So I want to get into that in a second, but let's go back and explain the Exxon deal, for instance, how that worked, how it functioned. What was the utility of the credit default swap in that case?
Well, the basic concept or the original driver of credit derivatives was for banks to be able to transfer credit risk off of their balance sheet without transferring the loan itself. Say, for example, Exxon has come to JPMorgan and said, "Can we borrow X billion dollars?" JPMorgan says: "You've been a client for a long time; we certainly want to help you out with this. We want to give you this loan, but it's a big number. You need to borrow a big number. And for our risk management purposes, that's a lot of risk to take on our books and for us to hold for whatever -- five, 10 years, whatever the majority is going to be. So in order for us to give you this loan, I think we're probably going to have to transfer some of the credit risk."
Now, they probably didn't have that conversation with Exxon, but they probably had that conversation internally, which was: "We want to service the client, but this is a big risk for us to take. What can we do with it? How can we manage it?" And so the best way to manage it is to buy protection, or like buying insurance from another party.
Now, JPMorgan had been involved in sort of test runs of writing credit derivatives prior to '98.
You had not -- they weren't --
They had actually traded.
Right. They had traded on a smaller scale.
Yes. They had certainly traded what we call single-name credit derivatives, a few of them. So the transaction on Exxon, or they had traded, you know -- so, for example, a credit derivative on IBM or a credit derivative on Wal-Mart, they would have traded, certainly, single-name credit derivatives before that.
And the trading book that I was asked to build was the exotic trading book. It wasn't about transacting single-name credit derivatives; it was transacting portfolio credit derivatives, in particular tranches of portfolios. So it was a very different risk from just a single-name credit risk.
Before everything became kind of the tranching of mortgage-backed securities, there were just the corporate swaps. Which was the first one?
… The earliest swap involved the World Bank. … People might remember the old "Bank of Drexel," Drexel Burnham Lambert, where Michael Milken, the infamous financier worked. A client of Drexel's, Fred Carr, created this thing called a collateralized bond obligation, or back then, it was called a CBO. It was a new technology.
And what he did and the genius of it was to go out and buy a bunch of bonds that had junk bond ratings, meaning they're graded from AAA down to C or D, and he would buy low-rated bonds. But he would put them together and mix them together in a way that would guarantee that a certain portion of them would get the highest possible rating, would get an AAA-rating.
He did this using corporate bonds. It had nothing to do with mortgages or complicated derivatives. But it was a new, innovative technique that no one had used before.
I'm just trying to figure out how junk becomes AAA?
So if you take $100 worth of junk bonds, bonds that are rated BB, and you put them in a vehicle, like a trust or a company, and you tell investors in that trust or that company that half of you will have a superior claim to the other half. Half of you will recover first whatever there is available from these junk bonds, and then the other half of you will be subordinated. You'll only make money if there's $51 of the $100 worth of junk bonds that is repaid. Otherwise, you're wiped out.
The best analogy I can think of is to imagine a building that has 10 stories, and you're thinking about flood insurance and the risk of flooding. And there are rivers nearby and dams and levees. And historically, there have been floods. So the flood insurance on the lowest floors is going to have a lot of risk. But the flood insurance on the highest floors, maybe floors six through 10 would be viewed as virtually risk-free. So it's a similar idea with junk bonds, that if you put a group of them together and then you say: "OK, I've got $100 worth of junk bonds. You will be the most senior person. You will get paid first. And you only have to give me $50."
So that means as long as there's $50, as long as half of these junk bonds are still performing, you're going to get paid, and you're going to get paid with certainty. So if all you're buying is that top slice of the $50, then we have a rationale for calling that AAA.
So the thinking is we'll look at the likelihood of default in these various bonds, and then we'll say, okay, how high is the flood going to go in the building? What is the risk associated with the flood?
But there are rivers nearby.
There are rivers nearby, and there's always a concern. But it's high. It's floors six through 10. And so, you think that you have protection from the first set of defaults. … The metaphor may break down if you stretch it too much, but it's the same thing with subprime mortgages, right? This is where the math enters. …
The mathematics of a lot of these complicated models rely on that certain degree of relationships among these assets, that they won't be correlated one to one -- in other words, that not every single one of these subprime mortgages or corporate bonds is going to default at the same time.
When we look historically at why people have defaulted on their mortgages, it follows that kind of normal distribution. You can array it along a bell curve, just like people's heights or weights or other natural phenomena. People default on their mortgages because they lose their job or they get a divorce, or because someone dies. Those are things that historically have been normally distributed bell curves that we thought we could rely on.
And if you're building a structure like one of these 10-story buildings, and you're worried about the flood coming in, if you know that you have a bell curve distribution, you can say, OK, the average flood is going to go to the second floor. And there's a tiny, tiny chance that it goes to the fourth floor. But it's never going to go to the sixth or seventh floor. And the reason for that is we know that people who have even subprime mortgages aren't all going to die at the same time. They aren't all going to get divorces at the same time. They aren't all going to lose their jobs at the same time.
The big mistake that everyone made in the subprime crisis was not understanding that the subprime mortgages had all become correlated. What had happened was the nature of the subprime mortgages had changed, so that when people aren't putting any money down, when they have these unusual kinds of mortgages, and when they're subject to a risk of a 30 percent housing decline, that they're all going to default at the same time. That the river's going to flood, that all of the dams are going to break at exactly the same time, and that even the safest floors of the building, even floors nine and 10 at the very top, are going to be flooded. People didn't imagine that there was this degree of correlation in the markets. …
[Was there an aha moment when someone decided to create derivatives based on subprime mortgages?]
I don't think there's an aha moment. I think Wall Street moves typically as a herd, so that it's not necessarily one person inventing something. I remember when I had moved from First Boston to Morgan Stanley, and I created a new kind of derivative instrument based on Mexican peso, and I closed a deal, we finished a deal, during the day.
And by the end of the day, my former colleagues at First Boston had already faxed me a completed copycat version of the same deal that they had already completed with another client that had happened in a matter of hours. So these kinds of things happen very, very quickly, and they tend to happen in herds. …
But people in general on Wall Street started to realize that subprime mortgages could be collected and packaged in ways that looked like they weren't risky, and it became a kind of cycle as well. Once the mortgage originators, the people who make mortgages, realized that Wall Street could do this, they knew that they could then go out to people, and say: We'll offer you these mortgages, because we don't have to keep the risk associated with the mortgages. We can sell it on to Wall Street, which is creating these complicated financial products. And so it kind of built, and built, and built on itself once it had started.
There were rules set up by the European community to try to limit the amount of deficit any country can have, a goal of 3 percent. One way [it's] been reported that that goal was reached was ... American banks came in with a version of these fancy financial instruments that had gotten us into trouble. And [they] actually worked, sold instruments to the Greek government that hid debt.
Two things. First of all, let's remember that the first country that actually breached the 3 percent rule was Germany. So once the large countries -- Germany, France -- breached the rule, smaller countries followed suit.
The kind of instruments that you're talking about to hide debt were used first and foremost by the large countries. Germany used them; France used them; Italy used them, because when they used them, they were deemed OK by the European statistical authority. So Greece used them as well.
But if you look at the numbers, those kind of fancy tricks do not account for a very large proportion of the debt or even of the increase in the debt. It is true that in critical moments, they managed to hide some percentage points of the debt, no question about it. And actually, after the European statistical agency had changed its rules in 2008, all countries bar Greece changed themselves and recorded on the debt the hidden figures.
At that point -- this was the previous, conservative government -- the government decided not to, at which point we had to do it, now to a cost of showing that the previous government was not being truthful with the figures.
So you had a period in the early '90s when most European governments were using those tools. Then the rules changed. Everybody became straight. Greece didn't until after we came to office and created an independent statistical agency which was audited by the European agency, came clean about all the figures. And finally everything has been recorded now in the official figures. ...
Can you give me an example of that in your own experience, a trade that you were witnessing that upset you, that morally made your blood boil? …
I'm not sure it's really about blood boiling. And it's also hard to make it concise. But I'll give one a try.
The National Power Corporation of the Philippines had borrowed money. They had issued bonds, and they had gone to the World Bank, and they had said, will you guarantee the principal repayment of these bonds? And the World Bank said yes.
And Morgan Stanley wanted to try to sell these bonds, National Power Corporation of the Philippines, to investors. But investors said, no, no, no. That's much too risky. The National Power Corporation of the Philippines? I mean, how could we possibly invest in these? We're a pension fund. We couldn't put our money there.
So Morgan Stanley's traders and structurers came up with the idea of adding a little sliver of United States government obligations to the National Power Corporation of the Philippines obligations, sort of like a cake where the cake itself is very risky, but the icing is safe. And they created in this trust structure, a combination of U.S. government bonds and Philippines bonds.
And then, they went back to investors and they said, "Well, what about now? Will you buy it now?" And overwhelmingly, the response was absolutely yes, we'll buy this now. And the reason we'll buy it now is that we can go to the rating agencies and they will tell us that the entire thing is rated AAA, because they'll only look at the icing on the cake. They won't look below at the risk.
And so, we were able to sell those bonds, which couldn't otherwise be sold, to clients who had to have them packaged in a way that looked like they were low risk, who wanted to take on the risk, but wanted to make sure that that risk wasn't transparent.
Help me understand the kind of finances of this. So I'm at a pension fund. … What do I get in return?
The pension fund manager wants to make a fair amount of money, doesn't want to lose everything, but wants to outperform his or her peers by a little bit, wants to do a little bit better, because then they'll be rewarded for that.
And so, what they're looking for is some kind of an investment that appears to be safe, but that will give them a little bit of extra juice, a little bit of extra return.
Also, pension funds are constrained, or at least used to be constrained, in terms of the credit ratings that they could invest in. So they had buckets of risk. And for example, they might be told you need to invest a certain amount of your money in AAA-rated bonds. And so, they would look out into the market, and they would say, well, I need some AAA-rated bonds. I could buy U.S. Treasurys, but that will only pay me 3 percent. I could buy some kind of corporate bond. That will only pay me 3.5 percent. Or I could go out and I could buy some kind of an esoteric thing, and I could persuade someone to wrap it up in a fancy package and rate it AAA, and then I could make more off of that. I might be able to make 4 percent or 5 percent, or maybe even significantly more.
And the incentives of the [people who] work at the pension fund are to try to find something that they believe in. It's not that they don't think that the National Power Corporation of the Philippines is a good bet. They believe in that bet. But they have constraints on them. They're not allowed to invest in something that's not investment grade, that's not labeled as AAA. So they're stretching as much as they can in order to outperform their peers, in order to do just a little bit better.
What is a synthetic CDO, and how did it make this whole mess worse?
A CDO is a collateralized debt obligation. It's essentially a mixture of lots of different assets -- that's the collateral -- that are put into a trust, or a company, and then that company issues securities. So it's basically a way of mixing together some kind of an investment to create a new investment.
And the way that it's typically done with subprime mortgages is that there's an arranger who goes out and buys up a bunch of subprime mortgages, and then will go to a bank, go to a credit rating agency, and say: How much of this can we say is safe? How much of it can we say is pretty safe? What kinds of ratings can we get for this group? That's a collateralized debt obligation. It's basically a mixture of subprime mortgages.
The key to a collateralized debt obligation is creating different layers of risk, sort of like the layers in a building, like the floors in a building where the top floors will be the safest, and then as you move down, the floors will be increasingly risky. …
The difference between a CDO and a synthetic CDO is that what you actually put into the building or the trust or the corporation is not real. What you put into the vehicle is synthetic. What do I mean by synthetic? By synthetic, people mean that you're putting side bets based on whether someone will default into the mix, instead of putting the actual bonds into the mix.
So for example, if I wanted to create a CDO based on my mortgage, I would put the actual mortgage, the physical claim on the mortgage, into the investment. And you would look to my payments themselves. If I wanted to create a synthetic CDO, I would have a bank enter into a side bet with another institution based on whether they thought I would keep making my mortgage payments. … And then we would take that side bet, that synthetic investment, and we would have the CDO be based on that side bet. …
The genius of the synthetic CDO was that if you found a CDO that worked, if you found a bunch of subprime mortgages in Riverside County, Calif., that could be bundled and resold in a way that would be attractive to investors, the fact that someone had done it one time in a cash CDO wouldn't stop you from doing it again, and again, and again. In synthetic CDOs, all you had to do was make a side bet based on what would happen to this group of people and their mortgages, and then take that contract -- which would be a side bet -- and have that be the basis of the CDO.
Explain how that caused the contagion, that sort of web that you were describing earlier that made everybody late.
One of the things that happened with synthetic CDOs was that there were certain pools of subprime mortgages which were regarded as the most attractive to use in CDOs. These were mortgages that were really cheap. They were very risky. But because of the credit ratings agency's models, they were going to get very high ratings.
Wall Street went nuts over those kinds of subprime mortgages. They were hungry for them. They wanted to use them as much as possible to create AAA-rated investments that looked like they were safe, but that still had a high return and a high yield.
And so one of the things that happened was the CDOs that were created increasingly were based on these very risky assets. These were the kinds of subprime mortgages that if there were a 30 percent decline in housing prices, they were all going to default. It wasn't the natural mix of mortgages throughout the country. They were highly focused, isolated in areas like California, Nevada, Florida. They were focused and isolated on people with low credit risk. They were focused and isolated on people who hadn't put any money down to buy their house. And these mortgages -- which were again, it's the synthetic idea -- they were being bet on over, and over, and over again. These were the ones which increasingly were populating the synthetic CDOs.
So what you were doing was creating a bunch of synthetic CDOs, all of which were doomed to fail if there was a 30 percent decline in housing prices. They didn't have the kind of protection that would necessarily be there if you were limited by reality, if you were limited by the fact that you have to put a real mortgage in here, and then it's gone. They used the kind of magic of being able to bet multiple times on these riskiest mortgages to massively increase the amount of risk in the entire system. …
So we get to a point where there's a big party going on before it all goes down. Who's bought into this idea that these synthetic CDOs are going to be the best thing since sliced bread?
I think certainly by 2006, almost everyone on Wall Street had bought into the idea that CDOs, synthetic CDOs, and in particular what were called super senior tranches of synthetic CDOs, meaning the safest parts of synthetic CDOs, were basically risk free.
This was the way the most senior people at the major banks were thinking about them. This is the way they were being disclosed, or not disclosed. Everyone was assuming that these kinds of instruments basically had zero risk.
There was a group at Goldman Sachs who looked at the risk exposure of the bank to these kinds of instruments in December of 2006, and they saw that there was quite a lot of risk there. And they more than other banks understood the risk exposure and reduced their risk. But really, Wall Street was still smoking the CDO dope into 2007 when the crisis began.
There were, on the other side of the market, a group of people who had taken the opposite bet. And those people understood the risk very well, and they made a fortune. They bet that the subprime mortgage related instruments were going to collapse. They were the other side of this two-sided bet.
But one of the great ironies, I think, of the financial crisis was that the senior people at the Wall Street banks apparently didn't understand or capture the magnitude of their own financial institutions' exposure to these risks, which is really stunning, if you think about it, that the people who are in charge of these banks don't know what will happen when there's a 30 percent decline in housing prices.
If you think about it, if you're the director or the CEO of a bank, isn't that the one thing you should understand? What will happen to my institution if the following financial variable changes by 30 percent? That kind of worst-case scenario analysis is why you're being paid millions of dollars. That's precisely what these people should have been doing.
And yet, if you believe them in the most charitable version of the story, they had no idea that their banks would be destroyed if housing prices declined 30 percent. They simply weren't able to figure it out. It was too complicated. That's what they say.
What do you think the real reason is?
I think that it's very plausible that the senior people did not understand these instruments, and didn't understand the risk. If you take Citigroup for example, Citigroup did not disclose the extent of its exposure to these super senior positions until relatively late in 2007. There were a whole series of meetings within Citigroup, a kind of fire drill of sorts within the company. At the highest levels, people were trying to figure out how much money they had lost or might lose, what their exposure was. They couldn't even figure this out.
So I actually find it very plausible that the senior people simply did not grasp the extent of the exposure. … I think people would like to believe that the senior executives were criminals. And I certainly think that there was a fair amount of activity that could be labeled "criminal" on Wall Street during this period of time. But I think in some ways, even the more troubling aspect of all of this is that people at the top of financial institutions genuinely believed that these incredibly complicated, Frankenstein instruments did not carry any risk. …
I do think there were several instances of absolutely reprehensible conduct that should be punished criminally. And I'm very hopeful that some of that will happen ultimately. But I think one of the most puzzling aspects of all this is that finance may have gotten too complicated for anyone to understand. That the managers of these large financial institutions in some ways have been given an impossible task that they won't be able to comprehend what it is their institutions are doing. And that is really, really scary. …
[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. ...
When you were looking at steel companies and putting together deals, there was a transformation going on in finance. How aware of it were you, and what was your take on what you were witnessing?
We were aware of it in the sense not that we were investors, but it was clear this subprime thing was getting a little bit nutsy towards around 2004, 2005.
I gave a talk at one of these securitization conferences in Florida. It's the first time I've never had any questions after, because I advanced my theory that the subprime thing was going to blow up, and here were people who were pretty much buyers or packagers of the paper.
At the end of the speech I asked were there any questions. There was not a single question. They couldn't wait to get me out of the room.
... All the way back in the '80s and '90s there is the advent of a lot of technological, financial engineering. People were able to do things they couldn't do in the past. Was that on your radar? ...
I don't think financial engineering as such is the problem. I think it's become a misused term. What it's really become at the peak of the frenzy was a polite way of describing the packaging of securities that should never have been bought into something that was saleable. So I think it was an abuse of the engineering.
The idea of securitization itself is a perfectly sensible idea, taking a lot of little scraps of paper that don't have much liquidity individually, making them into a larger instrument that could be traded -- to me that makes sense. And there should be, logically, a rate arbitrage.
Where I think it went wrong was in overreliance on black boxes and on little mathematical models, because the problem with models are they inherently assume that tomorrow will look a lot like yesterday. The fact is that at turning points, particularly crisis turning points, what really happens is tomorrow turned out not to look at all like yesterday or like today.
So there's an inherent flaw in models that they are inherently based on what had been. They don't really protect you against the so-called black swan events.
How is it that we came to rely so heavily on models?
Again, I don't think there's anything necessarily wrong with it. I think that what is wrong with it is thinking the model is the only reality and not allowing for real stress testing and real contingencies.
Rating agencies, for example, never went and did original field research in subprime. If they had walked into a Countrywide loan production office, they would've understood that this had much more resemblance to a Wall Street boiler shop than it did to somebody who was trying to figure out whether or not they should make a mortgage loan. ...
Why were there no incentives for the rating agencies to do that? How did we get things wrong to allow things to develop as they did?
I think that the models and the model salesmen were much more sophisticated than the people in the rating agencies. ... The people putting these things together are much higher-powered people than the people trying to analyze them at the rating agency.
And who are these people that are putting these things together and who are much more sophisticated?
It's Wall Street people, quants [quantitative analysts]. …
Banking seems enormously complex. You've been in the steel business, you've been in the coal business, you've done a lot of bankruptcy deals. Do you find banking more difficult as an industry?
It's different in that it is incredibly detailed in its regulation, much more than any other industry we've ever been in.
What I was talking about with the supervision of it was, for example, there were these special-purpose entities that banks would set up to keep these things off their books. The regulators knew they were doing it. They were not done covertly. There was a loophole in the regulation. People did it.
And there was not one regulator who said, "Wait a minute. This is going around the regulation. Let's pass a rule to stop it." Later when the whole thing blew up, they started to scream and yell. That was one example of poor implementation. You didn't need new regulations so much as you did implementation. ...
But it was a great deal for the banks. They freed up more capital and could come back and do more business.
Well, it turned out not to be a great deal because that's where a lot of the losses came from. ...
To me, the two most dreadful words in the English language are "financial engineering." Financial engineering is usually some guy creating a transaction that never should have been done but dressing it up so that it can get done.
Either to get around regulation or to fool some client.
Or some combination of the two.
I think banks should be what they were when I was a kid growing up. Simple things where people came, trusted them with their money. They made loans to people they knew, and that was more or less the end of their activity. Provided trust services. Straightforward, simple, uncomplicated things. ...
... How much money do you have invested in banks?
At this point, it's probably about $2 billion or so. ...
We've had over the last 10 to 15 years a tremendous amount of growth in the financial sector, and we were aware that there were a number of financial tricks used by governments to dress their balance sheets to get into the euro zone. How is it, with all that, that it seemed no one could see the trouble [that] was coming from Europe?
There has been a lot of growth in the financial sector, and that financial growth was very much out of control, very much off-site, because if you remember, the spirit prior to 2008 was very much about soft regulations, flexibility, financial creativity, sophistication of instruments.
I remember myself having had quite a few battles with some of my banking-sector interlocutors when I was minister of finance about precisely that. And that debate lasted quite a long time, actually the battle between those that were in favor of strong supervision and regulations and those who were eventually admitting that it was necessary but that we should, by all means, protect financial inventions and the creativity in the financial sector.
Now, that was clearly, in my view, at the root of the strong development of the financial sector. But that was the private-sector development; it had very little to do with sovereign credibility, with sovereign debt, and with the sovereign balance sheets.
In parallel -- and I think you're probably referring to a country like Greece, for instance -- there was some inaccuracy of data reporting. There was some shortfalls in the statistic agencies in that country. And possibly with the support of financial, highly reputable institutions, the actual portrait and landscape of the financial situation of a country such as Greece was inaccurate. I think there is no question in retrospect about that.
Now, at the time there was an element of "irrational exuberance," to quote Mr. [Alan] Greenspan, who was a very, very highly regarded and reputed central banker of the time. And that irrational exuberance also affected the way in which those data, numbers and statistics were looked at, because they were beautifully presented.
I was talking to a banker with JPMorgan who told me that it wasn't just Greece that was using derivatives to dress its deficit in order to gain admittance to the euro zone, but it was France, it was Germany, it was Italy.
Well, everyone was using derivatives, you know. Let's face it.
Everybody was using derivatives, but people were using them, and Eurostat was sort of looking the other way. Were you aware at the time of the kind of misuse of derivatives to dress balance sheets of governments?
Everybody was using derivatives. All agencies were looking somewhere else; all statutory auditors were looking somewhere else; all supervisors were looking somewhere else; many shareholders were looking somewhere else.
Were you aware of what the situation was when you took the job as finance minister in France?
I took the job as finance minister in July 2007. The first development of the big financial crisis hit the screen on Aug. 15. ... In those six weeks in the job, I had no idea of, number one, what was coming up; number two, the potential crisis of confidence that was going to hit all our radar screens in relation to the private sector, because don't forget that 2008 was really a crisis of the financial private sector, some portions of which had to be eventually nationalized in various corners of the world.
But the sovereign debt issues and the crisis of confidence toward sovereigns came as a second stage of that same crisis.
... 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. ...
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 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. ...
... It was in July of '09 that you called for regulation of financial derivatives. You made that a particular focus of your work as finance minister. Why that? Why were you so concerned about financial derivatives?
I was very concerned about it because it was one of the areas that was totally dark. When I asked my central banker and other central bankers that we met on occasions, they had no idea who were the parties buying and selling those products. The clearing of those instruments was very much what they call OTC, over the counter, which really means under the table, because we didn't know who was there.
And I thought, that cannot go on. You know, by background, I've done a lot of antitrust cases, and I'm a competition [antitrust] lawyer at heart, and I think that anything that is dark and ... obscure, not disclosed, is wrong and is not going to help.
So that's why I made a point of regulating derivatives, enabling the supervisor to actually hold and stop the clearing of particular derivatives, particularly in the financial sector and on sovereigns. And in my previous position, I battled for that.
So you're not at [the offsite weekend meeting in] Boca [Raton, Fla.]; you're in training. But then when do you join up with that team?
Well, I went into the JPMorgan training program in '94, and then at the end of '94 -- because I graduated from MIT in May '94 -- I believe my start date was sometime in October, probably on one of the crash dates, you know. (Laughs.) But I started in October '94, went into the training program through to early '95, and then I joined the interest rates swaps trading desk, and I traded interest rate swaps for three years, and then I was asked to move to the credit derivative business and build their exotic credit derivative trading book.
And that trading book was the first of its kind, certainly, anywhere on -- with any of the banks. We had just gotten approval from the Fed to be able to put [together] that trading book and create that new trading book. So I was asked to be the trader for that book.
And I imagine in any event, it's getting pretty addictive. Maybe you can tell me the way the culture starts evolving from the kind of George Bailey banking to all of a sudden, this sort of huge money machine that's probably making everybody just go like they're on cocaine or something.
It is very much like an addiction. And the derivatives markets during the 1990s were very much like an addicted rat tapping to get more and more cocaine year after year.
As the products get more complicated, the bets become more esoteric. It starts off with just bets on interest rates. Libor, for example, the London Interbank Offered Rate, is a popular measure used in bets. Then someone comes up with the idea of Libor squared. Let's bet on Libor times Libor. And then, someone comes up with the idea of Libor cubed, Libor times Libor times Libor. The amount of craziness and the leverage in the system starts to increase. And the people who make money are like the rat tapping, getting more and more of a high from the bets that they've won. And they double down. They make bigger bets. The losers do as well.
So it becomes a market that is infused with a kind of gambling mentality -- lots of complicated bets, lots of speculation -- and also becomes a market where the kinds of bets themselves are more esoteric.
I mean, I remember there was a derivative that was based on the number of times the Utah Jazz basketball team won games during a season. That's not some fundamental economic variable. It's simply pure speculation. And so, there was this surge of risk taking and increasing complexity of the variables that people were willing to bet on.
And the other thing that happens during this period is that there's a connection between the appetite for more risk-taking and the complexity of the math. So the Ph.D. who's down in the basement at Morgan Stanley invents some new complicated way to bet on whether an interest rate will remain within a band a certain number of days in a year. And then, the sales force goes out and markets that to clients, and clients are excited, because they won the last bet. And so, they'll take on this more complicated bet. And what happens very quickly is that no one understands what they're betting on, how much it costs or what the repercussions might be.
Talk about the clients. Who's drinking the Kool-Aid here? Who's getting excited about all these side bets?
During this period, the clients vary in terms of their sophistication. Everyone gets excited about the side bets. But the motivations for taking on more complicated risk differ pretty dramatically. There are hedge funds who are quite sophisticated, and they have a view, and they want to take on a particular risk. But then, there are less sophisticated clients as well.
And one of the things that happens in particular during the 1990s is that pension funds, insurance companies -- these are not as sophisticated as hedge funds. They want to find ways to take on more risk, but do it wrapped in a safe-looking investment. So some people on Wall Street called it the wolf in sheep's clothing. They wanted to find a way to take on a lot of risk, but still have it wrapped in an AAA-rated, very safe looking investment.
What was the role of the credit default swap in this machine?
The credit default swap became an important instrument because you could feel that you were actually insured against the loss, except for one problem: The insurance company was not really a good insurance company. It was gambling, so it didn't have the resource to back the insurance which it was riding. ...
The credit default swaps also had other functions in that they allowed, and CDOs allowed, the banks to do this outside of the view of regulators, even if one was assuming that the regulators would have been on top of it. ...
Lack of transparency and lack on understanding of what was going on was absolutely essential to the blowing up of our financial system. The regulators took at face value the insurance that was being written by AIG. AIG was effectively allowing the banks to print money willy-nilly. …
Did the regulators know generally where the credit default swaps were in the system, in other words, where the counterparty risk lay?
The way these over-the-counter credit default swap markets work is they are very non-transparent. In general, market participants could not see what was going on.
So if I were buying a share of Bank America or Citibank, there'd be absolutely no way that I could ascertain what was going on. There was no sense of market discipline, which is essential for the working of a market economy, no way that market discipline could be exercised.
We have really undermined the basic principles of capitalism, of a market economy. The regulators had the authority to demand that information, so in principle, they could have looked underneath this non-transparency. They could have said: You bought this insurance, but how do we know it's insurance? You claim it's insurance, but how do we know this company that you claim you have insurance from will be able to pay off?
In other words, is the insurer going to be solvent when there's a calamity?
Exactly, and that's why every state has regulations to make sure that insurance companies can pay off the insurance. It's a very regulated industry, because there's a long history of insurance companies taking advantage of people. ...
"The FRONTLINE Interviews" tell the story of history in the making. Produced in collaboration with Duke University’s Rutherfurd Living History Program. Learn more...