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 Page B
Authors: Gillian Tett
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defaults are connected. If a car company goes into default, say, its suppliers may go bust, too. Conversely, if a big retailer collapses, other retail groups may actually benefit. Correlations can go both ways, and working out how they might develop among any basket of companies is fiendishly complex. So what the statisticians did, essentially, was to study the past correlations in corporate default and equity prices and program the models to assume the same pattern in the present.
This assumption wasn’t deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that J.P. Morgan was dealing with. When Moody’s had done its own modeling of the basket of companies in the first BISTRO deal, for example, it had predicted that just 0.82 percent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 percent of the pool—the amount that would have been required to eat up the $700 million of capital raised to cover losses—was minuscule. That was why J.P. Morgan could declare super-senior risk so safe and why Moody’s had rated so many of the BISTRO notes triple-A.
The fact was, though, that the assumption about correlation levels was just human guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be higher than the statisticians had presumed, serious losses might result. What if, for example, a situation transpired in which if a few companies did default, numerous others would, too? The number of defaults that might set off such a chain reaction was a vexing unknown; maybe no chain reaction would result from a few defaults, but if ten happened—say, among big economic players—the rot might spread, destroying the entire portfolio.
Demchak had never seen that happen, and the odds seemed extremely long, but even if there were just a minute chance of such a scenario, Demchak didn’t want to be sitting on a pile of assets as big as $100 billion that could conceivably go bust. It just did not feel prudent. So hedecided to play it safe and told his team they needed to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were requiring.
Taking that stance cost the bank a fair amount of money, because it had to pay AIG or others fees to insure the risk, and those fees steadily rose as the decade wore on. In the first such deals that J.P. Morgan had cut with AIG, the fee had been just 0.02 cent for every dollar of risk insured each year, or in banking terms 2 basis points. By 1999, the price was nearer 11 basis points. But Demchak was determined that the team be prudent.
Around the same time, the team stumbled on a second potentially more worrisome problem with the BISTRO concept. As the innovation cycle turned and earnings from CDS deals declined, Bill Demchak asked his team to explore new ideas for the BISTRO concept, either by somehow modifying the structure or by putting new kinds of loans or other assets into the mix. Mortgage loans were one type they decided to experiment with.
Terri Duhon took charge of the endeavor. In 1998, Demchak had asked her to run the so-called exotics book, which handled a large volume of CDS. Only ten years earlier, Duhon had been a high school student in Louisiana. When she told her relatives she was going to work in a bank, they assumed she would be a teller. Now she was managing tens of billions of dollars. She was trained as a mathematician, and she thrived on adrenaline—in her spare time, she rode Harley-Davidsons—yet even so, she found the thought of being in charge of all those zeroes awe-inspiring, if not a little scary. “It was just an extraordinary, intense experience,” she would later recall.
A year after Duhon took on the post, she got the word that Bayerische Landesbank, a large German bank, wanted to use the BISTRO structure to remove the
This assumption wasn’t deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that J.P. Morgan was dealing with. When Moody’s had done its own modeling of the basket of companies in the first BISTRO deal, for example, it had predicted that just 0.82 percent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 percent of the pool—the amount that would have been required to eat up the $700 million of capital raised to cover losses—was minuscule. That was why J.P. Morgan could declare super-senior risk so safe and why Moody’s had rated so many of the BISTRO notes triple-A.
The fact was, though, that the assumption about correlation levels was just human guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be higher than the statisticians had presumed, serious losses might result. What if, for example, a situation transpired in which if a few companies did default, numerous others would, too? The number of defaults that might set off such a chain reaction was a vexing unknown; maybe no chain reaction would result from a few defaults, but if ten happened—say, among big economic players—the rot might spread, destroying the entire portfolio.
Demchak had never seen that happen, and the odds seemed extremely long, but even if there were just a minute chance of such a scenario, Demchak didn’t want to be sitting on a pile of assets as big as $100 billion that could conceivably go bust. It just did not feel prudent. So hedecided to play it safe and told his team they needed to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were requiring.
Taking that stance cost the bank a fair amount of money, because it had to pay AIG or others fees to insure the risk, and those fees steadily rose as the decade wore on. In the first such deals that J.P. Morgan had cut with AIG, the fee had been just 0.02 cent for every dollar of risk insured each year, or in banking terms 2 basis points. By 1999, the price was nearer 11 basis points. But Demchak was determined that the team be prudent.
Around the same time, the team stumbled on a second potentially more worrisome problem with the BISTRO concept. As the innovation cycle turned and earnings from CDS deals declined, Bill Demchak asked his team to explore new ideas for the BISTRO concept, either by somehow modifying the structure or by putting new kinds of loans or other assets into the mix. Mortgage loans were one type they decided to experiment with.
Terri Duhon took charge of the endeavor. In 1998, Demchak had asked her to run the so-called exotics book, which handled a large volume of CDS. Only ten years earlier, Duhon had been a high school student in Louisiana. When she told her relatives she was going to work in a bank, they assumed she would be a teller. Now she was managing tens of billions of dollars. She was trained as a mathematician, and she thrived on adrenaline—in her spare time, she rode Harley-Davidsons—yet even so, she found the thought of being in charge of all those zeroes awe-inspiring, if not a little scary. “It was just an extraordinary, intense experience,” she would later recall.
A year after Duhon took on the post, she got the word that Bayerische Landesbank, a large German bank, wanted to use the BISTRO structure to remove the
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