Book Review: Fool's Gold, by Gillian Tett

I must admit, I really liked this book, “Fool’s Gold” by Gillian Tett. Ms. Tett runs the global markets coverage for the Financial Times of London and has been named the 2008 British Business Journalist of the Year and the 2007 Wincott Prize for financial journalism. One of the major reasons for my admission is that she can tell a marvelous story. This may be because her Ph. D. is not in economics but in a field that can produce readable writing. Another reason is that she knows the finance field.

The subtitle of the book's U.S. edition - How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe - is misleading in that implies, to me, that the story is about a disaster at J. P. Morgan (JPM) and this is not what the work is about at all. (See the original British title, above.) If anything, the author writes mostly positive things about the bank and the people that worked there and how, because of its leadership and financial strength, it was able to contribute to the containment of the financial collapse that took place. In fact, Jamie Dimon and his management, as well as earlier leaders of the organization, come across very favorably.

The story begins in June 1994 at the Boca Raton Hotel on Florida’s Gold Coast. An off-site meeting was being held there of bankers from the “swaps” department at the Morgan bank. The purpose of the meeting was to brain storm (and party) with one another in order to create ideas for new, innovative derivative instruments. The concept that came out of this get-together was the credit derivative, or, more specifically, the credit default swap (CDS).

Ms. Tett works from this initial encounter to develop the story of the CDS and the various other types of derivative instruments that grew out of this creation, and the uses to which these innovations were put by the global financial community. Along the way she weaves into the narrative the personalities and events that make this period so intriguing. I have recently read and reviewed a lot of books covering this period and I believe that this author presents as readable and understandable a book as anyone.

What is most intriguing in this history is the image the book gives of innovation and the consequences of innovation. Certainly, the financial innovation that has taken place has been truly remarkable. I was in the Federal Reserve System as the Negotiable Certificate of Deposit and Eurodollars were created. I was at the Department of Housing and Urban Development in Washington, D. C. when the first mortgage-backed security was put together. Most of my professional career has been centered around all of these new financial tools. The CDS and CDOs and SIVs and so forth are nothing more than a natural part of the evolution of the economic and financial system.

In general, innovations are aimed at filling in “holes” in the market system. The economist speaks of the existence of missing markets or incomplete markets. That is, in the real world markets do not exist for every good for every kind of transaction for every possible time period. In many cases, either costs prohibit the existence of a market or the right question has not been asked about what is needed. The bankers who met at the Boca Raton Hotel were attempting to ask questions that might lead to a product that would satisfy a need that did not, at that time, have a market. The specific question that arose at this meeting pertained to the possibility of trading the risk that was linked to corporate bonds and loans. Why couldn’t a derivative be created that would enable a bank to place bets on whether a loan or a bond might default in the future?

The answer was the CDS. The timing of the answer could not have been better. And, as the pundits say, the rest is history. But the history is more than just the creation of this innovation. It is the story of the aftermath of the invention. And, in this case, the story involves the nature of financial markets and of financial institutions. It is a narrative of success and excess and their consequences.

Adding a new instrument and its spin-offs to the financial markets can create profits, big profits. This can happen with any innovation. In financial markets the barriers to entry into a new market are extremely low and so once a successful new product is brought to market it can be easily duplicated or enhanced upon. Since the CDS proved to be extremely successful, others jumped into the market almost immediately. Trading expanded exponentially, and this presented a problem. A law of finance is that if arbitrage profits exist, competition will soon drive away any interest rate spreads or profits and the “Law of One Price” will rule. Ms. Tett traces the progress of this process with respect to the CDS through its various stages.

However, as spreads narrow, investors try to maintain returns by increasing the risks connected with the assets they acquire or by increasing the leverage they build into their deals and or by mismatching the maturities of their assets and liabilities. That is the system becomes more and more fragile.

Why do the institutions do this? One reason given in the book is something called “Goldman envy.” In 2002 and 2003, Goldman Sachs (GS) turned in eye-opening financial performances. Other institutions wanted to emulate Goldman and so these other organizations pushed to at least duplicate Goldman’s results. Hence, these other institutions stretched the limits of the prudent to enhance their performance. These financial organizations attract very, very competitive individuals and very, very competitive people do not like to finish second!

Two final comments are in order. The first has to do with the understanding of the risk involved in the new instruments. New financial innovations have no way to be tested relative to their riskiness except by means of computer simulations that use historical data. There are no statistics that truly represent the environment surrounding the new instrument and, as a consequence, no one really fully knows what are the risks associated with the instrument. This is especially true of risks connected with the interaction of the new product and others products or the market: the “correlation” factor. Hence, innovations can always have “surprises” connected with their usage.

The second comment relates to the “absence” of the oversight of the bank regulators. Let me just say that regulators are always behind what is going on in the industry. That is just the nature of the relationship. This was true when the Eurodollar deposit and the negotiable Certificate of Deposit were created when I was at the Fed. It was also true of the CDS and associated derivative securities. And it will be true of future financial innovations.

Financial institutions will always attempt to get around regulations in one way or another because it is profitable to do so. Ms. Tett does an especially nice job in explaining how banks worked to get around capital requirements using the new tools and instruments. Part of the problem connected with the absence of the regulators during this period of time was that the banks worked very hard to expand their use of leverage in ways the policy makers could not see. Of course, this came back to haunt them when the collapse occurred.

I recommend this book very highly. It is a “good read”!

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. Published by Free Press, 2009.

Comments

[sticktoitiv...:]

Wow, maybe you've have more encounters with history than Forrest Gump. CDS's aren't necessarily bad, but you should be required to own the underlining bond to own one.

Jun 13 10:32 AM

[Vuke:]

Sounds like a very good read. It's a little trite to say but the idea of building an economy on bankers selling masses of paper to each other has always appeared a little dangerous.

Now that the foundation of the "new economy" has been found to be rotten to the core it's time to get back to basics. Wealth is created by adding real value to an asset, not by adding imaginary attributes.

There is, no doubt, some value within these instruments but when they take off like baseball cards or tulips some restraints are in order. When huge corporations like GM begin to focus on such things the damage is spectacular, much like a MOAB on an anthill.

Jun 13 11:35 AM

[Old Trader:]

Almost anything that mankind invents can be perverted, corrupted, or misused to great detriment.

Jun 13 11:51 AM

[Fighting Yoda:]

CDSs worked like the 'portfolio insurance' that caused the 1987 crash.

CDSs have been used as speculative instruments rather than hedging and the distinction should be very clear. They acted like the weapons of financial mass destruction. You are not able to buy insurance on somebody else's is life, but with CDSs you are able to do so. You have perverse incentives to wish and cause death. These deaths are (were) self fulfilling prophesies. The greed, corruption and stupidity on Wall Street will ensure that.

Financial innovation - per Volcker - the only useful financial innovation in the last 20/30 years has been the ATM. Even this was corrupted by Greenspan when he innovated it into the Home ATM.

Jun 13 12:19 PM

[John Lounsbury:]

John Mason - - -

Thanks for this timely (and excellent) review. "Fools Gold" arrived yesterday, along with Barry Ritholtz's "Bailout Nation". Don't know which one to read first. Maybe I'll start both and alternate, evening to evening, and see how it goes.

Jun 13 03:38 PM

[Market Sniper:]

Looks like an apology for the derivative "side bets." What they actually "invented" was weapons of mass financial destruction. Built on a basically flawed model that real estate pricing could only more in one direction and that was UP. Just because something CAN be done does not mean it SHOULD be done. Institutions with no stake in the underlying security should be barred from hedging it.

Jun 13 04:53 PM

[apppro:]

You originally brought up just another example of how blatantly exaggerated news flashes and rumors have been more responsible for the markets demise then we give them credit. 100 point swings every time someone passes gas have been far too commonplace. The end stability of our system lies in confidence, and all the rumorboarding and contrived scenarios have done nothing to promote it.. Quite the opposite!

Jun 13 05:15 PM

[MrZack888:]

the title is misleading, i thought he was referring to real god.

Jun 13 06:52 PM

[The-Stock-M...:]

A bulldozer works well in tearing down and removing debris of an old building. What if someone runs amok with it and tears down whole neighborhoods?

CDS was good if used within limits and responsibly. As in 5 or 10% of a portfolio. But when whole hedge funds were operated on just CDS and other 3 letter words, the financials were just being irresponsible.

Jun 13 08:09 PM

[Edward Ulys...:]

CDS is just another way to Cheat, Deny and Steal. If one wants to make bets, go to the casinos. I did not chose to live within a casino, with no way out. The real problem is that folks who are NOT party to the transaction are the ones that get burnt.

Jun 14 08:31 AM

[Ferdinand E...:]

Gillian Tett did not study economics, but has written a book about economics. Let's see what we can make of that.

She didn't study economics but works for an ignoramus who did. In these circumstances I really don't know if it's worth while for me to go to the local bookstore and steal a copy of her masterpiece.

Jun 14 09:00 AM

[max12345:]

regarding your paragraph:

"Adding a new instrument and its spin-offs to the financial markets can create profits, big profits. This can happen with any innovation. In financial markets the barriers to entry into a new market are extremely low and so once a successful new product is brought to market it can be easily duplicated or enhanced upon. Since the CDS proved to be extremely successful, others jumped into the market almost immediately. Trading expanded exponentially, and this presented a problem"

Allow me to indulge in a fanciful analogy inspired by Warren Buffet's comment about (at least some) derivatives being "weapons of mass destruction".

Once Einstein came up with general relativity and a few other smart physicists later decided it was more of a good idea than a bad one to develop nuclear weapons, lots of folks wanted to get on the bandwagon and get their hands on these brand new toys. (humanity's history is NOT riddled with intelligent decisions)

The political (as opposed to the financial) entry costs and the barriers to entry were not "extremely low" for "new participants" into this lucrative business of having nuclear weapons (nations that wished to avail themselves of their "big profits"....(i.e. not being attacked by anyone else for fear of being obliterated) were probably a bit higher than the financial entry costs of jumping onto the CDOs bandwagon.

Nevertheless a few other well meaning folks saw fit to come up with the Non Proliferation Treaty....(which calls on nations that do not have nuclear weapons to not develop nuclear weapons and on nations that already have them to gradually reduce their stockpiles to zero) (the latter of the two provisions having been conveniently forgotten by those who already have them)

But regardless of how well that particular regulatory regime has worked at least the world community has tried to put one in place, to regulate this other "brilliant innovation". (at first comprised only of atomic bombs, then H bombs, and then missiles with multiple H bomb warheads and other clever "delivery systems" such as submarines)....

Is my analogy getting duly stretched by now?

But unless the good old Mr. Buffet is completely wrong about "certain derivatives" shouldn't we now at least try to properly regulate the most dangerous amongst them? (though of course we CANNOT really hope to ever succeed?)

I hope my "very clever" (or very stupid) analogy provided some helpful comic relief.

Jun 14 02:24 PM

[Phil Trupp:]

Now that the radioactive dust has begun to settle around the all-out war the financial system declared on the world economy, we see more clearly what "innovation" truly means to the unfortunate clique of banking geniuses we have been forced to endure. There are no heroes to cheer--certainly not Mr. Dimond. He is simply one of the gang that perpetuated the present chaos. Ms. Tett deserves credit for unmasking the endless catch-me-if-can engagement between the corrupt subculture of the banking and brokerage syndicates and the regulators who are slow to act and too often indifferent to life-altering games of deception. We need a little less innovation in financial markets and fewer "holes" to be plugged in the broader economy. These so-called holes are in reality centers of weakness and opportunity to be exploited by manipulative bankers. We need more attention paid to risk, fair reward, and the need of rational capital flow to areas of the economy where it is most needed and will do the most good.

Jun 14 03:19 PM

[Long Silver...:]

The only problem is when these guys create a casino that is ultimately backed by taxpayer money. I have no problem with them betting and losing their own money. It bothers me to no end that the rest of us have to bail them out because of their cozy relationship with Fed/Treasury policy makers.

Jun 14 05:49 PM

[Deehena:]

Fine book review - thanks

Jun 14 07:32 PM

[Northstar10000:]

If we had no government at all we would have less problems than we have now. How do you fix something so big when the governments created it foster it and feed it. complete fools still blame everyone except the idiots in washington. We won't learn until the jerks blow the whole system up. The housing markets and banks, car comp. and insurance all grew under government feeding. How come only the regulated part of the economy blew up...The answer - GOVERNMENT in all its glory.

Jun 14 09:01 PM

[dragonpaw:]

Ponzi-schemes covered by shell games enshrouded by check-kiting scams promoted by schills to the financially in-ept. What a proud and venture-some gaggle of newly -minted wise-ass wags we have raised.! Just can't wait to see the next batch of Gecko-like clones; maybe these avant-gardes (no, most assuredly 'savant -gardes') may be imbeaued with the true avarice and 'cajones"(male or female) to really bring down the whole system in meteoric swiftness and splendor!
Only then can we all become true-believers in the "Protestant Ethic and the Spirit (however unholy) of Capitalism"! Only then, can we savor the final epitome of Western Civilization!
Sure hope someone like Gilly is around at the time to document and embellish their Herculean endeavors!
Can't wait tfor the sequel!!

Jun 14 09:53 PM