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 Page A

Wall Street figure who worked at Lazard Frères in corporate finance, far removed from derivatives, called derivatives “financial hydrogen bombs, built on personal computers by twenty-six-year-olds with MBAs.”
    Those “twenty-six-year-olds” vehemently disagreed. The innovation frenzy showed exactly why derivatives were so powerful and why government control must be fought off. “The surest way to stifle innovation is to take current best practices and convert them into rigid requirements,” Brickell liked to say, paraphrasing Friedrich von Hayek, the libertarian Austrian economist and one of Brickell’s intellectual heroes. Indeed, if there was one thing that united swaps traders, aside from a fascination with deconstructing financial instruments, it was the belief in the efficiency, and superiority, of free markets.
    Brickell took the free-market faith to the extreme. His intellectual heroes, in addition to Hayek, were economists Eugene F. Fama and Merton H. Miller, who had developed the Efficient Markets Hypothesis atChicago University in the 1960s and 1970s, which asserted that market prices were always “right.” They were the only true guide to what anything should be worth. “I am a great believer in the self-healing power of markets,” Brickell often said, with an intense, evangelical glint in his blue eyes. “Markets can correct excess far better than any government. Market discipline is the best form of discipline there is.”
    Peter Hancock shared that view, though he rarely expressed it so forcefully in public. So did most other swaps traders. Of course, they knew perfectly well that financial markets were not truly free. On the contrary, the financial system was smothered in the government rules that had followed repeated crises. What made derivatives so thrilling for Brickell and other true believers was that they lay outside the purview of that legacy regulation. They allowed pioneering financiers to compete freely, unleashing their creativity, just as theory advocated.
    This did not equate to a world with no rules, Brickell always liked to stress. On the contrary, the derivatives market could function only if the participants played according to a common law book. Indeed, crafting those legal guidelines had been a founding purpose of the ISDA. What made ISDA’s approach so different was that it asserted that rules were best designed by the industry itself and upheld by voluntary, mutual accord. Government bureaucrats should not be the sheriffs or high priests of this world; bankers and their lawyers were better informed, and they had strong incentives to comply. Like a hunter-gatherer tribe, all derivatives traders had an equal interest in upholding the norms. That was why any recommendation the G30 report might make about legislation to institute regulation was to be fought, argued Brickell, tooth and nail.
    Another key factor that influenced how J.P. Morgan bankers and others viewed regulation was the development of an idea known as value at risk, or VaR. In previous decades, banks had taken an ad hoc attitude toward measuring risk. They extended loans to customers they liked, withheld them from those they did not, and tried to prevent their traders from engaging in any market activity that looked too risky, but without trying to quantify those dangers with precision. In the 1980s, though, Charles Sanford, an innovative financier at Bankers Trust, had developedthe industry’s first full-fledged system for measuring the level of credit and market risk, known as RAROC. That eventually prompted other bankers to start trying to measure risk not according to vague hunches but by using precise quantitative techniques.
    Dennis Weatherstone, the Morgan CEO, played a crucial role in that wider industry trend. Having built his career on the volatile foreign exchange trading desks, not in the staid commercial arm of the bank, he was keenly aware of how risk could come back to bite you, if you did not