Satyajit Das

What were the things that were being deregulated? ...

The first thing that was deregulated was banks' ability to borrow, what rates they paid, what they could lend, at what rates they could lend. ... Banks became much freer in terms of what they could do. ...

But part of that also was two or three controls. Banks generally have a small amount of shareholders' money, and they borrow the rest. And traditionally, because banks make loans which could go bad, they had to hold a large amount of share capital. One of the crucial things that happened was that amount of share capital has gradually reduced.

Part of this was interestingly a sort of feedback loop from deregulating markets and introducing new instruments which we call derivatives or risk management techniques, because people felt with these instruments, because you could manage risk, you didn't need to have these buffers to the same extent that you did. Because you could take risks but then distribute it to other people, you didn't need these buffers.

And that's what actually happened, is the amount of capital that banks had to hold got less, and so banks became able to create more and more credit. They could make more loans. ...

Also new products proliferated. There were obviously new types of loans, things like credit cards to individuals, new types of mortgages. People loaned differently. You could also borrow against the equity in your house. ... In this world, borrowing became much more acceptable, much more available.

Then there was these much more esoteric products that we introduced, things like swaps, options, futures, securitization, all sorts of products which were either about managing risk or creating new investment opportunities for investors, where traditionally they could only buy shares or government bonds or a very limited range of assets.

This was almost revolutionary, and it was almost like a new frontier in finance when all these things were happening simultaneously. It was a very exciting time to be involved in finance because there was no rulebook, and as we worked through that period of history, we were almost making the rules as we went along. ...

... This [brave new] world of fancy new products and engineering different ways to offset risk, who was behind this?

I don't think it was ever any one person. I think there were people working in parallel, and there was sort of strange groups of people. There was a small group of people who worked at Bankers Trust who were very creative. There was a bunch of people who worked at a group of French banks, and they were interesting because they were not traditional bankers. They usually came from very much [more] mathematical fields, scientific fields, and they were highly trained in, I suppose, quantitative disciplines. ...

There was also a coincidence here because this was the period by the late '80s, early '90s when what had happened was the Cold War was ending, and essentially there was two parallel developments. One is there was a lot of people who were employed in the defense-industrial complex who were becoming unemployed both in the United States and in the former Soviet Union who were immigrating, and they were looking for areas to use their expertise.

And the Bell Labs in the United States were downsizing quite significantly, so this amazing bunch of quantitative talent ended up in different areas. Some ended up in information technology, some ended up in banking, but they were kind of catalytic. And this small group of people started to almost reinvent banking, as it were. ...

Why are they doing this? For the money?

I think a lot of them did it because of the fact that that was the only jobs available. The second thing, of course, was the actual rewards in banking far outstripped the rewards in science. ...

This was one of the perversities, if you like, of banking. There was an absolute change in the way remuneration is structured. We now know that people get paid very large bonuses, very large incentive payments, but people assume that was the case always. In reality it wasn't. Until probably the early 1990s, banking was a well-rewarded profession, but not an egregiously rewarded profession. ...

You're in Merrill Lynch and you're a trader. Tell me about what you're inventing; give me an idea of the complexity. It's not just paper you're shuffling. You're inventing something that's altogether different.

My specialty was really in risk and raising money for people using different instruments. ... A lot of banks around the world needed to raise capital, share capital, except they didn't want to use share capital. They didn't want to issue shares to the shareholders for a whole bunch of reasons.

What I was designing for them is what we call hybrid instruments. This is really debt, so it's like a bond but with special features, which means the regulatory authorities consider them to be close to share capital. And we'll give them what we call equity credit.

So I was coming up with different tricks to do that. I was also working on securitizing basically loans and debt that was sitting on the bank's balance sheet and transferring them in different ways, finding different ways to do that.

I was also working with companies managing some of their risk. You might have an airline which has a lot of fuel to buy, and they are exposed to the fuel price. I was coming up with different structures to manage that risk, so I was designing these instruments, setting them up, trading them, and the idea at that stage was that we would have a whole bunch of clients that would effectively pay us to do this for them.

But at the same time, what had happened is because it was a brutally competitive business, all our competitors would be doing the same thing. So one of the things we decided to do was to actually trade on our own account. So as we created these products, what we were very conscious of is the client would pay us, but because we had all these risks that we were taking on, we could then go out and trade in different instruments, try to make more money for the bank.

So it was like these two streams of income: what the client paid us, but on the back of that, we could go and trade, take risk with the shareholders' money, and try to make more money for the bank. And of course some of that went to us. ...

It became a way of life for us. That line of trading income became larger and larger and larger, and that was fundamentally the big change of banking in terms of risk taking. Banks, and the whole financial system, became inherently much, much more risky.

I presume that the bonuses make you want to take more risk. It's a little vicious cycle?

To some extent that's absolutely true. But don't forget, there are controls. The senior management, the board of directors and the bank shareholders want risk taking within certain limits, so there would be some level of control.

So we could take risks, but there were limits to it. But obviously if we could take the right risks and make more money, then there were immediately direct benefits for us.

But the other thing which is interesting about that process is it's a bit like setting up any sort of measurement metric. ... Very quickly we mastered the metrics. We knew how we were going to be measured, and so a game brewed up and got accelerated over time where people started to game the system. ...

Not only were we able to take the profits -- and some of those profits were legitimate -- but the system lent itself to a process whereby you could actually game it to recognize profits which may not have been real. And that process, to be very honest, accelerated in the late '90s, early 2000s, leading up to the problems of 2007, 2008. ...

... Explain a credit default swap. How is it structured?

A credit default swap, or CDS for short, is really a form of insurance. That's all it is. Now, think about a bank which has made a loan to ABC company. For whatever reason, it wants to avoid the risk of loss in case ABC doesn't pay them back.

What it could do is sell the loan to somebody, or the other alternative would be instead of selling the loan, they go to a third party, whether it's a bank, an investor, a hedge fund, and buy insurance from them. And the insurance would work something like the following: The bank which made the loan pays a fee to this party, and in return they say, "If ABC doesn't pay you back, we'll make good your losses." ...

It became a way that banks could make loans but reduce the risk of losing money on those loans. ...

Why do banks need this?

Well, couple of reasons. One is every time a bank makes a loan, it has a couple of issues. One, [there's] the risk that somebody doesn't pay you back, and therefore you have to manage that risk. And that limits, number one, who you lend to. And honestly, even for good clients, you don't want to lend a huge amount because you might be wrong, and they might not pay you back. So that limits the amount of credit that you can make available.

The second is effectively, you also may for a whole bunch of just logical reasons limit your risk to a particular country, a particular industry. And this is what we call concentration risk. Banks generally, because of where they're based, their geography or their client base, tend to build up concentrated risks to specific clients, so they want to manage that to some degree.

And the reason they prefer to do this using this quaint form of credit insurance rather than selling the loans is they have a relationship with the client, and they want to maintain their relationship with the client, because it's a basis for getting other forms of business.

So you don't want to go to the client and say, "Look, we love you very much, but we want to sell these loans off," because that is seen by the client as effectively a vote of no confidence in the client, ... whereas the insurance company who you're buying the actual credit insurance from, or the investor you're buying the credit insurance from, it's a completely separate contract. It never has to be disclosed to the ultimate borrower, and that became really central to this process. ...

Give another example of the Exxon Valdez. How did that work? ... JPMorgan came up with a new instrument because of this spill.

... JPMorgan used [the credit insurance market] on a scale which was quite revolutionary, and the transaction involved the settlement of the damages arising from the oil spill of the Exxon Valdez in the Alaskan Prince William Sound.

JPMorgan, as I understand it, extended money to Exxon to make the payment. But JPMorgan, in making that loan, were concerned about the risk that they were taking on, because Exxon is a very large [and] very creditworthy company, but it operates in some risky industries. And the amount involved is very, very large, and there was no guarantee that this was the final settlement of that stage either, because the litigation had been ongoing.

JPMorgan wanted to protect itself against the risk that something went wrong with its loan, so what they did was buy credit insurance on that loan from a whole bunch of players which were other banks. Some were genuine investors like pension funds and insurance companies. ...

And the fact that JPMorgan, which was a very reputable name, had actually entered the market in a large size and used this as such a pivotal transaction in managing its own risk created the environment for the growth of the credit default swap market. ...

So there was nothing bad about this?

There was nothing wrong, and there is nothing wrong with hedging, but there were two elements to the transaction. The first was obviously JPMorgan hedging its risk.

But the second element of it, which often is not concentrated on, every time a bank makes a loan, under banking regulations they're required to set aside certain reserves of capital for the loan. This is prescribed by what we call the Basel standards, ... and they actually set a framework for banking regulation.

So JPMorgan, when they made the loan to Exxon, would have had to set aside some capital. Now generally, highly rated companies like Exxon don't pay a lot for their loans, and so under those circumstances, the earnings relative to the amount of money that has to be set aside did not meet internal targets within JPMorgan.

So part of the transaction was the very notable one of managing the risk, but another part of the transaction was that by selling off this risk, we avoided making a loan which was going to give us a substandard return.

And in time, that second [element], which I call arbitrage or regulatory arbitrage, of doing things to manipulate the terms that a bank might make, ... became of greater importance and the much bigger driver of the credit default swap, or the credit insurance market.

... Explain to me how corporations were using these funds and these derivatives. How is it helping? ...

When the credit default swap market started to take off, it became very much a fashionable thing to do, and there were several groups involved. One, there were the banks, and the banks were basically able to make millions.

And they were able to make loans to people who did not necessarily qualify for loans in the first place with the bank, because the banks then said, "Well, I'll admit this loan, but because I can sell off this risk to somebody else, ... I can basically take the risk, which I normally wouldn't do." ...

For corporations there were two benefits. One, people who would normally not have received funding were receiving funding, and the people who would have received funding were able to raise more money. So the volume of credit available expanded quite substantially. That was the first benefit.

But the other thing was, smaller banks around the world could actually now get access to clients, because if you're a small bank in the world wanting to lend to, say, an Exxon or somebody like that, you may not have the direct relationships. But you could now acquire these loans quite easily through these credit insurance contracts in the secondary market.

So what happens is we saw this risk gradually permeate through the financial system, and that has two effects. The first is the pool of money available for a corporate borrower vastly expanded. But the second thing that happened, which was less probably impressive and far more risky, was we were gradually tying people in very different parts of the world, who you may not necessarily know, into this web of finance.

So you might have a loan to Exxon, which everybody thinks JPMorgan has made, but then JPMorgan has distributed the risk to, say, 30 banks in different parts of the world, like in Japan, China, in the United Kingdom, in Germany, in Australia. Then they may in turn have hedged their risk with somebody else.

So you get this almost web out there, and the regulators all loved this because they thought risk was being distributed, reducing the risk and the chance of a crash. But in reality, it was introducing a new risk into the system.

And that risk was not very well understood, because remember, an insurance contract -- what was actually happening is the contract is only as good as the credit quality of the insurer. They have to pay you, and if they can't pay you for whatever reason, then this whole process of risk transfer breaks down. And people didn't really understand that the insurance market wasn't getting rid of the risk; it was just moving the risk around in a very interesting way. ...

The other thing it did ... was kind of an interesting psychological process. People changed the way they looked at credit risk. ... Once you get into a world where you think you can at a moment's notice go and insure the loan with somebody else, there are a couple of psychological changes which occur. One, you're less concerned about the repayment risk, because you think your risk is only from the moment you make the loan to when you hedge it with these instruments.

Second, you're assuming that the market for these instruments is always going to be good, and it's going to be liquid, and it's going to be functioning. And one of the strange things about financial markets is they're liquid generally when you don't need them to be liquid, and when you need liquidity, unfortunately, they tend to be illiquid.

Why could all these geniuses and rocket scientists not have figured out that this could become such a problem?

That's a very good question, because I think fundamentally the financial market and the people who work in financial markets are overrated in terms of their, I suppose, ability to foresee certain problems. And there's a couple of reasons for that.

One is I think a lot of people who came into banking from the 1990s onward were relatively young, and because the business had changed, they were promoted to roles which were quite influential without having a long pedigree in banking. ... These people were almost parachuted into jobs where they did a very specific thing without necessarily understanding how a company works. ...

The second thing is a lot of the people who had quantitative skills came from the physical sciences and had very little financial experience. ... They didn't understand banking, but they understood the model. And the model, like all models, made huge simplifications in how things worked. ...

In financial markets, there are no hard and fast laws, and the models were built for a world of certainty when we worked in a world which was generally far more uncertain.

The last element is [that] in financial markets, there is a huge element of groupthink. ... Particularly when something is working and something is making money, there is a tremendous resistance to changing that.

And ... from, say, the early 1990s to, say, 2007, 2008, everything seemed to work. There were periodic setbacks, but they were minor, so everybody assumed we had found the new sort of touchstone; we could turn lead into gold. ...

Well, what happened to this genius company [AIG] that went down so fast?

AIG is a rather interesting case for a whole bunch of reasons. The first is, it's an insurance company, and if you think about the business of insurance, it's about risk. So everybody sort of assumed that if anybody knew something about risk, an insurance company would.

... Under Hank Greenberg, the company had grown enormously into this trillion-dollar company -- it was like a country rather than actually a company -- but it basically had this one unit which was kind of the strange, mysterious things off-center, known as AIG Financial Products, which was completely different from the rest of the company.

... The magical moment for AIG was very early in the piece when AIG Financial Products pulled off a transaction involving the Republic of Italy. They had a billion-dollar swap, which is a derivative contract, and that netted round about $10 million in up-front earnings for AIG.

And AIG Financial Products targeted an area which other banks couldn't operate in. Because of their AAA rating, they could work with things like sovereigns, like countries. They could work with people like the World Bank, which was AAA-rated but didn't like dealing with banks unless they were AAA-rated.

So they carved out this little niche of very credit-sensitive companies and sovereigns, and they dealt with AIG Financial Products. And the other thing they did, because of the insurance company name and their rating, is they could deal with very long maturities, like 30 years, which most banks struggled with, and they were able to carve this out. And the basic business that they created was immensely profitable.

But then around about the late 1990s, early 2000s, a couple things happened to AIG Financial Products. [Founder] Howard Sosin left in very acrimonious conditions, and the company evolved. The company then started to enter into credit insurance contracts, and this is an interesting crossover into the world of securitization. ...

They thought this was like catastrophe insurance -- because they were used to taking risk in terms of insuring against hurricanes, earthquakes, all these sorts of things -- and they thought they understood credit risk, because what they were doing was taking the risk of loss on portfolios of mortgages, but the risk they were taking is basically only if the losses on that portfolio of mortgages was extremely high. And historically, house prices have already gone up; mortgage loss rates were extremely low.

So their modeling, done by their own internal people, showed this was like a 1-in-a-10,000, 1-in-a-100,000-year event which would never happen. But there was a fundamental difference between this business and the business they've done before. And that business was, essentially, if they couldn't model properly and they couldn't match the contract in some way or hedge it by a mixture of other contracts, they would never do it.

In the case of these credit insurance contracts, they just went ahead and did them, because they saw it more like an insurance business where they would set aside some money, but they would never really have to pay, because this event wouldn't occur. ...

In 2007, 2008, the problems started for them. ... As the mortgage markets started to melt down in the United States and these underlying mortgages were losing value, the potential amount of money ... on these contracts that AIG had written started to rise.

Amazingly, AIG had never even considered this issue of them having to pay us collateral, because they just assumed that they could never lose any money on these contracts and they wouldn't basically have to ever pay.

So what they were faced with as their counterparties -- these are investment banks and banks like Goldman Sachs, JPMorgan, Societe Generale -- would come to them and say, "Give me money." There were huge disputes between them, and ultimately what brought AIG to its knees was these persistent series of collateral calls based on the fact that these contracts, on paper at least, were deeply out of the money, showing deep losses to the tune of several billion dollars.

What killed AIG, or was the straw that broke the camel's back, is after having paid across already $10 billion in collateral to these various banks, they realized they had to make a payment of $18 billion to these banks. And that's because AIG was going to be downgraded below a trigger level, which was AA, which was the usual trigger put into these contracts. ...

The scale of the AIG debacle was astonishing, because it spread through the world. ...

So this is the company you said [took] $450 billion worth of bets? ... What's the sort of ratio of the debt they took versus the money they had?

... Basically they were holding minuscule amounts of reserves, or cash, against these contracts simply because they believed they would never have to pay. ... And they had completely ignored the risk that effectively, irrespective of whether or not these contracts required them to pay, if the market value of these contracts changed significantly, then what would happen is they might have to put up this surety amount. ... It was astonishing. ...

[Explain the loan structuring known as tranching.]

The best way to think about this is like a very high apartment block. Let's say you live in a flood-prone region. ... You say, "Well, floods come along," so you buy, effectively, the penthouse suite, the assumption being, even if there are floods, the likelihood of the floodwaters rising to where you are is relatively modest. And you're assuming that basically you are going to get your money back.

Now, if you live lower, like you buy the mezzanine, ... you're saying, "Look, I don't believe the floods are going to rise that high." And if you live in the [lowest] bit, you're assuming there's never going to be any floods. They're a 1-in-10,000-year event, and it's never going to happen.

But there's a problem with all of this. And the problem with all of this is you have to assume that all the statistical assumptions you've made about how likely individuals are to default, and if one individual defaults, how likely somebody else is to default, you actually have numbers and models which can capture this.

And what happened in the area of subprime mortgages, which is interesting, is we don't have a lot of experience with subprime mortgages. So what we were doing is extrapolating from information about normal mortgages to understand the behavior of these pools, and as we know with the benefit of hindsight, that was disastrously incorrect. As somebody put it, it was like trying to predict the weather tomorrow but using the weather report from Antarctica from about a century ago to do your forecast. So we were disastrously wrong. ...

And the other reason this was so problematic was if you looked to the AAA tranches, they were bought buy a lot of people who used them to borrow money against, because you could actually, because of the high quality of these securities, borrow up to 98 cents in $1 of these securities. So you could actually buy these with borrowed money.

So if the value of that security falls by roughly 2 percent, then you are no longer covered in terms of your borrowing, and you've got to come up with more money to cover that. And that forces you sometimes to either stump up more money, but more likely to sell the securities. And this is precisely what happened in 2007, 2008. ...

... So how were these CDSs used to enable riskier and riskier collateralized debt obligations [CDOs], loaded with subprime mortgages and more and more deals?

The whole complex of transferring risk had some unintended consequences. So we had credit default swaps, or credit insurance, where banks could insure their risk. We had these securitizations like collateralized debt obligations, where we were packaging up loans and selling them in different forms. So banks essentially now had this whole armory of where they could go and make loans and basically transfer the risk. ...

Since I wasn't going to be holding the risk, I could afford now to do two things. One, I could go down the risk. In other words, I could basically start to lend people money where I was less confident that they would pay me back. Why? Because I wouldn't be left with the risk. Somebody else would be left with the risk, and as long as I was confident I could sell it, I would do this. ...

The second element about this, which is quite important, is I could lend more. Even to people I was very comfortable would pay me back, there were constraints on how much I would lend to them. Now I could lend them vast sums of money, because I could transfer some of that out and keep some of that.

... What quickly happened is people got greedy, and there [were] two dynamics to that. The first dynamic to that was the banks themselves. The banks had built these gleaming factories for making money, these securitization, these risk-transfer engines. I remember going into the dealing room at a London bank and visiting some people in the securitization or risk-transfer business, and there was probably 100 people in there, and 40 of them were Ph.D.s with very great quantitative skills, and cutting and dicing these cash flows differently.

The overheads of running that 100 people was just massive, so they needed to push things through this factory very quickly. And they just couldn't do it with what the bank actually did. So what they started to do was build these enormous networks to, almost like a vacuum cleaner, vacuum up all the loans in the world. And if there wasn't sufficient loans in the world, what they were then doing was encouraging people to make loans.

So they would go and finance mortgage brokers or other people to make new loans. And like all things in life, there are a certain number of people out there who are creditworthy, but now it didn't matter, because you just had to have the raw materials for this engine, so you kept moving down the credit curve. So you lent to the people who were creditworthy, then the people who were less creditworthy.

And in the end, this entire market got to the stage [where] the joke was you could lend to a ham sandwich as long as they filled out the forms, and these loans basically became ones where they were stated income; people just stated their income. People sometimes didn't have to state their income, and they came to be known as liar loans, because you'd lie your way to a loan. And it was to keep this engine sort of going along the way.

Then, of course, the other thing is the investors. People forget that this was not purely bank-driven. It was driven by investors on the other side as well. Investors were looking for assets. Through the '80s and '90s, what we saw was a huge buildup in savings, and part of this was mandatory saving schemes. Like in the United States, you had IRAs or 401(k) accounts, and people were just saving for their retirement.

In Europe, the same thing was going on. In Asia, the same thing was going on. There was this vast growth in the amount of money looking for a home, and particularly the money that was conservative and wanted safe investments were looking for high-quality assets, like AAA-rated bonds. They became almost like an exorable force driving this market, and they had an endless appetite.

You sold them something, and they would say, "I want more." And also they became very sensitive as interest rates came down. They wanted more and more return. So the engineers in the middle of this are saying: "How do we do this? How do we get more loans? All right, we go and buy mortgage brokers and do that."

But then the next question is, "How do we create more return?" So we started to tweak the leverage and play games. So instead of just selling the loans to an insurance company, a pension fund or whatever, we then came up with more and more elaborate structures, where we created a CDO off a CDO, which came to be known as a CDO to the power of 2 [CDO-squared].

We created a CDO of a CDO of a CDO, a CDO to the power of 3. And all of these things were basically buying not loans but securitized loans, and then buying a securitization of a securitized loans, and creating these endless chains of risk to basically create AAA paper, but also give the investors the higher returns they wanted.

And what the investors often failed to grasp is that in trying to do that to meet the demand or yield or returns, we were increasing the leverage and the toxic nature of the risk that was underlying that, because on one side, effectively, the quality of the underlying loans we were using is going down. ... But basically at the same time, the amount of leverage or borrowing we use to create these structures is going up. It was absolutely a devil's brew, and it was really always going to end in tears, which it did.

... Who's buying this stuff?

I think the money that was coming into the market was coming initially from people like, obviously, pension funds, insurance companies, mutual funds investing people's savings. And interestingly enough, over time, as it internationalized, it started to come from banks and savers in all parts of the world.

And then of course we had a new player, which was the hedge funds, and the hedge funds started to get interested in these sorts of securities and this sort of space probably in the late '90s, early 2000s. ...

... Explain to me how the moment happened when you sort of said, "Holy cow, this is insane!," and how long it took other bankers to come to that realization. ...

There was no magical "Eureka!" moment for me, but there was one that I recall. I was doing some work for a fund manager, and they were looking at a whole bunch of mortgage-backed securities, and they sent me a whole bunch of prospectuses to read.

As I was working through these prospectuses, I was almost getting a sense of deja vu, because there was usually a map of the United States which showed where the mortgages had come from. It was late at night, and I suddenly thought, "I've read that prospectus before." But then I went through them and said, "No, I haven't; this is a new one."

And then I realized why I had thought they were the same, [because] when you looked at the maps of the United States and where the mortgages were coming from, they were all coming from the same states. They were coming from California; they were coming from Florida; they were coming from Nevada; they're coming from Arizona and a few other states.

So I did something old-fashioned. I took a piece of transparent paper, drew maps of the United States, and copied each of those maps from each of the prospectuses. And I went to my client and laid them all on top of each other, and he said, "They're all from the same place." I said, "Exactly."

So what we are doing when we buy this stuff is we are taking massive bets on house prices continuing to rise in these particular states. And then I explained to him that when you looked at these mortgages, they didn't actually assume that house prices stayed stable; they were actually assuming that house prices would continue to go up steadily over time, because many of these mortgages had what were called teaser rates. Essentially the rates initially for the buyers, for the first year or two years, were very low, and then they would kick up.

And I said to the man that I was working for: "You're betting that, a, interest rates stay low, so when you get past the honeymoon period they will be able to refinance the mortgage and get another period of low rate. Or alternatively, you're assuming the house price is going to go up so quickly that they're going to be able to sell the price and reduce the mortgage in some shape or form and continue to make payments."

And he said to me, "How likely is this?" I said: "This is just like a Ponzi game. It depends on when somebody asks for their money back, and at that point, the whole game will unravel."

It unraveled relatively slowly, and there were some markers. The first marker was when the U.S. Federal Reserve started to put up interest rates, and as they started to put up interest rates, the housing bubble firstly peaked, and then started to slowly deflate. ...

I can remember the visceral change in the approach and attitude of people, because people for the first time homed in on this issue of what was going to happen to these mortgages if house prices came down. And at that stage, the Federal Reserve officials and the U.S. Treasury secretary were making soothing noises about how housing prices never have gone down consistently and how everything was fine.

Basically my reaction to that to somebody was, "If there's no fire, why do they keep saying there's no fire?" ... And when you looked through into the underlying mortgage market, you could see what the problem was. ...

Because there was no liquidity, as everybody started to try to exit this market, they couldn't, because it's like yelling "Fire!" in a theater where there aren't too many fire exits, because everybody's trying to get out.

And under those circumstances, what happened is the CDS prices, the fees you had to pay, blew out. At the same time, this index started to fall, and because they were completely in the public domain, people would look every day at these prices and find them dropping. People just literally panicked, and people started to want to sell. ...

All of that combined in a vicious cycle, forcing the price down, and that was the moment at which the whole game came to an end. Then it started to radiate out from the United States, and because these securities were held by people in Europe, in Asia, they started to feel the pain. That's when the whole global financial system started to gradually seize up. ...

I don't understand how a product that was invented to get rid of risk became the riskiest product of all. ...

The curious thing about risk transfer is that people assume that risk is something you can get rid of. In physics, there's a law of conservation of energy, which is you can neither create energy nor destroy it. You can change its location, you can change its form, but you can't get rid of it.

Risk is very similar. All you can do is -- there's a certain amount of risk in the financial system; what you can do is you can move it around. And generally the aim is to move it to somebody else who can bear that risk and is more willing to bear that risk because you don't want to or it doesn't suit your business model to do that.

Most people in finance assume risk can be eliminated. It can't. So in the credit-risk-transfer mechanism, what was actually happening was we were just moving the risk from one party to another party. Now, that in itself gave regulators great heart. Regulators thought if we could take the risk from one part of the system, which is the banking system, and slowly distribute it out across the economy to different holders across the world, the system would become more stable.

As a basic theoretical proposition, that's absolutely correct. But the theory is very difficult to practice for a number of reasons. The first is, risk was going from somewhere where you could see it, which was in banks which are highly regulated and there's a lot of oversight -- we can argue about whether the oversight is sufficient or not, but generally it was known -- ... to a place where nobody knew where it was. ...

If I have a mortgage with you as a banker and I can't pay, I can sit down across the table and we can have a discussion. We can change some of the terms of the mortgage and try to ensure that I repay you and you get repaid.

But now that these mortgages were in these pools, the first thing was, they didn't exist. They were little fractions of risk. They had been split up in different ways. So you couldn't really deal with me to restructure the mortgage because you as a banker didn't really own the mortgage; investors who you may not even be aware who they were owned the mortgage. And they didn't own the whole mortgage; they owned bits of the mortgage, so there's just no way you can resolve it.

... That's the first problem. The second is these chains of risk were created. ... Everybody anywhere was connected to a bad loan situation through these chains of risk. And the problem with these chains of risk is they're only as good as the weakest point. So effectively, you might have JPMorgan is hedged with Deutsche Bank, which is hedged with a hedge fund, which has then transferred the risk to Barclays Bank of England.

But the problem is if any part of that chain breaks down because they can't honor the contract, the entire system implodes. And this isn't new. We saw that when the Lloyd's reinsurance market blew up in England. And we saw these daisy chains of risk are very dangerous, but we somehow assumed that this wasn't going to occur again.

The other thing that people didn't really grasp was that this whole process of risk transfer had become an elaborate game, an elaborate ruse. In fact, the risk was not leaving the banking system; it was in fact a financial shell game where we were manipulating banking results by moving the risk out through one door but bringing it back into the banking system by another door. ...

... One bank is late to the party, Citibank. Tell me what happened there.

... In the late 1990s, the merger between Travelers and what was then Citigroup created this financial behemoth. And basically, there was enormous pressure to make the merger work and to make higher returns for shareholders, because the merger itself had been controversial for a whole bunch of reasons. They even had to get Glass-Steagall basically repealed to make the merger work, so it was a big deal.

They started to expand, ... and as the mortgage market started to spiral into this behemoth and this huge business, Citicorp, as did other banks, wanted a share of it. And basically they, being latecomers, bought into the market by sheer power of their balance sheet and their pricing muscle. They tried to buy shares, and one of their strategies was to take more risk. ...

This took several forms. One is they now very aggressively went and bought mortgages from their own operations but also from other people's operations, and they set up this massive securitization engine to repackage those mortgages and sell them.

But at the same time, what they did was they started investing in these mortgages and/or slices of these mortgages for their own return. ... Basically they were buying up these mortgages and putting them on their balance sheet because of a strange thing that had happened known as Basel II, which was the banking regulations which had existed since about the middle '80s had been tweaked and changed. ... So Citigroup and all these people started to buy up these mortgages in an enormous way.

And Citigroup got caught in the crisis in two ways. One is on all the stuff that they owned and was sitting on their balance sheet, they basically lost an enormous sum of money because of the fall in the value of these securities. But they lost on two other counts. One is they had a pipeline of mortgages which they'd bought up and were hoping to repackage and sell. But when the music stopped and the securitization market stopped, they were stuck with that, and they'd never really assumed they were going to get stuck with that.

And the third was all these off-balance sheet vehicles, what we call the shadow banking system, which Citigroup were very prominent in, they'd set up. Everybody assumed they'd sold the risk, but they hadn't because there were connections back to Citigroup, and these were known as liquidity puts. What that meant is if these vehicles could not raise any more money, then they would be able to sell the mortgages and the entire structure back to Citigroup.

When they blew up, [former Treasury Secretary] Robert Rubin was asked about these, and he said he wasn't aware of the liquidity puts, and the first time he heard about them was after the crisis started, which is curious, because if you look at the Citigroup annual financial statements, they disclosed in the notes to the account. So there was public disclosure about them, but nobody ever thought that these risks would actually become real. ...

One thing that has puzzled me to this day is where were the risk managers? Where were the senior management in these banks? Where was the board of directors? Where were all the regulators who were supposed to oversee this? It was a massive failure in the end, I think, of common sense. ...

Banks are freaking out, so they start building this stuff that's even more toxic to sell to other people, and then there's the case of Abacus.

By 2007, 2008 all the smart money knew the game had ended, and all the banks tried to effectively repackage what they were stuck with as quickly as possible and get it off their books, and get it to other people who perhaps were less aware of the problems. But there was a second parallel movement which was going on, which was all about, "How can we take advantage of it?"

And there was no one person, but there was a whole group of people who had identified that the bubble, which many analysts had been saying would burst from about 2002 onward, was now unwinding. Perhaps most sensationally the person to take advantage of that was John Paulson, through his hedge fund Paulson & Co. ...

Paulson realized that U.S. housing prices were going to fall, and indeed they were going to fall much further much more quickly than anybody had anticipated, and he wanted to take advantage of that. So he was looking around, as were other people, by the way, and these people -- both people within banks but also hedge funds in particular -- were trying to basically take advantage of this.

They started off by shorting the stocks of people involved in housing, like the construction companies and also some of the mortgage brokers that were publicly traded. But the real game everybody knew was: "How do we short these mortgage-backed securities themselves? Because they're going to fall in value."

Paulson came up with the deal that worked, and he did it with Goldman Sachs, and this is the deal that came to be known as Abacus. ...

How it worked was this: Paulson & Co. entered into a credit insurance policy with Goldman Sachs. The policy was based on round about 90 mortgage-backed securities. But Paulson had picked those mortgage-based securities very interestingly. They weren't actually mortgages; they were actually existing CDOs or pieces of securitized mortgages, and they were rated round about BBB, which is sort of investment grade, but modest investment grade, so riskier than, say, a AAA security.

And he placed a bet that they would go to zero, they would lose all their value, which was not a scenario that most people were expecting. Most people were expecting some losses, but he reasoned that if losses rose, these BBB pieces were far riskier and they would go to zero.

What he did was he actually structured the current insurance policy so he would only get paid if the losses on these securities were above 45 percent. In other words, if these securities lost less than 45 percent, he wouldn't get anything. But if it went about 45, for instance if they lost all value, he'd get 55 percent. And Goldman wrote him this contract, but Goldman did not want to take the risk on the other side, so what Goldman did was structure a CDO, which came to be known as Abacus, to get rid of this risk.

So what they did was transfer the risk to three people. One was IKB [Deutsche Industriebank], a smaller German bank which subscribed an amount of capital, round about $150 million of capital. They put it into the special purpose vehicle to take the risk from Goldman Sachs.

The other two people were related. One was an insurer called ACA, which insured some of the other risk, but because Goldman Sachs did not like the credit quality of ACA, they put a Dutch bank, ABN AMRO, between them and ACA. So this Dutch bank got paid 0.17 of a percent to basically insure, if you like, the risk of ACA in performing on this contract.

So Goldman Sachs was on both sides of this trade, if you like. They were hedging Paulson in terms of taking the risk of the mortgages from Paulson, but they then laid off the risk. Within about six months of this deal being put together, the underlying 90 mortgages had lost almost all their value, and eventually Paulson made about $1 billion. And the financial market's a zero-sum game, which is no money is ever really made or lost; it's just transferred between participants.

So Goldman paid them the $1 billion, but they recovered it by writing the securities they had issued to IKB and to ABN AMRO/ACA to zero. ...

Abacus came to light when the SEC, the Securities Exchange Commission, launched an action against Goldman Sachs, and the case was pretty straightforward. They thought that Goldman Sachs had not made proper disclosures about the risk of the structure. ...

Now, we will never know the truth or otherwise of these allegations, because Goldman Sachs ultimately settled the matter with the SEC for $550 million, which ironically was about a couple of weeks of Goldman's earnings for that year. And I think in the end, it was a bit like church on a Sunday when you put in some money on the plate to basically wipe out all your sins. So whether it was punishment or not, it certainly was the largest fine ever paid to the SEC. ...

But I don't think the Goldman Sachs deal actually solves anything, because the fundamental issue in Goldman Sachs, which the SEC did not really resolve, is the conflict of interest inherent in modern banking, which is you can be a principal -- in other words, trade on your own account -- and you can do transactions on behalf of clients. Obviously there is an inherent conflict of interest of what you do on your own account versus what you do for your client.

And this is a persistent train of problems in American finance, indeed global finance, because in the pre-2000 period and when the Internet bubble burst, similar accusations about the role of research analysts in investment banks was raised.

But there seems to be no willingness to address this issue of conflict of interest, because that would mean essentially pulling apart the two parts of the bank, the proprietary trading and the client-focused businesses. And there is no real energy or traction for dealing with that issue.

The case of MF Global. What's the moral of the story? ...

... If I look at MF Global, there are two quite discrete issues. One is they took a massive bet on European government bonds. ... What they did was they made a very, very large bet on the fact that Spain and Italy and some of the peripheral European countries, which are very beleaguered at the moment, would not default on their debt, in fact would improve and pay back their debt in full.

The chief executive of MF Global, Jon Corzine, believed that Europe would not let these countries fail. So he bought, as I understand it, round about $6.3 billion of these securities. But the real issue was then he actually leveraged the position. In other words, it wasn't $6.3 billion of MF Global's money alone. They actually used a small part of their own money, but they borrowed money against this collateral to buy these securities.

Unfortunately, the value of these Italian and Spanish and other bonds continued to fall, contrary to the expectation that MF Global entered the trade with, which meant that they would have to come up with more margin calls. And they lost a huge amount of money on that relative to their resources.

But there's another fascinating issue here if you look at MF Global. They have $1 billion roughly in capital, and their total balance sheet was somewhere in the mid-$30s to $40 billion. So they actually had borrowed the bulk of money to make their operations work. And that's the leverage that we've seen in companies like Lehman Brothers. ...

So the real problem is, number one, toxic bets combined with toxic amounts of leverage or other people's money. Once you combine those two and they go wrong, they actually have disastrous results. But part of that is the psychology now is that's how we make money in banking. ...

But that's what got us into trouble in the first place, being overleveraged. Why is this still happening?

Nobody ever learns. ... There's always a new generation of people who believe, or a same trader believes, it won't happen again; the leverage will work; we just keep doing it.

We're just absolutely married to this idea of finance and leverage, and that's almost like in our DNA now about how we approach investment. We never, ever look at the downside risks and what could go wrong. We just assume we're going to be right every time.

You talked a bit about the mentality of a trader, that you can't believe you can be wrong. It's not in their DNA.

I think fundamentally if you're going to be a trader, you've got to be highly opinionated, because you've effectively got to put a position on the table, and if you don't believe in it, it's very hard to do that. To some extent, the real trick is about controlling traders, because traders should take positions, because that's what they're paid to do if they're trading with your money.

At the same time, you've got to put some controls and make sure that they don't get too married to a position, and if it starts to lose money, that somebody decides at a certain point that enough is enough.

But in the case of, say, someplace like MF Global, when you have a charismatic and very strong-willed chief executive like Jon Corzine, the critical question is, is the board strong enough? Are the control processes strong enough to rein him in?

... Good trading is actually quite interesting. You lose money or you make money. The trick is in actually cutting your losses quickly enough and making more on the trades that are right than you lose on the trades that are wrong, because nobody's going to be right all the time.

It's about great discipline, and generally what happens is that discipline breaks down at an individual level. But most importantly, it breaks down at an organizational level. I suppose the best way to think about it is financial institutions are now so reliant on trading earnings, it's almost impossible for them not to take risk. And some of them have no capacity to control that risk taking, because if you go outside of the trading rooms and you look at the senior management, or the hierarchies of management and the board of directors, often they have no familiarity with the instrument that's being traded or with the risks except in the most general terms. ...

They think if you put a process in place this works, without understanding very deeply what the risks are. ... Then in the entire process, if they make money, they look good, and if they don't make money, they tend to sort of dismiss it as a rogue trader.

I read "rogue trader" these days as code for: "I couldn't have done anything. I as the board of directors, I as the senior executives, I as the shareholders, couldn't have done anything." And it's almost like wiping the slate clean. ...

When you look at the bet that Jon Corzine did, was he the dumbest trader yet, or did it make some sense?

I think his bet was not an uncommon one, because most people have underestimated the quantum and the depth of the European crisis. And to some extent, it's kind of a perverse bet on effectively the European bureaucrats and the policy-makers managing to get their act together to save these countries. ...

They weren't able to diagnose the problem in the first place, and going back further, they were the cause of the problem. So to some extent he was in the majority, but the majority in this case turned out to be wrong.

And bankers now believe that no matter what, there's bailouts. There's no moral hazard.

Well, one aspect of a trader's life, which is kind of interesting, is that it's always O.P.M. It's always "other people's money." ... If your bets are wrong and you lose money but you've played by the rules, what's the worst thing that can happen to you? You can lose your job.

But generally there isn't really [any] discipline in the market. So if you're a good trader and have a bad run, you basically end up ending up with a job somewhere else.

Most famously John Meriwether, who was one of the founders of Long-Term Capital Management, which had huge problems in 1998, was subsequently able to raise funds for a new fund despite the problems with Long-Term Capital Management.

Then when that second fund failed, he was actually able to basically raise funds for a third fund. ... If you look at financial markets, there seem to be second, third, fourth, fifth lives. There's no real discipline in that sense.

So under those circumstances, there is every incentive for a trader to take risks. And one of the most curious things about that is if you go around the world, it's not clear nine times out of 10 whether the trader is taking the risk with the tacit approval of management. ...

Tell me about your theories then on how financialization has sort of changed everything.

... Money originally was something very simple. It was a mechanism for exchange. So I gave you money, you gave me some real things like food, water, or whatever. ...

Somehow in the last 30 or 40 years, ... what we did was we take money but use it in a different way. Money in the form of debt in particular we used as a way to drive economies. And it's a different level. So individual lives, we basically borrow money to buy things which we can't afford. And that whole rise of debt was very much a phenomenon from the '70s onward. ...

The second element about that, which is really quite important, is if you actually look at the way we use money, speculation and debt certainly drive the economy on an individual level, but on a global level, countries get financialized as well. ...

So they start to drive countries in terms of as an industry. But most importantly, it also looks at how trade takes place. There's quite a lot of controversy in the relationship between China and America, but one essential element of that is a financial element. China sends goods to the United States, but the United States doesn't have money to pay for them.

What happens is when the payment is made, China lends the money back to the United States in the form of buying government bonds and other forms of debt. The entire cycle is very much like what we call vendor financing, where the seller of the goods actually finances the purchase.

That's happened between America and China, but it's also happened in Europe between Germany and ... the Southern European countries. That's essentially a part of what we do. Every transaction now has a financial element. ...

That's how entirely the world changed, and finance started to become a way to drive economies. And there's nothing wrong with debt. Within limits, debts are very sensible, because all we do with debt is basically accelerate consumption, so instead of saving over a period of time to have the money to buy something, we buy it today and pay it back over time.

But essentially that depends on two criteria which are crucial. One, when we borrowed the money, we need to have the capacity to pay it back. In other words, we have to have the income to pay it back. And the second is that if we bought something with it, that has value, and that value is maintained over time relative to the value of debt. Those two rules are pretty simple, basic rules of lending.

Fundamentally we've forgot all about that, because what was happening as we were accelerating consumption because we could borrow it to buy today, the economy kept growing; the prices of everything like houses and assets kept going up. So we somehow mysteriously assumed that we didn't need to worry about how to repay this debt, because what we'd bought with it would get more valuable and we could select to pay it off, except it was just a Ponzi game, because the game would go on and prices would go on as long as we could keep borrowing to pay that back.

Basically we were borrowing from the future, and unfortunately, there is no more future. We are at the future, and we don't have the income to pay back the debt. The things we bought with the debt are no longer worth as much as the debt, and that's a fundamental problem of financialization. ...

And one of the fundamental aspects of financialization was it sort of propelled a small group of people into positions of enormous power and authority: bankers. You know, when I started life in banking, banking wasn't exactly a glamorous profession. It was basically a simple profession, very much like being an executive at an electrical company or some sort of utility. You provided some sort of essential services.

But then as finance became crucial to driving the economy, banking became a much more esteemed profession and much better-rewarded profession. But bankers also gained enormously in terms of power. ... They became almost the only people with the knowledge and the power to drive the economy.

And to some extent we believed in that, and it was quite an extraordinary shift from what I call real engineering to financial engineering. We originally drove the economy by real businesses, you know -- productivity, innovation, all those types of things which we understood.

We now somehow believe that finance sort of drives everything. And curiously, in the crisis, our answer to this was not to go back for financial engineering to real engineering. It was more financial engineering. So we have different money games of printing money, quantitative easing and so forth.

It's as if our taste for finance has completely changed the way we think about the world. There is no way for us to seemingly go back. And we've got this strange economy. Eisenhower talked in the 1950s about the military-industrial complex. In the last 20 years, we've created the governmental-finance complex in running the economy. And fundamentally, this crisis was an opportunity, in my view, to change that, to revisit that question, ask questions like, how much debt is good? What is the role of finance in our economy? What is the role of banks in our economy? Do we want them to be more like utilities, matching borrowers and savers, providing safe payments mechanisms, providing rudimentary risk management tools?

It was a historical opportunity to revisit that, instead of which we haven't revisited any of that. Basically we continue to go down this path of assuming that financialization is the answer to everything, which in my judgment it's not. But the problem is, the only way we can do that is we have to accept that much of our growth is being driven by this financialization.

All the evidence is that roughly half the growth in the United States over the 10 years to 2007, 2008 was driven by debt. And that's probably true of many countries in the world; certainly in Europe we're seeing the same thing. We have to accept lower growth; we have to accept lower living standards; and nobody, it seems, can confront that reality. And we lack the political leadership to do that.

But I suspect it's very hard. And Fyodor Dostoyevsky in The Possessed has this wonderful line, which I always recall: "It's very difficult to change gods." And in the modern age, our god was finance, except it's turned out to be a very cruel and destructive god.