When a young team at investment bank JP Morgan pioneered credit derivatives in the 1990s, it classified some of them as “super-senior”, safer even than a triple-A rating. But 10 years later, as the US housing crash gained momentum, the world’s biggest banks were awash with mortgage-backed securities that were proving to be super-toxic. In the second extract from her book, Fool’s Gold, the FT’s Gillian Tett reveals how subprime spoiled the banking binge.
On October 11 2007, Moody’s cut its credit ratings on some $32bn of mortgage-backed bonds. Those had largely been issued in 2006 with medium-risk ratings of A or double-B. The ratings agency also warned that it might downgrade more than $20bn of mortgage-backed bonds that carried the triple-A stamp, and also downgrade collateralised debt obligations (CDOs) – credit derivatives made up of those bonds. All told, the cuts affected $50bn of securities.
The statement caused alarm among investors. Worse still, Moody’s seemed unsure how much further the downgrades might go. “The performance, particularly in the US housing [and] mortgage sector, [has been] deteriorating more quickly and more deeply than the ratings agencies or most other participants in the market anticipated,” Raymond McDaniel, chief executive of Moody’s, told the Financial Times on October 12. The subprime mortgage market was not behaving as the models had predicted. The “class of 2005 and 2006” borrowers were defaulting much faster than households which had taken out mortgages before those dates.
A particularly pernicious aspect of the defaults was that when this new breed of subprime borrowers walked away from their homes, they often left them in such a bad state that it was hard for lenders to realise any value from the repossessed properties. Until the autumn of 2007, Moody’s had assumed, on the basis of past housing cycles, that lenders could recoup 70 per cent of their loans in case of default. By October 2007, it had slashed that projection to just 40 per cent.
To add to the confusion, by the autumn of 2007 it seemed that events in some US neighbourhoods were throwing the ratings agencies’ models off even further. As house prices fell, defaults were rising to such a degree that they were blighting entire areas. That was pushing house prices lower still, sparking yet more defaults. This vicious circle had never been witnessed in the world of corporate loan defaults; nor did it fit the traditional “bell curve” central to the statistical risk assessment systems that were ubiquitous inside banks and ratings agencies.
When the JP Morgan team had created its original, prototype CDO deals they had bundled up loans from a well-diversified pool of companies, specifically to minimise the chance of widespread defaults. In making CDOs out of mortgages, bankers had supposedly tried similarly to diversify by including loans from numerous regions of the US. The common assumption was that even if one region suffered a crash, the property market would never collapse across the country as a whole. But by the autumn of 2007, it had become clear that this theory wasn’t working in the subprime mortgage world. Defaults were rising everywhere.
A few days after Moody’s cut its credit ratings, Standard & Poor’s followed suit. Then a third agency, Fitch, warned it might cut the ratings on $37bn of CDOs. Most chilling of all, the agencies warned that these reviews did not just affect the junior – and riskiest – tranches of CDO debt. The senior, or supposedly safe, triple-A portion was at risk of downgrades as well. The shock to the market was immediate. After all, the entire structured credit business had been built on the assumption that triple-A rating was ultra-safe, and double-A almost rock solid, too. Now that pillar of faith was crumbling. It was impossible for anyone to know exactly how the downgrades might affect the value of particular CDOs. By autumn 2007, these were still not being widely traded, but there was one guide that could offer a clue – the so-called ABX index, which tracked the price of mortgage derivatives. By mid-October, the component of this index comprising triple B-rated securities had tumbled to 30 per cent of its face value, down from 95 per cent at the start of the year. Most ominously of all, the triple-A tranche of the ABX index was trading at around 90 per cent of face value, while the AA was falling towards 80 per cent. To a casual observer, such dips might not have looked extreme. But, bankers and investors had always assumed that the prices of triple-A or double-A assets would never move at all. They were utterly unprepared for the damage that such price falls might inflict.
. . .
The super-senior scourge
On November 4, Bill Demchak, senior vice-chairman at the Pittsburgh bank PNC, dialled into a conference call arranged by the mighty Citigroup. Demchak, a key member of the team at JP Morgan that a decade earlier had created the forerunner of the CDO, had spent the autumn following events in the credit derivatives world with mounting alarm. Back in 2006, when his team at PNC had made the ballsy decision to start cutting the bank’s credit risk, Demchak had done so largely because he reckoned that conditions in the corporate loan market looked dangerous. He assumed that when the credit bubble burst, that was where the pain would be felt first. By autumn 2007, it was becoming clear that his prediction was only half right.
Conditions in the corporate loan market had indeed deteriorated, because investors had become reluctant to purchase CDOs built out of risky corporate loans and derivatives. The banks were left with some $400bn of corporate loans on their books that they could not sell on. What was worse, the price of those loans had fallen sharply. Demchak had expected as much. But by November 2007, he could see other problems brewing. In the middle of October, Citigroup had revealed that its net income had slumped from $6.2bn in the second quarter of the year to $2.1bn. The reason, it reported, was that it had been forced to write down the value of its corporate and mortgage assets by $5.7bn. That number looked quite large, but most analysts were not too surprised. Citi had a vast loan book, and other banks were announcing similar losses.
On November 4, however, Citi suddenly warned that it would report additional losses of between $8bn and $11bn. That was such shocking news that chief executive Chuck Prince resigned. It was also baffling to analysts. Citi was supposed to be expert at measuring credit risk, so how had it managed to misjudge its losses so badly? And why was it still so uncertain about the total bill?
Demchak dialled into the conference call eager to find out. “The issue is super-senior,” one of the executives explained. The problem, he added, was that the bank held on its books $43bn of super-senior risk, linked to CDOs backed by mortgage debt. Citi had previously assumed that the value of those assets was 100 per cent of face value. Now the price was falling.
Super-senior? Demchak could hardly believe his ears. Almost a decade had passed since Krishna Varikooty, Demchak and the rest of the JP Morgan group had invented the term to describe the part of a CDO that was supposed never to default – according to the computer models. Back then, super-senior had seemed a geeky in-joke, so quirky and obscure that only a few technical experts knew what it meant. Now the Citi executives had casually tossed the word into a conference call with hundreds of mainstream investors, analysts and financiers. Demchak didn’t know whether to laugh, cry or just shake his head in wonder. In other circumstances, he might have felt almost proud that his team’s once-obscure brainchild had suddenly burst into the limelight. In fact, he was horrified: the way Citi told the story, super-senior had turned into a scourge that had created most of its unexpected losses.
“How could this happen?” Demchak wondered. During his days at JP Morgan, his team had considered super-senior so safe that it was “more than triple-A”. Even though Demchak himself had gone to great lengths to sell JP Morgan’s super-senior risk to AIG and other insurance groups, he had never imagined that it could pose more than a moderate risk. Nor had he guessed that Citi was holding so much super-senior risk on its own balance sheet. Citi had never discussed the issue before on conference calls nor highlighted it in previous results announcements. “How did this happen?” Demchak asked himself again and again. As he listened to the rest of the call, he got the distinct impression that the Citi managers were almost as baffled as he was.
To most Citi executives, the bottom-line hit was as stunning as if the ground had opened up under the bank. On the day of the announcement, Jamie Dimon, chief executive of JP Morgan, bumped into a former senior colleague at Citi. “What happened?” Dimon asked. “We are not entirely sure ourselves,” the man replied. Dimon had no reason to doubt him. By 2007, Citi operated as a vast empire so fragmented – and feuding – that the many businesses within it rarely interacted. As a result, few of the bankers outside the CDOs team knew how the operation worked. “Perhaps there were a dozen people in the bank who really understood all this before – I doubt it was more,” one senior Citi manager recalled bitterly.
Investors were equally shocked. Back in July, Citi had been on a roll, posting record profits and holding an extremely large capital cushion. Now the super-senior disaster was blasting through that cushion, and Citi was looking befuddled. More frightening still, Citi’s woes were hardly unique. In early October, Merrill Lynch unveiled a $5.5bn write-down on its credit assets. Again, analysts weren’t unduly concerned at first. But in late October, Merrill raised the estimate to $8.4bn, large enough to force the resignation of its chief executive, Stan O’Neal. The losses at the giant Swiss bank UBS were arguably even more shocking. In early October, it had announced it was writing off about $3.4bn in mortgage-linked losses. Investors were stunned, but they also congratulated the bank for having the courage to come clean. By late October, however, UBS was indicating to analysts that it would soon need to revise that loss up considerably, and in December it announced another $10bn of write-downs. As with Merrill Lynch and Citi, the scourge was super-senior CDOs. Back at the start of 2005, the Swiss bank had barely held a single super-senior note on its books – by early 2007 it held $50bn of them.
. . .
“Can you find more capital?”
By late November 2007, the banking sector was barrelling into a full-blown crisis. Bank shares were tumbling at a startling rate – since June alone, more than $240bn had been wiped off the market capitalisation of the largest dozen Wall Street banks – and worse still, it appeared that the banks no longer trusted each other. They were so nervous about the prospect of new shocks that they were either refusing to lend to each other or were hoarding the cash they had for fear of what lay ahead.
The bigger the write-downs became, the more they started to have an impact beyond the banks in the “real” world. Six months earlier, regulators and investors alike had blithely assumed that American and European banks would be extremely well protected from any future turn in the credit cycle. In the first half of 2007, large western banks had posted a record $425bn in aggregate profits, and had capital reserves that vastly exceeded the minimum required by international banking rules. Global banks alone were estimated to hold core capital (known as “tier one”) of $3,400bn. That was why the Federal Reserve and others had been so confident that the banks would be able to absorb the $100bn-odd hit that was expected to arise from the subprime sector. Moreover, precisely because banks had been parcelling out their risks so enthusiastically, most regulators and investors had also assumed that banks would be exposed to only a tiny part of any credit losses. Risk was supposedly scattered throughout the system. But the more the subprime scourge hit the banks, the more wrong-headed all those assumptions started to seem.
When regulators had celebrated the benefits of “risk dispersion”, they had assumed that the banks were selling almost all their collateralised debt obligations to other players. They had not realised that so much super-senior risk was piling up on some banks’ books, in a manner that left those banks exposed to entirely unexpected concentrations of risk. Worse, the super-senior losses were so gigantic that they were eating through the banks’ capital reserves – even though these had appeared so impressively large just a few months before. In late November, Timothy Geithner, president of the New York Federal Reserve, placed furtive phone calls to some of the Wall Street banks. The gist was: “Can you find more capital? You need to – now!” Frantically, Citi, Merrill and other large banks looked for ways to plug the holes, no one even daring to hope that the government would step in. The UK and US governments hated the idea of using taxpayer funds to recapitalise banks, and there seemed to be little chance of attracting western investors.
In mounting desperation, some bankers looked east for help. During the first seven years of the decade, China, Singapore, Korea and the oil-rich countries of the Middle East had all built up large so-called sovereign wealth funds, dedicated to managing vast pools of government money. By 2007, such funds were estimated to control more than $3,000bn, though the precise tally was unknown because the funds were highly secretive. Traditionally, much of their cash had been invested in US Treasury bonds and other safe assets – the funds had shied away from taking direct stakes in American companies, partly because doing so tended to provoke nationalist ire. However, as the panic intensified on Wall Street and in the City of London, bankers set aside that concern, and senior dealmakers from Wall Street, London and Zurich hopped on aircraft in a frantic effort to persuade Asian and Middle Eastern funds to help.
Citi was the first to clinch a deal. In late November, the Abu Dhabi Investment Fund, the world’s biggest sovereign wealth fund, announced plans to inject $7.5bn into the bank. Soon after, UBS raised $11bn from the GIC fund of Singapore and Middle Eastern investors. Then Merrill Lynch raised $5bn from a Chinese government fund, while Morgan Stanley garnered a similar sum from Singapore. It was an extraordinary turn of fortunes. The western banks had been the ones to bail out their emerging-market counterparts in the past. Humiliating as it may have been, though, bankers were too relieved to worry about the source. Regulators were privately relieved as well. “If the banks are finding fresh sources of capital, then that is very good. They need to recapitalise, as swiftly as they can,” one of America’s most senior regulators observed in December 2007. “Once they have done that, the banking system can then move on. Or that is what we all hope.”
Yet while the capital raising looked impressively large, the losses were even bigger. As 2008 got under way, UBS, Merrill and Citi all revealed more big write-downs on their holdings of credit assets, taking the total to $53bn for those three banks alone. Super-senior write-downs accounted for a stunning two-thirds of that figure. Gamely, all three insisted they were near the end of the process. Nobody quite believed them. The essential problem was that the system was becoming trapped in a vicious circle. The more the banks wrote down the value of their super-senior assets – or any other credit asset – the more scared investors became, causing the prices of these assets to fall still further, which forced the banks to make more write-downs.
A decade is a long time in banking As the losses mounted, the former members of the JP Morgan team that had originated the idea of building collateralised debt obligations out of credit derivatives reeled in shock. A full decade had passed since Demchak’s acolytes had invented the seemingly innocuous concept of super-senior. In the intervening years, they had scattered but many remained friends. They e-mailed regularly, and from time to time some of them would meet for dinner or visit each others’ holiday homes in Tuscany, the Hamptons and other choice retreats. Like any family, the group was also driven by petty rivalries yet they almost never criticised one another to outsiders. A deep intellectual bond and a remarkable sense of affection still linked most of them.
But by late 2007, the e-mails bouncing between their BlackBerries were expressions of disbelief. Like Demchak, most of them were stunned at how perverted their super-senior brainchild had become. “What kind of monster has been created here?” one of the former JP Morgan group wrote in a heartfelt e-mail. Another observed: “It’s like you’ve known a cute kid who then grew up and committed a horrible crime.”
Gillian Tett is an assistant editor at the FT. In March, she was named Journalist of the Year at the British Press Awards
This is an edited extract from ‘Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe’ by Gillian Tett. It is published in the UK by Little, Brown, £18.99, and in the US by Simon & Schuster, where it will be available this week. To buy the book for £13.99, call the FT ordering service on 0870 429 5884 or go to www.ft.com/bookshop
To read the first extract from the book, “Genesis of the debt disaster”, click here
