Book Review: Fool's Gold
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In 1994 a group of young, bright JPMorgan bankers from the swaps department met in Boca Raton, Florida, for an alcohol-fueled weekend of frat-house pranks and intense financial discussions. At these meetings they generated an idea that would change modern finance: how to use derivatives to manage credit risk attached to the loan book of banks.
Tracing the history of the derivatives team from the Boca Raton meeting to the beginning of 2009, Gillian Tett describes in Fool's Gold the genesis and fall from grace of the booming credit derivatives market, and how the use and abuse of once-obscure products such as CDSs (credit default swaps) and CDOs (collateralized debt obligations) brought the world to the edge of a depression.
Tett, who oversees the global coverage of the financial markets for the Financial Times, brings to bear her training as a journalist and an anthropologist to examine why bankers, regulators, and rating agencies collaborated to build a system that was doomed to self-destruct. She identifies a number of contributing factors: ideological adherence to efficient market theory; monetary policy that created a low-interest-rate environment; investors hungry for yield; rapidly growing businesses that took on momentum of their own; and perhaps most important, the failure of bankers, traders, regulators, and investors to remember that credit derivatives could reduce risk, but also create a good deal more risk.
The Morgan team devised some of the first credit derivatives. Once the Federal Reserve issued guidance in 1996 that banks could use credit derivatives to reduce capital requirements, the opportunities presented by regulatory arbitrage unleashed demand for these new products. As business grew, Morgan and its competitors looked for ways to expand the use of their new inventions. Multitranche CDOs gave way to riskier single-tranche CDOs, CDOs of CDOs, CDOs squared, and synthetic CDOs (or CDOs of CDSs). Innovation led to more complexity, more leverage, and more risk that fewer and fewer people understood.
In the 1990s these products were used mostly for commercial loans and sovereign debt. After the tech bubble burst in 2000, however, derivatives became a larger contributor to profits, and banks intensified the search for new areas to apply their risk management skills. Mortgage finance was an obvious opportunity. As the Federal Reserve lowered interest rates in the wake of the NASDAQ crash and then the 2001 terrorist attacks, mortgage finance boomed.
JPMorgan’s team looked at mortgage financing and quickly decided that there was insufficient data to model correlation among mortgage loans with any confidence. The bank wisely chose not to pursue it. Correlation risk, however, did not stop the bank’s competitors from jumping in. New innovations in credit derivatives were now combined with innovations in consumer credit such as subprime mortgages, option ARMs (adjustable-rate mortgages), interest-only mortgages, and other forms of lending that layered risk factor on risk factor.
As thorough as Tett is in her history, the reader is left with a few nagging complaints: Drawing largely from interviews with Morgan alums, she depicts Morgan bankers as pursuing a dream of a perfect financial world, while their competitors are driven by short-term gain, and the reader is left questioning her impartiality. She is unprepared to ask if CDOs and CDSs actually create a more complete market or if they simply take advantage of regulatory arbitrage. If the idea is to move risk to the strongest hands, why should we suppose that society is better served by selling derivatives to underfunded pension plans or highly leveraged hedge funds instead of holding the risk on the balance sheet of the bank that originated the loan, knows the client best, and is required to hold sufficient reserves against the risk?
Credit derivatives, according to a guide published by JPMorgan in 1999, would enable investors to separate specific aspects of credit risk from other risks. This would allow even the most illiquid credit exposures to be transferred to the most efficient holders of risk. In 1992, however, Felix Rohatyn called derivatives “financial hydrogen bonds, built on personal computers by twenty-six-year-olds with MBAs.” History now seems to favor Rohatyn’s description.
–John Merante, CFA, is a banker and economist who has advised governments in Asia and Latin America on financial crises and debt restructuring.