Explaining the meltdown

In 1994, Exxon requested a $4.8-billion credit line from its banker J.P. Morgan as a result of its oil spill debacle. The loan was hardly attractive business — it would occupy a large space on Morgan’s credit books without generating much revenue. Yet Morgan was loath to deny a long-standing client credit. Blythe Masters on the Morgan derivatives desk had an epiphany. She convinced the European Bank for Reconstruction and Development to assume the default risk for the loan in exchange for an annual fee and crafted a pioneering financial instrument which became known as a ‘Credit Default Swap’. At the time, Masters could have hardly known that she was giving birth to the progenitor of a monster that would bring the global financial system to its knees.

Gillian Tett’s book Fool’s Gold is a lucid, forensic examination of how the arcane world of derivatives became a goldmine—and then a graveyard—for some of the most hallowed names in finance. Tett, Head (Global Capital Markets), Financial Times, gets into the guts of the derivatives industry to tell this tale of how derivatives experts in investment banks became the new cowboys in town. Yet, these gunslingers were geeks—mathematical wizards, developing complex models and inventing new ways to hive off and flog risk which no-one, save themselves, could understand. In the 2000s, the hottest instrument was the Collateralised Debt Obligations (CDOs)—essentially home mortgages bought by investment banks, sliced and diced, pooled together, and then sold to hedge funds and other investors.

Tett deftly paints the picture of a perfect financial storm: Greenspan had slashed rates to almost nothing following the implosion of the tech bubble and was a staunch devotee of both free markets and derivatives; Americans were practically being gifted houses regardless of their credit worthiness; investment banks were doing a roaring business splicing up mortgages and selling them; ratings agencies such as Standard & Poor’s were stamping CDOs with AAA ratings and collecting fat fees; meanwhile, the massive pile of mortgages that were yet to be sold were funnelled into Structured Investment Vehicles (SIVs) by banks anxious to keep debt off their books. Also, almost everyone in the derivatives industry was violently against regulation, insisting that their band of brothers was quite capable of self-policing.

Bank CEOs, meanwhile, were clueless about derivatives. Ironically, the exception was Jamie Dimon, CEO of J.P.Morgan, a shrewd, razorsharp banking industry maverick who remained unfazed by their aura. Dimon’s main preoccupation was mitigating Morgan’s credit risk. Since he simply could not calculate the risk that CDOs posed, he prevented Morgan from aggressively pursuing the CDO market while its peers were racking up massive profits. Today, Morgan stands tall amidst the wrecked landscape of banks—Lehman Brothers and Bear Stearns vapourised overnight, while Citigroup and Bank of America were severely mauled.

Tett’s tale is not quite the page-turner in the mold of James Stewart’s epic Den of Thieves, and she spends a little too much time on the financial side of things, neglecting an opportunity to tell us something about the culture of money, which is invariably what these sagas are about. Yet, Tett’s book is an invaluable contribution to our understanding of the most tumultuous period in financial history and raises burning questions about the American model of laissez-faire capitalism, lack of regulation in an era of financial innovation and the tendency of humans to quickly forget crucial lessons in our history.

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