Credit crunch: E&T reviews 'Fool's Gold: How unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe', by Gillian Tett.
Why did the bankers, regulators and ratings agencies collaborate to build and run a system that was doomed to self-destruct? Did they fail to see the flaws, or deliberately ignore them? Unlike many banking crises, this one was not triggered by war, recession or external economic shock.
All these questions and more are addressed in Gillian Tett's 'Fool's Gold', a fascinating inside story by a top-flight Financial Times journalist. It explores the shadowy world of complex finance and derivatives and how the business of slicing and dicing debt led to the global credit crunch. How, it asks, could a small group of talented bankers, linked to an iconic pillar of the banking world, dream up an innovative set of products such as 'credit default swaps' and others even more complex? It wasn't entirely the fault of a few greedy individuals. The entire financial system seemed to go wrong as a result of flawed incentives and lack of accountability.
In the early 1980s, JP Morgan and several other venerable banks jumped into the newfangled field of derivatives, and activity in that area exploded. "By 1994, the total notional value of derivative contracts on JP Morgan's books was put at $1.7tr, and derivatives' activity was generating half of the bank's trading revenue," says Tett. Most members of the banking and wider investing world had absolutely no idea how derivatives were producing such phenomenal sums, let alone what so called 'swaps' groups actually did.
The young bankers responsible, mostly under 30 and just out of college, were convinced they had the secret to transforming the financial world, as well as dramatically enhancing JP Morgan's profits. An ambitious young banker put in charge of one key group was told "you will have to make at least half of your revenues each year from a product which did not exist before". By Wall Street standards, that was a startling mandate.
What is a derivative?
A derivative is nothing more than a contract whose value derives from some other asset - a bond, a stock or a quantity of gold. Those who buy and sell them are each taking a bet on the future value of that asset. Between 1992 and 1993 the value of such deals rose from $5.3tr to $8.5tr. Deals were becoming more complex and were being sold to a wider range of customers, beyond sophisticated treasury departments and investment analysts who rushed in for a gamble with the prospect of big returns.
One banker referred to derivatives as "financial hydrogen bombs, built on personal computers by 26-year-olds with MBAs". A financial newsletter declared that derivatives might be "the equivalent of the next space shuttle disaster". The UK was rocked by its own derivatives scandal involving Hammersmith and Fulham Borough Council. In America Procter & Gamble's pre-tax loss of $157m in a deal with Bankers Trust badly damaged both the company's and the bank's standing.
Securitisation - an even older concept than 'swaps' - was the next bright idea. In the 1960s and 1970s some banks had started selling off mortgage loans to outside investors in an effort to diversify their portfolios and make a good profit in the mortgage business without needing the infrastructure required to originate loans.
To guard against the risk of default, bankers came up with the idea of bundling up large quantities of loans in packages to spread the risk of any problematic loans over the whole bundle; in other words: "if any borrowers with mortgages in the bundle did default, that loss would be covered by the profits made on the rest of the loans."
December 1997 saw the launch of perhaps the most potent financial product yet, the Bistro or "broad index secured trust offering". The team behind it sold all its $700m notes and felt they'd stumbled on a financial Holy Grail. At a stroke they managed to remove credit risk from the bank's books on an enormous scale. An English member of the team, Blythe Masters, who looked like a young intern, explained to potential investors how the scheme worked with a near evangelical passion and got results.
Other banks followed, triggering an explosion in credit derivatives activity. By December 1997, American banks had reported around $100bn of such deals on their books. By March 1998 this had grown to $148bn - and about $300bn globally. Most of JP Morgan's team took home over $500,000 that year and many received more than $1m. Little wonder head-hunters were gathering outside the door with contracts ready to sign. By October 1999 the official volume of credit derivatives deals in the market was estimated at $299bn, JP Morgan accounting for almost half the total.
There was still a problem with the regulators, especially the European regulators. Could the JP Morgan team find a way of removing or insuring the amount of risk that was unfunded in the Bistro scheme if they wished to get capital relief?
Enter the giant AIG insurance group, a pillar of the American financial establishment. Its capital market business, AIG Financial Products, run from London, where the regulator regime was less restrictive, saw it as a good business for AIG. Many years later it became clear that this trade set AIG on the path to near ruin.
By the early 2000s, Tett reveals, Lehman Brothers, Citigroup, Bear Stearns, Credit Suisse, UBS and Royal Bank of Scotland, all fiercely ratcheted up their derivatives operations. By 2002 and 2003, single-tranche CDOs (synthetic collateralised debt obligations) became all the rage.
Suddenly banks' CDO and mortgage teams realised it made sense to collaborate, since both were playing around with closely related concepts. The American housing market was benefiting hugely from low interest rates and rapidly mounting piles of relatively high-risk mortgage loans were fertile fodder for the CDO machine.
New mortgage lenders and brokers specialising in non-confirming mortgages, otherwise known as sub-prime, were increasingly extended to borrowers with poor credit history. By 2005 almost half of all mortgage-linked bonds in America were based on sub-prime loans. For returns-hungry investors, sub-prime mortgage-based CDOs were
By 2005 there were $12tr CDS (credit default swaps) contracts in the market, a sum equivalent to the size of the entire US economy, and there were more signs of concern. As one banker put it, "there is a type of euphoria about getting into structured credit products right now, and so you have to ask: could we be getting into a stage of irrational exuberance?" Or as another banker noted "there is such a buzz about credit derivative products now that there are hedge funds getting into it without the requisite abilities."
There were rumblings too in the mortgage world. Was it time to be more aggressive and actively bet on a housing crash? In 2006 two mortgage brokerages collapsed and more bad housing news tumbled out. By early 2007 HSBC admitted that mortgage defaults were rising sharply at Household Finance, a sub-prime lender.
By early 2007 policymakers and bankers "had never seen such eerily calm markets in their careers and they were uncertain and divided about what, if anything, they should do. They didn't know why credit conditions seemed so extreme. They were convinced that the high-rolling, risk loving hedge funds must somehow be to blame and hoped to persuade the rest of the G8 to regulate them."
Tension was rising. In August 2007 American Home Mortgage Investment Corporation filed for bankruptcy. A week later Countrywide, America's largest independent mortgage lender, announced that the rate of foreclosures and defaults on its portfolio of sub-prime loans had risen to its highest levels since 2002, due to unprecedented disruptions in the home loans market. In the same month the European Central Bank offered to provide as much funding as banks might wish to borrow at a rate of 4 per cent, in response to tensions in euro money markets - an emergency blood transfusion.
The crunch hits
Two hours later, 49 banks in Europe had demanded and received a staggering €94bn, three times the normal level of demand. Ten hours after the ECB's statement the price of gold was rising, so was the price of US Treasury bonds, while the price of risky corporate bonds and mortgage-backed assets tumbled. "Most ominous of all, the cost of borrowing dollars in the interbank market was also rising, which implied that banks and other key financial institutions were reluctant to lend money to each other, either because they needed the cash, or did not trust each other - or both. Did the authorities accept that this was an emergency, the market in turmoil?
A month later, in September, Robert Peston, the BBC's business editor, reported that Northern Rock, the fifth largest British lender had gone to the Bank of England and asked for emergency support. The Rock, a large regulated bank, extended loans to people all over Britain and held the savings of millions. By mid-morning the next day, terrified savers were queuing outside the bank. By 2007, less than a quarter of Northern Rock's funding came from retail deposits. The rest was raised by securitisation.
The banking world reeled in shock. Was the former JP Morgan team to blame? "This crisis," it said, "has nothing to do with innovation. It is about excesses in banking," but some of the team realised that a number of the assumptions that had driven them a decade ago had been naïve. Credit derivatives and CDOs, they assumed would disperse risk. Now it turned out that the risks had not been dispersed at all, but concentrated and concealed - a bitter irony.
'Fool's Gold' reads like a thriller. The author's contacts, built up over 15 years at the Financial Times, are legendary. Her narrative is blistering and brilliant - a must read if you want to understand the roots of the credit crunch and the recession and the fascinating and complex world of finance.
'Fool's Gold: How unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe' by Gillian Tett is published by Little, Brown, £18.99, ISBN 9781408701645.