All the Devils Are Here [53]
Inside FP, the biggest proponent for getting involved in BISTRO-type deals was not Savage, but one of his deputies, Joe Cassano, who had risen from the back office to become the chief operating officer of FP. Although he had come with Sosin from Drexel, he did not have a quant background; the son of a Brooklyn cop and a graduate of Brooklyn College, Cassano had learned the business by starting at the bottom and working his way up. It was Cassano who Blythe Masters first approached about getting involved in BISTRO, and it was Cassano who became the deal’s champion internally. The fees would likely be small—because the perceived risk was so low—but it was a business that FP could dominate, Cassano argued. (The fees would grow considerably over time.) If this structure proved popular, FP was likely to become the insurer of choice for everybody’s super-seniors, not just J.P. Morgan’s.
And the regulators? Once again, they eventually saw things exactly as J.P. Morgan had hoped they would. They ruled that when banks bought credit protection for their super-senior holdings, they could cut their capital requirements for the underlying credits by 80 percent. This became the rule that the Basel Committee embraced, and it was adopted by regulators around the world. Not surprisingly, every big bank in the world began clamoring for a chance to bundle their credit risk into BISTRO-like structures. The business took off, just as J.P. Morgan—and now AIG—had hoped it would.
Years later, by which time he was running FP—and not long before the first glimmers of the financial crisis could be seen on the horizon—Cassano spoke at an investment conference in which he boasted about being involved in that original BISTRO deal. “It was a watershed event in 1998 when J.P. Morgan came to us, who were somebody we worked with a great deal, and asked us to participate,” he said. “These trades were the precursors to what’s become the CDO market today.”
CDO stood for collateralized debt obligation, which is what that BISTRO-type structure was eventually called. By 2007, when Cassano made those remarks, Wall Street churned them out as if they were coming off an assembly line. There was, however, one giant difference between the early BISTRO deals and the CDOs of 2007. At the heart of the early BISTRO deals was corporate debt. But at the heart of the CDO market of 2007 was something far more dangerous: mortgages.
6
The Wizard of Fed
Inevitably, the nation’s first subprime boom ended badly. In its first iteration in the mid- to late-1990s, the subprime business had all the earmarks of a classic bubble. Subprime companies would go public and their stocks would skyrocket. Company founders got rich making loans to people who had never before been able to qualify for a mortgage. Shoddy business practices became the norm. Nobody seemed to care. Greed replaced fear, as it always does in a bubble. And then—poof!—it was over.
The first crack in the facade came when a crop of companies specializing in subprime auto lending went belly-up amid rising delinquency rates. That made investors nervous about securitizations based on any kind of subprime loans. Then, in the fall of 1998, came a financial crisis that ripped through Asia and so unsettled Wall Street that all the big banks and securities firms became momentarily cautious.
To compound matters, the subprime mortgage companies began taking unexpected write-downs. It had long been common industry practice for the subprime companies selling loans to Wall Street to keep what were called the residuals. These were the riskiest pieces of the securities, the ones that nobody else wanted; most of the time, they were the ones that came with the highest prepayment risk. Accounting rules required the companies to estimate the future value of the cash flows and book them as upfront profits, which they did very aggressively. But as more companies entered the business, they began to poach from each other by refinancing borrowers’ mortgages. More refinancings meant more people prepaying