Of the crop of books that aim to make sense of the global financial crisis, few are more lucid than Gillian Tett's 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. Tett, a columnist at The Financial Times who is trained as an anthropologist, delves into the origins of complex instruments like credit-default swaps and explains how they came to play such an outsized—and ultimately, destructive—role in the world's financial system. She spoke with NEWSWEEK's Daniel Gross about those confusing instruments, why even CEOs had a hard time understanding them and how Wall Street may evolve in the years ahead. Excerpts:
A podcast of their conversation can be heard here.
Your book is a history of these credit-default swaps, CDOs, SIVs, and the whole alphabet soup of financial innovation that seems to have caused so much trouble. Were they bad ideas from the beginning?
This is the story of potentially good ideas going horribly wrong. There was a group of JPMorgan bankers in the early- to mid-1990s that developed the concept of credit derivatives, contracts that are written to provide a type of insurance to prevent the credits from going into default. They thought they were developing a product that would make banks and financial system as a whole a lot safer, but it ended up having the complete opposite effect.
At first, they were trying to manage the risk involved with lending to lots of different people. Describe the first structure that they came up to deal with that.
One of the first dealt with Exxon. Exxon at the time had taken out a credit line with JPMorgan, and JPMorgan didn't want the risk of the potential default sitting on its balance sheet. So it cut a deal with the European Bank for Reconstruction and Development (EBRD), where [the bank] took on the risk that the Exxon credit line might go into default. In exchange, JPMorgan paid the EBRD a fee each year, which was kind of an insurance contract.
The second part of your book is called perversion. How and why did this good idea get perverted?
One way was that people started to put mortgages into this mix. Back in the late '90s, the JPMorgan group started experimenting with mortgages instead of corporate loans. They quickly decided there wasn't enough data to assess the risk of default. But something crucial happens in 2003 and 2004, when bankers started creating mortgage derivatives and bundling them up. Groups like Citigroup, Lehman Brothers, Merrill Lynch, Bear Stearns said that even though they weren't sure about the risks, they would sell the product because it would give them a good profit.
In America we think of this debacle that just happened as having its origins in the U.S, but what I've learned from your work is that a lot of this was happening in London. Can you describe the relative relationship between the two financial centers?
From the late '90s onward, the idea of taking bundles of debt and repackaging them and selling them again, which was originally an American concept, started being practiced in Europe, as well. London already had a more advanced derivatives market in terms of interest-rate derivatives, and people leapt on this idea of using credit derivatives. The second key issue was that when the wave of slicing and dicing mortgages took off in 2003 and 2004, a lot of it was sold to European investors.
Very few of the CEOs of these companies seemed to understand how these worked. How is that possible?
Many of the largest banks on Wall Street had become so big and complicated that it made it difficult for the people at the top to know what was going on across the bank. And to make matters worse, there were operating structures that were very fragmented. The banks' different "silos" were like Afghan warring tribes, where people would answer to the top but they were in such competition with each other that they would withhold information. And whichever silo was making the most money tended to have control and push the other silos away. The guys at the top were not asking hard questions.
Ironically, JPMorgan Chase wound up avoiding the worst of the fallout from these innovations. Part of this can be chalked up to a new chief of a tribe who actually did ask hard questions: JPMorgan Chase CEO Jamie Dimon. What did he know that every other banking CEO did not?
Jamie Dimon is an unusual combination of a very details-oriented geek, who wants to know the fine details of what's going on, but is also a very forceful character and not somebody who's going to be pushed around. He's also naturally pretty conservative in terms of risk. He came in and started looking at what was going on in the financial world and made risk control a priority inside the new JPMorgan Chase.
In retrospect, there were clear markers that things were going nuts. What were the early warnings to you?
One indication occurred from about 2005 onwards when mortgage lenders started to raise rates but the cost of borrowing for leveraged companies continued to fall. People were slicing and dicing debt so enthusiastically that there was an insatiable demand for loans to be put into these bundles of debt and the system was running according to its own logic. The big Wall Street firms all bought subprime lenders because they wanted to ensure themselves [a] steady supply of the stuff that they could turn into these other products.
Once things started to go bad, there were a lot of mistakes made by managers but also by policymakers on both sides of the Atlantic. What, in your mind, were some of the crucial ones?
One of the biggest policy mistakes was made by the American officials who repeatedly said that the subprime problem was contained and that there was no reason to worry about it at all. That represented a considerable misunderstanding of how the financial system had changed. They failed to calculate the enormous quantity of derivatives written … nobody knew how big they were. Secondly, the regulators were very slow to force the banks to come clean about their losses or to even take preemptive action. There was a complacency that this problem would just be absorbed like all the other small jolts they'd had in the previous seven years. The European Central Bank was proactive in August when it intervened. But it intervened in a very confusing mismanaged way. That probably sowed more panic than it actually contained.
You have a quote from Jamie Dimon where he blames the regulators. Of course, the people who ran the banks got paid huge amounts of money, and it was their job to make sure they didn't fail. Why do bankers have such an immense lack of self-awareness?
One of the things that has gone wrong in recent years is that not only have banks increasingly begun to operate as silos, but banking as a whole has begun to operate as a silo separate from the rest of the economy. Most of the bankers involved in subprime mortgaging have probably never set foot in a subprime-mortgage community themselves. There was this feeling that bankers had become financial priests in the medieval church; that they were the ones who spoke financial Latin, and they were the only ones who were allowed on the altar and the rest of the congregation was just supposed to sit and not ask hard questions.
In four or five years are we going to be talking about this financial innovation in the same way?
In an ideal world, I still believe that there are aspects of the derivative revolution that are worth preserving. The idea of insuring against risk and trading risk is not an entirely stupid concept. However, it became so abused that instead of containing risk it actually amplified it across the system as a whole. I hope the cycle we'll see unfold is that, after the bubble bursts, the useful bits eventually come to the surface and we're left with something that represents progress.