He started working at JPMorgan in 1983, and rose to become co-CEO of the firm's investment banking business from 2004 to 2009. Winters is now chair and CEO of Renshaw Bay, an asset management and advisory firm. This is the edited transcript of an interview conducted on Feb. 27, 2012.
What department are you in [at JPMorgan] in 1992?
I was sent over from New York to run the European swaps business, as it was called at the time.
And your primary concern is risk?
Primary concern was risk, but at that point a number of the markets that we were dealing in were still relatively young. So credit derivatives hadn't been invented yet. That was a risk category that just didn't exist in derivative form. It was primarily an interest rate and currency derivative business. ...
So how do you get from there to actually inventing credit derivatives?
I don't know who invented credit derivatives, but it was clear as we developed in our own thinking at JPMorgan through the 1990s that there were risks that we wanted to deal with ourselves that were difficult for us to deal with. So, for example, in our derivate transactions, we ended up taking what is called counterparty risk.
This is the risk in a derivative transaction where the guy on the other side goes bankrupt himself or herself sometime during the life of the transaction, and you're left with a credit risk that itself is a function of what's happened to markets. So they could end up owing us; we could end up owing them.
As the derivative markets became bigger and more valuable, this counterparty risk became bigger, and that was a risk that was very difficult -- in fact, it was impossible for anybody to manage at that point. You just took the risk, and if you were able to get some collateral against a transaction, you might be able to diminish the risk a bit. But for the most part, it was an open-ended, uncertain risk.
So as we sat around meeting rooms and conference rooms, thinking about on the one hand this good business that we were doing, helping our clients manage their risk on an ongoing basis, generating some profits for the bank along the way in exchange for intermediating these trading flows, we were accumulating outright risk. And we needed to find ways to hedge that risk, to eliminate that risk.
... We thought, well, if we could find a way to transfer credit risk the same way we transfer interest rate risk or currency risk or oil price risk, which were things that we had already become very active in, then we can reduce the riskiness to ourselves and therefore do more business with our clients.
... You had a number of meetings throughout this period of time. One that's gotten a lot of attention is a weekend in Boca [Raton, Fla.] What was happening there? ...
... We had the idea that it would make sense -- in fact, it had been going on for several years -- to take a couple of days over a weekend once a year, go someplace that's out of the office so the phones aren't ringing, the clients aren't knocking on the door, it's a weekend, so you're not distracted by market activity, and just think. And you sign out tasks before you go for different people to focus on different themes that may be interesting or relevant and then discuss it in groups.
The Boca Raton meeting was one of those, probably notorious more for some of the antics that were happening on the sidelines than for the main event, but it was like all of the conferences that we had from year to year. ...
There's a famous story about you getting your nose broken as you fell into the pool.
You can see this glorious nose that you're looking at right now did not always look like that. I used to have a cute little button nose, and after Boca Raton, it's now big and crooked. ...
So there was a lot of carousing.
I tell you, it was 85 percent real thinking. ... I can't remember how many people there were, maybe 60 people, 80, something like that -- a large number of people, not a small group around a table.
But at 8:30 in the morning, everybody was there, and we had session after session after session in a conference room, while the parrots were chirping outside in Boca Raton. Then sometime around 4:00 in the afternoon or 5:00 in the afternoon, things broke up. People went off in small groups. And some people drank; some people didn't. And I'm happy to say that most people stayed reasonably sober.
But the important part of the event, of course, was that people were thinking all day, and I think generally the relaxation time, whether it was on a tennis court or a sailboat or the bar, was an extension of that. I think people tended to talk about business and how we could develop business and how we could address some of the issues the clients had, etc.
But of course, when you get a group of 60 people together outside of their normal environment, there will be some excess as well.
In their mid- to late 20s or early 30s.
Yeah, in their 30s, and yes, things will happen. So yes, I went into the pool fully clothed, as did my boss in that session. And I think it made everyone feel good.
What was the idea that came out of that weekend in Boca Raton?
Honestly, I don't recall some sort of a cathartic realization that there was a great opportunity. ... The usefulness of something like the Boca Raton conference for JPMorgan was that it gave everybody a chance to sort of vet each other's ideas to a degree.
Some of them really resonated with people, and as a result, it became something that you were actually -- if it was a big enough idea, important enough -- you would take somebody and say: "This is now your job. Go make this happen." ...
... What is the sort of defining problem that you're dealing with there [in Boca]?
I think there was a defining problem and a defining opportunity. The defining problem was that banks were unable to adequately deal with their own credit risks. So for centuries, perhaps, the job of a bank was to lend money and then manage those loans. Then the derivatives markets came along, and at the outset, it was the same thing. Now it's to lend money in loan form, but also to take credit risk in derivative form. ...
... So you're there in Boca Raton figuring out, discussing, "How can we better manage these risks?"
That's right. How can we better manage these risks, and how can other people that have the same risks better manage those risks? ...
Was there a reason for this happening at this point in time? ...
I think there were two realizations in the background that were prompting our thinking. One was that the derivative markets were growing very quickly.
And so ... you had just much more of this risk floating around, correct?
Correct. You had more of the risk, but that risk was less certain. So if you lent somebody $100, you know that you were never going to be owed more than $100 plus interest. That was as much as you could be owed.
If you entered into an interest rate derivative contract with somebody, on the first day he didn't owe you anything at all, and you didn't owe him. But a year from now, he might owe you $5; he might owe you $10; he might owe you $100 if it was a really dramatic move in whatever you were hedging. So you had more risk, and you also had more uncertainty.
So in this way, derivatives spawned the need for more derivatives in the form of credit default swaps [CDS]?
That's right, and I think you'll find as the derivate markets developed over the subsequent 20 years -- and for that matter as the securitization markets developed, the close cousin to derivatives -- a lot of the product that was developed in the second, the third and the fourth generation was only necessary because of the product that had been created in the earlier generations. ... That was one of the motivations.
There was a second motivation as well, which was that banks were getting smarter. And that may sound shocking when we look back at what happened in the subsequent 15 years, but certainly at JPMorgan we did some really quite rigorous analysis to answer the question: "When we lend money to our clients, are we earning a decent return? Are we earning an acceptable return on our capital?"
And the answer was, in a nutshell, no, that the loan business, lending money to large corporations, not the small businesses, was a loss leader business. It's a business that banks were doing at a below-market or a below-cost spread in order to curry favor with the corporation, in order to do other business.
And by doing that you were tying up capital?
... Not only tying it up, but tying it up at a poor return. So banks were looking at ways to deal with this increasing risk from derivatives, this uncertain risk from derivatives, but also ways to just get rid of the risk so that that capital could be recycled into other things. ...
... At the end of that [Boca] weekend, had you made assignments? ...
I think there were a number of areas that we had committed as a group to advance. One was to more actively manage our own portfolio of risk, which was not common in banking circles those days. I mean, the risk management approach of banks in those days was you said yes or no. And if you said yes to the right ones and no to the right ones, you did well at the end of the day. But having said yes or no, you didn't get a chance to change your mind down the road.
I think we realized both as a group but also as a bank that we needed to have the ability to manage the portfolio of credit much more accurately.
... A credit derivative is essentially an insurance policy?
It is an insurance policy.
... So why do you call it a credit default swap?
Because the payout on the insurance policy isn't fixed. If you buy house insurance -- you've got a $200,000 apartment and you buy fire protection and the building burns down, you're going to get $200,000, not $190,000, not $210,000.
If you enter into a credit default swap, the first thing that has to happen is the equivalent of the fire. So the borrower needs to go bust or needs to default. That in and of itself already requires a little bit of contractual fine-tuning. What is actually a default? But we'll leave that aside for the moment.
The payoff, though, is a function of the ultimate payoff from that defaulted borrower to his creditors, the real creditors, and the people that actually lent the money. And typically that's measured shortly after the event of default. ...
JPMorgan loans money to, or at least insures -- writes a letter of credit, a line of credit, if you will -- to a big corporation. They then insure that by writing a credit default swap and getting somebody to buy it. Why would somebody else buy that? What's in it for them?The same reason anybody would write an insurance contract: because they think that the value of the premium is statistically, or actuarially, or from a market perspective, worth more than the likelihood of default.
And why would Exxon or some big corporation want their bank to sell off the risk of default to somebody else?
They didn't always want that, ... because when they held a bank meeting, ... if they did get into trouble, they want to be able to call their bankers together into a room and say, "Ladies and gentlemen, we're going to work through this together." And if the banks have sold the loan to somebody else, then they don't know who's going to show up in the room.
So they were very keen not to have the banks either sell or assign or novate their loans. In the early days of credit derivatives, they may not have been aware that the bank had bought insurance against their loan exposure, or if they were aware, they may not have been terribly concerned. ...
But in some cases they were concerned, and they were concerned for a very simple reason: That the bank was effectively influencing the market value of their debt without them being in control of it. So in some cases they were concerned, and legitimately. ...
What is the advantage [for JPMorgan] of getting that risk off the books?
That loan to Exxon consumed capital, required some capital to be set aside, and every bank has a limit to how much money they're prepared to lend to any one counterparty. And certainly at JPMorgan in those days, and I think it probably continues today, we always said to our clients: "When you really need us" -- because, for example, you've had the Exxon Valdez tragedy; if we take it in modern times the BP Gulf of Mexico disaster that required $20 billion in a hurry -- "if you really want to be sure that you can count on us, then you can't leave our balance sheet clogged up with stuff that we've accumulated through the years. Let us get that down to a relatively small amount so that we have the capacity."
By writing insurance on the line of credit --
By writing insurance, right.
-- so that if we have to pay up, we're insured.
If you cost us money because you default, we've got insurance on some of the old stuff.
So there were a lot of these sort of single deals?
There were a lot of single deals, and there were also the beginning of portfolio deals. I think that the first transaction we did in London, which was at about the same time, was what was called a first-to-default basket.
We took three European sovereigns -- and prophetic when we think about what subsequently happened 15 years later -- but you had the Kingdom of Belgium and the Republic of Italy and the Republic of Austria perhaps, and we said the first of those three names to go bankrupt triggers this insurance contract, but if the second two go bankrupt, no further payment is required.
That was a very attractive transaction for insurance companies and for some other banks that said: "European sovereigns are never going to go bankrupt. If these jerks at JPMorgan are prepared to pay me a third of a percentage point" -- actually probably even less than that then -- "to basically buy insurance against just one of these names going bankrupt, that's very good value for us and more than we could get if we just bought the bonds."
So it frees up your capital.
And so you're willing to pay a premium ... to the counterparty to insure your risk, even though you don't think that's a very big risk.
That's right. ...
Why would you write a credit default swap?
Because independent of what the regulators said -- and let's be clear: this is what kept JPMorgan out of trouble through the whole crisis -- we asked ourselves the question, "Does it make sense to have a whole lot of any risk?" ...
But in many cases not really because of the risk but because you wanted to free up capital, correct?
I would say in many cases, as this market developed across the banking sector, large proportions of the transactions that were done were motivated by regulation, no question about it. And we saw many transactions where banks very specifically chose the assets on which they sought insurance. They chose the assets that were likely to have the biggest impact on their regulatory capital requirement, independent of whether they were really releasing any risk or not. ...
To free up capital so they could have more money to lend.
And I think when you look at the firms that did relatively well through the crisis versus the firms that didn't do so well, for the most part, ... you can see that the firms that looked at their own view of the real riskiness, the real risk in a market -- and I would include JPMorgan and Goldman Sachs and a few other firms -- actually performed pretty well, and the firms that organized themselves in order to "optimize" their use of regulatory capital --
In order to end-run the regulations?
To end-run or just play by the rules. But [those] who didn't at the same time look at what they considered to be the real riskiness, they effectively let the regulators run their business for them. Those firms, almost without exception, went bust.
As [U.S. managing editor for the Financial Times] Gillian Tett tells the story, the first bistro deal was a 306 loan portfolio, and Terri Duhon had come in to help put that together? What was that deal? ...
I think this was at a time that Peter Hancock, who was running the derivative business, a pretty senior guy at JPMorgan at the time, had taken a very strong view, and he'd convinced his colleagues on the executive board of JPMorgan that we needed to be much more active in terms of managing our own credit exposure in the bank.
Peter had identified a few people to really drive that process. They were people like Bill Demchak and Blythe Masters and then Terri Duhon, and there were a number of different ways that I think that team -- and then by extension all of us -- thought about managing that risk, or managing our portfolio more actively.
But one was what ended up being this bistro transaction, which was a way to take a portfolio of relatively high-quality loans and move most of the risk from those loans off of JPMorgan's balance sheet and shift that risk to others who wanted that risk.
So of course when we look at insurance companies, their business is to write life insurance contracts on the one hand and buy corporate bonds on the other. That's what they do. Or they buy government bonds, or sometimes they buy some equities and sometimes they buy some other stuff, but basically they borrow money from savers who are buying insurance, and they lend money to corporations. That's like banks; the difference is they usually do it for very long-term.
So for these insurance companies and others like them to be told you can buy this bistro transaction and you'll actually earn a little bit more than you could if you went out and tried to buy those bonds or loans directly, but beside that, you can't go out and buy all those loans because you don't have access to the lending market, I mean, JPMorgan did a lot of work, built a lot of relations, wrote a lot of contracts, did a lot of due diligence to assemble this portfolio of loans, and you can get it in one easy bite-sized piece, and we're going to pay you a little bit to do that.
That made sense for us to do that, because we thought that the risk was really weighing down our balance sheet from a real risk perspective. It was also attractive from a regulatory capital perspective. The insurance company said: "This is great. This is what we do all day long anyway. Now, it's a little bit complicated, and it's a little bit less liquid than a bond, but we're getting paid more for it." So, you know, win-win on both sides.
Are the insurance companies facing similar capital requirements?
The insurance companies have an entirely different set of capital rules, not completely inconsistent. I think it's pretty clear that insurance companies are also required to hold more capital against lower-rated borrowers and more capital against longer-term loans. But the insurance regulation and bank regulation to this day are very separate. ...
... When you offered this first bistro deal, you then sliced it into different, what you call "tranches." ... Why slice it?
Because different investors wanted different levels of risk. There were some investors that wanted to earn a big return on really risky stuff, and there were some investors that wanted to earn a little return on stuff that wasn't risky at all. ...
... And that party that takes the higher-risk position is really designating where they stand in line when it comes to payday?
It's all perfectly clear in the contract. So the way that we structured the bistro transactions was the very first losses were for our own account. That way nobody could ever accuse us of flogging something that we weren't standing behind. ...
Why do these if you're not covered?
Because we were shifting ... the bulk of the risk. We retained some of it, which was this first-loss tranche. The next tranche typically went to insurance companies, pension funds, perhaps other banks. The bulk of the risk of the transaction went to other people, but only behind our own loss.
Then what subsequently became known as the super-senior risk, the stuff that was statistically highly unlikely to ever incur a loss at the beginning, we retained ourselves. As we developed this market more and more, we started to shed that risk as well, because there were people that were prepared to buy it.
... It's hard for us looking in from the outside to quite understand the speed with which this was growing and the kind of excitement that you must have felt.
Yeah, it was very fast-paced. I think there were a number of both motivations and sensations as we were going through this. Clearly one motivation was for us to keep our balance sheet very, very clean, because a clean balance sheet gave you complete flexibility to do more business, and perhaps interesting business, in the future.
So we felt a real constraint at JPMorgan, and I think a few other what I would say were very well-run firms also felt a real constraint. And the only way to free up these constraints was to find other people that were prepared to effectively share our risk with us. I think JPMorgan and no doubt a number of other firms, but not every firm, also placed a tremendous amount of emphasis on doing things the right way.
The reputation was critically important to JPMorgan, and [we were] very keen not to effectively sell risk or transfer risk to people that didn't understand what they were doing. So there was an education dimension to what we were doing as we developed these markets. We were trying to spread the word. I mean, we felt a little bit missionary-like in terms of spreading the word about risk management and how risk management tools could be used safely and soundly.
I think many of the firms took a similar approach, and as we know in retrospect, some firms absolutely did not take that approach. And they sold anything that could be sold at whatever price they could sell it at, in many cases to people that didn't understand what they were doing. And those were the seeds of destruction of this market. ...
... What kind of profits were you making off of writing these credit default swaps?
In the terms of the profits that we generated on our own business, hedging our own loans, very little. Those were really risk management transactions. But as we started to help other banks do the same thing for themselves that we were doing for ourselves but using JPMorgan as an intermediary, it was a profitable business. ...
Then along comes the idea that packages of mortgage-backed securities could be insured with credit default swaps. Walk me through that. ...
When you think about the securitization markets and the earliest applications of a lot of this financial technology, [it] was in the U.S. mortgage market. There were collateralized mortgage obligations years before there were collateralized debt obligations, so it was a standard feature of the market, having to do a lot with the fact that the U.S. GSEs [government-sponsored enterprises] Fannie Mae and Freddie Mac were very sophisticated financially themselves in terms of developing new tools and allowing their bank counterparts and broker dealer counterparts to access leverage in different ways.
The idea that bundles of mortgages had been created, and that those bundles of mortgages were then tranched into very risky tranches and less risky tranches and really not very risky tranches, that had been around well before credit derivatives were invented. And in fact, a lot of the most esoteric interest rate-related instruments had come out of the mortgage market. ...
But what was not done at that point was writing of credit default swaps on them? ... What did that change?
I think there were two big changes. One was that the U.S. mortgage market wasn't seen as a market itself, wasn't particularly risky. In other words, people tended to pay the mortgages back, or they were guaranteed by Fannie Mae or Freddie Mac or Ginnie Mae.
It wasn't a credit-intensive market. It was much more an interest rates and prepayment-intensive market, and what changed was the idea that the real credit risk in mortgages could be bundled up and sold to investors who hadn't normally taken that risk.
It started with mortgages that were just a little bit away from the very low-risk, Fannie Mae-type mortgages. So maybe it was the jumbo mortgages, the mortgages of more than, at the time I guess it was $300,000 or something, but then slipped further and further into what would eventually become subprime mortgages that in some cases were very risky indeed.
Do you remember when this idea first was put before you, that we should perhaps consider writing credit default swaps to offload the risk on collateralized mortgage obligations?
I think the way the market developed was not so much banks deciding to write credit derivatives to protect somebody else's subprime mortgage portfolio, but rather is there a business question to the team? Is there a business to take a bunch of subprime mortgages that we either originate ourselves, so through Chase branches and across the United States, or that we buy from brokers or buy from some other broker dealer, and put those into a pool and then write credit derivatives out to the market against that pool?
... So you were looking at whether or not you could get more into this market and write off the risk to make it worthwhile to you?
Yeah, and hedge the risk. That's right. ...
... In the beginning, you took a look at this, assigned to some others the job of really crunching the numbers on this.
The respective teams took it upon themselves to analyze what could be done at any point in time. And I think in terms of when it really came to my attention as a problem or an opportunity that we might be missing, the train had already left the station. Quite a bit of business had been done by our competitors.
The consultancy firms that will come in for a small fee every year and tell you how you stack up relative to your competition, and in 2002 and 2003, 2004, 2005, 2006, these consulting firms would come in and say, "JPMorgan made $100 million last year in the whole firm in securitized products and dealing with nonconforming mortgages" -- so mortgages that don't fit inside Fannie Mae or Freddie Mac -- "but the best in class made $400 million. And the next year it was $600 million. And the next year it was $1.2 billion. ... You're missing the boat," which would prompt us to say, "Well, what are we actually missing?" And in some cases it was clear to us that we charged ourselves more for the use of our own balance sheet than other banks seemed to be charging themselves.
In other words, you had capital tied up.
We had capital tied up.
But was there a moment when you looked at this hard and sat around a table or on a conference call and said, "This doesn't make sense."
I think I'd like to say that we understood exactly what was going on and concluded that it wasn't a smart thing to do.
Why did you make that conclusion?
We didn't make that conclusion. We didn't know what was going on. ...
We knew how much people said they were making. We saw that UBS and Merrill Lynch had fixed-income and securitized products earnings that were growing faster than ours. And we asked ourselves the question: "What are we doing wrong? What are we missing? Have we not figured out how to lay off some of this risk? Have we not figured out how to manage the risk ourselves on our own balance sheet?"
And honestly, we couldn't figure it out. What we never imagined was that those other firms weren't doing anything at all. They were just taking the risk and sitting with it.
If you saw that you were getting beat, why didn't you jump in?
We would have been happy to jump in if we could have managed the risk, and we couldn't find a way to manage the risk. ...
But of course we didn't assume that other people were stupid. We didn't assume that other people were generating a loss in every transaction. We assumed that they found somebody to take the other side of the trade at a different price, or that they were able to buy these mortgages much cheaper.
So you felt you were getting beat?
We thought we were getting beat, and the temptation at that point -- there's probably one or two people who worked with me who thought it would be a good idea -- was to say: "We don't really understand what's going on here, but let's just do a little bit of business anyway, and we'll just hold some of the risk. And then once we own it, we'll see if we can figure out where to sell it."
Did you do that?
You did do some early deals.
We did some deals. ... JPMorgan was not without its issues during the financial crisis. I think the thing that distinguished us from others is that our issues were all on a scale that ultimately we could handle. ...
You were in a management position, and your competitors beat you, and so you must have been frustrated that --
There was a lot of pressure.
There was pressure from top management.
There was pressure. Thankfully, I think I had supportive senior management. Jamie Dimon had bought Chase, JPMorgan Chase in 2004, and Bank One, and he was I think a very supportive risk-oriented manager, but he would ask the same questions I would: "Why are we falling behind in these areas?" ...
What did you tell him?
I told him as best we knew why we were falling behind. It's perhaps we're not clever enough, or perhaps we're not prepared to take the same risks that others are.
Saying you're not clever enough to Jamie Dimon isn't very reassuring.
No, but the fact is we didn't understand exactly why we were being beaten. …
In 2006 you make the decision to expand the CDO team, but do you at that time also reconsider your reticence previously dealing with subprime?
Yeah. As we added new people to those teams from outside of JPMorgan who had experience in some of the asset-backed security markets as well, but also as the salespeople that we added inside -- so the people that were responsible for our relationships with investors -- they were coming and saying: "Look, I'm operating with one hand tied behind my back. If I worked at Merrill Lynch, I can sell a high-yield CDO or a high-grade CDO or an auto loan CDO or a subprime mortgage CDO. I've got all these arrows in my quiver, and I come to JPMorgan, and I can do generic stuff." ...
We were never not in the mortgage-backed securities business. We were in the mortgage-backed securities business if we thought we could do it safely and soundly.
But in terms of subprime?
Including subprime. I think we would always have been happy to do subprime mortgage business if we thought we could do it safely and soundly for ourselves.
Right. But you were relatively out of that market.
We were relatively out of it.
And then with Magnetar that changes.
I think we were still relatively out of it. They were very small.
Right, it was a small deal, but this is where there's legal trouble with JPMorgan facing what other banks have faced with the accusation that you're putting together bad subprime loans and selling credit default swaps on them when people inside the bank knew they were bad.
I didn't review those deals individually myself, but I don't think there was anybody inside JPMorgan that knew they were packaging something bad for our clients. ...
All these things that we've come to understand were really substantially abused at every chain of the mortgage business -- from the borrowers themselves who lied about whether this was their primary residence and in fact they had 15 properties that they were buying to rent out, to the brokers that lied along the way, to the originating banks that didn't do their homework, to the servicer that ended up servicing these loans at every stage along the way -- we now know with the benefit of hindsight.
Of course there was some legitimate business being done, and there was some illegitimate and fraudulent business being done. And did the CDO originators -- which is where JPMorgan came into that transaction -- did the CDO packager do all the work that they could have done if they were the end investor in those products? No, I'm quite sure that the originators didn't do all the work that they could have done.
Did the investors do the work that they should have done? Did they ask the questions that they should have asked? No, absolutely not. They said, "Give me a portfolio of loans that's going to earn me X, because that's what I need in order to make my budget or satisfy my policyholders," or whatever.
So no, I don't think that there were people that were working at JPMorgan that were putting together packages of stuff that they knew were bad in order to flog to unwitting investors.
That allegation is out there.
It's out there.
It's out there with regard to Deutsche Bank. It's out there with regard to JPMorgan. It's out there with regard to Goldman Sachs.Yeah, and I've seen the e-mails where people have used derogatory terms to describe the transaction that they were trying to flog to investors.
It's one thing to know that the company has put together a CDO that's bad, and another person in another part of the company says, "Yeah, I'm going to short that thing, because that's junk; that's crap." It's another thing to build it knowing that it's full of crap and then bet against it, and that's what's being alleged. Do you think that happened?
I don't think that happened at JPMorgan.
Do you think that happened in general?
I don't know. Obviously I've read the transcripts of the Goldman Sachs testimonies. I've seen the settlements. I've seen that ultimately the SEC [Securities and Exchange Commission] allowed Goldman to pay a fine and neither admit nor deny guilt. I'm not sure I have all the facts myself, so I honestly don't know.
Why would Goldman or Deutsche Bank settle with the SEC rather than fight it if in fact they are clean?
We settled with regulators, or for that matter other plaintiffs, routinely. We settled with most of the plaintiffs in Enron. ... We paid out, if memory serves correct, $2 billion in the legal settlements, and knowing those facts inside out, there was not one iota of guilt on the part of my firm. But the risk was that you let that process run through the legal system and you end up paying not $2 billion but $20 billion.
In legal fees?
No, in damages.
But if you believe in your own case, why are you afraid of paying $20 billion?
And the legal system always works out just the way you think it should, right? No, of course not.
It's a calculated risk, you're saying?
It's a calculated risk, but it's asymmetrical, because the $20 billion final result bankrupts you. ... You can't put yourself in that position.
The reason I'm interested in this is because this is what people that are marching down there with Occupy Wall Street will bring up all the time. These banks are getting away with fines, getting a slap on the wrist, $300 million here, $400 million there. It doesn't amount to anything for them, and we're never allowed to take these things through the courts and figure out what really happened.
Well, that could be fair. And if what we really want is a Truth and Reconciliation Committee a la South Africa, that's a social objective. It's not a regulatory or a market objective. If that's what as a country we want to do, I'd be up for that.
I think the Occupy Wall Street tribe might be a little bit disappointed by the outcome of that, but I could be wrong. ...
What's your bet?
My bet is that if an objective process was gone through, it would be very hard to pin guilt for all this bad stuff that happened on any one party, but rather you'd find that pretty much everybody that was involved in the process contributed to it, of course including bankers. Bankers contributed to it substantially.
I feel like I contributed to it substantially for a number of reasons. One is that there was stuff going on that I didn't ring an alarm bell on, and I was as aware as anybody of what was going on. ... I didn't understand everything that was going on. In fact I missed some pretty big things in terms of the risk that was building up on banks' balance sheets.
But we saw product that we thought was probably being mis-sold. We saw risk that we thought was misunderstood by investors and where we reached that conclusion ourselves. It's not to say we had no lapses, because of course we did in our 30,000-person organization. But we treated those lapses very seriously, and we had quite a bureaucratic process, as it were, to screen those things out.
But when I saw what I believed to be other firms that were behaving in an irresponsible manner, I didn't ring alarm bells. I didn't come and speak to you on a documentary about the terrible things that are going wrong in our world, and I feel responsible for that today.
... If you had to do it over again, what would you do differently?
... I think I would have had more strength in my own convictions about what was really going on, and not only acted on it to defend my own firm but taken a bolder or broader stand in public and in private.
So you would have blown the whistle on other banks?
A bad practice, yeah. I can make all sorts of excuses for my own behavior, but the reason that I didn't blow the whistle was that I didn't have a high level of confidence that I was right. ...
As this began to devolve in 2005-2006, really, 2007, and the mortgage market peaks and starts to come down, what's going through your head?
... [We] saw that these transactions where we wondered where the risk was going, we now concluded that the risk wasn't going anywhere. There was no place for this risk to go. ... In other words, it was staying on somebody's balance sheet. ...
So now the bank is starting to sit on a lot of toxic debt.
That's right. And it became clear to us in 2007 that it wasn't just that perhaps we hadn't missed the point entirely in thinking that somebody else knew where this risk was going at a different price than we could see. Perhaps it was not going anywhere at all. It was sitting on bank balance sheets. And of course we felt very comfortable that we had not accumulated much of this risk.
We can put a complete lockdown on the incremental risk in these markets anywhere in the bank. Our lockdown was not perfect. We actually ended up in one sort of out-of-the-mainstream trading desk taking a position in subprime mortgages, which cost us a lot of money, and it was one of the big mistakes that we made, and it was a pure error of execution. We failed to live by our own edict. I mean, we put a bunch of rules down, and then we had a trader or a group that violated those rules. ...
... You got burned, but not badly.
Not badly. ...
... Had it not been for credit derivatives, how serious would the financial meltdown have been?
It's very hard to say. It's a tough question to answer, because the backdrop for the whole financial crisis was a complicated set of circumstances. One is investors had become very complacent about everything.
I've talked to other of your colleagues who have agreed that that was in part driven by the idea that you could always just sort of write another insurance policy; you could insure yourself. But finally we found out that people that were holding those insurance companies had no capital, couldn't pay up.
You're right. There was real complacency all around. There was a real search for incremental yield or incremental return, and combined with complacency was a very dangerous thing.
How much of that complacency ... was driven by the fact that everybody had laid off the risk through the use of credit default swaps?
I don't think that was a central feature. I think the complacency came about because nobody could imagine house prices dropping by 50 percent or 60 percent. Nobody could imagine interest rates being increased by 3 percent in a short period of time.
But had those things happened and everybody not having been sort of tied together with all these insurance contracts, would the damage have been the same?
I think if for whatever reason derivatives had never existed -- either nobody thought of them, or some regulator at some point in the '80s said, "There will be no derivatives," a little bit like what the Chinese say today -- what would the AIGs of the world had done instead?
What they would have done instead, most likely, is lent a huge amount of money to borrowers in the form of subprime mortgages. And in fact, what they probably would have done was lent the money to owners of this mortgage pool and that 30 percent or 50 percent loan-to-value mortgage.
Sen. [Carl] Levin [D-Mich.] had an investigation of Goldman Sachs. He revealed in one case that a $38 million subprime mortgage bond created in 2006 ended up in more than 30 separate debt pools and caused roughly $280 million of damage. That sounds like a lot of bets against one reference bond. That strikes me as a huge magnification of risk.
I think that the nature of the derivative markets is it allowed participants, either buying or selling, so on either side of the market, to take their positions without being constrained by the size of the underlying market. ...
... In other words, you could take a bet against a mortgage bond, and you can take the bet, and I can take the bet and --
So doesn't that then misalign the market in such a way that you magnify risk on one side of the ledger?
I don't think so.
Because for every buyer there's a seller. So in terms of the market as a whole, it nets out. ... I think for the most part, the idea that there were derivatives that were 10 or 20 or 100 times the size of the underlying bond in and of itself doesn't create a big problem in my mind. ...
If it's a risky bond, it creates a big problem for those people who would bet on it. When the mortgage market goes down, you've got many more bets against those bad mortgages.
But almost by definition there's going to be as many bets for it as there are bets against it, because there's another side to every trade. And every German Landesbank that took exposure to falling U.S. house prices were offset by somebody that was benefiting from --
Who were those people on the other side?
... It was relatively savvy hedge funds. It was banks like JPMorgan that tended to have inventory sitting on their books that they hedged, where they were managing their own risk.
In actual fact did this transfer money from the unsuspecting, the naive, suckers, fools, to people that were a lot smarter about the way markets worked?
In some cases, yes, although just pick, you know, two spectacular hedge fund collapses during that period. One was Peloton [Partners], which was a group of very smart Goldman Sachs-trained, mortgage-backed security experts that blew up spectacularly. And the second, perhaps a bit closer to my heart, were the blow up of the two large Bear Stearns hedge funds. ...
So there were some hedge funds that lost.
But really sophisticated. If you think about Bear Stearns, it was one of the leaders in the U.S. mortgage market. It was one of the leaders in the bundling of subprime mortgages. Yet their own hedge funds were the first to blow up, and not a little bit. They blew up spectacularly.
... So my only point is there were some really smart people on both sides of the trade, and there were some really not smart people on both sides of the trade.
When you were selling to the Landesbanks, or when you were cutting deals with various derivatives to governments or municipalities in Europe, did the buyers of those products understand them?
Look, as a rule -- and we were quite bureaucratic about this -- if we couldn't convince ourselves that the buyers understood what they were buying, we didn't sell to them, period, full stop, right? It doesn't mean we got it right 100 percent of the time, but I think we did.
... The story broke [in 2003] that Goldman had helped Greece dress its books, hide its debt. What was the reaction at JPMorgan?
I think there were two dimensions to that story. First was that the Greeks had entered into risky transactions to effectively hide their debt, and the second is that they'd lost a lot of money on those transactions. They'd made it much worse. What they ended up losing was much more than what they originally sought to hide.
But Goldman had assisted them.
I don't know exactly what Goldman did, but Goldman certainly was the counterpart to the trade. ... Did the Greeks devise a structure that was going to allow them to get around the Maastricht criteria and just go out to Goldman to execute the transaction, or was it cooked up in the halls of Goldman Sachs and sold to the Greeks? I don't know.
The issue from my perspective was that the Greeks had a very risky transaction on their books that could cause them to lose more money in the future, and they also needed to finance the losses that they had already incurred. So our first thought was, how can we help them solve this problem?
And how did you help them?
We worked for days and days and days on ways that they could offset the existing risk, so eliminate a risk that perhaps they never should have had in the first place, and effectively put an arrangement in place to satisfy their obligations to Goldman Sachs or whomever. ...
You talked to the Greeks, and they had been through this horrible experience during this Goldman deal. Did you not learn what had actually happened with Goldman?
No. As always happens when you're dealing with governments, if there's a problem, the guy that did the transaction is not there anymore. ... You're working alongside the person that's tasked with solving the problem.
I talked to [Claudio] Costamagna, the co-head of Goldman in Europe, and he said that there were lots of these kinds of deals that were going on, where investment bankers were helping governments of one type or another in Europe hide their debt.
Now, I'm sure that's right. ... The Germans, the French, the Dutch, all the people of course that are now paying for the Greek mistakes, were they aware of what Greece was doing with Goldman Sachs? I don't know for sure. I suspect they were.
But don't the banks have a fiduciary responsibility in this case to advise the governments about what they're getting into?
I think they do. And one of the criteria for any deals that we did with Greece -- would have been before the Goldman Sachs incident or after -- was that anything that they do be outlined specifically and in detail to Eurostat. Eurostat is the EU [European Union] organization that was tasked with determining whether a transaction complied with the European rules. So that would have been one of our requirements.
Another requirement would have been that the minister of finance personally signed off on the transaction and that somebody in a position of responsibility at JPMorgan spoke to the minister of finance and was sure that he understood what he was signing off on.
These are quite burdensome obligations, which meant that lots of times JPMorgan didn't do the business, as it were.
Those were burdensome obligations to make sure that your client understood what they were getting into. Do you think all banks went through that?
No, of course not.
Of course not? But that's a remarkable thing to say.
Well, perhaps. For me it's remarkable, and of course that's why we set the rules that we did. I think somebody else might have said it doesn't have to be the minister of finance. If you'd got somebody that runs the Treasury, that's fine. Doesn't have to be the elected official. It can be --
Or as long as they sign the paper, we're OK with it?
I think some banks might have set that criteria as well. ...
... You're saying that investment banks would sell derivative products to governments, whether it be a municipality or a federal government, that they knew the governments didn't understand?
You knew of deals like that?
I know of deals like that.
Did you ever raise that? Did you ever go to a regulator? ...
Yeah, I did, and so I'll give you a couple of examples. In terms of government entities dealing in derivatives, some of the worst abusers of the product, both on the government side but also in terms of banks dealing with governments, were the municipalities in Italy.
The local authorities in Italy in the '90s dealt very actively in derivative markets. They had no business dealing with derivative markets. They didn't understand the product, and they didn't have the underlying risk. They weren't risk management transactions. They were speculative transactions designed to generate income to fill up the government coffers.
Like interest rate swaps?
Interest rate swaps or currency swaps or commodity swaps or credit derivatives. ...
So the Italian Treasury was concerned enough about [it] that they came to us and other banks that I think they considered to be responsible and said, first of all: "We would be quite disappointed if you were participating in these markets. Confirm to us that you're not." And of course we said we're not.
No. No. The transactions that we did with Italian municipalities were entirely bona fide as far as I'm concerned.
You bought Bear Stearns--
--in 2008. And they had done some famous deals in the town of Cassino, outside of Rome?
Are you familiar with those?
Was that a clean deal?
I don't know. At the time that the deals were entered into, hard to tell. Would JPMorgan have done those deals? No. No. Too complicated, too small a counterparty.
So in this case you're holding banks responsible for leading less sophisticated municipal officials down the wrong path?
I would hold banks responsible for that.
Do you think that was widespread, and that was the abuse of derivatives, right?
There were abuses. In every market there are abuses. There were abuses in the derivative markets because of the opaqueness of derivatives. It was probably easier to abuse in some cases.
What does that say about the profession?
It obviously doesn't cover the profession in glory. And I think when you go through a period like we all did in the 1990s and the 2000s, where really large amounts of money were available to individuals on the condition that they performed well and performed honestly --
We're talking compensation.
We're talking bonuses. The incentive to cheat is very high. It's very high. And as a manager of those organizations, policing of prospective cheating becomes very difficult when there's huge amounts of money at stake. And there were cheaters.
I don't think the industry was full of cheaters. I don't think every firm was riddled with cheaters. In fact, I don't think most of the business that was done was cheating. I don't think most of the mistakes that were made can be chalked up to somebody cheating someplace. I think most of the mistakes that were made can be chalked up to incompetence. ...
Back to this European situation. ... How significant was the sale of faulty product to unsuspecting or naive investors in governments and municipalities? How much did that contribute to what we now see going on in Europe?
Very little, I think. So there were clearly some banks that went bust because they loaded up on stuff that they didn't fully understand. So IKB [Deutsche Industriebank] was the first major casualty.
And you sold [to] IKB?
We absolutely sold to IKB, and we banked IKB, and IKB had a team of 30 people that were completely focused on this market. They knew exactly what was going on in the market. They knew as well as anybody what was going on in the market. They had all the resources. They had the budget to be able to hire all the analysts that they wanted.
But you were selling to them as the market was going down. Why were they so willing?
It was their business. They had set up a business to manage asset-backed security funds that they had sold themselves to their investors. Thinking about what IKB did was to set up investment funds that they sold to third-party investors, they sold to their clients.
So they had to satisfy that demand?
They had to satisfy that demand. They made several mistakes, but the one enormous mistake that they made was that this small German bank extended credit lines to those funds so that actually it wasn't the investor that was on the hook; it was the bank itself that was on the hook. ...
So as we were selling to IKB, they were going out to five dealers at a time and saying: "This is what we're going to buy, and we're going to buy from the guy that has the best price. We've done our analysis, and this is what we want; this is how we're going to do it." Most of the buyers in Europe, certainly the buyers in size, were that kind of buyer; they were relatively sophisticated.
But when it comes to a country like Greece, participating in some dodgy derivative trades helps them get under the Maastricht level. So in that sense, had they not been provided that opportunity to dress their books, Europe today, it seems, might not be dealing with a Greek debt crisis.
It's possible. I was there at the time. I have an idea what European policy-makers were thinking, and European policy-makers wanted Greece inside the euro.
So the Germans wanted to sell them Mercedes for euros.
Sell them Mercedes or have a friendly country on the border of the Muslim world, or who knows what the motivation was. But I find it hard to believe that a continent that can figure out pretty precisely how many centrifuges Iran is running at this moment enriching plutonium and uranium couldn't figure out that the Greeks were cooking their books doing currency transactions with Goldman Sachs. I think they knew. In fact, I know they knew, and they just didn't care.
How do you know they knew?
Because I talked to them. They knew. The Greeks had a constant dialogue with Eurostat. Now, doesn't mean that they didn't play a few tricks along the way that Eurostat didn't know about, but the Eurostat knew the big ones. And Eurostat also knew the French were cooking their books by reclassifying their pension obligations with a parastatal organization called Cades, and they knew that the Germans were cooking their books with gold transactions.
This was the time when Europeans were generally cooking their books because they couldn't imagine what's actually happening today could ever happen. ...
How is it that we're four years out from this and derivatives are still not being traded in a transparent and open way on exchanges or even clearinghouses?
I think there's been a big migration for the straightforward derivatives into swap execution facilities at least, trading platforms that are easier to monitor for a regulator. And there's been a very large migration toward central clearing. But the most complicated transactions are still not traded in a transparent way and are not centrally cleared. ...
But why aren't we there yet?
I think there's a few reasons. One is it's really complicated technically. Two is there has not been global harmony in terms of the best way to do this. So the Americans passed the Dodd-Frank [Wall Street Reform and Consumer Protection Act], ... which was reasonably specific, but as you know, the rules that are underpinning that law still haven't been clarified. ... They're still writing the rules, and the rules are very complicated, hundreds and hundreds of pages.
The Europeans are going through a separate process that's also quite complicated and on which there's not perfect consensus. And of course where the Europeans and the Americans are coming out is not exactly the same place.
Along the way the folks in Singapore and Hong Kong and Dubai and other places may have a completely different set of ideas, and maybe they're trying to get a little bit of competitive advantage. Maybe they're just not so concerned about some of the issues that America or the Europeans are worried about, but this all drags the process down.
Perhaps the most interesting thing to note was that the number of end users of derivatives, really bona fide risk managers -- so the poor folks at Caterpillar that sell in 180 countries in the world that have some of the most complex currency exposures and interest rate exposures on earth, compounded by complicated tax treaties and other things -- are saying, "Please just let us manage our risk." ...
So the Caterpillars of the world took a little while to weigh in on the debate. But they did, and they said: "Please let us have our over-the-counter derivative market. It's really what we need to operate our business. It's worked very well for us. It's not been abused." And I've got real sympathy for that perspective. So all these things I think are weighing on progress.
Do you trust the banks to operate over-the-counter derivatives in a responsible fashion?
You don't think we need more regulation of derivatives? ...
I think we need tons of regulation of derivatives, but I think an over-the-counter market which is --
That means, to people listening to this conversation, an unregulated, non-transparent --
No, it's not. It never was unregulated.
Well, it's not easily regulated by the regulators. The regulators oversee the banks, but they don't have good visibility.
I think it's relatively straightforward to protect what's best about the over-the-counter derivative market while satisfying all the public policy objectives and the safety and soundness objectives.
For example, banks or any participant in a derivative market can be obliged to record their transaction with, for example, the DTCC [Depository Trust & Clearing Corp.], which is a good old industry consortium, central clearinghouse, regulated and regulatory entity.
So the SEC or the CFTC [U.S. Commodity Futures Trading Commission], when they want to review every trade that's been done in the OTC derivative market, can get it in one place, and they can see where all the risks are concentrated.
There's always a debate around whether big participants in this market are advantaged relative to small participants. So the reason in equity markets that every trade has got to be done on a recognized exchange and made public virtually immediately is because regulators have not wanted to disadvantage the mom-and-pa day trader, saver, IRA holder versus the big institutions that could get some inside information. And that's a very legitimate objective, particularly in equity markets.
When you get into the credit derivative market or the interest rate derivative market, the ma-and-pa [customers] don't trade in those markets. They don't have access to those markets. They shouldn't have access to those markets, and therefore do they need protection in terms of immediate transparency? No. They absolutely don't need that protection.
But we need protection against somebody like AIG taking a lot of one-way bets and then not being able to pay up when the time came that they needed to.
So we still don't have a regulator looking in on that kind of trading activity to know whether or not there's somebody sitting out there with a lot of one-way bets that gives them a lot of exposure.
First of all, I think the movement to central clearing is different than the movement toward exchange trading. So central clearing makes a lot more sense ... because it concentrates the information. And the AIG one-way bet? If all of their bets are with a clearinghouse, the clearinghouse knows exactly.
But why are we sitting here four years down the road and this could happen again?
... Probably the only thing I could imagine that would be worse than the position that we're in right now, which is that four years later we've made relatively little progress, is if policy-makers had been given the right to do whatever they wanted in the six months after it first became clear what the problem was, because the things that they would have done, we'd be regretting terrifically today.
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