Amplifying Derivatives Leading to a Worldwide Financial Catastrophe

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 from page 17 and I quote: “From time to time, the senior management would try to clip the swaps team’s wings. In 1986, Lewis Preston, then the chief executive of J.P. Morgan, flew to London and challenged the manner in which [Connie] Volstad was recording the value of deals. At the time, J.P. Morgan, along with every other bank, was unclear how to measure the worth of the swaps trades, as accounting guidelines were still being worked out. “You say your group has made a $400 million profit, but,” Preston challenged Voldstad, “It looks to me as if you have a $400 million loss!” Furious, Volstad assigned a team of junior analysts and interns to reexamine every single paper ticket recording the deals, and when he proved his case, Preston backed down. The episode was indicative of the way the upper management viewed the swaps traders: as a bunch of unruly teenagers.
As [Peter] Hancock watched the high-octane business of the swaps group from his humdrum perch in J.P. Morgan’s commercial banking team, he was fascinated and eager to join in. So in 1984, he joined the London bond group, and in 1986 wrangled his way to move across to New York, where the bank was expanding its derivatives operation. The J.P. Morgan managers had realized, to their utter delight, that there was no explicit provision in Glass-Steagall against trading in derivatives products.
Initially, Hancock’s role on the team was rather humble. He managed a small treasury team that used swaps to manage the bank’s on-balance-sheet assets and liabilities. But Hancock was articulate and opportunistic and soon found ways to make himself visible. After the 1987 stock market crash, interest rates fell and the bank suffered sizable unexplained losses in its derivatives books. Hancock was asked to explain to the bank’s senior management what had happened and ended up managing a small desk at headquarters that traded products known as ”floors” and “caps.” Then, when the bank rebranded itself as J.P. Morgan in 1988, Hancock, a keen sailor,organized a team that sailed round Manhattan with a vast J.P. Morgan logo on its sails. That garnered attention, particularly since Hancock’s team narrowly beat Goldman Sachs’s boat. He learned everything he could about how the derivatives world worked. He also impressed Dennis Weatherstone, CEO of the bank. Weatherstone was a legendary character. He hailed from working-class British stock, first joined the bank at age sixteen as a messenger boy in London, but later became a brilliant foreign exchange trader and eventually rose to the very top.
In 1988, a shock occurred that created Hancock’s opening. Connie Volstad defected to work at Merrill Lynch, taking half a dozen of his team. It left the bank with a conundrum.
At other banks, the obvious way to fill the huge revenue hole left by Volstad’s departure would have been to hire a new guru and build a new team from rival banks. But J.P. Morgan rarely hired outsiders into senior positions. The vast majority of its senior staff had come up through the ranks, giving the bank its insular culture, for good and ill. So the senior management initially appointed some of Volstad’s junior team members to take over. Before long, it was clear they couldn’t fill his shoes, and Hancock saw his chance.
In 1990, at only thirty-two, he was considered too young to run a department. But he was good at navigating office politics. So, about a year after Voldstad left, Weatherstone announced that Hancock would lead the swaps team. “Sometimes in life you just get a huge break, and you jut have to grab it and run with it,” Hancock later recalled. The would-be inventor now had a chance to let his penchant for invention run.
Over the next years, Hancock rode the cres tof the derivatives wave. When swaps had taken off, J.P. Morgan wasn’t at all viewed as an innovator; by 1994, its creative skills were as good as those of most rivals. Better still, the bank had advantages some rivals lacked. As a respected commercial lender, Morgan had access to a huge array of blue-chip companies and governments that were often eager to conduct derivatives deals. The bank was also one of the very few with a top-notch AAA credit rating, which reassured clients that the bank could stand by its trades. By the end of the 1980s, derivatives groups were no longer pairing only with other parties to make derivative deals, they also were using their own capital to make trades with clients on a huge scale. When clients cut deals with J.P. Morgan, the AAA rating assured them that the bank would always be around to fulfill its side of those deals.
As business boomed, the swaps department basked in the knowledge that it was producing an ever-increasing share of the bank’s profits. By the early 1990s, it accounted for almost half the bank’s trading revenues, and Hancock had been promoted to run not just the derivatives group but also the entire department it was part of, known as fixed income. He was considered a prime candidate for CEO.
A few months before the Boca off-site, a reporter from Fortune asked Hancock to explain how a complicated swap might work, and his response reaffirmed for her that derivatives traders were “like the spacecraft Galileo, heading for planet Jupiter.” “It would be something,” Hancock apparently said, “in which you get beyond binary risk and into a combination of risks, such as interest rates and currencies. Or take an oil company, which has risks of oil prices dropping and interest rates rising. To hedge, it could buy an oil price floor and an interest-rate cap.” But maybe, said Hancock, the company would like something a little cheaper: “In that case we could do a contract that would pay out only if oil prices are low and interest rates are high at the same time.” The man who had one dreamed of being an inventor was in his element.
Yet down in Boca, Hancock was not in a celebratory mood. On the contrary, he knew that the derivatives sector was reaching a crucial point in its evolution and his team had to adjust. The essential problem was the phenomenon he described as the “cause of the innovation cycle.” In manufacturing or pharmaceuticals, patent laws ensure that a brilliant new product or idea is protected; competitors cannot simply steal that innovation. In banking, however, patents haven’t traditionally been an option. When financiers have a brilliant idea, nothing typically stops competitors from copying it right away, and before long they are putting downward pressure on profit margins.
The swaps business epitomized this problem. As soon as Salomon Brothers cut its first deal, other banks such as J.P. Morgan copied it, and the market exploded. The burst of activity had a vexing impact on profit margins. While the first wave of swaps deals had high margins, once copycats jumped in, competition brought fees down. For years, the issue hadn’t really worried Hancock because the volume of deals was growing so robustly. But he was unsure how long the volume could continue to explode, and he knew that if he wanted to keep his department cranking, he had to find a new way before long to do deals. He was feeling tremendous pressure to find the next Big Idea.
So while his team viewed the weekend as a lavish party, Hancock has a serious agenda. By bringing his young group together from all over the world, and pushing them into close quarters for forty-eight hours, he hoped he could spark the innovation flame.
On the Saturday morning, the group assembled in a conference room a few feet from the sparkling blue sea for one in a series of meetings. How, Hancock asked, could they unleash a new wave of innovation in the derivatives business? Could bankers apply the principles to new areas? What about the insurance world? Or loans and credit?
The team was in little mood for mental gymnastics. Some were jetlagged and most were hung over. Bill Winters was nursing a badly swollen nose and wondering how he would explain it to his wife back home. “Frankly, I cannot remember much of our debate,” Bill Demchak, the team leader who was Hancock’s de facto deputy, would later say with a sheepish laugh. All he could remember, he added, was that when he checked out of his hotel, his bill included charges for a smashed Jet Ski and a vast quantity of cheeseburgers. They had been charged to him, as a joke, by the rest of the team.
But Hancock’s intensity was impossible to resist. He strode around the room, chucking out ideas with his Planet Pluto energy, and soon enough the debate heated up. One key idea started to emerge: using derivatives to trade the risk linked to corporate bonds and loans. Commodity derivatives, a voice pointed out, let wheat farmers trade the risk of loss on their crops. Why not create a derivative that enabled banks to place bets on whether a loan or bond might default in the future? Defaults were the biggest source of risk in commercial lending, so banks might well be interested in placing bets with derivatives that would allow them to cover for losses, using derivatives as a form of insurance against defaults.
In truth, that was not a new idea. Three years earlier, the eve oinventive Bankers Trust had conducted the first pioneering deals along those lines. So had Connie Volstad’s team at Merrill Lynch. But the notion hadn’t taken off because those trades didn’t appear particularly profitable. As the debate swirled around the room in Boca, though, Hancock and the others became excited about the concept. After all, they reasoned, the world was full of institutions—and not just banks—that were exposed to the risk of loan defaults. J.P. Morgan itself had a veritable mountain of loans on its books that were creating regulatory headaches. What would happen, they asked, if a derivative product of some kind could be crafted to protect against default risk—or to deliberately gamble on it? Would investors actually want to buy that product? Would regulators permit it to be sold? If so, what might it mean for the financial world if default risk—the risk most central to the traditional craft of banking—were turned into just another plaything for traders?
They had no idea that weekend how to answer those questions, but Hancock’s team was not used to taking no for an answer. They spent their days stretching their minds to the extremes, and they could see that the concept was potentially revolutionary. If you could really insure banks and other lenders against default risk, that might well unleash a great wave of capital into the economy. “I’ve known people who worked on the Manhattan Project—for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important,” Mark Brickell, one of the bankers on the J.P. Morgan swaps team, later recalled.
Recalling the Boca meeting, Hancock said, “The idea that we gave most emphasis to was using derivatives to manage the risk attached to the loan book of banks.” 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 that would come to dominate the business a decade later, eventually leading to a worldwide financial catastrophe.”

(WHEN CONNIE VOLSTAD, THE LEADER OF THE SWAPS TRADERS, WAS CONFRONTED BY LEWIS PRESTON, THEN THE CHIEF EXECUTIVE OF J.P. MORGAN AND SAID AS QUOTED ON PAGE 17: “You say your group has made a $400 million profit, but,” Preston challenged Volstadt, “it looks to me as if you have a $400 million loss!” Furious, Volstadt, assigned a team of junior analysts and interns to reexamine every single paper ticket recording the deals, and when he proved his case, Preston backed down. The episode was indicative of the way the upper management viewed the swaps traders: as a bunch of unruly teenagers.”
I DONT’ KNOW ANY HONEST TAX ACCOUNTANT THAT THE SAME ACCOUNTS COULD SHOW PROFITS AND LOSSES AT THE SAME TIME. IF THIS IS ALLOWED TO CONTINUE FOR CERTAIN CORPORATIONS AND INDIVIDUALS, I CAN EASY UNDERSTAND WHY THERE’S GETTING TO BE CLASS WARS TAKING PLACE ALL AROUND THE WORLD. THIS SEEMS EVIDENTLY TO BE SO BIG AND WIDESPREAD, I’M WONDERING IF EVEN THE UNITED NATIONS CAN GET IT UNDER CONTROL. ANOTHER GOOD QUESTION—WHAT CONNECTION DOES THIS HAVE with THE TRADE WARS THAT ARE POPPING UP IN EVERY COUNTRY. THIS IN TURN, REFLECTS ON EACH COUNTRY’S CURRENCY VALUE AND IS THIS GOING TO COME DOWN TO WHO HAS THE MOST GOLD ON HAND? OR WHO HAS THE MOST DERIVATIVES? I QUOTE FROM PAGE 22: “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 that would come to dominate the business a decade later, eventually leading to a worldwide financial catastrophe.”

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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