The Derivatives Dream

The following is an excellent excerpt from the book “FOOL’S GOLD: The Inside Story of J.P. Morgan and How Wall St. Greed Corrupted Its Bold Dream and Created a Financial Catastrophe” by Gillian Tett from Chapter One on page 12 and I quote: “By the time the J.P. Morgan swaps team gathered in Boca Raton in June of 1994, the total volume of interest-rate and currency derivatives in the world was estimated at $12 trillion, a sum larger than the American economy. ‘The speed at which the market grew just took everyone by surprise. It was quite remarkable,” recalled Peter Hancock, who had been a vital participant in the boom.
In many ways, Hancock’s career made him the perfect man to be at the center of that extraordinary innovation storm. He was born in 1958, into an upper-middle-class British family based in Hong Kong. Like many children from that background and generation, he was dispatched half a world away to a British boarding school, where he excelled at rugby and decided that his ambition was to be a great inventor. After spending many happy hours immersed in science books, he went to Oxford to study physics, but his plans were derailed when he was badly injured in a rugby game. Hancock was laid up in bed for some time, so couldn’t get to the physics laboratory, and he decided to switch to philosophy, politics, and economics. That he could study from his bed. By the time he graduated, he became intrigued about banking and the principles of free markets. “I decided that being an inventor would have to wait,” he recalled. He had decided he wanted a career that paid better than those in science did. It was a common decision for British graduates at the time. The city of London and Wall Street looked increasingly alluring.
On graduation, he applied for jobs at a range of international firms, hoping for a globe-trotting career. But when he was offered a job in the London branch of Morgan Guaranty Trust Company, or “The Morgan Bank,” later rebranded J.P. Morgan, he quickly accepted. It was an unusual choice for a British graduate. The City of London was dominated by British-owned banks, and though American groups had raised their presence in the City during the 1970s, those Wall Street institutions overwhelmingly recruited graduates from the United States.
But J.P. Morgan had always had a transcultural identity. Well known as one of the large Wall Street firms, its roots lay in the City of London, where American banker Junius Spencer Morgan took charge of the English brokerage George Peabody & Co. in 1864 and renamed it J.S. Morgan & Co. His son J. Pierpont Morgan worked at the firm for some years and was then dispatched to New York, where he formed a partnership with the wealthy Drexel family, Drexel, Morgan & Company, which after Anthony Drexel’s death was renamed J.P. Morgan. The American bank quickly swelled into a powerhouse, with J. Pierpont Morgan personally brokering many major deals, audaciously merging a number of steel companies he had bought to form U.S. Steel, and financing major concerns in railroads, shipping, coal mining, and other key industries. By the late nineteenth century, the group had become so preeminent that it appeared to wield as much power in the financial markets as the American government itself.
When crisis hit Wall Street in 1893, Morgan personally orchestrated a syndicate to provide the US Treasury with $65 million in gold, keeping it solvent. In the Panic of 1907, when the New York Stock Exchange plunged to half of its value, Morgan put up vast sums of his personal fortune and rallied other leading bankers to do the same, shoring up the banking system.
In the years after the Second World War, the bank lost some of its preeminence. After the crash of 1929, a populist backlash against Wall Street led to the introduction of the Glass-Steagall Act, which forced banks to split off their capital markets operations—the trading of debt and equity securities—from their commercial banking businesses. The J.P. Morgan empire was required to fragment into separate entities, including Morgan Stanley, the US brokerage; Morgan Grenfell, a British merchant bank; and J.P. Morgan, which was devoted to commercial banking. But the bank maintained an unusually close set of ties with both governments and powerful, blue-chip corporate clients, such as Coca-Cola and AT&T. The international heritage of the bank was also preserved, so much so that J.P. Morgan staff sometimes joked that joining the bank was akin to entering the diplomatic or British colonial service—albeit much better paid.
When Peter Hancock joined the bank, he was dispatched to New York to attend a yearlong training course, together with around four dozen other recruits, only half of whom were American. “It was an extraordinary experience. We had Chinese, Malaysians, French—you name it. And we were all housed together in one small building down on the Upper East Side of Manhattan,” Hancock recalled. The course itself, however, didn’t have much to satisfy Hancock’s penchant for invention.
The Commercial Bank Management Program, as it was called, was conducted in the bank’s historic headquarters at 23 Wall Street, right across the street from the Stock Exchange, in an imposing, column-fronted building where J. Pierpont Morgan himself had worked. The first half of the course was spent in a classroom, learning fundamental banking skills little different from the practices in J. Pierpont Morgan’s time; the nuts and bolts of assessing credit risk by reading a company’s balance sheet and analyzing its business. The goal was to drill into them how to measure the chance a company would default on a loan, the lifeblood of J.P. Morgan’s style of banking. For the second half of the training, the recruits acted as the junior analysts in actual deals.
The trainees were required to spend a good deal of time crunching corporate numbers. Only a few years earlier, those calculations had had to be done by hand. When they needed to look up bond prices, they consulted a voluminous book of tables. By the time Peter Hancock took the course, however, handheld calculators programmed with the power to use complex mathematics to assess corporate cash flows and measure risk were becoming the rage. A new technological elitism was taking hold, and the trainees were in the vanguard of a bold new breed of banker.
For the Morgan Bank trainees, though, the mathematics was stressed to be only part of what banking was about; social factors, such as client relationships and reputation, were also heavily emphasized. Back in 1933, during the height of the populist backlash against Wall Street, the son of J. Pierpont Morgan—J.P. “Jack” Morgan, Jr.–had been grilled by Congress about his ethos. He declared that the aim of his bank was to conduct “first-class business. . . in a first-class way.” Fifty years later, that mantra of Jack Morgan struck much of the banking world as quaint. Years of bold innovation had made high-risk trading and aggressive deal making the gold standard of the street, and a “kill or be killed” ethic prevailed.
At 23 Wall Street, though, the senior bankers still talked about banking as a noble craft, where long-term relationships and loyalty mattered, both in dealing with clients and inside the bank. While at other banks, the emphasis had turned to finding star players, offering them huge bonuses, and encouraging them to compete for preeminence, at the Morgan Bank the emphasis was on teamwork, employee loyalty, and long-term commitment to the bank.
Many of the staff had worked only at J.P. Morgan, and while the bank paid less than most of its rivals, the trade-off was greater job security. The young trainees in the training program were told solemnly that while the bank would tolerate “errors of judgment,” and “error of principle” was a firing offense. “First-class banking” remained the mantra.
Peter Hancock easily passed the course and was dispatched back to the London office, where he spent a couple of years analyzing the credit-worthiness of North Sea oil companies. That was considered a plum job, because the Norwegian and British oil industry was starting to boom. But Hancock was hungry for more. As he looked around the city, he could see the revolution in derivatives and swaps building, and he wanted in.
The Morgan Bank was considered too stodgy to be a pioneer in the business. Aggressive Salomon Brothers and iconoclastic Bankers Trust were the real innovators. But shortly after Salomon announced the big IBM-world Bank swap, J.P. Morgan started looking for ways to do more such deals.
Initially, the epicenter of experimentation was not J.P. Morgan’s New York headquarters but the London Branch of a corporate offshoot known as Morgan Guaranty Limited (MGL). While the Glass-Steagall regulations prohibited the main New York bank from playing in the capital markets, Glass-Steagall didn’t apply overseas. London’s regulatory authorities took a more laissez-faire attitude, generally permitting banks to engage in a wider range of services. As a result, Morgan Guaranty had built up a good capital-markets business. In the 1960s talented trader Dennis Weatherstone led the development of a flourishing foreign exchange business, and in the 1970s the office moved into the world of sovereign and corporate bond issuance. Business boomed in part because American companies realized they could pay less tax by raising finance in London rather than in New York.
That booming corporate bond business created the opening for Morgan Guaranty to move into the swaps world, and from the early 1980s, the Morgan Bank started to offer its clients deals through its London branch that allowed them to take advantage of the swaps magic. “This was an example of a fantastic innovation which really served a client need. It really solved problems in a useful way, Jakob Stott, one of the young bankers who was on the swaps team, recalled.
Initially, arranging these deals was clumsy and time-consuming. Before a contract could be struck, two parties with matching needs had to be found. That alone could take weeks. On one of the first such deals, a swap between the Austrian government and Commerzbank, they spent an entire afternoon tapping out the details on a telex machine, spelling out all the future cash flows to their clients. As the 1980s swore on, though, the pace of business picked up. So did the profits.
The young traders in the group were thrilled with the increasing power and freedom they enjoyed. Few at the bank outside the swaps team itself knew how their trades worked, and the leader of the team, Connie Volstad, widely recognized as one of the most brilliant minds in the derivatives world, was given great autonomy. Volstad showed outright disdain for the Morgan Bank senior management and would reveal only the scantiest details about the team’s business. Indeed, the team members loved teasing those in the more hidebound departments. “We had this sense of being special, of being detached from everyone else, a little team that was very tightly bound together,” recalled [Jakob] Stott.”

(SINCE DERIVATIVES ARE GROWING AT AN AWESOME RATE, THE QUESTION IS—HOW DO THE COMMODITIES COMPARE TO DERIVATIVES, CONCERNING VALUE? GOLD IS A COMMODITY AND FOR MANY YEARS WAS VALUED AS THE MOST VALUABLE AROUND THE WORLD. NOW, ALL OF A SUDDEN, SLICK-TALKING INVESTMENT BANKERS ARE TRYING TO TELL US DIFFERENT. AFTER ALL, THE PROBLEMS JUNK BONDS GOT US INTO WITH THE S&Ls THAT THE HUGE GROWTH OF THESE TOXIC DERIVATIVES, BECAUSE THEY’RE UNREGULATED AND HAVE NEVER PASSED ANY APPRAISAL CONCERNING THEIR VALUE, SUCH AS MOODY’S OR THE STANDARD & POOR’S RATINGS AGENCIES, THAT THESE RISKY FINANCIAL INSTITUTIONS SHOULD BE BAILED OUT by the TAXPAYERS, JUST BECAUSE THE HEDGE FUND DEALERS TELL US, WE CAN TRUST THEM. THE HEDGE FUND RECORDS AREN’T ANY MORE CREDIBLE THAN PRIVATE EQUITY OR VENTURE CAPITALISTS. CONSERVATIVES USED TO RUN OUR COMMERCIAL BANKING SYSTEM WHEN EVERYTHING WAS MANAGED WELL AND UNDER CONTROL, BEFORE THEY GOT SO BIG, THROUGH BANK MERGERS AND UNMANAGEABLE ENTITIES, SUCH AS J.P. MORGAN CHASE, WHOSE CEO, JAMIE DIMON, MISPLACED $6 BILLION. YOU MIGHT THINK OUR GOVERNMENT WOULD DO SOMETHING TO GET THINGS UNDER CONTROL BUT STILL NO ACTION FROM OUR FEDERAL GOVENEMENT BECAUSE THEY’RE LETTING JAMIE DIMON GO TO CHINA, HOPING HE CAN GET FEES AND COMMISISONS BY WRITING AN IPO FOR A COMPANY OVER THERE. I HEAR, THOUGH, THAT CHINA IS SKEPTICAL OF HIS VERSION OF THE WAY THE SYSTEM IS SUPPOSED TO WORK AND THAT MAY BE WHY, IN THE FUTURE, CHINA MIGHT BE ONE OF THE LEADING NATIONS IN the WORLD, AS WE DECLINE FROM A CREDITOR NATION TO ONE OF THE LEADING DEBTOR NATIONS. IT SOUNDS TO ME LIKE JUST A FEW WEALTHY INDIVIDUALS WILL COME OUT ON TOP. THIS BEARS OUT IN THE FACT IN THE BOOK WRITTEN BY CHRYSTIA FREELAND TITLED “PLUTOCRATS: THE RISE OF THE NEW GLOBAL SUPER-RICH AND THE FALL OF EVERYONE ELSE.”

LaVern Isely, Overtaxed Independent Middle Class Taxpayer & Public Citizen & AARP Members

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About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog (my.barackobama.com) and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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