Authors: Gillian Tett
Demchak, Feldstein, and the other so-called Heritage Morgan bankers were furious at the scale of mismanagement. Time and again, Demchak had warned of the need to diversify the risk from Chase loans, and that advice had been roundly rejected. He could take scant comfort now in knowing he had been proven right.
Demchak and his former J.P. Morgan colleagues mused about the bitter irony of it all. If they had just managed to stay independent for a few more months, the share price of Chase would have crashed. Events would have turned out quite differently. They felt as if the fates were laughing at them. But even as they reeled from the carnage, the innovation cycle was about to heat up again, and with the wonders of dot-coms soundly repudiated, attention would turn anew to the marvelous potential of credit derivatives and other forms of financial innovation.
On January 3, 2001, the US Federal Reserve suddenly announced a 50-basis-point cut in interest rates, reducing them to 6 percent. That news stunned the markets almost as much as the internet collapse. In the prior eight years, Alan Greenspan had made a virtue out of running monetary policy in a calm, controlled manner, decreasing rates steadily but slowly at just 25 basis points a shot. This gradualist approach was said to mitigate volatility.
Greenspan was convinced, though, that the collapse of the internet bubble required a forceful response. Back in late 1989 and 1990, when the US economy had suffered a similar downturn, he had stuck to mea
sured, slow rate cuts, and they had turned out to be too little, too late. The economy had sunk into a recession. He was determined to avoid that mistake this time around.
A few weeks after that first dramatic rate cut, Greenspan reduced rates again, and in the following months, he kept steadily cutting. When the attack on the World Trade Center sent the markets into a tailspin, he cut rates even further. By 2003, the prime rate was just 1 percent, its lowest level for many decades.
The policy worked, and worries of a recession abated, though the crash had wiped out $5 trillion in the market value of technology companies between March 2000 and October 2002. By 2003, the mainstream economy was rebounding. In stark contrast to the bursting of the savings and loan bubble, no European or American institution actually collapsed from its losses. Greenspan and other policy makers partly attributed that to the fact that so many banks were using credit derivatives to spread their risk around. Unsurprisingly, the J.P. Morgan bankers agreed. “Credit derivatives are a mechanism for transferring risk efficiently around the system,” Tim Frost cheerfully told journalists, noting that defaulted loans that would have knocked a hole in a bank’s balance sheet ten years ago were “now hits that we have spread around the system, and represent tiny blips on the balance sheets of hundreds of financial institutions.”
Indeed, as bankers and investors processed the lessons from the internet crash, credit derivatives began to look more and more appealing. So, just as bankers in the early 1990s had responded to falling interest rates by producing more complex and leveraged derivatives products, they now began searching for a new round of more complex credit ideas.
Investor attention was also drawn to another sector. The real estate world—unlike the corporate sector—was relatively unscathed by the internet bust. On the contrary, the low interest rates Greenspan had instituted had given the housing market quite a boost, as mortgages became less and less expensive. Unbeknownst to the J.P. Morgan bankers, and against their better judgment, these two booming businesses of mortgages and derivatives were about to become fatefully intertwined.
T
he onset of the new decade unleashed a new era of credit. Alan Greenspan’s lowering of interest rates prompted an explosion of borrowing by both businesses and consumers. The boom was particularly pronounced in the housing market, as mortgages became ever more affordable. Even as the stock market tumbled, the credit market had kicked into overdrive, and it was becoming clear that the new action in investing was on the credit side of the business,
not
in equities.
In the early years of the decade, many banks threw themselves more aggressively into the credit derivatives business, which translated into greatly increased competition for the JPMorgan Chase team. It also opened up tantalizing opportunities for other employment even as the frustrations of the merger grew more dispiriting. The bank remained plagued by its Noah’s ark bureaucracy and vicious internal fights. Moreover, so many bad loans made to internet companies were plaguing the bank’s balance sheet that Demchak and his group could clearly see the bank was heading for a grim few years in which profits would be squeezed as political scandals mounted. “This is just no fun anymore,” Demchak remarked regularly to his colleagues.
Despite all the larger bank’s setbacks, though, and the growing frustrations, the team continued to rack up strong profits. In the middle of 2001, Demchak was told he would be promoted. In addition to running global credit, he was told, he would be given responsibility for derivatives and the commodities section, making him one of the most senior investment bankers in New York. But to the shock of his team, the very day
after he was offered his new job, he tendered his resignation. “I just cannot do this anymore!” he declared. When the team heard the news, some of them cried, not only because Demchak was leaving but because they knew his departure also spelled the end of their remarkable run together. The team would never be the same without him.
Demchak was immediately approached by rival banks that were building their derivatives groups. Goldman Sachs was particularly persistent. But Demchak felt too exhausted and disenchanted to move right away to another bank. He also had no burning
need
to work; the value of stock held by managers of the J.P. Morgan side of the bank had surged with the merger. So for a while Demchak dreamed of dropping out of finance to fulfill a long-standing desire to train to become a boat builder. He traveled to the coast of Maine, finding it therapeutic to work with wood and traditional tools and to hang out with craftsmen who knew nothing about credit derivatives and cared less. In time, he persuaded some of them to decamp from Maine to the Hamptons, where Demchak had a house.
In due course, Demchak toyed with the idea of joining a hedge fund or a private equity group, but he decided he simply didn’t want to spend so much of his time staring at a computer screen again. Eventually, in 2002, he accepted an offer from PNC, the Pittsburgh-based lender, becoming vice chairman. Far from the glamour of Wall Street and the esoteric world of high finance, PNC afforded Demchak the chance to return to his Pittsburgh roots.
The offer was also alluring because the bank was badly in need of Demchak’s particular skills in managing risk. When the internet bubble burst, PNC had almost imploded from losses, and it desperately needed to remodel its balance sheet and credit portfolio to reduce its risk burden. That was music to Demchak’s ears. PNC’s balance sheet was tiny compared to J.P. Morgan’s, but it was large enough to offer plenty of challenge, and Demchak was being given the chance to apply all his theories about credit management just as he saw fit, with no internal bureaucratic fighting required. Managers at the Pittsburgh bank were hungry for his ideas on loan portfolio management, and Demchak was keen to get it right, third time around. The bruising fights from earlier years had taught
him some painful lessons. By 2002 he was wiser when dealing with critics and less ideological in propounding his views. The former Prince of Darkness had matured. Better still, he was able to take a number of his beloved team with him. Krishna Varikooty was keen to follow him, for one. Back at JPMorgan Chase, once Demchak had decamped, the rest of his team quickly followed suit. Like pollen seeds, the former team scattered across the financial world, implanting their ideas into dozens of firms. Terri Duhon was lured away to ABN AMRO; while Betsy Gile, the credit manager, joined Deutsche Bank, where she helped to remodel the German bank’s credit portfolio. Romita Shetty, the Indian banker, went first to Royal Bank of Scotland and then to Lehman Brothers.
A number of the team either started or joined investment funds. Andrew Feldstein left to launch a hedge fund. Over in London, Tim Frost became a partner in the investment fund Cairn Capital. Jonathan Laredo, a credit analyst in London, joined another fund, called Solent, and Charles Pardue created Prytania, a consultancy and fund.
Hedge funds hadn’t played much in the credit sphere before, but the credit derivatives explosion was creating a host of new trading opportunities that they began to find attractive. “The good thing about the credit markets at the moment is that they are liquid enough to trade, but not so evolved that there are no [price] inefficiencies,” Feldstein observed after setting up his fund. Hedge funds thrive on exploiting such discrepancies in the market’s pricing of assets. “Hedge funds are becoming so big in the credit derivatives sphere now that it is fair to say that the torch of innovation is being passed from the banks to the funds,” observed Frost around the same time. “In many ways, funds are now more innovative than banks.”
Those members of the old team who stayed at the bank maintained a brave face. One of the loyalists was Blythe Masters, who was given control of credit policy after Demchak left. Another was Bill Winters, who continued to quietly run his trading empire in London. Tony Best and Jakob Stott, two former swaps traders who were allies of Winters, also stayed on. They tried to shrug off the exodus, denying that the bank was losing steam. “We can promote outstanding people quickly here. That is what supports the business when people decide to leave—these very
smart young people coming through,” Best observed. But there was no denying that as the brain drain accelerated, morale sagged. Making matters worse, competition had turned so fierce that J.P. Morgan was no longer the undisputed king of the credit derivatives market.
Innovation was on fire around the financial world. “While J.P. Morgan has [been dealing] with these departures, the wider structured credit market has positively thrived as a result,” specialist financial magazine
Euroweek
reported. “It is unlikely that the sector would have grown at such a pace had it not been for the sheer number of ex-Morgan market participants that are now employed elsewhere.”
Goldman Sachs was quick out of the gate in developing a formidable credit derivatives business, and other leading brokerages, such as Morgan Stanley and Lehman Brothers, also joined the game with gusto. Most startling of all, jumping into the credit game was Deutsche Bank, which burst onto the scene from a standing start.
Traditionally, Deutsche was a large, stodgy commercial bank. But in the mid-1990s it formulated ambitious plans for becoming a major player in the international investment banking world. It hired teams of derivatives and bond traders from Merrill Lynch, acquired the operations of Bankers Trust, which had been at the forefront of derivatives innovation in the 1980s and early 1990s, and set out to build a preeminent platform in financial engineering in both New York and London. Derivatives were a prime focus. While the American bond and equity markets were so dominated by giant Wall Street banks that Deutsche would have had trouble breaking into that turf, the derivatives business was so new that it offered plenty of opportunity for outsiders.
Deutsche’s derivatives team hired many smart traders from other banks, including several from the J.P. Morgan team. Marcus Schüler, a highly visible salesman who had worked with Tim Frost in London, and Demchak acolyte Betsy Gile both moved to Deutsche. The bank then invested impressive resources to grab a big position in the commoditized business of trading CDS. It paid off quickly.
In 2003,
Risk
magazine designated Deutsche Bank the “Derivatives House of the Year,” knocking J.P. Morgan from that perch. Some Morgan staff started referring to Deutsche Bank as “enemy number one.”
Lehman Brothers, Citigroup, Bear Stearns, Credit Suisse, UBS, and Royal Bank of Scotland all also fiercely ratcheted up their derivatives operations. Not only was the competition demanding that they become more aggressive, but low yields on the more traditional credit investments were fueling the drive for higher returns. Yields on 10-year government bonds had dropped from 6 percent at the start of the decade to under 4 percent by 2002. Thirty years earlier, American pension funds had generally made easy money by investing in those bonds, which paid yields of around 9 percent a year while the funds were expected to deliver returns of only around 4 percent to 5 percent. Pension funds were now targeting higher returns even as the yield on bonds had fallen. Fund managers, and investors generally, were frantically looking for ways to boost profits, and that forced yet another turn of the innovation cycle. Banks devised a host of new tricks for offering investors better returns, which invariably revolved around creating products that employed more leverage, as well as more complexity and risk. The freewheeling experimentation centered on repackaging various credit into investment offerings, using either derivatives or bonds or a combination of the two.
By early 2001, the first generation of BISTRO deals had evolved into a class of standardized products widely referred to as “synthetic collateralized debt obligations.” A particularly popular variation on the BISTRO theme was known as “single-tranche CDOs.” These were essentially bundles of debt that were sold to a shell company, as with the BISTRO scheme, but then the company offered only
one
class of notes as opposed to junior, mezzanine, and senior. This meant that more of the risk of the loan bundles was retained on the shell company’s books, not just the super-senior risk.
In 2002 and 2003, single-tranche CDOs became all the rage. But insatiable investors quickly began demanding even better ways to juice up returns, so the banks produced a new twist on the CDO idea called a “CDO squared.” This was essentially a CDO
of
CDOs. In this scheme, rather than the shell company purchasing a bundle of loans, it would purchase pieces of debt issued by
other
CDOs and then issue new CDO notes. Typically, they would purchase only the riskiest notes from the other CDOs, because doing so allowed them to offer higher
returns. Those investments were more dangerous for investors, but no matter. CDO squared offerings became wildly popular. “The product development now is incredibly fast,” observed Katrien van Acoleyen, an analyst from Standard & Poor’s. “People are trying to put all different types of underlying assets into these structures—asset-backed securities, emerging-market debt, or mortgages…now there are even people talking about creating a CDO cubed (or a CDO of CDOs of CDOs).” The crucial goal of all this complexity was to create more leverage and thus more potential return.
Around the turn of the century, Robert Reoch, one of the former J.P. Morgan derivatives bankers from Winters’s team in London, was standing in the canteen at Bank of America when he noticed a striking thing. Reoch had joined Bank of America a couple of years earlier. Like many others, it was eager to expand into the credit derivatives world. As Reoch stood in the lunch queue, while visiting the Chicago branch of the bank, he bumped into some bankers from the mortgage department. Until then the two groups had had only limited contact at BoA or anywhere else. Derivatives traders viewed themselves as a different breed of financial animal from financiers working in the mortgage world, and vice versa. When Reoch exchanged pleasantries with his mortgage colleagues at the canteen, though, he saw they were holding diagrams that looked akin to those he also used in relation to corporate credit derivatives. A “bingo moment” took place, as he later observed: both teams suddenly realized it made sense to collaborate with each other, since they were playing around with closely related concepts.
Similar intellectual collisions were quietly occurring all over the American financial world. Ever since the 1970s, bankers had used mortgages to create bonds or bundles of debt, later known as CDOs. By the dawn of the new decade, though, this activity became dramatically more intense and mingled with other fields of finance, including credit derivatives.
The American housing market had benefited hugely from the low interest rates Alan Greenspan was holding to, and the rapidly mounting
piles of mortgage loans were fertile fodder for the CDO machine. This was especially true because so many of the new mortgages were relatively high risk, which allowed the banks to offer extremely attractive returns.
During the 1990s, CDOs had been constructed only out of “conforming” mortgages, meaning those that conformed to the high credit standards imposed by federal-government-backed housing giants Fannie Mae and Freddie Mac. That was in part because only a few lenders had been willing to extend mortgage loans to households that didn’t comply with the Fannie and Freddie standards. In the late 1990s, though, a swath of new mortgage lenders and brokers entered the field who specialized in offering “nonconforming” mortgages, more commonly called “subprime.” Loans were increasingly extended to borrowers with bad credit history. As more and more brokers jumped in, a free-for-all developed with the new players extending vast quantities of loans, on whatever terms they wished, without much government oversight, let alone control. In 2000, the amount of nonconforming mortgage bonds that were sold was tiny, running at a mere $80 billion, or less than a tenth of all mortgage bonds. By 2005, sales of nonconforming mortgage bonds hit $800 billion. Remarkably, that meant that almost half of all mortgage-linked bonds in America that year were based on subprime loans.