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The Derivatives Dream
On half a mile of immaculate private beach, along Florida's fabled Gold Coast, sits the sugar-pink Boca Raton Hotel, designed in a gracious Mediterranean style by the Palm Beach architect Addison Mizner. Since the hotel opened in 1926, it has styled itself a temple to exclusivity, boasting Italianate statues and manicured palm trees, a dazzling marina with slips for thirty-two yachts, a professional tennis club, a state-of-the-art spa, a designer golf course, and a beautiful strip of privatebeach. A glitzy roll call of celebrities and the wealthy have flocked to the resort, billed as a "private enclave of luxury," where they can relax well away from prying eyes.
On one summer's weekend back in June 1994, a quite different clientele descended: several dozen young bankers from the offices of J.P. Morgan in New York, London, and Tokyo. They were there for an off-site meeting, called to discuss how the bank could grow its derivatives business in the next year. In the humid summer heat, amid the palm trees and gracious arches, the group embraced the idea of a new type of derivative that would transform the wider world of twenty-first-century finance and play a decisive role in the worst economic crisis since the Great Depression. "It was in Boca where we started talking seriously about credit derivatives," recalls Peter Hancock, the British-born leader of the group. "That was where the idea really took off, where we really had a vision of how big it could be."
As with most intellectual breakthroughs, the exact origin of the concept of credit derivatives is hard to pinpoint. For Hancock, a highly cerebral man who likes to depict history as a tidy evolution of ideas, one step of the breakthrough occurred at the Boca Raton off-site. Some of his team, however, have only the haziest, alcohol-fuddled memories of that weekend. Full of youthful exuberance and a sense of entitlement, the young bankers had arrived in Florida determined to party as hard as they could.
They worked for the "swaps" department — a particular corner of the derivatives universe — which was one of the hottest, fastest-growing areas of finance. In the early 1980s, J.P. Morgan, along with several other venerable banks, had jumped into the newfangled derivatives field, and activity in the arcane business had exploded. By 1994, the total notional value of derivatives contracts on J.P. Morgan's books was estimated to be $1.7 trillion, and derivatives activity was generating half of the bank's trading revenue. In 1992 — one year when J.P. Morgan broke out the number for public consumption — the total was $512 million.
More startling than those numbers was the fact that most members of the banking and wider investing world had absolutely no idea how derivatives were producing such phenomenal sums, let alone what socalled swaps groups actually did. Those who worked in the area tended to revel in its air of mystery.
By the time of the Boca meeting, most of the J.P. Morgan group were still under thirty years old; some had just left college. But they were all convinced, with the heady arrogance of youth, that they held the secret to transforming the financial world, as well as dramatically enhancing J.P. Morgan's profit profile. Many arrived in Boca presuming the weekend was a lavish "thank you" from the bank management.
On Friday afternoon, they greeted each other with wild merriment and headed for the bars. Many had flown down from New York; a few had come from Tokyo; and a large contingent had flown over from London. Within minutes, drinking games got under way. As the night wore on, some of them commandeered a minivan to visit a local nightclub. Others hijacked golf carts and raced around the lawns. A large gaggle assembled around the main Boca Raton swimming pool threatening to throw one another in.
As the revelry around the pool intensified, Peter Voicke, a buttoned-up German who held the title head of global markets and, though only in his late forties, was the most senior official present, earnestly tried to calm them down. Voicke had agreed to stage the off-site in the hope it would forge camaraderie. "It is important to develop a healthy esprit de corps!" he liked to say in his flat Teutonic accent. But the camaraderie was getting out of hand. In no mood to heed his admonitions, several of them pushed Voicke into the pool. "My shoes, shoes!" he shouted, shocked, as expensive loafers drifted off his feet.
The drunken crowd then turned on Bill Winters, a jovial American who, at just thirty-one, was the second most senior official of them. Halfheartedly, he tried to dodge the crowd. But as he ducked, his face slammed into an incoming elbow, and a fountain of blood spurted out. "You've broken my nose!" Winters shouted, as he too tumbled into the pool. For a moment, the drunken laughter stopped. Voicke was obviously furious. Now Winters was hurt. But then Winters let out a laugh, hauled himself out of the pool, and clicked his nose back into place. The drinking games resumed.
At some banks, dousing the boss would have been a firing offense. But J.P. Morgan prided itself on a close-knit, almost fraternal culture. Those on the outside viewed the J.P. Morgan crowd as elitist and arrogant, overly enamored of the bank's vaunted history as a dominant force in American and British finance. Insiders often referred to the bank as a family. The derivatives group was one of the most unruly but also most tightly knit teams. "We had real fun — there was a great spirit in the group back then," Winters would later recall with a wistful grin. When he and the rest of that little band looked back on those wild times, many said they were the happiest days of their lives.
One reason for that was the man running the team, Peter Hancock. At the age of thirty-five, he was only slightly older than many of the group, but he was their intellectual godfather. A large man, with thinning hair and clumsy, hairy hands, he exuded the genial air of a family doctor or university professor. Unlike many of those who came to dominate the complex finance world, Hancock sported no advanced degree in mathematics or science. Like most of the J.P. Morgan staff, he had joined the bank straight from getting his undergraduate degree, but notwithstanding the lack of a PhD, he was exceedingly cerebral, intensely devoted to the theory and practice of finance in all its forms. He viewed almost every aspect of the world around him as a complex intellectual puzzle to be solved, and he especially loved developing elaborate theories about how to push money around the world in a more efficient manner. When it came to his staff, he obsessively ruminated on how to build the team for optimal performance. Most of all, though, he loved brainstorming ideas.
Sometimes he did that in formal meetings, like the Boca off-site. But he also spewed out ideas on a regular basis as he strode around the bank's trading floor. The team called his exuberant outbursts of creativity "Come to Planet Pluto" moments, because many of the notions he tossed out seemed better suited to science fiction than banking. But they loved his intensity, and they were passionately loyal to him, knowing that he was fiercely devoted to protecting, and handsomely rewarding, his tribe. They were also bonded by the spirit of being pioneers.
The J.P. Morgan derivatives team was engaged in the banking equivalent of space travel. Computing power and high-order mathematics were taking finance far from its traditional bounds, and this small group of brilliant minds was charting the outer reaches of cyberfinance. Like scientists cracking the DNA code or splitting the atom, the J.P. Morgan swaps team believed their experiments in what bankers refer to as "innovation" — meaning the invention of bold new ways of generating returns — were solving the most foundational riddles of their discipline. "There was this sense that we had found this fantastic technology which we really believed in and we wanted to take to every part of the market we could," Winters later recalled. "There was a sense of mission."
That stemmed in part from Hancock's intense focus on the science of people management. He was almost as fascinated by how to manage people for optimal performance as by financial flows.
The moment he was appointed head of the derivatives group, Hancock had started experimenting with his staff. One of his first missions was to overhaul how his sales team and the traders interacted. Against all tradition, he decided to give the sales force the authority to quote prices for complex deals, instead of relying on the traders. He expected that doing so would more intensely motivate sales, and the change produced good results. He then started inventing new systems of remuneration designed to discourage taking excessive risks or hugging brilliant projects too close to the vest. He wanted to encourage collaboration and longer-term thinking, rather than self-interested pursuit of short-term gains. The teamwork ethos was already well entrenched at the bank, especially by comparison to most other Wall Street banks, but Hancock fervently believed that J.P. Morgan needed to go even further.
In later years, Hancock pushed his experimentation to unusual extremes. He hired a social anthropologist to study the corporate dynamics at the bank. He conducted firm-wide polls to ascertain which employees interacted most effectively with those from other departments, and he then used that data as a benchmark for assessing employee compensation, plotting it on complex, color-coded computer models. He was convinced that departments needed to interact closely with each other, so that they could swap ideas and monitor each other's risks. Silos, or fragmented departments, he believed, were lethal. At one stage he half-jokingly floated the idea of tracking employee emails, to measure the level of cross-departmental interaction in a scientific manner. The suggestion was blocked. "The human resources department thought I was barking mad!" he later recalled. "But if you want to create the conditions for innovation, people have to feel free to share ideas. You cannot have that if everyone is always fighting!"
One of Hancock's boldest experiments focused on the core group within the swaps team known as Investor Derivatives Marketing. The bankers attached to this team sat around a long desk under low ceilings on the third floor of the J.P. Morgan headquarters, and the group was somewhat anomalous in its responsibilities. Though some marketing of products to clients was done, the group acted more like an incubator for ideas that had no other obvious departmental home and handled a ragbag of products, including structured finance schemes linked to the insurance world and tax-minimizing products.
A few months before the meeting in Boca Raton, Hancock had approached Bill Demchak, an ambitious young banker with a good reputation around the bank, to run the IDM group. Determined to drive innovation, Hancock told him, "You will have to make at least half your revenues each year from a product which did not exist before!" By Wall Street standards, that was a truly peculiar mandate. Normally, a group that hit on a brilliant moneymaking idea would claim exclusive ownership of it and milk it as long as they could. Hancock, though, wanted IDM to invent products and almost immediately hand them off so it could move on to new inventions.
Demchak happily accepted the daunting mandate. He was amused by the challenge, and in many ways, he appeared the perfect man to act as a foil for Hancock'screative ambitions. He came from an unassuming background and hadn't forgotten his roots, having grown up in a middle-class family in Pittsburgh and studied business at Allegheny College in Pennsylvania. He earned an MBA from the University of Michigan and joined J.P. Morgan in the mid-1980s. Generally, he had a jovial demeanor, but if he felt someone had crossed him or was being stupid, he could explode. He was hardworking but also loved to party. "If you met him, you wouldn't know he was from Wall Street!" one of his college buddies from Pittsburgh observed.
Demchak's razor-sharp mind dissected problems at lightning speed. A particular talent was lateral thought, pulling in ideas from other areas of banking. He was also a natural leader, and he instilled extreme loyalty among his staff. His colleagues often joked that if it were not for the practical Demchak, Hancock "would have stayed on Pluto." He was the perfect man to implement his boss's schemes.
Hancock installed another ambitious and driven banker in the London office of the team. Bill Winters, who had taken the breaking of his nose with such good cheer, also came from a relatively modest background by comparison to the Ivy League pedigrees of so many of the banking elite. He had studied at Colgate University in New York State, and joined the bank in the mid-1980s. He was blessed with good looks — female colleagues thought Winters looked a little like the actor George Clooney — but he preferred to stay out of the limelight. And whereas Demchak was given to explosions when confronting resistance, Winters was more flexible and tended to dance around problems, getting what he wanted with finesse. He was intensely hardworking.
Hancock first noticed Winters in the late 1980s, when he was working in the area of commodities derivatives. "We sent him down to Mexico and somehow — I still don't know how — he persuaded the government to hedge half of its oil production and interest-rate exposure with us," Hancock recalled. "There was no drama, he just did it. That is his style." Hancock appointed him to run the European side of the derivatives team with the expectation that the "two Bills," as their colleagues dubbed them, would work well together in tossing innovative ideas back and forth across the Atlantic.
Central to the swaps team's quest now was to take the newfangled breed of financial products called derivatives into new terrain.
When bankers talk about derivatives, they delight in swathing the concept in complex jargon. That complexity makes the world of derivatives opaque, which serves bankers' interests just fine. Opacity reduces scrutiny and confers power on the few with the ability to pierce the veil. But though derivatives have indeed become horribly complex, in actuality, they are as old as the idea of finance itself.
As the name implies, a derivative is, on the most basic level, nothing more than a contract whose value derives from some other asset, such as a bond, a stock, or a quantity of gold. Key to derivatives is that those who buy and sell them are each making a bet on the future value of that asset. Derivatives provide a way for investors either to protect themselves — for example, against a possible negative future price swing — or to make high-stakes bets on price swings for what might be huge payoffs. At the heart of the business is a dance with time.
Say that on a particular day, the pound-to-dollar exchange rate is such that one British pound buys $1.50. Someone who is making a trip from England to the US in six months and thinks the exchange rate may become less favorable might decide to make a contract to ensure that he can still buy dollars at that rate just before his trip. He might enter into an agreement to exchange 1,000 pounds with a bank in six months' time, at $1.50, no matter what the actual exchange rate is by then. One way to arrange that deal would be to agree that the trade must happen, no matter what the actual rate of exchange is at the time, and that would be a future. A variation would be that the traveler agrees to pay a fee, say $25, to have the option to make the exchange at the $1.50 rate, which he would decide not to exercise if the rate actually became more favorable.
Versions of derivatives trading have existed for centuries. Rudimentary examples of futures and options contracts have been found on clay tablets from Mesopotamia dating to 1750 bc. In the twelfth and thirteenth centuries, Englishmonasteries made futures deals with foreign merchants to sell wool up to twenty years in advance, and famously in seventeenth-century Holland, when tulip prices began to rise substantially, merchants frantically bought and sold tulip futures, leading to a bubble that ended in a spectacular crash.
The modern era of derivatives trading began when the Chicago Board of Trade was established in 1849, allowing for the buying and selling of futures and options on agricultural commodities. Wheat farmers might buy futures before harvest on the price their wheat would bring in, hoping to hedge against low prices in the event of a bumper crop. Speculators would take on the risk of the losses farmers feared in the hopes of big payoffs that all too often turned horribly bad.
In the late 1970s, a bold new era of derivatives innovation was inspired by a set of technological breakthroughs and increasing volatility in the financial markets. It brought derivatives from the world of commodities into the domain of finance. The post-WWII Bretton Woods system of credit and exchange controls, which had maintained relative stability in world markets, broke down, and the values of foreign currencies, which had been pegged to the dollar, became free-floating. That led to unpredictable swings in exchange rates. Oil price shocks then sparked a pernicious blend of recession and inflation in the US, with inflation eventually peaking at 13.2 percent in 1981. Shocked investors scurried to find ways to protect themselves from the devastating impact of the high interest rates — in the US the prime rate rose to a high of 20 percent in June 1981 — and from relentless swings in exchange rate.
Historically, the best way to insulate against such volatility was to buy a diversified pool of assets. If, for example, a company with business in both the United States and Germany were concerned about swings in the dollar-to-deutsche mark rate, it could protect itself by holding equal quantities of both currencies. That way, either way the rate swung, the losses would be offset by equal gains. But an innovative way to protect against swings was to buy derivatives offering clients the right to purchase currencies at specific exchange rates in the future. Interest-rate futures and options burst onto the scene, allowing investors and bankers to gamble on the level of rates in the future.
Another hot area of the derivatives trade, which evolved shortly thereafter, was the highly creative business Peter Hancock's team specialized in, known as "swaps." In these deals, investment banks would find two parties with complementary needs in the financial markets and would broker an exchange between them to the benefit of both, earning the banks large fees.
Say, for example, two home owners each have a $500,000 10-year mortgage, but one has a floating-rate deal, while the other has a rate fixed at 8 percent. If the owner with the fixed rate thinks that rates are going to start to go down, while the other owner thinks they are likely to go up, then rather than each trying to get a new loan, they could agree that each quarter, during the life of their mortgages, they will swap their payments. The actual mortgage loans don't change hands; they stay on the original banks' books, making the deal what bankers call "synthetic."
Salomon Brothers was one of the first banks to exploit the potential of derivatives swaps, brokering a pioneering deal between IBM and the World Bank in 1981. In 1979, David Swensen, a PhD from Yale who had recently started working on the Salomon Brothers trading desk, spotted that IBM needed to raise a good deal of cash in dollars and had substantial excess quantities of Swiss francs and deutsche marks from having sold bonds to raise funds in those currencies. Normally, IBM would have had to go to the currency market to buy dollars. Swensen realized, though, that IBM might instead be able to swap some of its francs and marks for dollars without actually having to sell them if some party could be found who could issue bonds in dollars to match IBM's bonds in francs and marks.
The World Bank was a likely candidate, as it always needed cash in many currencies. As with the two home owners who write a contract to swap the terms of their mortgages, IBM and the World Bank could swap their bond earnings and their obligations to the bondholders without any bonds actually changing hands. In 1981, after two years of wrangling over the details of the deal, Salomon Brothers announced it had concluded the world's first currency swap between IBM and the World Bank, worth $210 million for ten years.
This new form of trade quickly spread across Wall Street and the City of London, mutating into wildly complex deals that seemed to give bankers godlike powers. With derivatives, they could take existing assets or contracts apart and write contracts that reassembled them in entirely new ways, earning huge fees.
Of course, making these deals still relied on bankers being able to find two parties who both believed they would benefit. In synthetic finance, just as in "real" markets, trades can occur only if there is a buyer for every seller. But given the growing globalization of banking and how many players in the world economy had complementary needs and different expectations about future market conditions, the bankers had a wealth of options. Some players needed deutsche marks, while others wanted dollars. Some wanted to protect against expected interest-rate increases, while others believed rates were likely to fall.
Players also had different motives for wanting to place bets on future asset prices. Some investors liked derivatives because they wanted to control risk, like the wheat farmers who preferred to lock in a profitable price. Others wanted to use them to make high-risk bets in the hope of making windfall profits. The crucial point about derivatives was that they could do two things: help investors reduce risk or create a good deal more risk. Everything depended on how they were used and on the motives and skills of those who traded in them.
By the time the J.P. Morgan swaps team gathered in Boca Raton in June of 1994, the total volume of interest-rate and currency derivatives in the world was estimated at $12 trillion, a sum larger than the American economy. "The speed at which the market grew just took everyone by surprise. It was quite remarkable," recalled Peter Hancock, who had been a vital participant in the boom.
In many ways, Hancock's career made him the perfect man to be at the center of that extraordinary innovation storm. He was born in 1958, into an upper-middle-class British family based in Hong Kong. Like many children from that background and generation, he was dispatched half a world away to a British boarding school, where he excelled at rugby and decided that his ambition was to be a great inventor. After spending many happy hours immersed in science books, he went to Oxford to study physics, but his plans were derailed when he was badly injured in a rugby game. Hancock was laid up in bed for some time, so couldn't get to the physics laboratory, and he decided to switch to philosophy, politics, and economics. That he could study from his bed. By the time he graduated, he became intrigued about banking and the principles of free markets. "I decided that being an inventor would have to wait," he recalled. He had decided he wanted a career that paid better than those in science did. It was a common decision for British graduates at the time. The City of London and Wall Street looked increasingly alluring.
On graduation, he applied for jobs at a range of international firms, hoping for a globe-trotting career. But when he was offered a job in the London branch of Morgan Guaranty Trust Company, or "The Morgan Bank," later rebranded J.P. Morgan, he quickly accepted. It was an unusual choice for a British graduate. The City of London was dominated by British-owned banks, and though American groups had raised their presence in the City during the 1970s, those Wall Street institutions overwhelmingly recruited graduates from the United States.
But J.P. Morgan had always had a transcultural identity. Well known as one of the large Wall Street firms, its roots lay in the City of London, where American banker Junius Spencer Morgan took charge of the English brokerage George Peabody & Co. in 1864 and renamed it J.S. Morgan & Co. His son J. Pierpont Morgan worked at the firm for some years and was then dispatched to New York, where he formed a partnership with the wealthy Drexel family, Drexel, Morgan & Company, which after Anthony Drexel's death was renamed J.P. Morgan. The American bank quickly swelled into a powerhouse, with J. Pierpont Morgan personally brokering many major deals, audaciously merging a number of steel companies he had bought to form U. S. Steel, and financing major concerns in railroads, shipping, coal mining, and other key industries. By the late nineteenth century, the group had become so preeminent that it appeared to wield as much power in the financial markets as the American government itself.
When crisis hit Wall Street in 1893, Morgan personally orchestrated a syndicate to provide the US Treasury with $65 billion in gold, keeping it solvent. In the Panic of 1907, when the New York Stock Exchange plunged to half of its value, Morgan put up vast sums of his personal fortune and rallied other leading bankers to do the same, shoring up the banking system.
In the years after the Second World War, the bank lost some of its preeminence. After the crash of 1929, a populist backlash against Wall Street led to the introduction of the Glass-Steagall Act, which forced banks to split off their capital markets operations — the trading of debt and equity securities — from their commercial banking businesses. The J.P. Morgan empire was required to fragment into separate entities, including Morgan Stanley, the US brokerage; Morgan Grenfell, a British brokerage; and J.P. Morgan, which was devoted to commercial banking. But the bank maintained an unusually close set of ties with both governments and powerful, blue-chip corporate clients, such as Coca-Cola and AT&T. The international heritage of the bank was also preserved, so much so that J.P. Morgan staff sometimes joked that joining the bank was akin to entering the diplomatic or British colonial service — albeit much better paid.
When Peter Hancock joined the bank, he was dispatched to New York to attend a yearlong training course, together with around four dozen other recruits, only half of whom were American. "It was an extraordinary experience. We had Chinese, Malaysians, French — you name it. And we were all housed together in one small building down on the Upper East Side of Manhattan," Hancock recalled. The course itself, however, didn't have much to satisfy Hancock's penchant for invention.
The Commercial Bank Management Program, as it was called, was conducted in the bank's historic headquarters at 23 Wall Street, right across the street from the Stock Exchange, in an imposing, column-fronted building where J. Pierpont Morgan himself had worked. The first half of the course was spent in a classroom, learning fundamental banking skills little different from the practices in J. Pierpont Morgan's time; the nuts and bolts of assessing credit risk by reading a company's balance sheet and analyzing its business. The goal was to drill into them how to measure the chance a company would default on a loan, the lifeblood of J.P. Morgan's style of banking. For the second half of the training, the recruits acted as the junior analysts in actual deals.
The trainees were required to spend a good deal of time crunching corporate numbers. Only a few years earlier, those calculations had had to be done by hand. When they needed to look up bond prices, they consulted a voluminous book of tables. By the time Peter Hancock took the course, however, handheld calculators programmed with the power to use complex mathematics to assess corporate cash flows and measure risk were becoming the rage. A new technological elitism was taking hold, and the trainees were in the vanguard of a bold new breed of banker.
For the Morgan Bank trainees, though, the mathematics was stressed to be only part of what banking was about; social factors, such as client relationships and reputation, were also heavily emphasized. Back in 1933, during the height of the populist backlash against Wall Street, the son of J. Pierpont Morgan — J. P. "Jack" Morgan, Jr. — had been grilled by Congress about his ethos. He declared that the aim of his bank was to conduct "first-class business...in a first-class way." Fifty years later, that mantra of Jack Morgan struck much of the banking world as quaint. Years of bold innovation had made high-risk trading and aggressive deal making the gold standard of the street, and a "kill or be killed" ethic prevailed.
At 23 Wall Street, though, the senior bankers still talked about banking as a noble craft, where long-term relationships and loyalty mattered, both in dealing with clients and inside the bank. While at other banks, the emphasis had turned to finding star players, offering them huge bonuses, and encouraging them to compete for preeminence, at the Morgan Bank the emphasis was on teamwork, employee loyalty, and long-term commitment to the bank.
Many of the staff had worked only at J.P. Morgan, and while the bank paid less than most of its rivals, the trade-off was greater job security. The young trainees in the training program were told solemnly that while the bank would tolerate "errors of judgment," an "error of principle" was a firing offense. "First-class banking" remained the mantra.
Peter Hancock easily passed the course and was dispatched back to the London office, where he spent a couple of years analyzing the creditworthiness of North Sea oil companies. That was considered a plum job, because the Norwegian and British oil industry was starting to boom. But Hancock was hungry for more. As he looked around the City, he could see the revolution in derivatives and swaps building, and he wanted in.
The Morgan Bank was considered too stodgy to be a pioneer in the business. Aggressive Salomon Brothers and iconoclastic Bankers Trust were the real innovators. But shortly after Salomon announced the big IBM-World Bank swap, J.P. Morgan started looking for ways to do more such deals.
Initially, the epicenter of experimentation was not J.P. Morgan's New York headquarters but the London branch of a corporate offshoot known as Morgan Guaranty Limited (MGL). While the Glass-Steagall regulations prohibited the main New York bank from playing in the capital markets, Glass-Steagall didn't apply overseas. London's regulatory authorities took a more laissez-faire attitude, generally permitting banks to engage in a wider range of services. As a result, Morgan Guaranty had built up a good capital-markets business. In the 1960s talented trader Dennis Weatherstone led the development of a flourishing foreign exchange business, and in the 1970s the office moved into the world of sovereign and corporate bond issuance. Business boomed in part because American companies realized they could pay less tax by raising finance in London rather than in New York.
That booming corporate bond business created the opening for Morgan Guaranty to move into the swaps world, and from the early 1980s, the Morgan Bank started to offer its clients deals through its London branch that allowed them to take advantage of the swaps magic. "This was an example of a fantastic innovation which really served a client need. It really solved problems in a useful way," Jakob Stott, one of the young bankers who was on the swaps team, recalled.
Initially, arranging these deals was clumsy and time-consuming. Before a contract could be struck, two parties with matching needs had to be found. That alone could take weeks. On one of the first such deals, a swap between the Austrian government and Commerzbank, they spent an entire afternoon tapping out the details on a telex machine, spelling out all the future cash flows to their clients. As the 1980s wore on, though, the pace of business picked up. So did the profits.
The young traders in the group were thrilled with the increasing power and freedom they enjoyed. Few at the bank outside the swaps team itself knew how their trades worked, and the leader of the team, Connie Volstadt, widely recognized as one of the most brilliant minds in the derivatives world, was given great autonomy. Volstadt showed outright disdain for the Morgan Bank senior management and would reveal only the scantiest details about the team's business. Indeed, the team members loved teasing those in the more hidebound departments. "We had this sense of being special, of being detached from everyone else, a little team that was very tightly bound together," recalled Stott.
From time to time, the senior management would try to clip the swaps team's wings. In 1986, Lewis Preston, then the chief executive of J.P. Morgan, flew to London and challenged the manner in which Volstadt was recording the value of deals. At the time, J.P. Morgan, along with every other bank, was unclear how to measure the worth of the swaps trades, as accounting guidelines were still being worked out. "You say your group has made a $400 million profit, but," Preston challenged Volstadt, "it looks to me as if you have a $400 million loss!" Furious, Volstadt assigned a team of junior analysts and interns to reexamine every single paper ticket recording the deals, and when he proved his case, Preston backed down. The episode was indicative of the way the upper management viewed the swaps traders: as a bunch of unruly teenagers.
As Hancock watched the high-octane business of the swaps group from his humdrum perch in J.P. Morgan's commercial banking team, he was fascinated and eager to join in. So in 1984, he joined the London bond group, and in 1986 he wangled his way to move across to New York, where the bank was expanding its derivatives operation. The J.P. Morgan managers had realized, to their utter delight, that there was no explicit provision in Glass-Steagall against trading in derivatives products.
Initially, Hancock's role on the team was rather humble. He managed a small treasury team that used swaps to manage the bank's on-balancesheet assets and liabilities. But Hancock was articulate and opportunistic and soon found ways to make himself visible. After the 1987 stock market crash, interest rates fell and the bank suffered sizable unexplained losses in its derivatives books. Hancock was asked to explain to the bank's senior management what had happened and ended up managing a small desk at headquarters that traded products known as "floors" and "caps." Then, when the bank rebranded itself as J.P. Morgan in 1988, Hancock, a key sailor, organized a team that sailed round Manhattan with a vast J.P. Morgan logo on its sails. That garnered attention, particularly since Hancock's team narrowly beat Goldman Sachs's boat. He learned everything he could about how the derivatives world worked. He also impressed Dennis Weatherstone, CEO of the bank. Weatherstone was a legendary character. He hailed from working-class British stock, first joined the bank at age sixteen as a messenger boy in London, but later became a brilliant foreign exchange trader and eventually rose to the very top.
In 1988, a shock occurred that created Hancock's opening. Connie Volstadt defected to work at Merrill Lynch, taking half a dozen of his team. It left the bank with a conundrum.
At other banks, the obvious way to fill the huge revenue hole left by Volstadt's departure would have been to hire a new guru and build a new team from rival banks. But J.P. Morgan rarely hired outsiders into senior positions. The vast majority of its senior staff had come up through the ranks, giving the bank its insular culture, for good and ill. So the senior management initially appointed some of Volstadt's junior team members to take over. Before long, it was clear they couldn't fill his shoes, and Hancock saw his chance.
In 1990, at only thirty-two, he was considered too young to run a department. But he was good at navigating office politics. So, about a year after Volstadt left, Weatherstone announced that Hancock would lead the swaps team. "Sometimes in life you just get a huge break, and you just have to grab it and run with it," Hancock later recalled. The would-be inventor now had a chance to let his penchant for invention run.
Over the next four years, Hancock rode the crest of the derivatives wave. When swaps had taken off, J.P. Morgan wasn't at all viewed as an innovator; by 1994, its creative skills were as good as those of most rivals. Better still, the bank had advantages some rivals lacked. As a respected commercial lender, Morgan had access to a huge array of blue-chip companies and governments that were often eager to conduct derivatives deals. The bank was also one of the very few with a top-notch AAA credit rating, which reassured clients that the bank could stand by its trades. By the end of the 1980s, derivatives groups were no longer pairing only with other parties to make derivative deals, they also were using their own capital to make trades with clients on a huge scale. When clients cut deals with J.P. Morgan, the AAA rating assured them that the bank would always be around to fulfill its side of those deals.
As business boomed, the swaps department basked in the knowledge that it was producing an ever-increasing share of the bank's profits. By the early 1990s, it accounted for almost half the bank's trading revenues, and Hancock had been promoted to run not just the derivatives group but also the entire department it was part of, known as fixed income. He was considered a prime candidate for CEO.
A few months before the Boca off-site, a reporter from Fortune asked Hancock to explain how a complicated swap might work, and his response reaffirmed for her that derivatives traders were "like the spacecraft Galileo, heading for planet Jupiter." "It would be something," Hancock apparently said, "in which you get beyond binary risk and into a combination of risks, such as interest rates and currencies. Or take an oil company, which has risks of oil prices dropping and interest rates rising. To hedge, it could buy an oil price floor and an interest-rate cap." But maybe, said Hancock, the company would like something a little cheaper: "In that case, we could do a contract that would pay out only if oil prices are low and interest rates are high at the same time." The man who had once dreamed of being an inventor was in his element.
Yet down in Boca, Hancock was not in a celebratory mood. On the contrary, he knew that the derivatives sector was reaching a crucial point in its evolution and his team had to adjust. The essential problem was the phenomenon he described as the "curse of the innovation cycle." In manufacturing or pharmaceuticals, patent laws ensure that a brilliant new product or idea is protected; competitors cannot simply steal that innovation. In banking, however, patents haven't traditionally been an option. When financiers have a brilliant idea, nothing typically stops competitors from copying it right away, and before long they are putting downward pressure on profit margins.
The swaps business epitomized this problem. As soon as Salomon Brothers cut its first deal, other banks such as J.P. Morgan copied it, and the market exploded. The burst of activity had a vexing impact on profit margins. While the first wave of swaps deals had high margins, once copycats jumped in, competition brought fees down. For years, the issue hadn't really worried Hancock because the volume of deals was growing so robustly. But he was unsure how long the volume could continue to explode, and he knew that if he wanted to keep his department cranking, he had to find a new way before long to do deals. He was feeling tremendous pressure to find the next Big Idea.
So while his team viewed the weekend as a lavish party, Hancock had a serious agenda. By bringing his young group together from all over the world, and pushing them into close quarters for forty-eight hours, he hoped he could spark the innovation flame.
On the Saturday morning, the group assembled in a conference room a few feet from the sparkling blue sea for one in a series of meetings. How, Hancock asked, could they unleash a new wave of innovation in the derivatives business? Could bankers apply the principles to new areas? What about the insurance world? Or loans and credit?
The team was in little mood for mental gymnastics. Some were jet-lagged and most were hung over. Bill Winters was nursing a badly swollen nose and wondering how he would explain it to his wife back home. "Frankly, I cannot remember much of our debate," Bill Demchak, the team member who was Hancock's de facto deputy, would later say with a sheepish laugh. All he could remember, he added, was that when he checked out of his hotel, his bill included charges for a smashed Jet Ski and a vast quantity of cheeseburgers. They had been charged to him, as a joke, by the rest of his team.
But Hancock's intensity was impossible to resist. He strode around the room, chucking out ideas with his Planet Pluto energy, and soon enough the debate heated up. One key idea started to emerge: using derivatives to trade the risk linked to corporate bonds and loans. Commodity derivatives, a voice pointed out, let wheat farmers trade the risk of loss on their crops. Why not create a derivative that enabled banks to place bets on whether a loan or bond might default in the future? Defaults were the biggest source of risk in commercial lending, so banks might well be interested in placing bets with derivatives that would allow them to cover for losses, using derivatives as a form of insurance against defaults.
In truth, that was not a new idea. Three years earlier, the ever-inventive Bankers Trust had conducted the first pioneering deals along those lines. So had Connie Volstadt's team at Merrill Lynch. But the notion hadn't taken off because those trades didn't appear particularly profitable. As the debate swirled around the room in Boca, though, Hancock and the others became excited about the concept. After all, they reasoned, the world was full of institutions — and not just banks — that were exposed to the risk of loan defaults. J.P. Morgan itself had a veritable mountain of loans on its books that were creating regulatory headaches. What would happen, they asked, if a derivative product of some kind could be crafted to protect against default risk — or to deliberately gamble on it? Would investors actually want to buy that product? Would regulators permit it to be sold? If so, what might it mean for the financial world if default risk — the risk most central to the traditional craft of banking — were turned into just another plaything for traders?
They had no idea that weekend how to answer those questions, but Hancock's team was not used to taking no for an answer. They spent their days stretching their minds to the extremes, and they could see that the concept was potentially revolutionary. If you could really insure banks and other lenders against default risk, that might well unleash a great wave of capital into the economy. "I've known people who worked on the Manhattan Project — for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important,"Mark Brickell, one of the bankers on the J.P. Morgan swaps team, later recalled.
Recalling the Boca meeting, Hancock said, "The idea that we gave most emphasis to was using derivatives to manage the risk attached to the loan book of banks." It was only many years later that the team realized the full implications of their ideas, known as credit derivatives. As with all derivatives, these tools were to offer a way of controlling risk, but they could also amplify it. It all depended on how they were used. The first of these results was what attracted Hancock and his team to the pursuit. It would be the second feature that would come to dominate the business a decade later, eventually leading to a worldwide financial catastrophe.
Copyright © 2009 by Gillian Tett