some ratings officials worried that $700 million was not enough to insure the entire pot of $10 billion–odd loans, and suggested ways of potentially tweaking the scheme. The J.P. Morgan officials, though, pointed out that the ratings agencies’ own data indicated that the chance of any widespread default was laughably small. In essence, all that J.P. Morgan had done was to use the default models created by Moody’s—and take them to the logical extreme. So, finally, after much back-and-forth, they decided to accept J.P. Morgan’s arguments and out of the pool of $700 million in notes, two thirds were given the all-important AAA tag. The rest were stamped Ba2.

In December 1997, just as most of the New York financial world was packing up for the Christmas holidays, Demchak’s team finally unveiled its creation. They had given it the ugly name “broad index secured trust offering,” shortened to BISTRO. With great hopes, the group set out to sell the notes. Some investors were dumbfounded. “It looks like a science experiment, with all those arrows!” one baffled fund manager quipped. Masters, however, was formidably good at marketing. Over and over again, she explained to potential investors how the scheme worked with a near-evangelical passion. She got results. Within a matter of days, the
team had sold all the $700 million of notes. Indeed, the appetite was so strong that Masters concluded there was scope to conduct plenty more such deals.

The team was jubilant. They felt they had stumbled on a financial version of the Holy Grail. At a stroke, they had managed to remove credit risk from the bank’s books on an enormous scale. That would immediately enable J.P. Morgan to relieve some of the pressure on its internal credit limits. The team also hoped that once regulators had a chance to examine the scheme, they would agree to let the bank reduce its capital reserves. But there were wider economic implications too, not just for J.P. Morgan but for the financial system as a whole.

If it was now so easy to shift large volumes of credit risk off the bank’s books, banks would be able to truly fine-tune their loan portfolios. “Five years hence, commentators will look back to the birth of the credit derivatives market as a watershed development,” Masters earnestly declared. “Credit derivatives will fundamentally change the way banks price, manage, transact, originate, distribute, and account for risk.” She, like her colleagues, took it as self-evident that these “efficiency gains” from shifting risk this way could only lead to a
better
financial world, and they pleaded their case with an almost religious zeal.

“When you heard these guys speak, you realized that they really believed this stuff,” Paula Froelich, a journalist from Dow Jones who had extensive contact with the BISTRO team during that period, recalled. “They thought they were the smartest guys on the planet. They had found this brilliant way to get around the [Basel] rules, to play around with all this risk. And they were just so proud of what they had done.”

B
ISTRO-style CDS trades quickly took off. In early 1998, the J.P. Morgan swaps team conducted a second $10 billion deal, “insuring” another huge chunk of the bank’s loans and bonds. That success led the team to start marketing the service to others.

Japanese banks were among the first to bite. By 1998, Japan was in the throes of a full-blown banking crisis that had left the largest banks desperate to find a way to reduce their risk. In the summer, the team cut a series of billion-dollar deals with lending institutions including Fuji, IKB, Daiwa, and Sanwa. Soon after, Masters arranged a BISTRO structure for Pittsburgh-based bank PNC. Demchak already knew that group well, since PNC was his hometown bank, and he had helped to restructure some troubled interest-rate derivatives deals that PNC had made in the early 1990s. A flurry of other American regional banks and European banks expressed interest. The European banks were usually reluctant to reveal the names of the companies whose loans were included in CDS deals; they feared they would lose customers if companies found out that their bank was buying insurance against its loan book risk. Undaunted, Demchak’s team tweaked the scheme again. In the early deals, they printed the names of the bonds and loans being covered. They later stopped printing the names of the companies whose loans were included in deals and marketed the tool as a way to maintain “client confidentiality” even while reshaping a bank’s balance sheet.

Other banks did the same. In early 1998, Credit Suisse unveiled its own BISTRO-style CDS structure. So did BNP Paribas. More US and
European banks quickly followed suit, triggering an explosion in credit derivatives activity. By December 1997, American banks had reported around $100 billion of such deals on their books. By the end of March 1998, that figure had grown to $148 billion in the US and was estimated to be about $300 billion globally, and J.P. Morgan alone accounted for $51 billion of that. The market for credit derivatives had grown overnight from a cottage industry into a bazaar where tens of
billions
of dollars of risk was changing hands.

Demchak’s team was both stunned and thrilled. When they had first dreamed up the scheme, they hadn’t expected it to be a gold mine of profits. Their intent was to fine-tune a bank’s exposure to risk in order to free up credit limit constraints and reserve capital. But as the idea spread, the team started to hope that these deals might generate quite substantial revenues from clients through hefty fees. The status and reputation of those associated with creating BISTRO soared, both inside and outside the bank. Masters was promoted to be the head of credit derivatives marketing. Andrew Feldstein was put in charge of high-yield loans. Demchak was handed responsibility for the entire credit division. Hancock rose, too: he was named both chief financial officer and chief risk officer for the entire bank, a post that put him in the running for CEO when Sandy Warner retired.

“The business opportunities created by credit derivatives, their relevance to clients, the size of the credit markets globally, and the gross in efficiencies in pricing and liquidity that exist are frankly staggering,” Masters said in a press interview in the summer of 1998. “The pace of change in the way banks manage credit risk has accelerated to a point where we can confidently predict credit risk management will be completely different in two years than it was even two years ago.”

Demchak had decided at an early stage that Masters would be the perfect “face” to sell the idea to the outside world. Some of her colleagues resented that, pointing out that the true flashes of inspiration had come from Feldstein, Demchak, or Varikooty. Masters herself sometimes worried about the risks of being in the spotlight. But nobody could deny that she was a highly effective marketer. “Blythe Masters still looks more like a J.P. Morgan intern (which she was ten years ago) than the head of the
credit derivatives marketing team,” one article said. “But it takes about a minute of conversation to learn that she possesses the knowledge and experience to lead the bank’s team…in overseeing the marketing of a $51 billion business.”

At other banks, such success would have led to huge bonuses and pay packages, whereas J.P. Morgan paid the team relatively modestly. In 1998, they were handed a set of bonuses that were high by the standards of the rest of the bank but low by comparison to rivals’. Most took home at least $500,000 of pay that year, and many received more than $1 million. Headhunters swarmed around the group, offering to double, triple, or quadruple that compensation if they would move. “There would be all these cars with headhunters just hanging outside the door,” Demchak later remembered. “Some even turned up with contracts from other banks, ready to sign.”

Almost nobody left; the team spirit was just too strong. By the summer of 1998, activity was so frenetic that the team was spending almost all their waking hours together, either hunched over their desks arranging deals or letting off steam at bars after long work hours. In other departments of the bank, there was a long-standing tradition that brokers would take traders out in the evenings to party. The credit derivatives group was so new that there was no such tradition, so the BISTRO group took themselves out, heading to Harry’s Bar or the Bull and Bear or Wall Street bars, or sometimes to Atlantic City for a wild night of gambling. On warm summer weekends they would head out to Long Island, where Masters and Demchak had each spent some of their swelling pay on beachfront houses. They were always
together
. “We just hung out 24/7. It was incredibly intense,” Terri Duhon later recalled. For some, the intensity took its toll on their family lives, prompting several divorces.

Inside the office, the team increasingly developed its own subculture. When they had a moment free from arranging deals, they would stage contests on the trading floor to see who could throw a Frisbee or a baseball farthest before a computer screen was hit. Once, Masters declared she wanted to celebrate “bow tie” day, so the team arrived wearing cheap, colorful ties, to the astonishment of the rest of the bank.

Pranks proliferated. One trader took to stripping down to his under
wear “to let the air in” after all-night sessions arranging deals. A salesman started nicknaming all his clients after famous soccer players in the bank’s internal sales reports. When the regulators suddenly visited one day and demanded to see the team’s books, Demchak had to explain why “David Beckham” was buying BISTRO notes on a massive scale.

Other divisions sometimes complained that the antics were getting out of hand, that Demchak was becoming “boorish” and the team was behaving like a frat house. Demchak brushed aside the complaints as sniping due to jealousy. He wasn’t worried; he knew his team was slavishly devoted to him, to Hancock, and, most important, to the mission of proving the revolutionary implications of credit derivatives. “Yes, it was a bit like a frat culture at times,” Demchak would later recall with a wistful smile. “But we had an amazing team spirit, it was just an amazing time. And, of course, we assumed it would last forever.”

The first sign that there might be a structural weakness in the architecture of the BISTRO idea emerged in the second half of 1998. During the early months of the year, Masters and Demchak repeatedly pestered regulators, trying to get a clear answer about the degree to which the bank would be able to cut its capital reserves by using the BISTRO scheme. They had conducted the first couple of deals without knowing for sure. After all, the bank had other, more fundamental reasons for wanting to reshape its credit risk, irrespective of any capital “win.” But when Demchak’s group started performing deals for other banks, the question of reserve capital became more important. The others wanted to do these deals primarily to cut their reserve requirements.

In 1996, when the Federal Reserve wrote its first formal letter to the banking community about credit derivatives, it warned that regulators would allow the banks to cut capital reserves only if they had
truly
removed the risk of loans from their books. Demchak and Masters decided to push the Fed and OCC about exactly what guidelines they would approve of for lowering capital reserves for bundles of credit derivatives, in respect not just to J.P. Morgan but to all the other banks, too.

The regulators were still unsure. When officials at the OCC and Fed
had first heard about credit derivatives, they had warmed to the idea that banks were trying to manage their risk. But they were also uneasy because the newfangled derivatives didn’t fit neatly under any existing regulations. They were particularly uncertain about what to make of the low level of funding available for covering losses on J.P. Morgan’s creation. The original BISTRO deal stipulated that if financial Armageddon ever did hit and wipe out all of the $700 million funding cushion, J.P. Morgan itself would absorb the additional losses. In the eyes of Masters and Demchak, that still meant that the bank had removed all the pieces of credit risk that actually mattered; the chance that losses would ever eat through $700 million were vanishingly slim. Effectively, there was no real risk, and no real liability. In any case, Hancock liked to argue, it was ridiculous to worry about the eventuality of massive defaults. If the corporate sector ever suffered a tidal wave of defaults large enough to eat through the $700 million funding cushion, then the disaster probably would have already wiped out half the banking system anyway. There was no point, he argued, in running a bank on the assumption that the financial equivalent of an asteroid would devastate Wall Street.

That argument didn’t wash with European regulators. Officials at the Fed were uneasy, too. Christine Cumming, a senior Fed official, indicated to Masters and Demchak that the J.P. Morgan team should look for a way to remove or insure the amount of risk that was unfunded in the BISTRO scheme if they wished to get capital relief.

So Masters and the rest of the team set out to find a solution. They started by giving that bundle of risk a name. They had never referred to that portion of the risk pool in any standard way. Masters liked to refer to it as “more than triple-A,” since it was deemed even safer than triple-A-rated notes. But that was too clumsy to market. So they came up with the name “super-senior.” The next step was to explore who, if anyone, would want to either buy or insure it.

The task didn’t look easy. As Masters said later, “There were just not that many natural buyers,” because the payoff for taking it on would be relatively low. As far as the bank was concerned, this risk was not really at all risky, so there was absolutely no point in paying anything other than a token amount to get it insured. On top of that, whoever stepped
up to acquire or insure the super-senior risk had to be brave enough to step into an unfamiliar world.

Masters eventually spotted one solution to the super-senior headache. In previous decades, one of J.P. Morgan’s long-standing, blue-chip clients had been the mighty insurance company American International Group. Like J.P. Morgan itself, AIG was a pillar of the American financial establishment. The insurer had risen to prominence by building a formidable franchise in the Asian markets during the early part of the twentieth century. That business was later extended in the US, making the company a powerful force in the American economy after the Second World War. AIG was considered a hefty but utterly reliable market player, and, like J.P. Morgan, it basked in the luxury of a triple-A credit rating.

But within AIG, an entrepreneurial upstart subsidiary was booming. In the late 1980s, the company hired a group of traders who had previously worked for Drexel Burnham Lambert, which had infamously developed the junk bond business under the leadership of Michael Milken in the mid-1980s, before it blew up. They had been tasked by AIG with developing a capital-markets business, known as AIG Financial Products, which was based in London, where the regulatory regime was less restrictive. This was run by Joseph Cassano, a tough-talking trader from Brooklyn.

Cassano was creative, bold, and highly ambitious. More important, AIG, as an insurance company, was not subject to the same burdensome capital reserve requirements as banks. That meant AIG would not need to post capital reserves if it insured the super-senior risk. Nor was the insurer even likely to face hard questions from its own regulators, because, though AIG’s insurance arms were regulated by state-level insurance groups, AIGFP had largely fallen through the cracks of oversight. It was regulated by the Office of Thrift Supervision, but OTS officials had only limited expertise in the field of cutting-edge financial products.

Masters pitched to Cassano that AIG take over J.P. Morgan’s super-senior risk, either in the form of a purchase of securities or by simply
signing credit derivatives contracts that would insure Morgan against any loss. Cassano happily agreed. It was a “watershed event,” or so Cassano later observed. “J.P. Morgan came to us, who were somebody we worked with a great deal, and asked us to participate in some of what they called BISTRO trades [which] were the precursors to what [became] the CDO market.” It seemed good business for AIG.

AIG would earn a relatively paltry fee for providing this service, of just 0.02 cent on the dollar each year. But, that said, if 0.02 cent is multiplied a few billion times, that adds up to quite an appreciable income stream, particularly if no reserves are required to cover the risk. Once again, the magic of derivatives had produced a “win-win” solution. Only many years later did it become clear that Cassano’s trade set AIG on the path to near ruin.

With the AIG deal in hand, the team returned to the regulators and pointed out that a way had been found to remove the rest of the credit risk from their BISTRO deals. Then the group started plotting other sales of its super-senior risk, to other insurance and reinsurance companies. The insurance companies snapped it up, not just from J.P. Morgan but from other banks, too.

Then, ironically, just as this business was taking off, the regulators weighed in again. Officials at the OCC and the Fed indicated to J.P. Morgan that after due reflection they thought that banks did
not
need to remove super-senior risk from their books after all. The lobbying by Masters and others had seemingly paid off. The regulators were not willing to let the banks get off scot-free; if they held the super-senior risk on their books, they would need to post reserves worth 20 percent of the usual capital reserves (or 20 percent of 8 percent, meaning $1.60 for every $100 that lay on the books). There were also some conditions.