All the Devils Are Here [35]
4
Risky Business
The most cutting-edge firm on Wall Street in the early 1990s was not Drexel Burnham Lambert, which had dominated the 1980s with its junk bonds, or Goldman Sachs, whose sheer moneymaking prowess would first dazzle and then repulse the country during this last decade. No, the firm that everyone on Wall Street wanted to emulate was a one-hundred-year-old commercial bank: J.P. Morgan. During the same era that the subprime mortgage industry was rising from the primordial ooze and Fannie Mae was consolidating its power over the mortgage securitization market, J.P. Morgan was making an important series of innovations around the concept of risk.
Risk was the bank’s obsession. It wanted to measure risk, model risk, and manage risk better than any institution had ever done before. It wanted to embrace certain risks that no bank had ever taken on, while shedding other risks that banks had always accepted as an unavoidable part of banking. To this end, J.P. Morgan (along with other firms, too) hired mathematicians and physicists—actual rocket scientists!—to create complex risk models and products. They were called “quants” because they tried to make money not by examining the fundamentals of stock and bonds, but by using more quantitative methods. They devised complex equations rooted in modern portfolio theory, which held as its core principle that diversification reduced risk. They searched for securities that seemed to move in tandem, and then used computers to take advantage of tiny discrepancies in their price movements. Their risk models were statistical marvels, based on probability theory. The new securities they invented, designed to shift risk from one firm’s books to another’s, were practically metaphysical. After the transaction was completed, the original security remained on the first firm’s books, but the risk it represented had moved. These new products were called derivatives, because they were “derived” from another security. J.P. Morgan’s chief contribution in this area was something called the credit default swap. Its breakthrough risk model was called Value at Risk, or VaR. Both products quickly became tools that everyone on Wall Street relied on.
What did these innovations have to do with subprime mortgages? Nothing, at first. J.P. Morgan and Ameriquest could have been operating on different planets, so little did they have to do with each other. But in time, Wall Street realized that the same principles that underlay J.P. Morgan’s risk model could be adapted to bestow coveted triple-A ratings on large chunks of complex new products created out of subprime mortgages. Firms could use VaR to persuade regulators—and themselves—that they were taking on very little risk, even as they were loading up on subprime securities. And they could use credit default swaps to off-load their own subprime risks onto some other entity willing to accept it. By the early 2000s, these two worlds—subprime and quantitative finance—were completely intertwined.
Not that anyone at J.P. Morgan could see what was coming. Like Ranieri in the 1980s, the bank’s eager young innovators were convinced they were making the financial world a better, safer world. But they weren’t.
The chairman and CEO of J.P. Morgan in the early 1990s was a calm, unflappable British expatriate named Sir Dennis Weatherstone. Knighted in 1990, the year he took over the bank, Weatherstone had the bearing of a patrician despite working-class roots; his first job, at the age of sixteen, was as a book-keeper in the London office of a firm J.P. Morgan would acquire. When he died in 2008 at the age of seventy-seven, an obituary writer described him as “dapper, precise,