Fool's Gold: How Unrestrained Greed Corrupted A Dream, Shattered Global Markets And Unleashed A Catastrophe by Gillian Tett

My rating: 4 of 5 stars

British voters paid little attention to Jamie Dimon’s threat to relocate 4,000 JP Morgan jobs from London in the event of Brexit. But underneath the small print they might have missed the real concern – the world’s most prestigious bank relies on its London offshoot to nurture its Derivatives operations. In reality, England’s capital has been a welcome centre for American retail banks hoping to blur the lines between commercial and investment banking for the last five decades. Will that now change?

Gillian Tett’s story of how a team of innovative bankers at JP Morgan designed today’s Credit Default Swap (CDS) as a means of revolutionising finance and freeing up capital for other lending projects is a well-rehearsed tale that applies to all areas of science and industry. A passionate clique of idealists put their creative talents to use thinking up ways to make the world more productive. Building on the work of other pioneers, they have an idea: what if you can securitise the one thing banks most fear – the potential loan defaulter who forces you to keep capital reserves locked in a vault doing nothing? A concept is born, but much like the inventors of Zyklon B who saw their creation misused by the Nazis, so we have a similar situation with enlightened research applied by unenlightened practitioners. The end result is hubris and eventual catastrophe.

Though a contender for the most ridiculous sub-title in the post-2008 genre of crisis studies, Fool’s Gold may well be the first work to define the complexities of Derivatives in an intelligible language. As Tett explains, these financial products ‘provide a way for investors to either protect themselves, for example, against a possible negative future price swing, or to make high-stakes bets on price swings for what might be huge payoffs.’ She then goes on to give basic examples of Forward Contracts, Options and Swaps and furnishes us with a brief history of Derivatives from the establishment of the Chicago Board of Trade in 1849 to the ground-breaking currency Swap between IBM and the World Bank brokered by Salomon Brothers in 1981. A survey of this magnitude is no mean achievement, especially when condensed to less than ten pages.

Often, the finest books beg you to read one more paragraph until your eyes can no longer take the strain – Fool’s Gold is one of those works. Throughout these 313 pages, Tett’s writing is fused with prescient observation and a unique ability to explain opaque concepts to a wider audience – you want more. Her academic training as a Social Anthropologist may well be a blessing (though unusual for a financial journalist), but her grasp of history is just as important. A seminal event for her is JP Morgan’s 1994 CDS deal with Exxon Mobil and the European Bank of Reconstruction and Development (EBRD). British financier, Blythe Masters, gets the credit for achieving two complimentary goals with this landmark CDS by reducing capital holdings on her bank’s balance sheet and paying a third party to insure against a loan default.

From a modern perspective this is a moment that changed the world of Finance. Even today Exxon Mobil is the least likely candidate (other than Apple) to default on a credit line of $4.8 billion, and is the very definition of a triple-A asset. Why keep so much capital tied up when you can pay a third-party (EBRD) an annual fee to assume full liability in the event of default? JP Morgan can reduce their equity reserves, Exxon Mobil get their credit line and the EBRD earns an annual fee for keeping an ultra-safe asset on its books. Everything about this deal made sense: the EBRD was forbidden from investing in risky assets and was looking for a higher yield outside its usual portfolio of sovereign bonds; JP Morgan could maintain its loyalty to its client, Exxon Mobil, by not selling the loan to another party.

The term ‘Financial Engineering’ is now used scathingly and often substitutes for the word ‘alchemy’ when describing the sinister machinations of high finance, but it wasn’t always this way. The trouble begins when everyone catches on and applies a good idea to inappropriate concepts. As the JP Morgan team were later to realise – credit derivatives are not the problem, it’s the people that package them. Underwriting CDS contracts for bundles of mortgages containing both Triple-A and Subprime assets is the opposite of what Blythe Masters had in mind in 1994, but AIG took the idea to its logical conclusion and never imagined how this could bring them to the brink of bankruptcy twenty years later.

But Tett is not just content with writing a narrative of events. Like any academic she wants to know why things happened as they did. How did the US Federal Reserve and Bank of England allow OTC Derivatives to evolve into the financial WMDs that brought the world economy to its knees in 2008? What about the nature of financial innovation, where an idea is quickly imitated by competitors and margins are driven down as more participants flood the market? Is ‘creative destruction’ the engine that underpins the next crisis by forcing banks to adopt an ‘innovate or die’ mentality? Against this backdrop the author introduces every CEO’s nightmare – the hostile takeover bid from a rival bank, or, even worse, defenestration by disillusioned shareholders.

In keeping with every account of the 2007-08 banking crisis, Fool’s Gold is also not alone in highlighting JP Morgan CEO, Jamie Dimon, as a special talent on Wall Street. As in Andrew Ross Sorkin’s Too Big to Fail (2009), Dimon is portrayed as a boss with an unusual command of his brief, even to the point of challenging his traders and quants with poignant questions they would never expect from someone so high up. It may not be sycophantic, but Tett is gushing in her praise for the Rock Star of modern banking: ‘The JP Morgan Chase staff would have reason to be grateful that Dimon had arrived on the scene, and held true to his principles of risk management, even as most of the rest of the banking world broke free from all bounds of rational discipline,’ we are told. To be fair, the same might be said about Lloyd Blankfein of Goldman Sachs, but the world’s most envied (and hated) investment bank traded their way out of the Subprime mess in early 2007 by betting against the market with its own capital. Though not as glamorous, JP Morgan simply tightened its mortgage-lending criteria and didn’t ramp up its CDO trading desks when others were in overdrive, but it still took big hits on its balance sheet.

Many assumptions about the western financial system have collapsed since the fall of Lehman Brothers. The timeline of events from BNP Paribas’ decision to suspend three money market funds in August 2007 to Northern Rock’s nationalisation the following February are now considered seminal moments in the crisis. However, Tett prefers to use the collapse of US Investment Bank, Bear Stearns, in March 2008 as the climax to her book, seeing in this one event the first real sign that ‘unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe.’

JP Morgan may have created the conditions for bringing CDS contracts into the mainstream, but the world of credit derivatives that grew out of it, including the proliferation of Collaterised Debt Obligations and other mortgage-backed securities, will always be remembered as a collective folly unsurpassed in the world of finance since 1929. But whether the house of Pierpoint Morgan should be off the hook is another question, and Tett is ambivalent enough to keep us guessing.

What we are left with is a superb account of how banking became an insular, proprietary pastime where the people supposed to be oiling the wheels of finance forgot about infrastructure projects and building factories. But, as Tett shows, the intentions behind that famous 1994 CDS deal had the fundamentals of banking at heart, namely how to release more capital to build the things we need to prosper as a civilisation.

How tragic that collecting easy fees and repackaging risk became an end in itself instead of the means to a better future. As Iain Fraser notes when quoting a banker in his seminal study of what went wrong at RBS: ‘We are investment bankers. We don’t care what happens in five years.'

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