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 (NYSE: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 (NYSE: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”!