TO BE NOTED:
1
Draft review essay for London Review of Books. Third draft
Safer than Safe
FOOL’S GOLD: HOW UNRESTRAINED GREED CORRUPTED A DREAM,
SHATTERED GLOBAL MARKETS AND UNLEASHED A CATASTROPHE by
Gillian Tett. Little, Brown, 338 pp., £12.99, 30 April, 978 1 4087 0167 6
Donald MacKenzieFew people’s reputations have been improved by the credit crisis. One is the BBC’s
Robert Peston; another Vince Cable. A third is Gillian Tett, capital markets editor of
the Financial Times. Prior to the crisis, she and her team were the only mainstream
journalists who covered in any detail the then arcane, technical world of ‘credit
derivatives’ (of which more below). Tett saw – however imperfectly – the huge risks
that were accumulating unnoticed within that world, and spoke out about them.
Fool’s Gold begins in a conference room in Nice in spring 2005. Tett admits
that at that point she was baffled by the technical language – ‘Gaussian copula’,
‘attachment point’, ‘delta hedging’ – being spoken by the participants. However,
before joining the FT she had conducted fieldwork in Soviet Tajikistan for a PhD in
social anthropology, and the ethnographer in her re-awoke. The conference reminded
her of a Tajik wedding. Those attending it were forging and refreshing social links,
and celebrating a tacit worldview – in this case, one in which ‘it was perfectly valid to
2
discuss money in abstract, mathematical, ultra-complex terms, without any reference
to tangible human beings’.
Who were the key actors in the ceremony, those up on the conference hall’s
stage? She whispered the question to the man sitting beside her. ‘They used to all
work at J.P. Morgan. … It’s like this Morgan mafia thing. They sort of created the
credit derivatives market.’ The answer surprised her. J.P. Morgan was not Goldman
Sachs: it wasn’t an exciting bank. It bore the name of America’s most celebrated
financier, but it was ‘dull’: safe, boring, perhaps a little snobbish. (When its current
chief executive, the now well-respected Jamie Dimon, joined the bank from Bank
One, which was headquartered in Chicago, Tett reports one Morgan banker muttering
‘Not another retail banker from Hicksville, USA!’)
The core of Tett’s fine book, which is by far the most insightful of the first
wave of books on the crisis, is the story of J.P. Morgan’s credit derivatives team. For
all the bank’s traditionalism – the door staff at its London offices wear uniforms that
would not be out of place outside the Ritz – it was quietly innovative, and its blueblooded
heritage did not block all diversity. One of the team’s driving forces was a
young Englishwoman, Blythe Masters; another, Terri Duhon, makes no secret of her
upbringing in a trailer in Louisiana; central to its technical work was an Indian
mathematician, Krishna Varikooty. Boisterousness that would have horrified John
Pierpont Morgan was tolerated. Tett describes how at one off-site gathering in
Florida, one of the team’s managers broke his nose when he was being pushed into a
hotel swimming pool by drunken colleages.
3
The team’s pivotal innovation was a December 1997 deal they called ‘Bistro’
(Broad Index Secured Trust Offering). For a decade, banks had been experimenting
with credit derivatives, which are ways of separating out the ‘credit risk’ involved in
lending (the risk that borrowers will default on their obligations, failing to make the
required interest payments or not repaying their loans) and making that risk into a
product that can be bought and sold. Bistro helped turn this tentative activity into big
business.
Bistro transferred to external parties the credit risk of loans totalling $9.7
billion that J.P. Morgan had made to 307 companies. The scheme was an influential
version of the CDOs (collateralised debt obligations) that I described in LRB on 8
May 2008. Like other CDOs, Bistro was divided into ‘tranches’, of which originally
there were two. Investors in the lower or ‘junior’ tranche received a healthy rate of
return, 375 basis points over Libor (London interbank offered rate), which is the
average rate at which a panel of leading banks report they can borrow from other
banks. (A basis point is a hundredth of a percentage point.) This compensated the
junior investors for the fact that their investments would bear the initial losses,
beyond a small reserve built up during the deal’s first five years, should any of the
307 borrowers default.
Only if those losses were to exceed the entirety of the investments in the
junior tranche would the holders of Bistro’s senior tranche – which paid only 60 basis
points over Libor – suffer. The loans that made up Bistro were well-diversified across
industries, and predominantly to blue-chip companies, so losses to Bistro’s senior
tranche seemed unlikely enough to Moody’s, one of the three leading credit rating
4
agencies (the others are Standard & Poor’s and Fitch), that it awarded the tranche its
highest rating, Aaa.
Aaa was a rare distinction. Only a dozen corporations and less than two dozen
governments were judged worthy of it: neither Italy nor Japan, for example, has an
Aaa rating. (As readers will know, Standard & Poor’s has indicated that the UK is
now also in some danger of losing its top rating.) Blythe Masters had formidable
powers of persuasion, which helped when selling a deal that ‘look[ed] like a science
experiment, with all those arrows’, as one investor quoted by Tett described Bistro’s
documentation. Yet 60 basis points over Libor, for an investment judged safer than
the sovereign bonds of some of the world’s leading economies, was the most
powerful argument of all: an investor would normally struggle to find an Aaa
investment that yielded as much as Libor.
For J.P. Morgan, Bistro solved one problem and potentially addressed a
second. First, while the 307 corporations were low risks, even the most creditworthy
borrowers can default. So $9.7 billion in loans to the 307 corporations was a
significant constraint on the bank’s future lending. Bistro removed that constraint.
Second, the Basel Capital Accord, signed by the world’s leading banking regulators in
1988 and implemented by them in 1992, forced banks to carry reserves equal to 8
percent of their risk-weighted lending. While certain categories of lending – to other
OECD banks, for example – qualified for a reduced reserve requirement, loans to
even the safest industrial corporation incurred the full 8 percent, a figure that bankers
felt was far larger than justified by the risks involved. J.P. Morgan hoped that the
transfer of credit risk achieved by Bistro would persuade regulators to reduce that
5
requirement considerably, and Tett reports that Blythe Masters and her colleague Bill
Demchak pushed the Federal Reserve and the Office of the Comptroller of the
Currency to clarify what exactly would be needed to achieve that.
Bistro differed from earlier CDOs in that it did not, in fact, transfer to external
investors all the credit risk of the $9.7 billion of loans. The junior and senior tranches
amounted in total to only $700 million; the bank believed that the chances of losses
ever exceeding that figure were too tiny for it to be worth paying investors to shoulder
them. The regulators, however, demanded that the bank do something to remove that
residual ‘unfunded risk’ before they would relax the 8 percent capital requirement.
The residual risk was like a topmost tranche, sitting on top of the senior
tranche; it would come into play only if losses wiped out the latter in its entirety. The
senior tranche was Aaa, as safe as it gets; the residual ‘super-senior’ tranche (as the
J.P. Morgan team christened it) was thus safer than safe. To satisfy the regulators,
however, the team turned to the Financial Products division of the leading US insurer,
AIG. Sharing J.P. Morgan’s analysis that the super-senior tranche was ultrasafe, AIG
agreed to insure it against all remaining losses, charging an annual premium of only a
fiftieth of 1 percent of the sum insured. From the viewpoint of AIG Financial
Products, it was small-scale business but apparently highly profitable: by covering an
effectively non-existent risk, the firm earned $1.8 million a year.
In that little afterthought to Bistro – what to do with the super-senior tranche –
lay the germ of much of the credit crisis, especially of its disastrous effects on many
of the world’s leading banks. Bistro-like deals started in the world of corporate
6
borrowing, but from 1999 onwards began also to be implemented in the world of
consumer debt, especially mortgages. There was actually longer experience of
packaging mortgages into securities than of packaging corporate debt into CDOs, and
mortgage-backed securities had acquired an admirable reputation for safety.
Mortgage-backed securities have a structure like that of CDOs, with different tranches
carrying various levels of exposure to risk. The safest, Aaa, tranches of those
securities had impeccably default-free records, and even the riskier tranches had
performed well: indeed, on average generally better than corporate bonds with the
same ratings. It wasn’t that people never defaulted on their mortgages – they did –
but the securities were designed to take this into account, for example by building up
reserve funds (analogous to but usually proportionately larger than Bistro’s small
reserve) that would absorb the anticipated losses. For many years, such provisions
proved in general fully adequate.
What happened from 1999 on was that mortgage-backed securities, which
already represented one layer of packaging of debt, then started to be repackaged into
CDOs, thus creating a ‘Russian doll’ product: a tranched, packaged product each of
the components of which was itself a tranche of a packaged product. Given their
excellent reputation, putting mortgage-backed securities rather than corporate bonds
or loans inside CDOs might seem a small step. Yet when in 1999 Bayerische
Landesbank, which had become involved in the US mortgage market, approached J.P.
Morgan to package $14 billion of bundles of mortgages and other forms of
predominantly consumer debt into a Bistro structure, there were initially serious
doubts within the Morgan team.
7
The problematic issue was correlation( NB DON ), which is at the core of evaluating a
CDO. Low correlation means that defaults are essentially idiosyncratic events, with
the consequence that only the bottommost tranche of a typical CDO is at significant
risk. In contrast, high correlation means that if defaults happen they tend to cluster,
and the clustering of defaults puts investors in the higher, apparently safer, tranches at
risk of loss.
Participants in the emerging credit-derivatives market tended to be confident
that they had a fair grasp of the correlation( NB DON ) of corporate defaults. The rating agencies
had large databases of such defaults from which the extent of clustering could be
inferred at least roughly, and other market participants often took the easily measured
level of correlation between the moves of different corporations’ stock prices as a
guide to the correlation of their net asset values. (The link between the latter and
default is that the most important cause of corporate default is bankruptcy, which can
be though of as happening when a corporation’s net asset value falls below zero: that
is, when its liabilities exceed its assets.) Clearly, the correlation of the asset values of
two different corporations was unlikely to be zero, since general economic conditions
will affect both. Nor, however, were corporate asset correlations thought likely to be
1.0, the value that indicates perfect correlation. 0.3 was a commonly-used figure.
That, for example, was the standard level of correlation between the asset values of
firms in the same industry that Standard & Poor’s initially assumed in CDO
Evaluator, the software system it began using in 2001 in the rating of CDOs.
The credit crisis has inured us to gigantic numbers – losses measured in
billions or trillions of dollars – but we need to pay attention to its little numbers as
8
well as its big ones if we’re going to understand it properly. A correlation of 0.3 was
modest. If it was correct it would be highly unlikely that the senior tranche of a CDO
such as Bistro would suffer a loss – unlikely enough to warrant an Aaa rating – and
effectively inconceivable that the supersenior tranche would be hit.
However, the analysis that had initially produced the widely-used figure of
0.3 was of corporate debt. How could one estimate the equivalent correlation for
mortgage-backed securities? Paradoxically, their very safety was a disadvantage in
this respect: there was effectively no record of default that could be scrutinised for
traces of clustering. Nor did such securities trade often enough for the correlation of
their prices to be measured: most investors in them simply held them until they
matured. Intuitively, though, it seemed conceivable that defaults in bundles of
mortgages or other forms of consumer debt could be quite highly correlated, because
of the likely role played by matters such as the overall unemployment level, and that
could make a CDO based upon mortgage-backed securities an unduly risky product.
In an interview I conducted with her, Terri Duhon, who led the Bayerische
Landesbank mortgage-backed CDO, told me that this caused some of her J.P. Morgan
colleagues initially to doubt whether the deal should proceed: they argued that ‘there
is no way that we should be doing this because it’s way too correlated’. Tett reports
that Krishna Varikooty, for example, was concerned by a correlation risk that seemed
to him to be unquantifiable. Intensive discussion and analysis, and very conservative
structuring of the deal eventually led to agreement that it was safe to go ahead (it
helped that unlike in many more recent deals the ratings of the underlying assets were
high – around 95 percent had Aaa ratings – and it contained no securities based on
9
subprime mortgages). Yet the reservations remained, and J.P. Morgan was only ever
to construct one further large CDO, and a limited number of smaller ones, in which
the underlying assets were bundles of mortgages.
In consequence, the bank remained on the sidelines as the previously largely
distinct worlds of CDOs and of mortgage-backed securities became increasingly
linked from 2002 on. It was an encounter of two subtly different cultures, with for
example quite different mathematical approaches. (Understandably, Tett, the former
anthropologist, limits the more ethnographic aspect of her analysis to only on one of
those cultures, that surrounding CDOs.) The CDO world developed explicit and
increasingly elaborate models of correlation – the ‘Gaussian copula’ that initially
puzzled Tett is a correlation model – while the mortgage world handled the
phenomenon entirely implicitly. In most investment banks, and also – as far as I have
been able to discover – in the New York head offices of the rating agencies, separate
groups or departments handled mortgage-backed securities and CDOs based on
corporate debt. In the investment banks, for instance, those different departments
seem to have had surprisingly little to do with each other. The two cultures never
really merged; instead, the CDO, a structure invented by the corporate-debt world,
was applied to the products of the mortgage world.
Members of both cultures now see the encounter as corrupting. ‘They’ –
constructors of CDOs based on mortgage-backed securities – ‘took our tools’ and
misused them, one specialist in corporate credit derivatives told me a few weeks ago.
Those with a background in mortgage-backed securities blame CDOs (with some
justice) for being indiscriminate buyers of those securities, concerned only with their
10
ratings and the spreads (increments over Libor) they offered. Two experienced
industry observers, Mark Adelson and David Jacob,1 suggest that the fatal point was
when CDOs became the almost the only purchasers of the riskier tranches of
mortgage-backed securities. Previously, those tranches were either guaranteed
against default by specialist insurers, or bought by canny investors with their firms’
own money at risk, who would carefully assess the risks involved. These insurers and
investors acted as a brake on the riskiness of the lower tranches, and thus on the
overall riskiness of mortgage-backed securities, and they demanded a healthy rate of
return for taking on their risks. They were displaced by those buying tranches in
order to package them into CDOs, who were prepared to buy them at lesser rates of
return, and who cared a lot less about their riskiness, because those risks were going
to be passed on to the investors in the CDOs.
With the brake removed, the construction of CDOs based on mortgage-backed
securities became a fast-moving assembly line (participants frequently turn to
machinic metaphors when describing the process). Brokers sold mortgages knowing
that they could readily be sold on in the form of mortgage-backed securities. Instead
of having to worry whether the couples sitting on the other side of their desks really
had the wherewithal to keep up their payments, all that mattered was the dozen or so
quantitative characteristics – such as borrowers’ FICO (Fair Isaac Corporation)
creditworthiness scores – that influenced rating agencies’ mortgage models. The
constructors of mortgage-backed securities no longer had to satisfy specialist insurers
or experienced investors: CDOs had an apparently insatiable demand for those
securities.
1 Their papers can be found at http://www.adelsonandjacob.com/
11
Essential to the assembly line was that the higher tranches of its final products
– CDOs in which the underlying assets were mortgage-backed securities – be able to
gain Aaa ratings. A critical issue was the likely correlation of mortgage-backed
securities. Standard & Poor’s, for example, used the same system, CDO Evaluator,
that it employed for CDOs based on corporate debt, and it employed the same modest
baseline correlation assumption, 0.3, for mortgage-backed securities that it initially
used for corporations within the same industry. (S&P would later reduce this last
figure, while increasing its assumption about cross-industry correlation. These
baseline correlation figures could be increased by the analysts rating a specific CDO
if it was highly concentrated in a particular industry or consumer-debt sector.) I
haven’t been able to ascertain the equivalent figures used by the other agencies,
whose methods differed somewhat from Standard & Poor’s, but the similarity of their
ratings to S&P’s suggest similar judgements. My focus is on S&P here simply
because – commendably – it seems to have been more explicit than the other agencies
in laying out in CDO Evaluator’s publicly-available documentation these crucial
assumptions underpinning how the system worked.
The choice of 0.3, or a number close to it, as the baseline was critical: one
specialist has told me that even a moderate increase in the baseline correlation
assumption, for example to 0.5, would have made many CDOs based on mortgagebacked
securities much less attractive, perhaps even not economically viable.
However, as far as I can discover, analysing CDOs built out of mortgage-backed
securities using only modest correlation levels seems in general to have been
uncontroversial. Certainly, the performance of mortgage-backed securities – which,
12
as noted above, had in general been better than that of corporate bonds – offered little
reason to be more stringent when rating CDOs based on them. For example, S&P’s
statistical analyses suggested a correlation of mortgage-backed securities lower than
0.3; the latter figure was retained as a baseline because it was understood that the
correlation would rise when economic conditions became less benign.
Had the world remained as it was in 2002, the agencies’ assumptions and
ratings might well have turned out to be perfectly appropriate. The trouble with an
assembly line, though, is that it produces identical products. The only person outside
of J.P. Morgan I’ve so far found who thought, at the time, that the correlation
estimates being used to analyse CDOs of mortgage-backed securities were much too
low had discovered this by accident. In a previous job as an auditor, he was checking
the statistical tables that the sellers of mortgage-backed securities provide to
prospective buyers. These tables show the breakdown of the underlying loans by
state, FICO score, loan-to-value ratio, and so on. When checking the tables for one
security, he inadvertently used the loan tape (the underlying mortgage data) for
another, and found almost complete agreement. ‘These deals’ – apparently different
mortgage-backed securities – ‘were the same deal’, he told me. Even geographical
dispersion of the underlying mortgages across the US (a desirable feature when an
individual mortgage-backed security was considered in isolation, because it reduced
exposure to the vagaries of particular local housing market) had the paradoxical effect
of increasingly the homogeneity of different mortgage-backed securities. In a
situation of severe economic stress – falling house prices, rising unemployment – not
just some of those securities would perform badly: they all would. Instead of
correlation remaining modest, my interviewee came to fear that it would be nigh on
13
perfect.
Specialists in mortgage-backed securities in the US have not been entirely
surprised at the fraud and malpractice in mortgage lending that has come to light: it
was always present, and changed only in scale( NB DON ). (There had been an earlier US
subprime crisis in the late 1990s, which only specialists seem to remember.2 It was
much more limited in its scale, but it revealed extensive over-optimistic accounting by
lenders.) That mortgage defaults have risen, and the value of repossessed homes
fallen, is not in itself surprising to specialists, although the size of the changes
certainly is. At least some of them did begin to suspect that longstanding statistical
relationships – for example between individuals’ credit scores and the risk of them
defaulting on their mortgages – had ceased to be valid, but as far as I can tell that
suspicion arose only in 2006, by which time the processes that led to the credit crisis
were well underway. One problem, for instance, seems to have been that with
individuals’ scores increasingly determining their access to credit and the rates of
interest they had to pay, they found ways to manipulate those scores. A modest webbased
industry developed which arranged (in return for fees of around $1,000-$2,000
per person) for people – in some cases, apparently dozens of people – with low credit
scores to be added as ‘authorised users’ to the credit card account of someone with a
high score and an impeccable payment record. Within one to three months, the
benefits of the primary cardholder’s regular payments fed through into improvements
in the credit scores of the card’s ‘renters’.
If, however, CDOs backed by mortgages had worked as the J.P. Morgan team
2 It is discussed in the final chapter of an excellent book that, while more limited in scope and more
technical than Tett’s, deserves to be better known: Laurie S. Goodman et al., Subprime Mortgage
Credit Derivatives (Wiley 2008, $80.00, 978-0-470-24366-4).
14
had envisaged when designing Bistro, the losses to investors in those CDOs that the
US housing bubble and its collapse have caused, though very large, would have been
spread widely across the many institutions that bought the tranches of such CDOs. As
Tett notes, what has shocked the members of that team – many of whom now work
for other banks and hedge funds, but still stay in touch – is the concentration of such
losses, especially at apparently sophisticated global banks such as Bear Stearns,
Lehman Brothers, UBS, Citigroup, Merrill Lynch, Morgan Stanley and the Royal
Bank of Scotland.
The primary vehicle by which risk was concentrated was Bistro’s afterthought,
the super-senior tranches of CDOs. Even the riskiest mortgage-backed CDOs – those
that predominantly bought the ‘mezzanine’ (next-to-lowest) tranches of mortgagebacked
securities – have super-senior tranches that are bigger than all the other
tranches put together. These super-senior tranches were hard to sell to most outside
investors, because the need for attractive returns on lower tranches means a supersenior
tranche can offer only a slender increment over Libor. By 2005, Tett reports,
that spread was as low as 15 basis points.
So many banks did as J.P. Morgan did with Bistro: they kept the super-senior
tranches, sometimes insuring them via AIG or the specialist bond insurers. (Adelson
and Jacob point out the resultant irony. Risks that the mortgage experts in the
insurers would have charged heavily for or perhaps even declined were insured in
packaged form in huge amounts – and quite cheaply – by different departments of the
same firms.) If only a handful of deals had been insured in this way, it would have
made perfect sense. As Tett notes, however, AIG insured super-senior tranches
15
totalling $560 billion. Its bail-out by the US taxpayer dwarfs that of any bank, and as
John Lanchester wrote in the LRB on 28 May, it keeps rising (the current total is $173
billion), but AIG cannot be allowed to fail, because the loss of these crucial supersenior
insurance contracts could bring much of the banking system down with it.
Perhaps most surprising of all, top banks also bought super-senior tranches
originated by other banks. If you are a top bank, you can borrow at around Libor
(that, after all, is what Libor means); if you are particularly well regarded, it may be
possible to borrow at a rate a tiny bit lower than Libor. So you could borrow at Libor
or below, buy a tranche that seemed safer than safe, and from it earn a slender spread
over Libor. It looked like free money. It was especially tempting to traders whose
banks ‘charged’ them for their use of capital, in the systems by which traders’ P&L
(profit and loss) is measured, at around Libor, and credited them with the small
additional spread that super-senior tranches offered. The slenderness of the spread
meant that you had to do the trade on a very large scale to earn a really big bonus, so
traders did just that.
As I’ve already indicated, the vulnerability of super-senior is correlation.
Losses on uncorrelated assets are unlikely ever to impact on super-senior tranches.
When correlation approaches 1.0, however, a CDO’s asset pool starts to behave like a
single investment. It may suffer no defaults, or it may default effectively in its
entirety. If the latter happens, even the super-senior tranche, safer than safe, is
doomed.
As the US historian of economics Perry Mehrling points out, events in
16
financial markets cast their shadows ahead of them, not behind. What has haunted the
banking system for the last two years is above all the shadow of the gigantic, systemwide
default of the super-senior tranches of all the CDOs based on those US
mortgage-backed securities issued towards the end of the bubble( NB DON ). (Residential
mortgages have been the focus of most of the attention, but there are also lots of
problems with commercial mortgages.) Although, alas, the losses will not stop there,
most immediately at risk have been CDOs made up primarily of the mezzanine
tranches of subprime mortgage-backed securities issued from late 2005 on. Defaults
have risen enough, the value of repossessed homes has fallen enough, and the
structure and composition of these securities has been similar enough, that as far as I
can tell almost all such tranches have been or will be wiped out in their entirety. So if
a CDO contains little else but such tranches, even its super-senior portion faces closeto-
total losses. So far, only a limited part of those losses have actually been realised,
but the banking system is braced for the rest of them – and, with the massive aid of
taxpayers, it is hopefully now well enough capitalised to survive it and the other
losses that sharp recession will bring.
Unfortunately, this analysis – that the crux of the problem has been not in
CDOs per se but in the uncomfortable encounter between the world of CDOs and that
of mortgage-backed securities – remains only a hypothesis. The world of corporate
CDOs has itself manifested some of the phenomena of the mortgage CDO assembly
line: increasingly risky loans were made to private equity firms and to other highlyindebted
corporate borrowers because it was possible to package and sell on those
loans in the form of CDOs. I’ve just come back from New York, where I questioned
some of those I spoke to on the magnitude of the problems that may lurk below the
17
still comparatively quiet surface of this other sector of the CDO market, which, while
not as large as as the mortgage sector, is still huge. My interviewees seem convinced
that while the problems are real they do not approach the same scale: the amount of
truly irresponsible lending to corporations was much smaller. I hope they are right.
At its heart, the tale Tett tells is a moral one. She believes that the history of
the J.P. Morgan credit derivatives team shows that banking can be technically
innovative while remaining responsible( NB DON ). Her readers may fear that the anthropologist
has here simply gone native, but I don’t think so. I have met a good number of those
she is writing about, and have studied many of the events she has, and I largely share
her judgement. In particular, J.P. Morgan’s decision not to set up a mortgage CDO
assembly line (despite Dimon at one point wanting one) has meant that the bank has
not suffered the catastrophic losses that so many of its peers have; unlike theirs, its
solvency has never been in doubt. It is too easy right now to condemn all of those
who work at the heart of the financial system as either rogues or fools: for example,
Tett reveals that Blythe Masters, who stands out because even today female senior
bankers are relatively rare, gets hate mail. So Tett is right to emphasise that despite
all the pressures and all the temptations, prudent banking was still practised ( NB DON ) –
sometimes – even at the centre of history’s largest-ever credit bubble.
9 June"
Posts
