Solved by verified expert:Summary: Clearly describes thesis, argument and conclusions of text. Shows good understanding of relevant main points and avoids extraneous detail.Evidence: Describes and evaluates the kinds of evidence used to support the claims in the text.The assignment is to summarize chapters 9,10,11,12,13,14,15 of the book of (Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe).The summary should be no less than 4 pages essay.The attachment is the summary of the whole book to be familiar with what the book is about.
credit_derivatives.docx
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In this summary, you will learn
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How and why J.P. Morgan bankers pioneered credit derivatives;
Why the combination of credit derivatives and mortgage securitization created
enormous, hidden systemic risks; and
What happened to tip the world into global financial crisis.
Take-Aways
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J.P. Morgan bankers pioneered credit derivatives, but used them cautiously.
Other banks took risks Morgan’s experts found imprudent and intolerable.
J.P. Morgan’s revenue and stock price suffered in comparison to its peers’ results, but
CEO Jamie Dimon refused to let it run with the risk-chasing herd.
The growth of the credit derivatives market, especially combined with mortgage
securitization, created many poorly understood links among financial institutions.
The pioneers of derivatives struggled to exempt them from regulation; they succeeded
with dire results.
When the U.S. housing market began to slide in 2006, Dimon prioritized shedding
exposure to subprime mortgages. Few other bank chiefs took the problem that seriously.
Banker and regulators were in the dark about the real risks in regulated institutions.
Many of them failed to react to increasing risk in mortgages and derivatives.
Chase Manhattan purchased once-proud J.P. Morgan, the U.S. government rescued
Bear Stearns and AIG, but let Lehman Brothers fail.
Bankers and governments had to scramble to protect the overall global financial system.
Hatching the Idea
Pinpointing where and when credit derivatives were born is difficult, but a 1994 party for
J.P. Morgan bankers at Florida’s Boca Raton Hotel could claim that distinction. Between
pranks and drinking games, the young, aggressive financiers considered new ways to
profit from derivatives, which are essentially wagers on future values. Users often regard
them as insurance. For example, a company may expect to receive income in foreign
currency, but it pays vendors in its domestic currency. Currency markets fluctuate
continuously, so how can the company make sure the foreign currency it gets will cover
its obligations? The company can use a derivative to ensure that the foreign currency
coming in tomorrow, next month or next year will be worth at least as much as it is today
in domestic currency. The many kinds of derivatives share one trait: their value and risk
depend on changes in some other asset price, like an interest rate or credit rating.
“As with most intellectual breakthroughs, the exact origin of the concept of credit
derivatives is hard to pinpoint.”
By 1994, the global interest rate and currency derivatives market already had grown to
$12 trillion in volume. In its early days, during the 1980s, bankers earned rich fees on
relatively simple derivatives. Yet, unlike patented high-tech innovations, derivative
innovations were easy to copy – and banks duplicate each other with gusto. Competition
drove down the margins in the derivative business. J.P. Morgan’s bankers realized that
derivatives were producing an enormous proportion of their total profits. One of the best
ways to keep producing such profits was to create innovative, new products other bankers
could not yet match.
“Derivatives…could do two things: help investors reduce risk or create a good deal more
risk.”
In Boca Raton, the financiers began to talk about a new type of derivative that would let
banks insure themselves against the risk that a borrower might default. A few derivative
deals for that purpose had already happened, but no one had developed credit derivatives
into a real business.
“There was a critical juncture, around the time that Peter Hancock’s team seized on the
idea of credit derivatives, when financial innovation might have followed a subtly
different path.”
Cast of Characters
The primary players in developing J.P. Morgan’s derivatives and derivative credit swaps
(exchanges between two parties “with complementary needs in the financial markets”)
were:
“In the absence of regulatory oversight, the eventual innovation frenzy would later fuel
a boom beyond all bounds of rational constraint – or self-discipline.”
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Peter Hancock – Coming from an upper-middle-class British family, he went to Oxford.
Cerebral, professorial and committed to innovation, he led the J.P. Morgan derivatives
team.
Bill Demchak – A middle-class boy from Pittsburgh, he earned an M.B.A. from the
University of Michigan. A work-hard-play-hard type, he had strong leadership skills. His
job was to implement Hancock’s ideas.
Bill Winters – A graduate of Colgate University, flexible, low-key, hard working, he ran
the derivatives team in Europe.
Krishna Varikooty – A mathematical model builder known for his ethics, he
recognized the risks of mortgages and kept Morgan away from such dangerous unknowns.
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Blythe Masters – This British executive studied economics at Cambridge, put together
Morgan’s first credit derivative and became its CFO by age 34.
“Unbeknownst to the J.P. Morgan bankers, and against their better judgment, the two
booming businesses of mortgages and derivatives were about to become fatefully
intertwined.”
Forestalling Regulation
In 1991, the president of the New York Fed, E. Gerald Corrigan, acting upon regulators’
dawning interest in derivatives, asked Morgan’s CEO Dennis Weatherstone to talk with
him about the business. Weatherstone called in Hancock to help explain it. In January
1992, Corrigan gave a speech to the New York State Bankers Association, expressing
misgivings about the reasons behind the fast growth of derivative trading.
“Financiers had created a vast ‘shadow banking’ system that was…out of control.”
Washington’s influential “Group of 30” (G30) decided to study it. Weatherstone agreed
to chair the study, knowing its findings could influence future derivatives regulation. J.P.
Morgan swaps banker Mark Brickell, a libertarian who opposed regulation, stepped in to
defend the derivatives business against federal rule making. Known as a “Rottweiler” in
the fight against regulation, he said the industry itself was best equipped to manage risk.
In fact, J.P. Morgan had developed “Value at Risk,” a quantitative model that is used to
assess a portfolio’s probability of loss. Brickell’s tenacious antiregulation lobbying ruffled
feathers in Washington, but the regulators backed off from derivatives. The G30 report
prescribed in detail how banks should manage derivative risk, but accepted the
proposition that government intervention was unnecessary.
“There was absolutely no shortage of players willing to…insure J.P. Morgan against the
danger that the market might turn sour.”
BISTRO Action
Soon after the 1994 Boca Raton party, Blythe Masters arranged a credit swap with the
European Bank for Reconstruction and Development that let J.P. Morgan offload the
credit risk of a loan to Exxon without actually selling the loan itself. She and Demchak
began calling on regulators to see if banks using credit derivatives to offload credit risk
could carry lower capital reserves. In 1996, the Fed approved. J.P. Morgan applied
securitization technology, bundling pools of loans and selling the bundles to specialpurpose vehicles (SPVs) that were paid to insure against the risk of default. The SPVs sold
these loan-backed securities to other investors, putting the proceeds in very creditworthy
securities to guarantee funds for payment in the event of default.
“In Europe, regulators and policy makers seethed…most European officials – like
investors – had assumed that the U.S. government would…save Lehman.”
J.P. Morgan called this innovation the “broad index secured trust offering,” BISTRO for
short. Members of Morgan’s derivatives team pocketed rich bonuses as business boomed.
However, regulators raised some troubling questions, particularly, what if defaults were
so widespread that the SPVs cushion (the funds it invested in high-rated securities) was
insufficient? The bankers saw this as highly unlikely, because the risk that concerned
regulators was safer than AAA ratings require. American International Group (AIG)
began to build a business insuring banks against this “super-senior risk” even as bankers
eventually persuaded regulators that the super-senior risk was not risky enough to require
capital reserves.
“Since ABCP investors…could not tell exactly where the rot had ended up, they were
boycotting all SIV notes.”
In 1999, a German bank, Bayerische Landesbank, asked J.P. Morgan for help. It wanted
to use the BISTRO approach to offload its $14 million U.S. mortgage loan risk. After
analysis, Varikooty said he could not derive a precise estimate of the default risk, because
determining the correlation of mortgages across the entire U.S. was impossible. Not
wanting to say no to Bayerische Landesbank, Morgan did the transaction, paying so much
to hedge the risks that the deal was not very profitable. J.P. Morgan’s bankers soon began
to hear of other banks selling credit default swaps against mortgages. They wondered how
those banks were handling the risk.
“That created the potential for a chain reaction; if SIVs collapsed…money-market funds
would suffer losses and consumers would then suddenly discover that their supersafe
investments were not so safe.”
Perverting Innovation
J.P. Morgan had a proud tradition and a tightly knit, rather conservative culture. During
the 1990s, banks began to move into nontraditional businesses, a trend accelerated by the
1999 repeal of the Glass-Steagall Act, which previously limited their role. Financial
institutions gobbled each other up in a merger mania that created huge financial
supermarkets. J.P. Morgan began to look small and stodgy compared to its peers. The
apparent setting of J.P. Morgan’s star contributed to the 2000 resignation of derivatives
chief Peter Hancock. Shortly after he left, Chase Manhattan bought J.P. Morgan – a
humiliating shock to Morgan’s tradition-proud bankers. Bill Demchak, now co-head of
credit in the newly merged institution, realized that Chase was earning revenue
dangerously, by making highly risky loans to the Internet sector and to scandalous
borrowers. In 2001, when the Enron scandal broke, Chase was in the headlines. It also
was a lead banker for Global Crossing and WorldCom, both scandal-plagued. Chase
apparently did not share a tradition that began at J.P. Morgan a half-century ago, when
founder J. Pierpont Morgan’s son J.P. “Jack” Morgan Jr., mandated conducting a “firstclass business…in a first-class way.”
“Faced with a financial system that few people seemed to understand anymore, the G8
did nothing – other than hope that the losses…in the U.S. subprime mortgage world
would be absorbed quickly.”
Jamie Dimon Comes to J.P. Morgan
In 2000, Demchak resigned from Chase, followed by the ethical, meticulous Varikooty.
Meanwhile, other financial institutions raced to imitate BISTRO. They pushed the risk
envelope, not only doing deals against the ordinary mortgages that J.P. Morgan had found
too risky when approached by Bayerische, but even doing deals against subprime
mortgages. Rating agencies approved such deals, in part, because if one rating agency
refused to bless a deal, the bank could take the deal and its revenues to another agency.
Losses on credit drove Chase’s stock price down (as Demchak had feared), paving the way
for its merger with Bank One, whose CEO Jamie Dimon became CEO of Chase in January
2004. Dimon had been pivotal in building Citigroup and had turned Chicago’s faltering
Bank One into a powerhouse. A detail-oriented manager, Dimon worried about costs and
risks.
‘“Pile ‘em high and sell ‘em cheap!’ Tim Frost, a young trader, sometimes quipped. He
was utterly convinced that a mass-market approach could be found for derivatives.”
The Business of Risk
Dimon wanted Chase to catch up with the rest of the industry on mortgage securitization,
so he set up a team for that purpose. Shortly, though, he began to worry about the risk.
Some anomalies were cropping up in the housing market. Borrowers were starting to
default on high-risk mortgages, even though the economy was strong and mortgage
interest rates were low. Other banks continued to take mortgage risk, but J.P. Morgan
started looking for ways to cut its exposure. Even experts like Winters, part of the original
Morgan credit swap team, could not understand how other banks could manage
mortgage-related risk and still make profits. Then, the housing market stalled and began
to slide. Chase’s annual revenue lagged its competitors by some $1.5 billion because of the
money its rivals were making on mortgage securitization. Fortunately, Dimon accepted
his team’s risk analysis. As real estate fell and housing dropped, he insisted on getting out
of mortgages, especially subprimes. Demchak, now vice-chairman of PNC Bank in
Pittsburgh, did the same. Yet, other banks continued assuming mortgage risks as if
nothing had changed. So, for that matter, did financial regulators – for the most part.
“‘The fact is that every five years or so, something bad happens. Nobody ever has a right
to not expect the credit cycle to turn!’ Dimon kept saying.”
Bank for International Settlements economists warned the industry about potential risks
from financial innovations in 2003, at a conference in Jackson Hole, Wyoming. Alan
Greenspan’s Fed took a strong pro-market, pro-innovation approach, but other central
bankers were skeptical, including [now U.S. Treasury Secretary] Timothy Geithner,
president of the New York Fed. In 2007, Germany’s G8 representatives worried that
hedge funds were a source of massive, hidden risk. Jim Chanos, a prominent hedge fund
founder, attended a meeting where financial officials mulled those concerns. “It’s not us
you should be worrying about – it’s the banks!” he said, but his warning seemed to fall on
deaf ears.
Fear and Panic
In June 2007, problems at a Bear Stearns hedge fund hit the headlines. J.P. Morgan had
made loans to the fund, and demanded its money back. Merrill Lynch, which also
extended credit to the fund, threatened to sell the collateral – complex securities that
would have driven down the market – and made Bear Stearns’s problems worse. Bear
avoided that by giving the fund emergency credit. Another crisis hit in July in Germany.
Deutsche Industriebank had a special enterprise that raised funds by selling commercial
paper, which it had invested in mortgage-backed securities. As rating agencies moved to
downgrade mortgage-backed securities – especially those with subprime mortgages – the
German bank unit couldn’t find buyers for its commercial paper. J.P. Morgan could not
help but the German government itself intervened with a plan to support the bank.
Throughout 2007, fears spread about the global financial system. A liquidity crisis made
bankers and investors unwilling to take risks they no longer felt they could understand.
Central bankers took unprecedented actions in Europe, where the European Central Bank
publicly announced that it would support the markets. The Bank of England, however,
was inclined to let market discipline take its course against imprudent bankers and
investors. By August, the U.S. situation was serious enough for President George W. Bush
to offer public, rhetorical reassurance. Bankers, regulators and the public discovered the
existence of a vast shadow banking system, a source of immense hidden risk.
Regulators and bankers scrambled to protect the system from collapse. In 2008, the
Treasury and the Fed blew hot and cold on rescuing institutions, saving Bear Stearns,
letting Lehman fail, then saving AIG. Dimon summed up the course of events, “We think
we are going to be fine, in terms of our bank,” he said. “But it’s going to be very, very ugly
for others. Worse than anything that any of us have seen in our lives.”
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