Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett
Authors: Gillian Tett
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they wished to get capital relief.
So Masters and the rest of the team set out to find a solution. They started by giving that bundle of risk a name. They had never referred to that portion of the risk pool in any standard way. Masters liked to refer to it as “more than triple-A,” since it was deemed even safer than triple-A-rated notes. But that was too clumsy to market. So they came up with the name “super-senior.” The next step was to explore who, if anyone, would want to either buy or insure it.
The task didn’t look easy. As Masters said later, “There were just not that many natural buyers,” because the payoff for taking it on would be relatively low. As far as the bank was concerned, this risk was not really at all risky, so there was absolutely no point in paying anything other than a token amount to get it insured. On top of that, whoever steppedup to acquire or insure the super-senior risk had to be brave enough to step into an unfamiliar world.
Masters eventually spotted one solution to the super-senior headache. In previous decades, one of J.P. Morgan’s long-standing, blue-chip clients had been the mighty insurance company American International Group. Like J.P. Morgan itself, AIG was a pillar of the American financial establishment. The insurer had risen to prominence by building a formidable franchise in the Asian markets during the early part of the twentieth century. That business was later extended in the US, making the company a powerful force in the American economy after the Second World War. AIG was considered a hefty but utterly reliable market player, and, like J.P. Morgan, it basked in the luxury of a triple-A credit rating.
But within AIG, an entrepreneurial upstart subsidiary was booming. In the late 1980s, the company hired a group of traders who had previously worked for Drexel Burnham Lambert, which had infamously developed the junk bond business under the leadership of Michael Milken in the mid-1980s, before it blew up. They had been tasked by AIG with developing a capital-markets business, known as AIG Financial Products, which was based in London, where the regulatory regime was less restrictive. This was run by Joseph Cassano, a tough-talking trader from Brooklyn.
Cassano was creative, bold, and highly ambitious. More important, AIG, as an insurance company, was not subject to the same burdensome capital reserve requirements as banks. That meant AIG would not need to post capital reserves if it insured the super-senior risk. Nor was the insurer even likely to face hard questions from its own regulators, because, though AIG’s insurance arms were regulated by state-level insurance groups, AIGFP had largely fallen through the cracks of oversight. It was regulated by the Office of Thrift Supervision, but OTS officials had only limited expertise in the field of cutting-edge financial products.
Masters pitched to Cassano that AIG take over J.P. Morgan’s super-senior risk, either in the form of a purchase of securities or by simplysigning credit derivatives contracts that would insure Morgan against any loss. Cassano happily agreed. It was a “watershed event,” or so Cassano later observed. “J.P. Morgan came to us, who were somebody we worked with a great deal, and asked us to participate in some of what they called BISTRO trades [which] were the precursors to what [became] the CDO market.” It seemed good business for AIG.
AIG would earn a relatively paltry fee for providing this service, of just 0.02 cent on the dollar each year. But, that said, if 0.02 cent is multiplied a few billion times, that adds up to quite an appreciable income stream, particularly if no reserves are required to cover the risk. Once again, the magic of derivatives had produced a “win-win” solution. Only many years later did it become clear that Cassano’s trade set AIG on the path to near ruin.
With the AIG deal in hand, the team returned to the regulators and pointed out that a
So Masters and the rest of the team set out to find a solution. They started by giving that bundle of risk a name. They had never referred to that portion of the risk pool in any standard way. Masters liked to refer to it as “more than triple-A,” since it was deemed even safer than triple-A-rated notes. But that was too clumsy to market. So they came up with the name “super-senior.” The next step was to explore who, if anyone, would want to either buy or insure it.
The task didn’t look easy. As Masters said later, “There were just not that many natural buyers,” because the payoff for taking it on would be relatively low. As far as the bank was concerned, this risk was not really at all risky, so there was absolutely no point in paying anything other than a token amount to get it insured. On top of that, whoever steppedup to acquire or insure the super-senior risk had to be brave enough to step into an unfamiliar world.
Masters eventually spotted one solution to the super-senior headache. In previous decades, one of J.P. Morgan’s long-standing, blue-chip clients had been the mighty insurance company American International Group. Like J.P. Morgan itself, AIG was a pillar of the American financial establishment. The insurer had risen to prominence by building a formidable franchise in the Asian markets during the early part of the twentieth century. That business was later extended in the US, making the company a powerful force in the American economy after the Second World War. AIG was considered a hefty but utterly reliable market player, and, like J.P. Morgan, it basked in the luxury of a triple-A credit rating.
But within AIG, an entrepreneurial upstart subsidiary was booming. In the late 1980s, the company hired a group of traders who had previously worked for Drexel Burnham Lambert, which had infamously developed the junk bond business under the leadership of Michael Milken in the mid-1980s, before it blew up. They had been tasked by AIG with developing a capital-markets business, known as AIG Financial Products, which was based in London, where the regulatory regime was less restrictive. This was run by Joseph Cassano, a tough-talking trader from Brooklyn.
Cassano was creative, bold, and highly ambitious. More important, AIG, as an insurance company, was not subject to the same burdensome capital reserve requirements as banks. That meant AIG would not need to post capital reserves if it insured the super-senior risk. Nor was the insurer even likely to face hard questions from its own regulators, because, though AIG’s insurance arms were regulated by state-level insurance groups, AIGFP had largely fallen through the cracks of oversight. It was regulated by the Office of Thrift Supervision, but OTS officials had only limited expertise in the field of cutting-edge financial products.
Masters pitched to Cassano that AIG take over J.P. Morgan’s super-senior risk, either in the form of a purchase of securities or by simplysigning credit derivatives contracts that would insure Morgan against any loss. Cassano happily agreed. It was a “watershed event,” or so Cassano later observed. “J.P. Morgan came to us, who were somebody we worked with a great deal, and asked us to participate in some of what they called BISTRO trades [which] were the precursors to what [became] the CDO market.” It seemed good business for AIG.
AIG would earn a relatively paltry fee for providing this service, of just 0.02 cent on the dollar each year. But, that said, if 0.02 cent is multiplied a few billion times, that adds up to quite an appreciable income stream, particularly if no reserves are required to cover the risk. Once again, the magic of derivatives had produced a “win-win” solution. Only many years later did it become clear that Cassano’s trade set AIG on the path to near ruin.
With the AIG deal in hand, the team returned to the regulators and pointed out that a
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