November 28, 2009

“Fool’s Gold” by Gillian Tett

So I recently read Gillian Tett’s Fool’s Gold, her account of the “Morgan Mafia” at JP Morgan who “innovated” the credit default swap and the mass marketization thereof.
The book is well-written and does a good job of explaining all the financial gizmos and machinations which destroyed our economy once and for all.
But in the end Tett does not successfully defend her explicit or implicit theses which are as follows.
Her overt claim is that derivatives and securitization are inherently good and useful, constructive and value-creating, and that it was only their abuse by bad apples which caused everything to go wrong.
This is on display in her very section titles: Innovation, Perversion, Disaster.
More specifically, she claims that the folks at JPMorgan (to whom she had access and who willingly cooperated with her in giving interviews, from Dimon on down to the most obscure cadres; so to a large extent this is JPM’s version of events) did their best to be responsible, accountable, prudent actors, while the bad apples were at most of the other banks.
Her implicit claim is that financialization of the economy and the extreme growth and concentration of the finance sector are also good things. (I take it for granted, after all that has happened, that anything written on the subject which isn’t attacking the sector as such has an obligation to defend its existence.)
But the evidence of the very history she and JPM lay out contradicts all of this.
Tett opens her story with a bunch of drunken frat droogs partying in Boca, reveling in vandalism and mugging one another. This kind of behavior continues throughout the story, unfortunately on more socially destructive levels.
It was at this Boca conference in 1994 that the Morgan Mafia, as the swaps team called themselves, zeroed in on the idea of credit default swaps. This was an extension of existing interest rate swaps, and wasn’t a completely new idea, but the JPM crew really made it work. As will be the pattern throughout the tale, they weren’t doing this in response to any social or even “market” need, but proactively thought it up toward the goals of greater rents and attacking regulation.
They spent the next few years mucking around (by their standards) with the idea, doing a few big deals. But the real goal was to standardize this method of selling risk. They eventually bundled $10 billion worth of JPM risk on existing corporate loans, securitized it, induced Moody’s to give these securities a AAA rating, and in December 1997 marketed it through an SPV shell company (in order to evade taxes). The model was now complete.
When the dotcom bubble crashed, followed by the Enron and Worldcom troubles, nobody took these as evidence that financialization needed to be reined in. On the contrary, CDS were touted as having successfully spread out the risk. Meanwhile, the Fed had embarked upon its easy money policy. So for CDS the lesson and the incentive were clear: They were now to be used to help blow up the mortgage bubble.
Ironically, after having “innovated” the CDS instrument, JPM itself never fully committed to mortgage securities. They could never figure out how correlated mortgage defaults might be, and therefore what the real level of risk was. So they only did two big CDS-MBS deals and then backed off. Similarly, in 2005 Dimon wanted to prioritize mortgage securitization. They spent much of the year setting up an “assembly line” structure to compile, bundle, slice, and sell these securities. But no sooner was the mechanism in place than in early 2006 the mortgage market showed signs of stalling. As defaults started racking up in San Francisco, Las Vegas, Miami and elsewhere, JPM held back once again.
In the end this conservatism served JPM well. When the crash finally came, it was one of the few banks whose balance sheet wasn’t loaded down with toxic paper, and the only one the government could readily turn to as the “private” face of the corporatist bailouts. Tett attributes this to a longstanding corporate culture which allegedly valued teamwork, loyalty, long-term relationships over the Darwinist “eat what you kill” ethos at other banks. Back in 1933 under Congressional grilling JP Morgan Jr. had assured the world that the bank’s mission was to engage in “first class business…in a first class way”. This became a mantra at the bank.
By 2008 this branding, after the neglect of some years, came back to the fore. When Chase Manhattan bought JPM in 2000, although they placed Morgan’s name first in the new combined name “JPMorgan Chase” for this branding purpose, they studiedly dropped the pretentious periods from “J.P. Morgan”, something the JPMers had always taken pride in, just to show who was boss.
Now the periods were back with a vengeance. With the whole system on the verge of collapse, the J.P. Morgan brand name was of great value. But any social value connotation of this was a scam. JPM was in disaster capitalist mode, with Dimon scanning the horizon for M&A opportunities among the wounded. First Bear and later WaMu were the two big feasts JPM enjoyed using public backstops to again mitigate their risk.
As the whole story shows, JPM’s conservatism was never out of any social responsibility or even a real desire to be “first class”, but only out of self-interest. Nothing in the book can elide the fact that even at relatively conservative JPM most of this “innovation” was not in response to any market request but was gratuitously dreamt up and aggressively marketed to buyers who had originally wanted no such thing. Tett quotes Peter Hancock, the early head of the derivatives team: “The idea that we gave the most emphasis to was using derivatives to manage the risk attached to the loan book of banks”.
She goes on:

Players…had different motives for wanting to place bets on future asset prices. Some investors liked derivatives because they wanted to control risk, like the wheat farmers who preferred to lock in a profitable price. Others wanted to use them to make high-risk bets in the hope of making windfall profits. The crucial point about derivatives was that they could do two things: help investors reduce risk or create a good deal more risk. Everything depended on how they were used and on the motives and skills of those who traded in them……

It was only many years later that the team realized the full implications of their ideas, known as credit derivatives. As with all derivatives, these tools were to offer a way of controlling risk, but they could also amplify it. It all depended on how they were used. The first of these results was what attracted Hancock and his team to the pursuit. It would be the second feature which would come to dominate business a decade later, eventually leading to a worldwide financial catastrophe.

But this is belied by every action of this team. On the contrary, from day one team members were focused on politically leveraging risk insurance toward deregulatory lobbying, in order to further amplify risk and rents. The real motives were never anything more than unproductive rent-seeking and regulation-bashing. As for better managing risk, on the evidence of this book no one ever valued any opportunity to build resiliency into the system, to create slack. On the contrary, every space that risk management opened immediately had further risk crammed into it. Nobody seems to have noticed the fallacy here, that is assuming, as Tett seems to, that anyone ever actually cared about “better” risk management, as opposed to generating the fraudulent simulacrum of it to extract further rents and attack regulation.  
Hancock’s real mindset came through more clearly when he decried the “curse of the innovation cycle”, meaning that he lamented that all real financial innovation had long since been completed. He hated what human beings call the proper functioning of an economic sector as it matures, provides its necessary services more efficiently, because then profits go down to their natural mature level. Hancock and his fellow mafioso were out to “innovate” new scams in order to prevent sector maturation and efficiency from prevailing. Similarly Mark Brickell, another Morgan cadre, aptly compared what they were doing to the Manhattan Project. Then there’s the charming Tim Frost, a hard core corporatist ideologue who liked decorating his work space with portraits of “shabby unemployed British miners”. These were a comic centerpiece for his jokes about what happens when returns are bad.
In Brickell’s case the intent to wage total war on society was overt, as his incessant Hayekian market fundamentalist proselytization demonstrates. His real passion was deregulation.

Brickell took the free-market faith to the extreme. His intellectual heroes, in addition to Hayek, were economists Eugene F. Fama and Merton H. Miller, who developed the Efficient Markets Hypothesis at Chicago University in the 1960s and 1970s, which asserted that market prices were always “right”. They were the only true guide to what anything should be worth. “I am a great believer in the self-healing power of markets”, Brickell often said, with an intense, evangelical glint in his blue eyes. “Markets can correct excess far better than any government. Market discipline is the best discipline there is.”

Peter Hancock shared that view, though he rarely expressed it so forcefully in public. So did most other swaps traders.

The International Swaps and derivatives Association (ISDA), the “industry” lobbying group, under Brickell’s personal leadership spread the gospel of voluntary “market discipline”, “the self-healing power of markets”, “rules designed by the industry itself and upheld by voluntary, mutual accord”. “Bankers and their lawyers were better-informed, and they had strong incentives to comply.” The libertarian bullshit was piled high. The quants added the mystique of math, “Value at Risk” (VaR) to the mix.
Between the Chicago ideology, the mathematical assurance that risk had been tamed, and of course the bribes, Brickell and his horde accomplished their goals. They first staved off new regulation in the aftermath of the Orange County bankruptcy in 1994, then launched their real lobbying offensive. The dream was to not only get risk off the books so that it didn’t eat up the reserve requirements, but to convince regulators to lower the requirements themselves. They convinced the Fed and the CFTC in 1996. (They actually had a harder time convincing JPM’s own management to loosen internal restrictions.)
Led by the Morgan cadres, the deregulatory offensive reached its crescendo at the turn of the millennium with the repeal of Glass-Steagal and, with the CFMA in 2000, the explicit declaration that swaps were not securities and beyond CFTC purview. This happened in an atmosphere of absolute fanaticism over technology, “innovation”, and most of all “growth”. The very fact that none of it had any real-world basis played up the religious aspect of it all.
What was the role in all this of derivatives in general and the Morgan mafia in particular? Tett’s own evidence demonstrates that:
1. The JPM cadres themselves took the lead in using these innovations as the pretext for deregulation.
2. Any “innovation” was quickly put to “abusive” uses.
3. That everyone “abused” securities, and that the clear goal of deregulation was to open up space for these abuses, seems to indicate that these uses weren’t really abuses, but rather that the banks entered the deregulated vacuum using CDS and everything else exactly as intended. It seems that, rather than being the only “responsible” player, JPM was unusually conservative.
More to the point, they got lucky. In particular, the mortgage problems arose in early 2006 just when JPM was about to take the plunge. If this had been delayed for another year, or if JPM’s strategy had been implemented one year earlier, they’d have been caught out just like the others.
So the evidence proves that their intentions were always malevolent, and also doesn’t strongly support the proposition that they “knew” what they were doing much better than everyone else.
This is reinforced by JPM’s behavior since the crash. By then the original JPM team was dispersed throughout the sector, but the diaspora rejoined for a collective bout of whining, finger-pointing, CYA and ideological reaffirmation, even cultivating martyr fantasies. The basic line is the same: We’re innocent, derivatives are good, it was just bad apples who abused them. Most still sing the ideological gospel (though Greenspan’s partial recantation has given a few pause).
As for JPM itself, it has used the strength it gained from the bailout to go hunting. It’s now the world’s biggest bank in terms of market capitalization. It has used its prime position to follow Goldman Sachs into a more overt corporatist partnership with government. (If Dimon really is gearing up to become Treasury Secretary as some reports say, this would be the public consummation of that process.)
The real voice of JPM, most truly in synch with JPM’s actions and the actions of the sector as a whole, remains the fascist Mark Brickell. As the crisis descended he never flinched from triumphalism, self-congratulation, and continued ideological assault.
In April 2008, basking in the glow of JPM’s public-enabled fire sale purchase of Bear Stearns, Brickell raved at the ISDA’s annual conference:

As Brickell stood at the podium in the ballroom of the Vienna Hilton, history weighed on him. ISDA had gathered in the same city two decades earlier, and Brickell considered that symbolically appropriate. Vienna was the home of the great free-market economist Freidrich von Hayek, Brickell’s hero. “[Twenty years ago] we set out to design a business guided by market discipline because we believed it should be an even better guide to good behavior than regulatory proscription”, he observed. “The credit crunch gives good evidence that market discipline has guided the derivatives business better than regulation has steered housing finance.”

Brickell remained as opposed as ever to the idea that governments should intervene. “Hayek believed that markets would create a rhythm of their own, that they are self-healing. That is something we should all remember and honor today”, he told the audience. “When governments arrive to help, there is always a price to be paid that often takes the form of greater regulation”.

Every word of this is an Orwellian window into the black larcenous nihilism of gutter evil. The destruction of the real economy, of millions of jobs, is indeed the “discipline” and the “healing”, most of all the “good behavior”, they want to impose upon us all. JPM and the stronger elements of the sector were entering full disaster capitalist mode.
Tett’s book makes clear, in matching words to actions, that not only was there never any good, constructive intention on the part of these operatives, but almost none of them even learned a lesson from or feel remorse over the crisis and all the destruction it has wrought.
On the contrary, most of them are geared up for further battle. They fully intend to keep committing the same crimes. I think this book could provide some useful evidence for a future Nuremburg-style tribunal. It’s an important history of how this gangster network conspired against the wealth and social stability and security of the people.
One of the few cadres who retained some skepticism during the process was Andrew Feldstein.

Back in the days when the JPMorgan team had concocted its derivatives dream, Feldstein had believed deeply in the intellectual arguments behind financial innovation. He was utterly convinced that if tools such as derivatives were implemented in a rational, efficient manner, they would vastly improve the financial system and economy. It was the dream that drove them all.

But after living through the mess of the Chase-JPMorgan merger, Feldstein became cynical. He still believed derivatives had the theoretical potential to make markets function better, but in practice, dysfunctional management and warped incentives for traders and the ratings agencies were badly distorting the CDO market. He understood the ways in which the banks were playing around to garner good ratings and make end runs around the regulatory system, and the situation troubled him. But it also presented a trading opportunity.

So – he was an ideological believer, and he still “believed”, yet in doublethink, as he saw how it didn’t work in the real world. But so what; it was also a “trading opportunity”.
That can sum up every ideologue of all times.


  1. Another chock a block filled analysis of epic financial shenanigans. Well done.

    It’s been a while since I looked at “the numbers”, but it seemed to me that Morgan Chase had and has massive amounts of exposure in derivatives. And whatever the truth of the matter, the story that I have heard was that- I think it was Bear- was, in essence, sacrificed to help cover up JPMs derivative exposure. Suffice it to say that the truth behind the downfall of Lehman and Bear is almost certainly full of underhanded maneuvers on the part of officialdom on behalf of some of Wall Street’s most powerful banking and investment entities.

    Comment by Edwardo — November 29, 2009 @ 8:44 pm

  2. I know the fear with Bear was that if it was allowed to go bankrupt that would trigger a fire sale of securities held as collateral by Bear’s counterparties.

    Everyone would then have to mark everything to market under adverse circumstances. It sounded (to them) like the apocalypse.

    According to the Tett book the same thing came up the previous summer when the Bear hedge funds collapsed and Merrill was threatening to sell “$400 million” notional worth of CDO collateral.

    I guess to this day the nightmare scenario is that the market would ever be allowed to actually discover the real prices for this junk by having a lot of it being sold at once.

    That’s the sticking point to this day – all the banks, probably JPM as well, are simply pretending they’re not insolvent.

    As long as everybody adheres to mutually assured destruction where it comes to trying to sell the toxic crap, and as long as the Fed gravy train keeps flowing, they can keep up the pretense.

    Comment by Russ — November 30, 2009 @ 4:56 am

  3. The irony is that these firms have set into motion the death of the goose that laid the golden egg. In their desperate attempt to wring yet more juice from the
    orange they have managed to do almost unfathomable damage.

    As far as The Fed gravy train, I spend a considerable amount of time pondering what the path of the monetary PTB will be, and what the rest of the world will do in response, or proactively. It seems to me that our “authorities” are hoping to devalue the dollar over a long enough period of time and at a great enough rate to allow extend and pretend to somehow “work.”

    However, paradoxically, with each passing day that the dollar becomes less and less ensconced as the world’s reserve currency, the local PTB loose their ability to manage the dollar’s death in an orderly fashion. In short, by my reckoning, the odds of the PTB pulling off an orderly morphine drip dollar death decrease markedly over time.

    Comment by Edwardo — November 30, 2009 @ 12:06 pm

  4. Yeah, I don’t see how they can possibly bring it in for any kind of soft landing. Especially since they have no choice but to keep running up new debt, since what else can America do? It doesn’t produce anything. It’s just drawing down the old principal, leveraging its fast-eroding military muscle, and living off the dollar’s reserve currency status.

    America’s just a bigger Dubai which can still print its own money. But there’s no such thing as a perpetual motion machine. Now that no new force will be added (or has been for a long time), the mechanism must wind down.

    Not to mention all the unnecessary friction America added on its own, like its obnoxious aggression (which this idiot’s about to expand, even though according to the prelims even he has no idea why he’s doing it) which has only encouraged the world to start fervently looking for alternatives to the dollar.

    Heckuva job.

    Comment by Russ — November 30, 2009 @ 3:09 pm

  5. Good review. I agree that Tett’s book was long on JPM propaganda and short on analysis. What she missed was the impact of leverage on the mortgage securitizations. She doesn’t see that $1.4 trillion in questionable mortgages are supporting $140 trillion in CDO’s. Not one person in ten million understands this. Do you?

    Comment by jake chase — December 2, 2009 @ 7:19 pm

  6. I understand that apparently no one has any real idea at all what the level of securitization is. I’ve heard numbers as high as a quadrillion.

    All anyone seems to know is that nobody wants to find out what would happen if you had to start selling this stuff in any kind of bulk in the real market.

    It looks to me like all policy is meant first of all to prevent such a sale.

    Comment by Russ — December 3, 2009 @ 6:55 am

    • The problem isn’t the debt. The problem is the leveraged bets structured around the debts. The strategy of extend and pretend is based upon a hope that inflation will validate the underlying debts, but it is hard to create inflation in a consumer economy where the consumers are no longer positioned to accumulate more debt. This suggests that we will be moving soon to a war economy. Expect another draft, possibly an assault on Iran. People would be diverted with flag waving. National security will justify an end to criticism and privacy, financial sacrifice by anyone who has managed to protect himself up until now. You might want to reconsider your own literary efforts. I have heard Vancouver is an attractive city.

      Comment by jake chase — December 3, 2009 @ 9:24 am

      • All of it will have to be defaulted, one way or another, almost certainly through hyperinflation, now that exponential growth is no longer possible.

        (I don’t see how they’ll be able to do it with “normal” inflation – to get that going or to maintain it for long. The free market wants very badly to deflate.)

        I’ve heard nice things about Vancouver too.

        Comment by Russ — December 3, 2009 @ 11:17 am

  7. […] finally found a bright and honest account of some of this gamble’s […]

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