Fools Gold

I have been reading Fools Gold by Gillian Tett, a senior editor at the Financial Times. This is an important book for understanding the global financial crisis.

Tett describes how staff at JPMorgan developed a new credit derivatives to sell the risk of loans on the banks balance sheet defaulting. The derivatives were carefully designed to ensure that none of the risk remained with JPMorgan, but was sold to parties willing to bear the risk in exchange for a higher return. This eliminated the most difficult to manage risk that existed for a bank.

Soon a wide range of banks were producing similar products, but they were not so carefully designed. To boost revenues from these derivatives, competing banks cut corners that meant a significant part of the risk remained on their books.

The irony is that bad practice turned a product designed to mitigate the risk carried by banks into one that magnified default risk.

The derivatives team at JPMorgan was asked to develop a similar derivative for mortgage backed securities. However, when they looked for statistical data to track mortgage defaults over several business cycles, they found that it did not exist. Without that information, they believed that a safe product could not be produced, so they refused to get into the business, despite huge opportunities for profits.

When they heard that other banks were producing CDOs based on mortgage debt, they wondered how the problem had been solved. Once the credit crisis struck, it became clear that the problem had not been solved, and that these banks had been left carrying huge risks that they did not understand.

A different approach to risk, explains why JPMorgan remained strong, whereas others like Bear Stearns and Lehman Brothers failed.