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Rewriting the rules on corporate world greed
By Paul M. Barrett |
June 21, 2009, Sunday
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Print Edition
Print Edition
TO understand the calamity on Wall Street, we need erudite financial analysis and good old-fashioned stories about human fallibility. Gillian Tett, who oversees global market coverage for The Financial Times newspaper, offers some of each. In "Fool's Gold," she describes how a small group of bankers at J.P. Morgan built a monster that got out of control and helped destroy much of their industry. Tett's tale doesn't explain all of the recent mayhem, but it is one place to start.
She shows the financial world through the eyes of her talented but short-sighted subjects: geniuses at math and marketing, they thought they had discovered how to defy the laws of nature. The old rules didn't apply.
Beginning in the mid-1990s, the wizards at Morgan decided they could defeat the banker's oldest foe -- the danger that borrowers will not repay their loans. If that sounds as audacious as bringing the dead to life, it's not far off. The Morgan team thought they could combine esoteric financial instruments so cleverly that repayment risk would simply disappear, or at least become so diluted to no longer matter. Relieved of risk, banks would lend more money, corporations would grow more quickly and capitalism would blossom.
Accomplishing this "bold dream," as Tett puts it, required arduous toil in the financial laboratory -- accompanied, at times, by after-hours antics of "Animal House" proportions. The author excels at recreating this fevered environment. She also deciphers Wall Street mumbo-jumbo in terms that a determined lay reader can understand.
The Morgan bankers assembled innovative amalgams of what are known as credit derivatives. In its simplest form, a credit derivative is a contract between two parties in which the seller agrees to compensate the buyer if a loan goes into default. Used conservatively, a derivative can provide a hedge against risk. Bank A, worried about a loan it has made, strikes a derivative deal to pay a fee to Bank B in exchange for Bank B's promise to compensate Bank A if the loan sours. Bank A sheds some of the uncertainty related to its loan and feels emboldened to make fresh loans. Bank B assumes some of the risk but immediately enjoys the fee income. It's "win-win" as the Morgan bankers told themselves and anyone listened.
They went on to combine the derivatives with a process called securitization, which traditionally involved lenders selling their loans to an investment bank. The bank "bundled" the loans together and sold pieces to pension funds and investors. The original lenders, having off-loaded loans, could make new ones. Investors acquired a slice of the loan bundle and its interest income without going to the trouble of meeting or assessing borrowers. Win-win, again.
The Morgan group broke new ground by securitizing not just loans but credit derivatives. They industrialized the procedure, selling securitized debt and derivatives on an extraordinary scale. It got very, very complicated.
The intricacy itself appealed to the Morgan bankers, as did the magical idea of dispersing risk to investors far and wide so that lenders could lend without hesitation. The author introduces characters like the evocatively named Blythe Masters, a pretty blond British woman with a "BBC accent," an economics degree from Cambridge and fervor for credit derivatives. "I think these products appealed to me because I had a quantitative background," Masters told Tett, "but they are also so creative."
Masters became the alluring public face for Morgan's derivative "products," marketing them to clients impressed by the concept that risk could vanish. Channeling Masters, Tett writes: "For the first time in history, banks would be able to make loans without carrying all, or perhaps even any, of the risk involved themselves.
That would, in turn, free up banks to make more loans, as they wouldn't need to take losses if those loans defaulted." By now, you must be seeing the too-good-to-be-true aspect to all this.
Morgan exercised some restraint in imbibing the derivatives potion it peddled to others. That's one reason that, years later, it is one of the survivors on Wall Street.
Tett notes, however, that Morgan provided key manpower and initiative in a ferocious Wall Street lobbying campaign that persuaded Congress, the Securities and Exchange Commission, and the Clinton and Bush administrations to back off from regulating derivatives trading in any meaningful way to protect customers.
She shows the financial world through the eyes of her talented but short-sighted subjects: geniuses at math and marketing, they thought they had discovered how to defy the laws of nature. The old rules didn't apply.
Beginning in the mid-1990s, the wizards at Morgan decided they could defeat the banker's oldest foe -- the danger that borrowers will not repay their loans. If that sounds as audacious as bringing the dead to life, it's not far off. The Morgan team thought they could combine esoteric financial instruments so cleverly that repayment risk would simply disappear, or at least become so diluted to no longer matter. Relieved of risk, banks would lend more money, corporations would grow more quickly and capitalism would blossom.
Accomplishing this "bold dream," as Tett puts it, required arduous toil in the financial laboratory -- accompanied, at times, by after-hours antics of "Animal House" proportions. The author excels at recreating this fevered environment. She also deciphers Wall Street mumbo-jumbo in terms that a determined lay reader can understand.
The Morgan bankers assembled innovative amalgams of what are known as credit derivatives. In its simplest form, a credit derivative is a contract between two parties in which the seller agrees to compensate the buyer if a loan goes into default. Used conservatively, a derivative can provide a hedge against risk. Bank A, worried about a loan it has made, strikes a derivative deal to pay a fee to Bank B in exchange for Bank B's promise to compensate Bank A if the loan sours. Bank A sheds some of the uncertainty related to its loan and feels emboldened to make fresh loans. Bank B assumes some of the risk but immediately enjoys the fee income. It's "win-win" as the Morgan bankers told themselves and anyone listened.
They went on to combine the derivatives with a process called securitization, which traditionally involved lenders selling their loans to an investment bank. The bank "bundled" the loans together and sold pieces to pension funds and investors. The original lenders, having off-loaded loans, could make new ones. Investors acquired a slice of the loan bundle and its interest income without going to the trouble of meeting or assessing borrowers. Win-win, again.
The Morgan group broke new ground by securitizing not just loans but credit derivatives. They industrialized the procedure, selling securitized debt and derivatives on an extraordinary scale. It got very, very complicated.
The intricacy itself appealed to the Morgan bankers, as did the magical idea of dispersing risk to investors far and wide so that lenders could lend without hesitation. The author introduces characters like the evocatively named Blythe Masters, a pretty blond British woman with a "BBC accent," an economics degree from Cambridge and fervor for credit derivatives. "I think these products appealed to me because I had a quantitative background," Masters told Tett, "but they are also so creative."
Masters became the alluring public face for Morgan's derivative "products," marketing them to clients impressed by the concept that risk could vanish. Channeling Masters, Tett writes: "For the first time in history, banks would be able to make loans without carrying all, or perhaps even any, of the risk involved themselves.
That would, in turn, free up banks to make more loans, as they wouldn't need to take losses if those loans defaulted." By now, you must be seeing the too-good-to-be-true aspect to all this.
Morgan exercised some restraint in imbibing the derivatives potion it peddled to others. That's one reason that, years later, it is one of the survivors on Wall Street.
Tett notes, however, that Morgan provided key manpower and initiative in a ferocious Wall Street lobbying campaign that persuaded Congress, the Securities and Exchange Commission, and the Clinton and Bush administrations to back off from regulating derivatives trading in any meaningful way to protect customers.
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