PIERRiE OM IDVAR EXPLAINs ]IHEWHV 1IHE FRENIGH AN]D THE ENIGLISH

The dreammachine

Ten years ago a group of young bankers had a weekend away in Boca Raton.

In between throwing each other in the poot, and a tot of drinking, they

invented something that changed the wortd of finance. By GiLtian Tett

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he first time I ran into the "Morganmafia" - or, more accurately, the ex-

JPMorgan mafia - was at a banking'conference in Nice last year. It was,

I later learned, the tlTe of ritual typical ofhigh finance: around a plush, darkened lec-

ture theatre and well-stocked bar, a gaggle ofsuited men (and the occasional woman)earnestly muttered about "delta hedging","correlation risk" or "CDO squared".

For all I could tell, they might have beendiscussing nuclear physics or ancientChinese. What distinguished this meetingfrom those topics, however, was the whiffof money: these people might have lookedlike nerds, but they sported very expensivewatches, and their chat was peppered withcasual references to billions of dollars.

Uneasily, I tried to work out what wasgoing on. A few weeks earlier I had startedreporting on the capital markets and heardthat something called "credit derivatives"was revolutionising global finance. Just fiveyears ago the sector was a tiny niche busi-ness. Now the volume of all the outstandingcredit-derivatives deals in the world is esti-mated at $12 trillion. However, like mostpeople, I had little idea what a number thatbig actually meant (for reference, it is aboutthe size of the American economy, oralmost four times the total value of all theshares on the London Stock Exchange). So Ihad flown to Nice hoping to get some bear-ings in this strange land.

"Who's that?" I whispered to a balker nextto me, pointing to a platform where two menand two women were discussing whetherinvestors "really understand the full ramifi-cations of CDO risk". (Their conclusionseemed to be: "not always", which didn't sw-prise me, given how little of the jargonanyone might have understood.) My neigh-bour firtively whispered that he worked forone of the biggest US banks and was there-fore forbidden to talk to journalists, "sinceyou guys keep writing that crap about deriv-atives blowing up the world". But then he

relented: the speakers, he said, were appar-ently consultants or partners in hedge (bigprivate investment) funds; but almost allused to work for JPMorgan, the bis US bark.

Why JPMorgan? I asked. WhY notGoldman Sachs or Morgan Stanley? Or aBritish, French - or Chinese - bank, cometo that?

"It's the Morgan mafia - they sort of cre-

ated the whole credit derivatives thing," hechuckled, and then clammed up as if he hadrevealed a sensitive commercial secret.

As I sat watching slick PowerPoint pre-

sentations, I wondered how this had comeabout. Every year, the anonymouseggheads who work on Wall Street and inthe City of London produce a stream ofbright ideas that push money around theworld in an evet more efficient way (andmake the banks they work for, and them-selves, richer in the process). Most of these

It was the financialequivatent of calorie-f ree

chocotate: a[most toogood to be true

ideas simply vanish; but every so often a

few - such as credit derivatives - mush-room with extraordinary speed.

To anyone outside finance, these con-cepts generally seem so complex that suchinnovation might exist in a parallel uni-verse. But that is only half true. For if theoil of high finance does not keep lubricat-ing the wheels of the global economy, theworld as we know it would quickly slowdown. Moreover, we live in such an inter-connected economic system that every timeyou convert money at a foreign exchangetill, pay your mortgage to a bank or useyour ATM card, you are plugging into agiant web of capital flows that is being con-tinually rewoven by these innovations.

But where, I wondered as I sat in the lec-

ture theatre, do these ideas come from? Andwhy do some fail and others blossom into a

$12 trillion business? And what does thattell us about the way that financial innova-tion really works and shapes all ow lives?

In the months that followed the confer-ence in Nice, I started to track down someof this "Morgan mafia" in an effort tounderstand the credit derivatives tale. Itwas not an easy task: traders live in a

world in which information costs money,numbers speak louder than words andjournalists are - at best - viewed withextreme distrust. But, as it turns out, oneplace to start this story is not on the deal-ing floors of London or New York, but onthe humid coast of Florida. For it wasthere, at the plush holiday resort of BocaRaton, that about 80 JPMorgan bankersworking in their derivatives departmentlassembled about a decade ago, to hold a so-'called "weekend offsite".

By now you might be feeling like I didwhen I showed up at that banking confer-ence in Nice, wondering what everyonewas talking about. First you need tounderstand what a derivative is. And to do

that, you might as well start with the lit-eral meaning: a derivative is somethingwhose nature is derived. or comes, fromsomething else. In the financial world,where we are interested in the value ofsomething, the value of a derivativedepends on the value of something else. So

far so simple.There are many things in the financial

world that have value: shares. bonds, cur-rencies. commodities, cash, loans. The

,'secret of the derivative is that it makes itpossible for you to have some of the valueof one of those assets, even if you don'tactually own it. Why would anyone wantto do that? Part of the answer is that it actsa bit like an insutance policy. If you thinkyou might have an accident in your car,you don't have to set aside the entire value

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of a new car. You can pay a premium thatwill cover the cost only if you crash. If youthink your shares are going to fall, youdon't have to sell them. You can take out acontract to sell them at a certain price ifindeed they do fall. If they don't fall, youwon't have sold. That's how you build sta-

bility and predictability into your finances.It's the same in business. Let's say youmake tyres: you can contract to buy rubberat a certain price without actually buyingit and having to stash it in a warehousebefore you need it. That way you build sta-bility into your tyre business. Perhaps youknow you will need to borrow money in sixmonths. You don't have to do so now attoday's interest rate and sit on the moneyfor half a year. You can take out a contractto borrow in six months at a rate that you

can then build into your budget. And so

on. Useful things, derivatives.However, there is a second asPect to

derivatives that also makes them occasion-'ally dangerous. Some investors use themto make "speculative" bets on how themarkets will move. Imagine, for example,that you were absolutely sure rubberprices were going to surge: you might bor-row money to buy a derivative that letsyou benefit from a rubber price increase,even if you never owned any rubber at all(or never needed to own it). However, ifsuch bets go wrong (say rubber prices actu-ally fall), or you misunderstand thecomplex mathematics behind the contract,you can lose an awful lot of money, partic-

ularly if you have borrowed heavily tomake your bet. It is this second, "specula-tive" feature that makes derivativesManichean in nature, capable of producingboth negative and positive outcomes.

ow, back to Boca Raton. The "offsiteweekend" was part of a well-wornritual in the banking world, designed

to let the bankers celebrate and let offsteam. On this occasion, the YoungJPMorgan bankers (and they were mostlyyoung) were determined to have fun. BocaRaton has golden sands, a swanky tennisclub and a sparkling marina, and in theearly 1990s the bank had plenty of money tosplash around: some of the bankers flew inby Concorde, stayed in smart, pink Spanish-style villas and drank heavily at the bank'sexpense. Inileed, by the end of the weekend,the party spirit was running so high thatthe bankers started throwing each otherinto the swimming pool fully clothed.

"There was a great group spirit - weworked hard, but we also had a lot of fun,"recalls BilI Winters, an American banker

'Peter Hancock is tike an ideasmachine - throws a thousand

thoughts on to the wa[t.Most never fty at a[t, but every

so often one does'

with a straight-talking manner anddebonair features, who was one of thosewho ended up dripping wet. These daysWinters, 45, is a man who exudes gravitas:his current job is co-chief executive ofJPMorgan's entire investment bank, whichmakes him one of the most powerful people

in investment banking today. But back atBoca Raton he was just an up-and-comingderivatives expert who, like the rest of hisilk, was hungry for opportunity - and fun.

But partying aside, Boca Raton also hada very serious agenda. For it came as

JPMorgan was confronting an odd paradoxthat haunts the banking world. While lawsexist to protect people from stealing bril-liant inventions from each other in areassuch as industry or design, in the appar-ently frighteningly powerful world ofmodern finance, there is nothing to preventsomeone from pinching a rival's ingeniousinventions and replicating them (if theycan get the resources in place). Or as PeterHancock, then a JPMorgan banker whowas in charge of the Boca Raton meeting,explains: "All ideas in the financial worldcan be copied pretty quickly - financialinnovation does not enjoy patent protectionlike other fields of engineering."

Hancock knew the problems this posedperhaps better than anyone else. At thattime he was running JPMorgan's deriva-tives team. It was not a job anyone mighthave associated with Hancock if they weremeeting him for the first time: a highlyintellectual man, with an amiable face, he

exudes the courteous manner of an Englishcountry doctor rather than a Wall Streetfinancier. Initially he had had little ambi-tion to become a banker. His dream was tobe an inventor. and with this in mind hestudied science at Oxford. But he driftedinto derivatives because he sensed that itwas one thing in the banking world thatcame close to offering the thrill of scien-tific research. More specifically, at thattime - in the late 1980s - the concept ofderivatives was so new that it was largelyuntested, and thus offered plenty of scope

to be creative.At first, this was a rarefied business that

few people understood. However, Hancockwas one of those who spotted the potential,and when he took over the derivativesdepartment (then known as the "swaps"team) at JPMorgan, at the age of 29, he

quickly built it up into a global operation.However, by the time the team came tomeet in Boca Raton, Hancock had sensed

that this triumph was starting to carry theseeds of potential decline. In the early daysof the "swaps" business, it had seemed so

exotic that relatively few clients wanted tobuy the services - but those who did wouldpay high fees. Then, as demand mush-roomed, profits boomed and a new wave ofcompetitors was attracted into the mar-kets. They were able freely to copy thistechnology - and undercut the bank onprice. What had started as the bankingequivalent of the couture dress designtrade was becoming a mass market cloth-ing fashion game.

That meant JPMorgan needed a new idea

- one that its rivals could not copy too fast.As the bankers assembled in a hotel confer-ence room, close to the Boca Raton marina,Hancock tried to prod them through theirhangovers and jetlag into some brainstorm-ing. "The idea was that we should thinkabout how to take forward this large swaps

business we had built... and apply it toother areas," Hancock says.

(One of his colleagues remembers:"Hancock is like an ideas machine - throwsa thousand thoughts on to the wall. Mostnever fly at all, but every so often one does.")

The irlea that attracted most excitementwas the concept of mixing derivatives withcredit. One of the pemicious problems thathave always dogged business is so-called"credit risk" - or the danger that a loan (orbond) might turn sour. And as they sat intheir conference room in Boca Raton, some

of the bankers started to wonder if there wasa way to create derivatives that could bet onwhether bonds or Ioans would default.

After the meeting ended, the bankersflew back from Florida and started hunt-ing for ways to put these icleas intopractice. One was Robert Reoch, a youngBritish banker who had recently joinedJPMorgan's London derivatives desk,which was tucked in a former boys' schoolon Victoria Embankment. At that time,this derivatives team was very busy inEurope doing its "usual" business of trad-ing currency and interest rate "swaps".But at the time, JPMorgan also hadanother booming business in London -trading government bonds. And in themonths after Boca Raton, Reoch and hiscolleagues started to work on the idea of acredit derivative.

No one on the team knew how to Pricethis type of contract, let alone create thepaperwork needed to keep the lawyershappy. But Reoch found an investor willing

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ito buy such a deal, and one day he quietlysold a contract that placed bets on whether

Ithree European bonds would default. "Itwas the first time we had done a transac-tion like that," Reoch proudly recalls.

What was it they did? The trade waswhat is known as a "first to default" swap.At that time JPMorgan was heavilYinvolved in trading European governmentbonds and bond derivatives that left itexposed to losses if any bonds suddenlywent into default (not an irrational fear inthe pre-euro mid-1990s). However, the bankcreated a contract which effectivelyinsured itself against such a default for a

basket of bonds (say, that of Sweden, Italyand Belgium). It stipulated that if any ofthese bonds went into default, an investorwould pay JPMorgan compensation. If thatdefault never occurred, the investor wouldmake money because they were receiving a

fee to take this risk; but if any bondsdefaulted, JPMorgan was covered. Thus as

long as a price could be found that kepteveryone happy, it was a win-win deal:JPMorgan reduced its risk, and theinvestors could earn nice returns. It tookanother three months for the team to sortout the paperwork for this experiment.And it didn't at first make waves in thefinancial markets. At that time, otherbanks were also experimenting in this way

- and groups such as Bankers Trust andCreclit Suisse were considered more inno-vative and aggressive in this area than

fJPMorgan. Yet, as 1994 turned into 1995,

'iJPMorgan moved out in front.Quite why remains a matter of debate.

JPMorgan's rivals say it was a simple mat-ter of business expediency - and, above all,accounting pressure. International bankinglaws place strict limits on how much risk abank can take before it has to stop doingnew business, and the bank was hittingthose limits. This meant JPMorgan had astrong incentive to look at credit in aninnovative manner, because it had a biggerloan book than rivals.

This does not explain the whole story -or at least not as the JPMorgan's bankersnow tell it. They say it was corporate cul-ture: the bank's background as a blue-chiplender meant that it prided itself on hav-ing a more gentlemanly ethos than someof its Wall Street competitors. Hancockplaced a heavy emphasis on recruitingindividuals willing to work within a strongteam ethos.

He started by recruiting a loyal deputy,Bill Demchak, a practical young Americanwho was skilled at turning Hancock'sabstract musings into concrete plans.

'You cannot produce thistype of innovation ifyou are too narrowly

focused on... personalprofits and tosses'

("Wlthout'Demchak, half of Hancock's ideawould have probably just stayed onanother planet," laughs one colleague.)Then they pulled a group of young, highlyambitious - and all exceedingly numerate -wannabe bankers into their orbit, some-times from unlikely quarters.

In London, the team included anAmerican, Bill Winters, and Tim ("Frosty")Frost, who hailed from Nottingham andsported an economics degree from theLondon School of Economics. ("A lot ofpeople in this [credit derivatives business]came from the LSE," he says today, speak-ing with the flattened vowels from hisMicllands childhood.) Over in New York,Demchak and Hancock pullerl in AndrewFeldstein, an ambitious and articulateyoung trader. Another recruit was TerriDuhon, a vivacious, dark-haired woman,who had grown up in humble circumstancein rural Louisiana, but then won a scholar-ship to study maths at MassachusettsInstitute of Technology, where - like manyof her generation - she succumbed to theintellectual and pecuniary lure of finance."I had read Liar's Poker and thought thattrading derivatives sounded sexy and fun,"she recalls.

Another - more unlikely - youngwannabe was a well-spoken, horse-madBritish woman called Blythe Masters. She

had grown up in the south-east of England,where she attended the exclusive King'spublic school in Canterbury on a scholar-ship before completing an economicsdegtee at Cambridge university. From anearly age, Masters decided that she wanteda career in derivatives. It was an unusualchoice for a middle-class Englishwoman atthe time. And even today she does not looklike the usual stereotype of a Wall Streethotshot. When I met her recentlY inJPMorgan's London offices she was sport-ing a well-cut blonde bob and an elegantcandy pink suit, with matching shoes andbag. As i.f explaining this to me, she said: "Ihave a quantitative background, but reallyderivatives appealed to me because theyrequire so much creativity."

At first she joined JPMorgan's commodi-ties clesk. But after she attended the BocaRaton meeting she - like "Frosty" and theothers - sensed an opportunity. So shemoved across to New York and startedhunting for ways to use the credit deriva-

tives idea. Around this point, in her mid-twenties, she also had a baby (in an earlymarriage that did not last). This appar-ently did not put her off her stride: whenshe went into labour, she kept monitoringher financial trades from the hospital. She

also kept brainstorming with colleaguesabout how to turn the creclit derivativesidea into tangible profit. "We had a culturecreated by people such as Peter Hancockand Bill Demchak which emphasised team-work and where no single individual couldown a product," says Masters. "That isquite different from the turf-driven envi-ronment of many investment banks. Youcannot produce this type of innovation ifyou are too narrowly focused on... per-sonal profits and losses."

T-l y 1997, Demchak and Masters came

Kup with their Big Idea: a product'Llknown as Bistro, short for Broad"Index Secured Trust Offering. (Bankerswho work in the world of derivatives lovecreating odd names out of complexacronyms - it appeals to their problem-solving skills, no doubt.) What Bistro didwas to use credit derivatives to "clean up"a bank's balance sheet. The scheme startedby taking a basket of bank loans and sepa-

rating out - in accounting terms - thetheoretical risk that these loans wouldturn sour from the loans themselves. Thisdefault risk was usually then sold to a"paper" company, known as a special pur-pose vehicle, which then issued bonds thatinvestors could buy. If lots of loans wentinto default, the value of these bondswould fall, of course; but if the loans werehonoured, the bonds would be a safe betfor the investors. Either way, the pointwas this: anyone buying such bonds wasessentially betting on the risk of loandefault. And as long as the deal was struc-tured in a way that made the bonds lookcheap, relative to the risk of default, theninvestors would think they had got a good

deal. The pricing itself was based on whathad happened to banks' loan books inrecent years (together with some complexnumber crunching).

The deal looked even better for the origi-nal bank. For the act of selling the rlefaultrisk on to new investors had crucial regula-tory implications. International bankingrules say that banks have to hold a certainlevel of spare funds (or reserves) to protectthemselves from the danger that their loansmight turn bad. However, since the bankshad sold the risk of default on to somebodyelse, they could now argue that they did notneed to hold these funds.

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Peter Hancock, a former science student,always wanted to be an inventor. Instead he

spotted the potential of credit derivatives

To anybody outside the world of finance,this might look odd (after all, the banks werestill making loans); but the regulatorsaccepted this argument, since the risk hadmoved, in accounting terms. And that let thebanks free up funds to make even moreloans. It was the financial equivalent of calo-

rie-free chocolate: almost too good to be true.Hancock's group started using Bistro to

clean up JPMorgan's own portfolio ofloans. Then they started offering it to otherbanks. And within the space of a fewmonths, they were handling not just bil-Iions of dollars of loans, but tens ofbillions, and then hundreds of billions. Itwas an intoxicating time for the youngbankers. Many had been impoverishedgraduates just a few years earlier; nowthey were earning bonuses bigger thanmost had ever dared to imagine. Not thatthey had any time to spend the cash: as

demand swelled, JPMorgan's tiny team -which still numbered just a few dozen -found themselves almost every wakinghour in each others' company. "The busi-ness we were doing grew exponentially,"recalls Duhon. "We went out and 'Bistro-ed' everything we could."

By the end of the decade, Hancock hadbeen promoted to chief financial officer ofthe bank - and the success of Bistro had leftMasters running the credit derivativesgroup. But soon, in 2000, JPMorgan mergedwith one of its grant rivals, ChaseManhattan. Such mergers are common onWall Street, but they rarely occur withoutinternal fights or defections. And this was noexception: Hancock resigned, later followedby Demchak. And with these men gone, ateam that had held together with unusualIoyalty for almost a decade (or a lifetime ininvestment ba*ing) started to cnrmble.

These days, some of this originalJPMorgan "dream team" - as they weredubbed by specialist financial magazines -remain at the bank. There is Winters, ofcourse, and Masters recently became chieffinancial officer of the investment bank atthe age of just 35 - which makes her one ofthe most powerful women on Wall Streetand almost certainly the most senior Britishfemale there. (She remains horse-mad to thisday: in what little spare time she has fromher career and daughter, and a new fianc6,she also owns an equestrian business.)

But most of the JPMorgan team have scat-

tered to the winds. Some are running creditderivatives businesses at other investmentbanks. Others have moved to the fast-expanding world of hedge funds. The Britishbanker "Frosty", for example, recently co-

founded Cairn Capital, a hedge fund based in

A decade or two ago, a new idea

could stay'secret' for a year ortwo; now it can leak from

NewYorkto Tokyo - and back -in the press of a button or two

Mafair; Feldstein co-founded BlueMountainCapital Management, a New York-basedhedge fund; the would-be inventor Hancockco-runs lntegrated Finance Ltd, an advisorygroup; Demchak is vice-chairman of PNCFinancial Services Group; Reoch, the Britishbanker who did JPMorgan's first creditderivatives trade, is a consultant based inthe pleasant climes of Dorset; and Duhon -the banker from rural Louisiana - has cre-

ated a consultancy in Mafair.

/f\hese days banks such as Deutsche

I Bunk. Citigroup, Morgan Stanley andI Goldman Sachs are also big in credit

rderivatives. Thus the dispersion of theJPMorgan innovators has helped to trans-form a niche product into a vast industry

iwith extraordinary speed. Indeed, JPMorganitself, having at first tried to keep its prod-

ucts to itself. decided in this decade tocollaborate with its rivals to build the tlpeof industry-wide infrastructure that couldmake the overall market as big as possible.

But that success has come at a cost. Ascredit derivatives have spread, they havealso become another, Iower margin, massmarket game - just like the swaps businesswhen the JPMorgan bankers met at BocaRaton. Indeed, everyone agrees that theinnovation cycle is now speeding up dra-matically, as technology integrates marketsmore closely. A decade or two ago, a newidea could stay "secret" for a year or two;now it can leak from New York to Tokyo -and back - in the press of a button or two.That makes it harder than ever to protectprofitable inventions - and creates evenmore pressure for innovation.

Most bankers insist that these newinstruments make the financial world a

safer place. After all, for the first time,institutions making loans now have aneffective way to insure against defaults; so

does anyone investing in bonds (including,perhaps, your pension fund). Moreover, thefact that loan risks are now being tradedmeans they are now spread among a muchwider pool of people. That should make thefinancial system more resilient to shocks. Ifa cataclysmic event ever hits (say, 10 largecompanies suddenly collapse) the blow willbe spread around in millions of tiny pieces,

not concentrated on just one spot.There is also a downside: spreading risk

around makes it much harder for bankers,

central bankers - or anybody else - to pre-

dict what might happen if a cataclysm didhit. For the whole credit derivatives worldhas exploded at such a dizzy pace thatnobody is exactly sure where the loan riskhas gone. Have all the investors who havebought credit derivatives contractschecked the fine print to see what losses

they could sustain? Does anybody under-stand the chain reaction that might betriggered by such losses? Could theworld's trading systems cope? And whatwould happen to all those hedge funds thathave been jumping into the credit deriva-tives world?

And what of the future? Some of theleading figures, such as Masters, thinkthere is room for more innovation in thecredit derivatives world. For while thebasic ideas are now so widely dispersedthat they are almost "mass-market" fortraders, she believes that "the point aboutthat process is that when somethingbecomes commoditised it lets you createsecond- or third-generation products". Thatshould make it easier for bankers toreassemble these derivatives in new andmore complex ways - in much the sameway that it becomes possible to createmore complex computers when there ismass-market production of circuit boards.The next round of innovation, in otherwords, will be derivatives of credit deriva-tives, or even "derivatives cubed".

None of the ideas that are around at themoment is entirely new: on the contrary,most were on the list of concepts thatHancock tried to "throw on the wall" * as

his colleagues say - back in Boca Raton inthe early 1990s. Yet somehow those con-cepts never found such fertile businesssoil as the credit idea. But maybe that isjust a matter of time. "Ideas can floataround for ages and then suddenly getpicked up," says Hancock.

So perhaps, somewhere out on WallStreet or in the City - or Mayfair - theseeds for fresh innovation are already ger-

minating. Ambitious young bankers areeagerly sniffing for them, just as Masters,Winters and Frosty were a decade ago. Butwherever the next brilliant innovationappears, one thing is certain: inside everymoment of stunning success on WallStreet and in the City are the seeds offuture decline. And by the time humblejournalists such as me ever get to knowwhat the next really Big Idea is, the mostprofitable moment in that cycle willalready have occurred.Gillian Tett is the FT's capital nxarketseditor.

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