The following is an excellent excerpt form 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 Five on page 82 and I quote: “As they reeled in shock, Hancock’s former acolytes tried to work out what the merger meant for their derivatives dreams. On paper, most of them seemed well placed to flourish. Mindful of the need to hang on to J.P. Morgan’s derivatives skills, [William] Harrison had agreed to put the innovation stars into seemingly plum positions. Demchak was named a cohead of credit; Masters was a cohead of asset-backed securities; Feldstein was named head of the global credit portfolio. In London, Bill Winters was named cohead of fixed income, and Tim Frost was appointed cohead of European credit. Technically, that gave them all positions as good as in the old J.P. Morgan bank, but now in a firm that was a true powerhouse.
These developments might have been appealing. Chase Manhattan had always had a formidable sales force, covering numerous corners of the financial world that J.P. Morgan had never managed to reach. It also had its own pool of creative financiers, including some in the CDO world. And, of course, the combined bank now had the advantage of vast size. The combined bank was estimated to control about half of the market for interest-rate swaps, a potentially formidable platform. Indeed, in early 2001, a few months after the merger [J.P. Morgan with Chase Manhattan] was completed, the bank was named “Derivatives House of the Year.”
Yet, as the J.P. Morgan swaps alums tried to adjust to the Chase influence, it was impossible to recapture the thrill of their early achievements. The fraternal spirit had dissipated, as had the fun, in the new dog-eat-dog atmosphere. Chase also had a different approach altogether to managing risk. The senior managers at Chase had always been wary of derivatives risk, but they had neither tried to shed credit risk on any large scale nor worried about excessive concentrations of credit risk. On the contrary, to boost profits the bank had heavily weighted its loan book to fast-growing sectors, such as the internet, with few controls.
From his perch as the new cohead of global credit, Demchak tried to convince the Chase side of the value of shedding risk, as his team had so successfully managed for J.P. Morgan. So did Feldstein. When they got a look at the Chase Manhattan portfolio, they became adamant. They were shocked by the concentrations of risk, and asked for the power to radically remodel the loan portfolio. The former Chase officials, however, dragged their feet. Those concentrated credit risks had earned the bank extremely fat profits in the internet boom, and the bank’s share price had soared, enabling it to purchase J.P. Morgan. The Chase officials saw no reason to copy a strategy J.P. Morgan had ridden with such a notable lack of commercial success.
To Demchak the business of remodeling the loan book was not just a good idea, it was an article of faith. He found the stance of the Chase bankers utterly infuriating, and he didn’t bother to conceal his disdain. “I can’t believe they’re running the bank like this!” he would wail to his colleagues, as his battle over the loan book grew more and more intense. His mission seemed hopeless until a dramatic turn of events.
On December 2, 2001, the American energy group Enron filed for bankruptcy. The news stunned the markets and corporate world. Enron had been a poster child for innovation and free-market competition. It employed 22,000, had reported revenues of $101 billion in 2000, and had been named as “America’s most innovative company” by Fortune magazine for six years in a row. However, In the autumn of 2001, it emerged that those stunning profits had been a mirage; the company had used creative accounting tricks to inflate its results, seemingly with the knowledge of its banks and accountants. When these schemes came to light, confidence in Enron collapsed, and the company filed for what was then the largest bankruptcy in American corporate history.
The news delivered a shocking blow to JPMorgan Chase. During the 1990s, Chase had developed a tight relationship with Enron, lending the company vast sums, underwriting its bonds, and creating a series of structured financial products and schemes in collaboration with the company, including some of those with which Enron had inflated its results. Just two months before Enron’s implosion, co-CEO Harrison had gone out of his way to tell bankers and journalists in the City of London just how “proud” he felt that Enron was a key client. Now Harrison found himself vehemently denying that the bank had engaged in any wrongdoing. “I believe we handled everything with integrity, but we had too much exposure,” he told employees in a speech broadcast over the company’s internal voice-mail system in early 2002.
The bank’s losses from Enron’s failure were initially estimated to be $900 million, but that number doubled as the scale of damage became clear.
Irrespective of Harrison’s denials, it swiftly became clear that former Chase employees not only had created some of the controversial Enron schemes, but also had done so knowing they were distorting the energy giant’s balance sheet. A structure known as “Mahonia” was a case in point. In 1995, Chase created an off-balance-sheet vehicle bearing that name as a tool to channel funds to Enron, and the bank subsequently used it to conceal up to $8.5 billion of debt in its accounts. Technically, the Mahonia structure was legal. “We did it according to accounting conventions and rules. It was transparent. It was on our balance sheet, and to our best knowledge, it was on Enron’s balance sheet,” Harrison said. However, US lawmakers dubbed Mahonia one of a collection of “shame trades” and railed against both Enron and its two main banks, JPMorgan Chase and Citigroup. When it emerged that two banks had earned around $200 million in fees creating such structures, the anger became intense.
Then even worse carnage struck. In the second half of 2000, the internet bubble started to burst. After reaching 5000 in March 2000, the NASDAQ quickly plummeted to 3000, and a vast swath of dot-coms went bust. In January 2001, the fiber-optic network operator Global Crossing, a client of Chase Manhattan, filed for bankruptcy protection, with debts of $12.4 billion. In July 2002, the telecom giant WorldCom imploded under $32 billion of debt. JPMorgan Chase had underwritten bonds for WorldCom and took another big hit. What was worse, by mid-2002, lawsuits in relation to WorldCom, Enron, and Global Crossing were flooding into the bank. Unsurprisingly, the bank’s share price slumped to less than half the level when the merger was struck. “It’s unnerving how the bad news keeps piling up at J.P. Morgan,” observed BusinessWeek. Or as the Evening Standard of London tartly declared: “Name a scandal-plagued US company in the headlines and one bank keeps showing up behind the scenes: JPMorgan Chase.”
Demchak, Feldstein, and the other so-called Heritage Morgan bankers were furious at the scale of mismanagement. Time and again, Demchak had warned of the need to diversify the risk from Chase loans, and that advice had been roundly rejected. He could take scant comfort now in knowing he had been proven right.
Demchak and his former J.P. Morgan colleagues mused about the bitter irony of it all. If they had just managed to stay independent for a few more months, the share price of Chase would have crashed. Events would have turned out quite differently. They felt as if the fates were laughing at them. But even as they reeled from the carnage, the innovation cycle was about to heat up again, and with the wonders of dot-coms soundly repudiated, attention would turn anew to the marvelous potential of credit derivatives and other forms of financial innovation. On January 3, 2001, the US Federal Reserve suddenly announced a 50-basis-point cut in interest rates, reducing them to 6 percent. That news stunned the markets almost as much as the internet collapse. In the prior eight years, Alan Greenspan had made a virtue out of running monetary policy in a calm, controlled manner, decreasing rates steadily but slowly at just 25 basis points a shot. This gradualist approach was said to mitigate volatility.
Greenspan was convinced, though, that the collapse of the internet bubble required a forceful response. Back in late 1989 and 1990, when the US economy had suffered a similar downturn, he had stuck to measured, slow rate cuts, and they had turned out to be too little, too late. The economy had sunk into a recession. He was determined to avoid that mistake this time around.
A few weeks after that first dramatic rate cut, Greenspan reduced rates again, and in the following months, he kept steadily cutting. When the attack on the World Trade Center sent the markets into a tailspin, he cut rates even further. By 2003, the prime rate was just 1 percent, its lowest level for many decades.
The policy worked, and worries of a recession abated, though the crash had wiped out $5 trillion in the market value of technology companies between March 2000 and October 2002. By 2003, the mainstream economy was rebounding. In stark contrast to the bursting of the savings and loan bubble, no European or American institution actually collapsed from its losses. Greenspan and other policy makers partly attributed that to the fact that so many banks were using credit derivatives to spread their risk around. Unsurprisingly, the J.P. Morgan bankers agreed. “Credit derivatives are a mechanism for transferring risk efficiently around the system,” Tim Frost cheerfully told journalists, noting that defaulted loans that would have knocked a hole in a bank’s balance sheet ten years ago were “now hits that we have spread around the system, and represent tiny blips on the balance sheets of hundreds of financial institutions.”
Indeed, as bankers and investors processed the lessons from the internet crash, credit derivatives began to look more and more appealing. So, just as bankers in the early 1990s had responded to falling interest rates by producing more complex and leveraged derivatives products, they now began searching for a new round of more complex credit ideas.
Investor attention was also drawn to another sector. The real estate world—unlike the corporate sector—was relatively unscathed by the internet bust. On the contrary, the low interest rates Greenspan had instituted had given the housing market quite a boost, as mortgages became less and less expensive. Unbeknownst to the J.P. Morgan bankers, and against their better judgment, these two booming businesses of mortgages and derivatives were about to become fatefully intertwined.”
(JPMORGAN CHASE, WHO HAD CLIENTS AROUND THE WORLD WAS BRAGGING ABOUT HAVING ENRON AS A CLIENT, WHO WAS NAMED AS “AMERICA’S MOST INNOVATIVE COMPANY” SIX YEARS IN A ROW BY FORTUNE MAGAZINE AND ALL OF A SUDDEN IN DECEMBER 2, 2001, FILED FOR BANKRUPTCY. HOW CAN THIS HAPPEN IF OUR REGULATING SYSTEM IS SUPPOSED TO BE DOING ITS JOB? WHEN THE FED CHM TESTIFIES IN FRONT OF CONGRESS, HE’S SUPPPOSED TO BE THE OFFICIAL BOOKKEEPER OF OUR BANKING SYSTEM. THEN ON TOP OF THAT, THEY SAID in the LATTER HALF OF 2000, THE INTERNET BUBBBLE STARTED TO BURST, THEN GLOBAL CROSSING AND WORKCOM FILED FOR BANKRUPTCY. IT’S A MIRACLE THESE INVESTMENT BANKS COULD HAVE HELD THE SYSTEM TOGETHER THIS LONG , USING THOSE WORTHLESS, TOXIC DERIVATIVES. YOU WOULD HAVE THOUGHT SOMEBODY IN CONGRESS AND GOVERNMENT, WITH THE EXCEPTION OF BROOKSLEY BORN, FORMER CHAIR OF CFTC [COMMODITY FUTURES TRADING COMMISSION], SENATOR BERNIE SANDERS, AND SENATOR BYRON DORGAN, WOULD HAVE WANTED TO PUT SOME REGULATIONS ON THE WAY THESE FREE-WHEELING INVESTMENT BANKS WERE USING DERIVATIVES BUT THE PROBLEM WAS, the BIG MONEY INTERESTS, ESPECIALLY ISDA [INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION] LOBBYING AGAINST ANY MEANINGFUL REGULATIONS ON DERIVATIVES. THE PROBLEM IS STILL THERE TODAY WITH THOSE SAME PEOPLE LOBBYING TO NOT REGULATE DERIVATIVES, SO IT LOOKS LIKE WE WILL HAVE ANOTHER BIGGER FINANCIAL BUBBLE THEN WE HAD IN 2008 BECAUSE OF THE MUCH HIGHER AMOUNTS OF DERIVATIVES IN THE MARKET.
LaVern Isely, Overtaxed Independent Middle Class Taxpayer & Public Citizen & AARP Members