In the Light of What We Know (38 page)

As I think about this lack of understanding, I am reminded of something Zafar said concerning the teaching of mathematics in schools; it was an obvious point, so obvious I was left wondering why it had never occurred to me, who had also studied mathematics. One bad maths teacher, he explained, can wreak havoc. A bad history teacher, when you’re twelve years old, say, might mean you don’t acquire a very good grasp of the First World War or the Potsdam Conference. It leaves a hole in your education. The next year, you manage. The early deficiency doesn’t hinder you very much when you later study the Russian Revolution, not in those years when you’re not studying any of these things in any great depth anyway. But mathematics is different. If you fail to digest the material prescribed for that year, then everything that follows, in every subsequent year, is next to impossible to take in. Right from the beginning, mathematics education is accretive, a pyramid, each layer of brickwork building up carefully on the last. You can’t understand trigonometry if you haven’t grasped the idea of similar triangles. You can’t grasp calculus if you haven’t understood areas and velocities. And you can’t understand anything at all if your basic algebra is poor. It’s why mathematics professors have such a hard time explaining their work to the public. The great majority of students are vulnerable to one bad teacher. It isn’t enough for a child’s mathematics teachers as a whole to be generally just as bad and just as good as his history teachers. In fact, even if mathematics teachers were generally, which is to say as a group, better than history teachers, the presence of one bad maths teacher early on hampers him mathematically if it doesn’t doom the child to mathematical ignorance.
*

General incomprehension of derivatives, from the bus driver and waiter to the classics professor and newspaper editor, is understandable: Any decent exposition requires a fair bit of mathematics. My father tells a story about Richard Feynman, who’d been dubbed the Great Explainer because of his talent for explaining theoretical physics. When a journalist asked him to describe in three minutes what he’d won the Nobel Prize for, Feynman replied that if he could explain it in three minutes, it wouldn’t be worth a Nobel Prize. Feynman, I think, is making the wider point that an explanation of something by reducing it and simplifying it over and over, until all that’s left is some familiar metaphor that is actually without content, helps no one’s understanding of the thing itself and is only the repetition of a familiar image.

Even the basic elements of financial derivatives are mathematical. But quite apart from the mathematical content, the other problem is that to understand derivatives requires, I think, an understanding of other more basic ideas in finance, whether or not they in turn have some mathematical content. It’s accretive, to use Zafar’s language. Perhaps this is not exclusive to finance. As far as I can tell, medicine is just the same, as well as the law.

Reading over all this, it sounds like the beginnings of a kind of defense. And that it might be. I know that my own lawyers will draft something to submit to the congressional committee and that this should form the basis of my oral submissions. They’ll also groom me in fielding questions. And the firm will doubtless make available its own lawyers, even to a former employee, but on them, needless to say, I won’t be relying. There is defending to be done, I know. But the attack, more than likely, will take the form of that imprecise populist haranguing that politicians excel in. Lynching has a civilized form. But while there’s plenty to apologize for, apologizing wholesale for some vague offense of “getting us into the mess we’re in” can’t be one of them. It doesn’t stand up. Back in September 2008, at supper in my parents’ home, I was already quite defensive. These days I’m even more so. I have a dialogue going on in my head, a defense I’m crafting in pieces.

*   *   *

In the midnineties Zafar left the industry for law but I remained in banking, joining the Structured Products group in London. The group had been newly established to explore opportunities for the firm in a field where others had taken the lead, notably a team at JPMorgan headed by Bill Demchak and Peter Hancock. In late 1994, I had been asked to look at a deal JPMorgan had recently closed with the European Bank for Reconstruction and Development. The deal had created a buzz, but there’s no doubting that as much as the deal, it was the glamorous and spunky deal maker at the center of it who had set tongues wagging.

The background was an environmental disaster five years earlier. In 1989, the oil tanker
Exxon Valdez
ran aground off the Alaskan coast, releasing a massive oil slick. In a class action suit four years later, Exxon was fined $5 billion. It’s true that on appeal in 2008, the U.S. Supreme Court would cap the oil company’s liability at $500 million, one-tenth of the jury’s award back in 1994, but at the time Exxon faced the prospect of making a massive payout. It turned to its banker, JPMorgan, for a credit line to draw on as need arose. But providing such a large credit line would have hefty implications for JPMorgan.

Every time a bank makes a loan, it runs the risk of the borrower not paying back. Moreover, a bank relies on loan repayments in order to run its own business, to repay depositors who want their money and even to make payments to its own creditors. So the risk of a borrower defaulting entails a risk to the bank, its customers, depositors, and creditors and, if the bank is big, a risk to the financial services sector. Regulators, who, in theory at least, are looking out for customers and the industry, step in here and require a bank to set aside capital every time it lends—just put it in a reserve account where the bank can’t touch it. With this reserve, barring the catastrophic default of a large number of its borrowers, the bank ought to be able to take a few knocks without going down and damaging the sector in the process.

If JPMorgan ran a credit line to Exxon, it would be huge, and JPMorgan would have to reserve a huge amount of capital, capital which could not be put to any use, not even to earn interest. Of course, banks don’t like this; they want their money to be making money. That’s where Payne came in.

I met Meena, as I’ve mentioned, on the training program in New York, fell in love, courted her, and wooed her. I remember I even cooked for her—or tried to, balls of spinach and pine nuts or something, which fell apart in my hands and had me stabbing the phone with my forefinger in search of a decent restaurant near Wall Street that would deliver in half an hour. With training over, Meena and I returned to London. More and more, I stayed over at her small apartment, even as week by week the contents of her wardrobe migrated to my house, where they garlanded the furniture. On a very cold night in December, when I’d persuaded her to come for a walk on the Albert Bridge to see its famous Christmas lights that didn’t exist, I proposed. Two weeks later, on a bright Monday morning in January, I saw Payne, for the first time, in a breakfast seminar at the Guildhall in London, sitting on a panel with two men. When it came her turn to speak, Payne sprang to her feet, this slim, beautiful woman, her chair taking the force of the recoil, and in a dozen bold strides, with legs that went, as they say, all the way to the ground, she crossed the stage to the lectern. She wore knee-high boots, black leggings, and a tartan skirt, her hands free of any notes. Payne had bright blue eyes—
with flecks of gray
, she would insist—and long blond hair, sometimes tied up in a bun. Descended from an old Boston family of jurists and commercial men—two ancestors, I learned, had sat on the state Supreme Court and another, one Josiah Edgerton, a business associate of John Quincy Adams, had boasted the largest agricultural holding in the Commonwealth of Massachusetts—Payne was as blue-blooded as they come in America, and yet she had little to show of the genteel manners you’d imagine would come with high birth. For one thing, having the certain knowledge of what she wanted, with not one sinew of self-restraint or inhibition in that body to hold her back, she did not hide her intention to get it, and for another, as financial journalists have noted, she swore like a trooper. In the world of finance she had acquired the sobriquet House of Payne. I think she took pride in it.

The European Bank for Reconstruction and Development was established in London in 1991. Its stated mission, Payne explained, was to invest in market economies in the formerly Communist countries of Europe. In 1994, it had considerable credit, which it was looking to extend to the right borrower. JPMorgan—which meant
she
—grabbed an opportunity and negotiated a deal with EBRD under the terms of which EBRD would cover JPMorgan in the event that Exxon failed to meet any repayments once Exxon began drawing on the credit line. EBRD would effectively insure JPMorgan against the credit risk posed by Exxon, and in return JPMorgan would pay EBRD a modest annual premium. The deal was the first, or the first to garner attention. Because of the European aspect of the deal and the prospective business it had opened up, Payne moved to JPMorgan’s London office, after receiving promotions so fast even the rubberneckers got whiplash.

With this arrangement in hand (it had recently been given a name: credit default swap), Payne went to the SEC and successfully argued that JPMorgan had effectively removed the credit risk exposure incurred by extending a credit line to Exxon and should therefore be excused from having to set aside vast amounts of capital to cover default by Exxon.

When my firm asked me to find out about these credit default swaps, I jumped at the opportunity. There’s a lot of money to be made as a market innovator, but the number two position also has its benefits. Number one takes on the costs of developing a bold idea and the risk it might fall flat, while number two can avoid number one’s mistakes. After all, it’s the second mouse that gets the cheese.

After the presentation, I dropped Payne an email suggesting we meet over coffee to discuss her ideas. She agreed, and we met at a bistro near the Bank of England. She wore a figure-hugging black skirt stopping above her knees, with a matching jacket, which she slipped off before sitting down. Beneath this she wore a white cotton shirt, with upturned collars, fitted to her figure, tapering down to a narrow waist and cinched into her skirt. The shirt was unbuttoned down to her cleavage. It seems appropriate to mention these matters in order to set the scene.

What Payne told me over coffee changed my life. The scheme is easy enough to explain because, once I got to grips with it in my own time, it came to form the basis of pretty much everything I did for more than a decade.

In a securitization, a so-called sponsor takes mortgages or corporate loans, things that promise a stream of cash flows, and synthesizes securities out of them. Like any bright idea, it was really startlingly simple, once someone had it. You create a special company, somewhere offshore for perfectly legal tax reasons, and then have that company buy a pool of mortgages, say, so that it stands to receive mortgage repayments. The company then offers to sell to investors a security of its own creation that promises a series of payments funded by the pool of mortgage repayments. When I say pool of mortgage repayments, I mean repayments from upward of tens of thousands of mortgages. That was part of the point: Investors who might be interested in buying these synthetic securities, pension funds and hedge funds, for instance, had no interest in an anemic dribble from a few mortgages.

As I gather my thoughts here in order to get to the point, I am reminded of a joke Zafar made when he was still in banking. I say joke, but Zafar was always rather serious about banking and often talked about accountability, as he called it. This stuff is so esoteric, he once said, that the only people who understand it are in the business. What about regulators? I asked. Regulators, he replied, have one eye on the revolving door. Academics make money teaching traders their latest research, and politicians don’t know their arses from their elbows. Can you imagine the people on a march against finance? The guy on a megaphone shouting:
What do we want?
And everyone answering: Specific curbs on short selling in certain circumstances.
When do we want it?
In phases and at appropriate times.

That’s the joke. It was funny at the time.

However important the details of securitization may be, the important thing here is what I took away from my conversation with Payne.
*

The synthetic securities we offered to investors had to be assessed for risk. Potential investors needed to know how likely it was that the mortgage repayments behind the securities would dry up. Rating agencies have the job of assessing the risk in a security before it’s offered for sale and of giving it a credit rating, as if its being a separate company from the ones arranging the creation of the securities guaranteed independence! Not so much arm’s length as shoulder to shoulder. Securities with triple-A ratings, the same ratings enjoyed by U.S. government bonds, are considered the safest. And the ratings go down the list, all the way down to subinvestment grade, the ratings given to so-called junk bonds or distressed debt (or where there’s no rating at all). The triple-A rating is the one that’s prized, the one investors in CDOs were looking for.

At our meeting, Payne described the difficulties she’d been having persuading ratings agencies to give the securities a high rating.

I’m sure you can be very persuasive, I said.

Yellow-bellied, spineless chickenshits. Ask what’s bugging them and they can’t say. If they weren’t so gutless, they’d be making money as traders and not working nine to five as actuaries in ratings agencies. Fucking salarymen.

How do they rate the securities?

They haven’t yet.

I mean, what’s the methodology?

Can’t get their heads around them. We asked them to work with us. Moody’s, S&P, they’ll work with you on a consultancy basis. But they’re just so damn slow. We’re going round the fucking houses with them. We need one of them to bite, and the others will climb aboard. They actually stand to make a fuckload of money in fees.