Last Man Standing (32 page)

The media responded to the message, at least in part. In April,
Fortune
magazine’s authority on Dimon, Shawn Tully, wrote a cover story headlined “The Toughest Guy on Wall Street” that extolled the virtues of a certain kind of anal micromanagement. In the article Steve Black pointed out, “He jumps into the decision-making process. If you just want to run your business on your own and report results, you won’t like working for Jamie.” (Inside JPMorgan Chase, there were snickers at the suggestion that Dimon was really all that tough. “My secretary wouldn’t stop giggling about it,” he recalls.)
Time
magazine followed up by putting him on its 2006 “
Time
100” list of the world’s most influential people.

(On balance, the coverage of Dimon in the press over the years has been overwhelmingly positive—the
Wall Street Journal
has called him “reliably quotable.” That’s due in large part to the fact that reporters find his candor refreshing. “When I talk to the press, I may not answer
all their questions,” he says, “but I’m accessible. I may tell them that something is none of their business or that it’s privileged information. But one thing I don’t do is lie to them.”)

Analysts and investors, however, weren’t quite so jazzed by the company’s cautious tilt. The chief financial officer, Mike Cavanagh, recalls being harangued by investors demanding a reason why they should bother with JPMorgan Chase stock when they could own “best-in-class” competitors like Goldman Sachs in investment banking or American Express in credit cards—companies that were two to three times as leveraged as JPMorgan Chase. And analysts were losing interest in merely watching costs go down. They craved big news, like an acquisition or significant gains in market share. “He told us to expect big progress in 2005,” the CIBC analyst Meredith Whitney told
Fortune
. “Now we won’t see major improvements until 2007.”

JPMorgan Chase’s quarterly calls became known for their regularity. The presentations to investors, used during quarterly conference calls, have been largely the same since the beginning of 2006, right down to the fonts and colors used to highlight the company’s results. Mike Cavanagh, who presents the company’s financial results along with Dimon, admits that little effort is put into making them entertaining. “The routine is nice and boring,” he says. “The information isn’t boring but the way we go about it is painfully monotonous, even to me. We set up the presentation so people can compare profits brutally to natural competitors in each of our businesses. It causes us to need to fall on our sword when it’s obvious that the numbers say so. We’re not trying to figure out how to tell the story differently every three months.”

Still, the company’s stock was stuck in neutral, while other firms’ stocks were on the move. From the beginning of 2005 through mid-2006, JPMorgan Chase shares rose just 7.7 percent, while Goldman’s had rocketed 44.6 percent. Shares of Morgan Stanley were up 13.8 percent, while Wells Fargo—which could claim no “Dimon effect”—had edged out JPMorgan Chase with a 7.9 percent gain. Wall Street was bored with Jamie Dimon.

• • •

By the fall of 2006, the U.S. housing and mortgage markets had gone off the rails, but Wall Street seemed not to notice or care, shrugging off some analysts’ warnings of impending disaster. The bull market in real estate had essentially unshackled itself from the underlying reality. No one wanted to hear the bad news, so few did.

Much of Wall Street, in fact, doubled down just as the real estate market was reaching its peak. In September 2006, Merrill Lynch paid $1.3 billion to buy the subprime lender First Franklin Financial. A month before, Morgan Stanley had spent $706 million for Saxon Capital, another subprime lender. Subprime loans had risen from $145 billion annually in 2001 to $625 billion in 2005, accounting for 20 percent of all issuance. Wall Street was paying little attention to where loans came from—firms just wanted the raw material for their mortgage securitization assembly lines.

In the summer of 2004, Bill Winters had persuaded Dimon to unload a so-called structured investment vehicle (SIV) that had come onto the company’s balance sheet as part of the Bank One deal. (Despite his skill at micromanagement, Dimon had apparently not noticed this potentially explosive asset.) Essentially arbitrage vehicles that borrow short-term to finance investments in longer-term debt—including mortgage and bank securities—SIVs were, in times of easy credit, perfect fee generators for banks, which typically managed them for investors. Banks held these entities off their balance sheets, since they were not technically the owners of the assets themselves. But should credit ever become scarce, as it inevitably does in a slowing economy, they could be obligated to step in and cover losses.

Winters helped Dimon to realize that the fees didn’t offer a high enough return to offset the implied risk, and they unloaded the sole SIV, worth $8 billion, that sat on their books to the London-based bank Standard Chartered. “We sold it to someone who thought the best way to manage the risk was to take on twice as much of it. Scale is the answer every time except in the tail,” Winters later said, referring to how concentrated risks in SIVs worked out just fine until they instantaneously blew up in their sponsors’ faces. Citigroup, true to form, was moving in the other direction, piling into SIVs just as JPMorgan Chase pulled out.
Winters also reduced the credit lines the bank was extending to other banks’ SIVs from $12 billion to $500 million.

With regard to structured products, Winters was no neophyte. He had been part of the J.P. Morgan team that had revolutionized credit derivatives in the late 1990s. The first innovation came to be known as a “credit default swap” (CDS). In looking for a way to reduce exposure to their client Exxon—which had recently tapped a multibillion-dollar credit line with the bank in anticipation of having to pay substantial fines for the
Exxon Valdez
’s oil spill—Winters’s colleague Blythe Masters had found another investor willing to insure the debt for the bank in exchange for an annual fee. In the process, J.P. Morgan was able to reduce its exposure to Exxon without having to sell the loan, thereby keeping client relations strong. (No corporate borrowers want to see their bank unloading their loans.) It was nothing short of revolutionary. What the J.P. Morgan team had done, writes Gillian Tett in
Fool’s Gold
, was to “overturn one of the fundamental rules of banking: that default risk is an inevitable liability of the business.”

The Federal Reserve later ruled that banks could reduce the required level of capital reserves by using credit derivatives. From that point, it was clear that there would be no shortage of buyers of CDS. Nearly every bank in existence had loans it would like to get off its books. There would surely be no shortage of sellers, either, whether these sellers were hedge funds making outright bets or insurance companies thinking their expertise in traditional forms of insurance could easily extend into the realm of credit.

To turbocharge the market for credit derivatives, the J.P. Morgan team eventually created a product called a broad index secured trust offering (BISTRO). Complex in its details and accounting, the product was nevertheless simple in essence—it aggregated the odds of default on a whole package of loans, not just on a single credit. Collateralized debt packages had long been around, but BISTRO represented a whole new segment—synthetic collateralized debt obligations (CDOs). Wall Street has an endless ability to slice and dice, though; and as soon as it was created, BISTRO was separated into various “tranches” that carried different levels of risk and return. Investors in the junior tranche would eat
the first losses due to any defaults, and therefore earn the highest return. The mezzanine tranche came next, and after that was the senior tranche.

The credit rating agencies agreed that the different tranches deserved different credit ratings, and convinced themselves that even if a CDO was made up of low-rated credits, the senior tranche might actually have a higher rating than any of the individual loans. Even if every single credit in the CDO had a 30 percent risk of default, the thinking went, the odds that most of them would default at once were arguably infinitesimal. If you held the senior tranche, therefore, you were actually holding something whose probability of default was less than 30 percent. Thus, it had a higher rating.

Although both rating agencies and investment banks were pilloried in 2007 and 2008 for what was eventually reduced to a joke about filling a bag with crap and calling it gold, the intellectual argument behind the tranche ratings wasn’t dishonest or entirely flawed. It just failed to properly take into account the low-probability scenario in which most of the loans
did
default at once. And it’s not as if bankers weren’t aware of the possibility. Because J.P. Morgan had agreed to step in and guarantee BISTRO in the event that its funding was wiped out in some sort of über-default, they gave
that
risk its own name—super-senior. Better yet, they found a buyer of that risk (or, more precisely, a seller of insurance against it)—the insurance giant AIG. Joseph Cassano, head of a unit called AIG Financial Products, figured he was getting something for nothing with the transaction. It was like selling insurance against the end of the world. Why not take the money now, especially considering that if the end did come, you probably wouldn’t be around to have to pay the bill anyway? A decade later, AIG would pay a colossal price for Cassano’s cynicism.

(What Cassano and many others missed was the auto-synchronous relationship of many loans. Buy 12 different loans, and you’re pretty diversified. In principle, this is true. Unless, that is, those loans are all mortgages for houses sitting next to each other on a beach in Charleston, South Carolina. One strong hurricane, and the portfolio would be decimated. And the global real estate crisis hit like the mother of all hurricanes.)

Although the company occasionally kept a portion of that hived-off risk on its own books, the members of the BISTRO team considered themselves financial intermediaries as opposed to investors in the product itself. They saw it as a way to reduce their corporate lending risk, as opposed to taking on more. As the author of
Fool’s Gold
, Gillian Tett, pointed out in the
Financial Times
, however, Wall Street turned the product inside out. “As often occurs with Wall Street alchemy, a good idea started to be misused—and a product initially devised to insulate against risk soon morphed into a device that actually concentrated dangers.” Money was still cheap in the first half of the decade, and investors were clamoring for higher yields. Wall Street responded by creating newer flavors of synthetic CDOs that added leverage and delved into riskier asset classes, including subprime mortgages. The only conceivable problem for investment banks was that tranches for which they couldn’t find a buyer had to be held in inventory.

Demand for synthetic CDO product was so high that the yields on these newer, far riskier structures were pushed downward, raising doubts about whether the market was properly pricing the risk. That was especially the case, as a pioneer in collateralized mortgages, Lewis Ranieri, told
The New Yorker
in 2008, because by this point banks were lending to almost anyone who wanted to borrow, to buy whatever house they wanted, for no money down, no matter what their financial wherewithal. “They had created the perfect loan,” said Ranieri. “They didn’t know what the home was worth, they didn’t know what the borrower earned, and the borrower wasn’t putting any money into the purchase. The system had gone completely nuts.”

By late 2006, Winters had concluded that it was no longer worth the risk to underwrite or hold any such product on the company’s books. At the time, CDOs were yielding just 2 percentage points more than Treasuries. To hedge the CDO risk, JPMorgan Chase needed to buy credit default swaps, but the cost of those was rising. (In this, at least, the market was getting it right. Investors in CDOs might be taking too little yield, but sellers of insurance on those CDOs were starting to demand more money, even though it ultimately proved to be nowhere near enough.) Winters had no problem convincing Dimon of his concerns,
and the bank began to pull back from all asset-backed CDO underwriting, while also selling the majority of subprime mortgages originated by the bank during the year. “I’d love to say we saw what was coming,” Winters later said, referring to the housing collapse that crushed the value of these securities. “But that would be a lie. We just couldn’t see the return in them.”

Merrill Lynch’s CEO Stan O’Neal, among others, disagreed, and revved up his firm’s production of the complex securities. In 2006, Merrill underwrote $44 billion in CDOs, three times its 2004 output, collecting $700 million in fees. It created another $31 billion in 2007. O’Neal had personally intervened to set the company on this course, providing all the necessary capital to take the firm from fifteenth place in CDO underwriting in 2003 to first place in 2005. In mid-2006, he fired three executives who had warned that the firm was becoming dangerously overexposed in CDOs.

Wall Street firms issued $178 billion in mortgage- and asset-backed CDOs in 2005 and almost twice that in 2006. They effectively overstuffed the pipeline, and an increasing volume of the securities stayed in-house. At first, that didn’t worry executives such as O’Neal. The idea that Wall Street functioned merely as intermediary was officially out the window. Wall Street firms were acting like drug dealers who forgot the cardinal rule of the trade: don’t start taking the junk yourself. By mid-2007, Merrill owned more than $32 billion worth of CDOs.

In keeping only the highest-rated portions of the CDOs on their books, Wall Street executives looked at it as the perfect double-dip: fees for underwriting and profits from owning the least risky component of a package of debts—the probability that everything would default at once. Most of the stuff they kept on their books was AAA-rated, top-notch stuff, as good as the debt of Johnson & Johnson or General Electric. The world would have to come to an end before the strategy backfired. This was an echo of the flawed perspective at Long-Term Capital Management in the late 1990s. “The source of the trouble seemed so small, so laughably remote, as to be insignificant,” Roger Lowenstein wrote about LTCM in
When Genius Failed
. “But isn’t that always the way?”