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 Gilliam Tett from Chapter Two on page 27 and I quote: “A few weeks after he had summoned Dennis Weatherstone and Peter Hancock to meet with him, in January 1992, Corrigan delivered a stern speech to the New York Bankers Association. “Given the sheer size of the [derivatives] market, “ he said. “I have to ask myself how it is possible that so many holders of fixed- or variable-rate obligations want to shift those obligations from one form to the other.” Translated from central bank jargon, this suggested that Corrigan was dubious about the banks’ motives for making these deals. “Off-balance-sheet activities have a role,” he continued, “but they must be managed and controlled carefully, and they must be understood by top management, as well as by traders and rocket scientists,” he added. “I hope this sounds like a warning, because it is!”
Derivatives bankers were shocked. Corrigan seemed poised to institute regulation. Sure enough, a few weeks later it emerged that international regulators, led by Corrigan, were preparing to define how the Basel rules should be applied to market trading activities with more precision. Then, around the same time, Mark Brickell, a member of [Peter] Hancock’s team, received a surprising overture from a Washington-based organization, the Group of Thirty. Brickell had joined J.P. Morgan straight out of Harvard Business School around the same time as Hancock and was a true believer in the wonders of swaps. Hancock had selected Brickell to act as his key point man in lobbying regulatory officials and politicians, who had been asking so much of late about the derivatives business. Brickell was ideally suited for the job. He was an intense man, with passionate libertarian views, who had entertained the idea of pursuing a career in politics. Unlike most swaps traders, he therefore relished dealing with politicians, and he was so enthusiastic about lobbying that by 1992 he held the post of chairman of the ISDA. He was Hancock’s and the industry’s Rottweiler in fending off regulatory concerns.
The G30, it turned out, was planning to write a study of the derivatives world, and the caller told Brickell the group wanted J.P. Morgan to lead the process. It was clear that the report could be crucial for setting government policy. The G30 was a highly influential group of economists, academics, and bankers, set up in 1978 with funding from the Rockefeller Foundation, with a mission to promote better international financial cooperation. Paul Volcker led the group.
J.P. Morgan officials debated what to do. Inside the swaps group, the young traders were wary of collaborating on the study. At best, they feared it might result in J.P. Morgan sharing proprietary secrets; at worst, it would be leading to regulations that the bank would be seen as instrumental in instituting. “The whole project was fraught with peril for the swaps world,” Brickell later said. “There was a clear danger of having any recommendations codified as regulation.” Dennis Weatherstone nevertheless insisted that the bank cooperate. As CEO, he was highly mindful of the bank’s legacy of public duty, and he suspected that Corrigan, and therefore the weight of the New York Fed, was behind the initiative.
Truth be told, Weatherstone was concerned about the risks of the swaps business. If the industry kept growing without controls, he heard the chances were good that excesses would lead to an implosion that would hurt not just other banks but J.P. Morgan, too. “If you are driving along the motorway in a smart Maserati and see an old car belching fumes,” he sternly told Hancock and his other young turks, “it’s no good just driving on. If that told car crashes, it could wipe out the Maserati, too.”
So Weatherstone agreed to chair the G30 report., and Hancock, Thieke, Brickell, and other J.P. Morgan bankers set to work on it with a host of representatives from other banks. Patrick de Saint-Aignan, a derivatives banker at Morgan Stanley, and David Brunner of Paribas coheaded the report; officials from HSBC, Swiss Bank, and Chase Manhattan also took part. Peter Cooke, a former Bank of England regulator offered advice; so did Merton Miller, the Nobel laureate and leading free-market economist from the University of Chicago. “We knew that we were setting the foundation for the derivatives world,” recalled Brickell.
The time had definitely come to do so. Between 1992 and 1993, the value of deals rose from $5.3 trillion to $8.5 trillion, according to ISDA data. What was more striking, however, was that deals were becoming more complex and were being sold to a wider range of customers. The initial customers for swaps had been large international corporations or banks, with sophisticated treasury departments and investment analysis, groups like Coca-Cola, IBM, and the World Bank. By 1992, small banks, midsized companies, pension funds, and many other asset managers were joining the market. And more and more of them were turning to derivatives not to control for future risks but to make big gambles and realize big returns. By 1983 it was running at 3.2 percent, down from 13.5 percent in 1981. The Fed was then able to trim short-term interest rates, which stimulates economic growth. In 1987, Alan Greenspan replaced Volcker as Fed chairman, and from 1989 onwards, he steadily reduced rates to fight a mild recession. That was good news for borrowers, and it also boosted bank profits, because when rates are low, banks can borrow money cheaply and lend it out to customers at higher rates, making easy returns. But falling rates made it harder for investment managers to earn decent returns by purchasing relatively risk-free government or corporate bonds. Those pay less when rates fall. Thus, while the absolute level of rate still relatively high (at least, compared with what it would be a decade later), the direction prompted some bond investors to look for new tactics.
Merrill Lynch, Bankers Trust, Salomon Brothers, and J.P. Morgan itself suggested to their clients that they could use derivatives to boost their returns, and the banks invented a new wave of products to provide that service, with obscure names like “LIBOR squared,” “time trade,” and “inverse floaters.” Some federal agencies, such as Sallie Mae, the student loan provider, also began offering investment products that included derivatives. Most of these products produced high returns by employing two key features. They involved bets on the level to which interest rates would fall in the future, and with rates falling so dependably on Alan Greenspan’s watch, those bets produced easy money with what seemed like very little risk. Most of these deals also involved a concept that is central to the financial world, known as “leverage.” This essentially refers to the process of using investment techniques to dramatically magnify the force or direction of a market trend (just as a lever will increase the force of a machine). In practical terms, the word can be used in at least two ways in relation to derivatives. Sometimes investors employ large quantities of debt to increase their investment bets. For that reason, borrowing itself has often come to be called “leverage” in recent years. However, the economic structure of derivatives deals can also sometimes leave investors very sensitive to price swings, even without using large quantities of debt. Confusingly, that second pattern is also referred to as “leverage.” In practice, though, these two different types of leverage tend to be intermingled. And the most important issue is that both types of leverage expose investors to more risk. If the bet goes right, the returns are huge; if it goes wrong, though, the losses are big, too. Using leverage in the derivatives world is thus the financial equivalent of a property developer who buys ten houses instead of five: owning more properties will leave that developer more exposed to losses and to gains if house prices rise or fall, particularly if the properties are financed with debt.
In 1992 and 1993, though, many investors thought it was worth taking those risks, by buying products with high leverage. “It was a type of crazy period,” recalls T.J. Lim, one of the early members of the J.P. Morgan swaps team, who worked with Connie Volstadt in the 1980s and decamped with him to Merrill Lynch. “The herd instinct was just amazing. Everyone was looking for yield. You could do almost anything you could dream of, and people would buy it. Every single week somebody would think of a new product.”
The rush into derivatives was partly driven by aggressive marketing efforts by the banks and regulatory changes in the asset management world. Another factor that fueled the trend, though, was falling interest rates. After Paul Volcker jacked up rates in 1979, inflation had tumbled.
Some prescient warnings were issued. Allan Taylor, the Royal Bank of Canada chairman, said that derivatives were becoming like “a time bomb that could explode just like the Latin American debt crisis did,” threatening the world financial system. Felix Rohatyn, a legendary Wall Street figure who worked at Lazard Freres in corporate finance, far removed from derivatives, called derivatives “financial hydrogen bombs, built on personal computers by twenty-six-year-olds with MBAs.””
(THE REASON GERALD CORRIGAN WANTED A REPORT, CONCERNING THE HUGE GROWTH OF THE DERIVATIVES MARKET AND THE PEOPLE INVOLVED IN THEM AND I QUOTE FROM PAGE 29:
“”We knew that we were setting the foundation for the derivatives world,” recalled Brickell.
The time had definitely come to do so. Between 1992 and 1993, the value of deals rose from $5.3 trillion to $8.5 trillion, according to ISDA (International Swaps and Derivatives Association) data. What was more striking, however, was that deals were becoming more complex and were being sold to a wider range of customers. The initial customers for swaps had been large international corporations or banks, with sophisticated treasury departments and investment analysis, groups like Coca-Cola, IBM, and the World Bank. By 1992, small banks, midsized companies, pension funds, and many other asset managers were joining the market. And more and more of them were turning to derivatives not to control for future risks but to make big gambles and realize big returns.”
WE”RE GETTING FORCED INTO DEALING RECKLESSLY BECAUSE WHILE PAUL VOLCKER HAD RAISED INTEREST RATES TO CURB INFLATION, ALAN GREENSPAN LOWERED THEM VIRTUALLY FORCING PENSION FUNDS TO GO INTO RISKY INVESTMENTS TO SUPPOSEDLY GET A HIGHER RATE OF RETURN. NOW, AS BAD AS ALAN GREENSPAN WAS, FED CHM, BEN BERNANKE, HAS BEEN EVEN WORSE BY LOWERING THE INTEREEST RATE TO ALMOST ZERO AND THAT EVEN INCLUDES SAVINGS BOND RATES, WHICH IS 0.20 PERCENT FROM MAY 1, 2013 THROUGH OCTOBER 31, 2013 AND AS THE ECONOMY SLIDES INTO AN EVEN BIGGER GROWING INCOME DEBT AND WHO IS GOING TO BE PAYING IT OFF, PARTICULARLY ALL THE MONEY THE GOVERNMENT HAS BORROWED FROM SOCIAL SECURITY in the PAST, RATHER THAN BLAMING THE BILLIONAIRES THAT ARE HIDJING THEIR MONEY OFFSHORE AND EARNING RECORD PROFITS, WHILE THE 99 PERCENT OF US ARE GETTING SLOWLY STARVED OUT BECAUSE THE REPUBLICAN-CONTROLLED HOUSE OF REPRESENTATIVES CAN’T EVEN PASS A FARM BILL THAT INLCUDES THE FOOD STAMP PROGRAM AND THAT’S REALLY, REALLY SERIOUS ON THE ELDERLY THAT ARE TOO OLD TO WORK. THEY EVEN WANT TO CUT THE COST OF LIVING ON SOCIAL SECURITY. IT’S VIRTUALLY LIKE A BUNCH OF RICH BILLIONAIRES STEPPING ON LITTLE ANTS.
LaVern Isely, Overtaxed Independent Middle Class Taxpayer & Public Citizen & AARP Members