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 by Gillian Tett Read Free Book Online

the banks and regulatory changes in the asset management world. Another factor that fueled the trend, though, was falling interestrates. After Paul Volcker jacked up rates in 1979, inflation had tumbled. By 1983 it was running at 3.2 percent, down from 13.5 percent in 1981. The Fed was then able to trim short-term interest rates, which stimulates economic growth. In 1987, Alan Greenspan replaced Volcker as Fed chairman, and from 1989 onwards, he steadily reduced rates to fight a mild recession. That was good news for borrowers, and it also boosted bank profits, because when rates are low, banks can borrow money cheaply and lend it out to customers at higher rates, making easy returns. But falling rates made it harder for investment managers to earn decent returns by purchasing relatively risk-free government or corporate bonds. Those pay less when rates fall. Thus, while the absolute level of rate was still relatively high (at least, compared with what it would be a decade later), the direction prompted some bond investors to look for new tactics.
    Merrill Lynch, Bankers Trust, Salomon Brothers, and J.P. Morgan itself suggested to their clients that they could use derivatives to boost their returns, and the banks invented a new wave of products to provide that service, with obscure names like “LIBOR squared,” “time trade,” and “inverse floaters.” Some federal agencies, such as Sallie Mae, the student loan provider, also began offering investment products that included derivatives. Most of these products produced high returns by employing two key features. They involved bets on the level to which interest rates would fall in the future, and with rates falling so dependably on Alan Greenspan’s watch, those bets produced easy money with what seemed like very little risk. Most of these deals also involved a concept that is central to the financial world, known as “leverage.” This essentially refers to the process of using investment techniques to dramatically magnify the force or direction of a market trend (just as a lever will increase the force of a machine). In practical terms, the word can be used in at least two ways in relation to derivatives. Sometimes investors employ large quantities of debt to increase their investment bets. For that reason, borrowing itself has often come to be called “leverage” in recent years. However, the economic structure of derivatives deals can also sometimes leave investors very sensitive to price swings, even without using large quantities of debt. Confusingly, that second pattern is also referred to as“leverage.” In practice, though, these two different types of leverage tend to be intermingled. And the most important issue is that both types of leverage expose investors to more risk. If the bet goes right, the returns are huge; if it goes wrong, though, the losses are big, too. Using leverage in the derivatives world is thus the financial equivalent of a property developer who buys ten houses instead of five: owning more properties will leave that developer more exposed to losses and to gains if house prices rise or fall, particularly if the properties are financed with debt.
    In 1992 and 1993, though, many investors thought it was worth taking those risks, by buying products with high leverage. “It was a type of crazy period,” recalls T. J. Lim, one of the early members of the J.P. Morgan swaps team, who worked with Connie Volstadt in the 1980s and decamped with him to Merrill Lynch. “The herd instinct was just amazing. Everyone was looking for yield. You could do almost anything you could dream of, and people would buy it. Every single week somebody would think of a new product.”
    Some prescient warnings were issued. Allan Taylor, the Royal Bank of Canada chairman, said that derivatives were becoming like “a time bomb that could explode just like the Latin American debt crisis did,” threatening the world financial system. Felix Rohatyn, a legendary