Fool’s Gold on Wall Street

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 Timeswho 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.