Derivatives

… What was the state of play for the bank in 1994? I know that the '80s had been tough on everybody, but by '94, what's happening?

JPMorgan at that point in time was a very different company than it is today. It was a much smaller company. Remember, this is long before the combination even between JPMorgan and Chase, which didn't occur until several years later. So, we were a small company. …

Our legacy, our history was that we were by origin a commercial bank, and we were essentially evolving from being a bank that had its core traditional corporate lending practices to one that was much more oriented towards capital markets execution, the underwriting of securities, and the development of these relatively new products in the form of derivatives, which were all oriented towards risk management and optimization of risk and return profiles.

Had the bank been battered pretty badly in the late '80s?

I wouldn't say battered, but we had one major strategic challenge, which was that we still had a significant amount of our core capital tied up in traditional corporate lending activities. And by virtue of the competitiveness of that business and the low returns that were associated with it -- particularly associated with the low returns that were derived from lending to high quality companies, which was our core customer base -- it was very difficult to generate an attractive return on equity in the core lending activity. …

That was one of the motivating factors that led us to be thinking about the use of derivative technology and securitization technology to better manage our own capital. We wanted to continue to remain relevant to clients; we wanted to continue to have relationships with them and to be able to lend to them to meet their needs.

But we didn't want to be essentially forced to continue to have so much capital deployed in that lending activity that it adversely impacted our overall return on equity as a company and made us uncompetitive relative to our best in class competitors.

… Do you have a boss you have to sell this to? Is it complicated to get it done? Are people kind of excited about the innovation of this?

I think through time this process evolved from being a very bespoke, highly negotiated invention process at the beginning to becoming a very liquid, very transparent, very routine, very standardized market transaction several years later.

So in the case of this example of Exxon and EBRD, we're talking about the very, very earliest transactions, everything had to be made up as we were going along. Five years later, the act of inventing -- what did we mean when we say a "credit event" of Exxon, how do we define that -- five years later, all of that work had been done. …

In terms of how to develop this business within the context of a major global diversified financial institution, I think the important thing to understand is that we were leveraging preexisting capabilities of the bank. Remember that JPMorgan was a big global bank servicing major investors and corporations all around the world already. So for every one of those clients, there was a salesperson or a banker who was servicing those clients needs on a day-to-day basis.

So my job was to articulate this new capability, or opportunity, to those people who were relationship managers. … Actually the way these opportunities evolved more often than not was a buyer process of reverse engineering, meaning that you would have a client who would approach the bank with a problem, and listening to the nature of the problem, you would go away and think about a potential solution and then revert with an idea that could often involve the use of a derivative to tailor a solution to the needs of that particular client. And that's typically how the derivative business evolves.

Because derivatives themselves are in some respects standardized, there are certain elements of them that are repeatable and look the same from transaction to transaction. But in many respects, [they] are tailored to meet the needs of the individual.

So the particular maturity, the particular payment dates, the size of the transaction, various features of it will be changed from deal to deal. That indeed is one of the inherently important strengths of the over-the-counter derivative markets is the fact that you don't have to have a one-size-fits-all solution.

Many of the risks in the financial world differ from moment to moment and problem to problem and company to company. Over-the-counter derivatives are designed to fit those needs on a case-by-case basis, and then the residual or portfolio effect of those risks is managed on a portfolio basis by the big financial intermediaries like a JPMorgan.

Was it exciting?

Yes, very exciting. It was amazing feeling to be able to be involved in invention -- but not just invention, the creating of a marketplace that had real value to add. What in the long run this all meant was that credit, which is a vital part of the lifeblood of any economy, global economy, became a more readily available asset, more readily risk distributed. And the thinking behind that was [it] would be an unambiguously positive thing because credit helps drive growth, helps companies deploy capital, helps employment, etc.

Now the irony is that credit became too loose. …

Let's take Exxon as a case. You were involved directly in that idea. That was one of the first, or the first?

One of the firsts. Exxon was the client at the bank, and we had credit exposure associated with that relationship in conjunction with a letter of credit that had been issued by JPMorgan on behalf of the company. And a letter of credit creates credit risk. If Exxon were to fail on their obligations, then JPMorgan would have to step in and make good on those obligations on their behalf. It was a large amount of exposure, and there was a significant amount of risk associated with that.

The idea was that we wished to purchase protection from others. In this case, the example that was made public was from the EBRD, which is the European Bank for Reconstruction and Development. So we paid them a fee in return for their assuming the credit riskiness of Exxon in this case. That was it, very simple concept.

And why did JPMorgan do that? Because we wanted to free up our capacity to do more business for Exxon. Why did EBRD do that? Because they felt that Exxon was a strong company whose business model they understood. I believe it was AAA rated at the time. They would receive compensation from JPMorgan from taking on or assuming credit risk to Exxon and felt that that was a good risk/reward proposition. They took on a modest amount of risk, we reduced our risk. They didn't create a significant concentration in their case, and so risk was essentially dispersed.

And if you imagine that example multiplied by hundreds of different examples, you can see how concentrated risks on the balance sheet of one bank, in this case JPMorgan, begin to make their way into the hands of investors at prices that those investors are comfortable with and pleased with.

In many cases, this represents credit risk that those investors could not themselves have originated directly. Exxon was not issuing large amounts of corporate debt at the time, so the existence of this letter of credit, which was a bank market product, meant that that credit asset, if you will, was really not available to an institutional investor like the EBRD was at the time.

So tell me how people make money? In that deal, how did JPMorgan make money?

In that particular example, it would have been essentially between the price at which we originated the credit and the price in which we laid it off. Or alternatively, imagine that that was a flat proposition, meaning that they were the same prices. The opportunity that was created was the opportunity to do more business with our customer and to get paid by the fees associated with that incremental business.

Had we not laid off this risk, we would have been full up with that credit risk and unable to do more business. So the future revenue-generating opportunity would have been curtailed.

So capital requirements … would ordinarily lock you into holding a bunch of money on the side?

Correct.

The fact that you can lay that risk off on somebody else means you can free your capital to do other things for Exxon or do other things.

Or another client, indeed. That's exactly right.

So that's how you make your money. How does EBRD make their money?

They're acting as an investor. … Their job was to take credit risk, to make investments. But they were constrained as to the availability as to what they could do. There wasn't another way to take on Exxon credit risk in this form at the time, so that was the opportunity for them.

They had capital to deploy. If they didn't deploy it, they'd earn no return on it. Their job was to deploy it, but they had limited choices. This was a way of expanding their choices.

Importantly, they made the decision as to whether or not they were comfortable at this pricing with Exxon's credit risk, because they're a major, sophisticated, institutional investor in this context. That wasn't an act of persuasion on JPMorgan's part. What we were providing them was a means to an end where the end was defined by them.

Their end was they had an investment objective, and we achieved it for them. We weren't marketing the merits per se of the company in question and had no inside information as to its respective strengths and weaknesses, or at least not in the area that was working on these transactions. Rather we were, on the basis of publicly available information, transacting that risk on an arm's length basis at a transparent price.

Consenting adults?

Correct.

Everybody knows what's going on.

Correct.

[What did your team do in Boca Raton?]

Boca Raton was a gathering of people that were part of the then global derivatives group at JPMorgan. That group was run by Peter Hancock, and in some shape or form, all of us worked for him or with him and/or had been hired by him over the previous three to five years I would say.

One of the core philosophies that Peter used in running his business was that he believed that innovation was really the key to success over the long run, and that innovation naturally occurred when you encouraged interactions between people that were informal but business-oriented.

Peter brought us together in part as a celebration, in part as an opportunity to relax, but perhaps much more importantly, as an opportunity to get creative, innovative people together in a room to discuss a whole variety of different topics.

They ranged from risk management challenges to capital optimization to the issue of credit risk management, all sorts of different topics. Credit derivatives was just one of the many topics that was discussed at those sessions.

… So what actually happened at Boca Raton? What happened in those meeting rooms that was exciting enough that people comment on it as a sort of ground zero moment?

I don't see it as a ground zero moment. But what was notable about those meetings and the era that followed was that it was a very unique group of people who were brought together by a management structure that was visionary, and which explicitly was seeking to promote innovation along a number of dimensions. Again, credit derivatives only being one of quite a number of different angles of investigation. And what occurred subsequently was those efforts, those endeavors, became successful. So if you trace them back, you do see them having roots at that time. …

Financial innovation, by the way, is something that has happened repeatedly over the years. And if you think about credit derivatives, they share many characteristics with other financial innovations that happened many years before that. … Interest rate derivatives, for example, were precursors. The credit derivative market would never have evolved but for the preexistence of the derivative markets because so much of the technology was borrowed.

Subsequently, as credit derivatives expanded into forms of synthetic securitization, … that step in the evolutionary process came because the derivative technology borrowed from the securitization market's technology.

The thing about innovation in financial markets is they're always building on what has come before. It's a natural process. And the way great innovators and great innovating organizations arrange themselves, organize themselves, is so that we try to socialize the knowledge of what has come before in the hope that it will spawn new ideas that come from that application of similar concepts to new contexts. And it's those new contexts and new challenges or new problems that really create the solutions.

I think that was what was important about what was going on at Boca Raton, is here are some problems, let's use the tools that we have in our tool kit to think about how one might solve these problems. And in particular, one of the challenges was look at the credit markets. They're a real challenge. There's huge inefficiency, huge lack of transparency. What is different about credit markets than other markets? And it was simple. There was no risk-transfer mechanism.

How does that idea come forward? Are you excited? Is it a eureka kind of a moment, or is it incremental in its bits and pieces; you already had thought about it and it isn't a moment of invention at all?

People are always disappointed to hear it, but really this wasn't a eureka moment. It was, as you've suggested, very much an iterative process. It was over time, a coalition of people working together whose ideas were coalescing and they built upon each other.

The essence of the idea of a credit derivative in and of itself is intellectually compelling, and one can imagine instantly if you say, "Well, if I could buy credit insurance, then I could use it to free up risk, I could use it to improve returns on capital deployed, I could use it to create investment vehicles for investors." But unless you actually have a market in which all of these things can occur with reasonable liquidity and transparency, the idea in and of itself is not that significant.

What was significant was the work that began in the early '90s and continued throughout that decade to create a market for the ready transfer of credit risk in derivative form. And that took many years to evolve, and it was a function of many different things occurring cumulatively.

It was the initial ideas, of course, but it was then the discussion around those ideas, the introduction of those ideas to clients and customers and other competitors. It was creating documentation so that whenever you thought about doing a transaction, you didn't have to make up the terms of that transaction from scratch and imagine them and write them down. Rather, you could refer continuously to a template that other people were familiar with.

That took many years of negotiation and work and industry forums, working with ISDA, the International Swap Derivative Association, in order to standardize documentation. It meant working with regulators to establish, is this a permissible activity? And if so, how would that activity be accounted for from a regulatory point of view, from a capital requirement point of view?

It meant working with ratings agencies. If a rating agency is able to assign a rating to a company and say, "This is an A-rated company," then how would they create a credit derivative referencing that company? And all of these dialogues, many, many steps along the way, together cumulatively created eventually a market for the free transfer of credit risk.

Initially [it was a] transfer of credit risk referencing individual companies, so Ford Motor Company, or XYZ Corp., each individual transaction referencing one company. Over time, that too evolved so that just as in the equity markets you see index transactions, so you can buy a stock or you can buy an index, the S&P 500, for example, which is a basket of stocks.

In just the same way, in credit markets we saw indices referencing multiple companies at once evolve, so that now transactions could occur where, for example, you defined the investment grade corporate credit universe and transacted on several hundred names in that universe at once.

So the same tools that you saw in other markets began to be deployed in credit markets as part of a natural progression, and that really was the process of innovation. It was all of those small steps incrementally adding up to the creation of an entire marketplace, so it wasn't any longer just an idea in a room in Florida, it was transactions that had a reasonable likelihood of being able to be transacted in a transparent fashion on an arm's length basis between sophisticated counterparties.

I should emphasize, there was never any retail dimension to this whole market. It was always sophisticated counterparties, so banks and financial institutions and major corporations transacting amongst themselves rather than individuals on the street.

And indeed, that is one of the reasons why when subsequently, in later years, credit derivatives became entangled in the recent financial crisis, your man on the street was so shocked and surprised. There was this large market that he had no familiarity with.

Well, the reason for that is because individuals at a retail level, unlike in the equity markets, were never really involved in transacting in these transactions because by their very nature they were designed for large, sophisticated institutional activity rather than retail investment. …

So let me try to boil it down to English that I understand. You had a business that basically had to keep capital on the side in a kind of conservative way because there were requirements about it, it was sort of core business, and it wasn't making as much money as you want it to. So there were new things that you guys knew about and that the market knew about that let you operate a little freer, a little more profitably, whatever phrase you want to use.

Maybe a good place to start is to explain what were the products that came out of that era. And then it'll be a little easier to understand how you use them to improve performance.

A credit derivative at its core is actually a very simple concept. … The simplest way to think of a credit derivative is it is analogous to insurance against the risk of a credit default by your counterparty, your business counterpart. One party, who's essentially buying insurance, pays a fee to the other so that in the eventuality that the referenced credit were to have a credit event, so if it were to go bankrupt, for example, then the seller of insurance would essentially make a payment to the buyer insurance to reflect the potential for loss that could be incurred in the event that that company failed.

There are important legal differences between these contracts and insurance. For example, the buyer does not have to prove loss in order to be paid under this contract. Rather, there is an objective decision made as to whether this event occurred, and if it occurred then the payment is made. It's as simple as that.

Now, why is this useful? In the era before credit derivatives were invented, credit markets were well developed. They were very large. Multiple trillions of dollars were deployed in the form of loans, bonds, contracts, receivables on corporate balance sheets, many different forms of credit risk.

But what was common across that entire asset class was that it was very, very difficult to change or to manage your credit risk profile after the fact. If you lent some money to someone, you were going to live with that decision for the five years until the contract says that they have to repay you the loan.

And that illiquidity essentially meant that credit risk was a very imperfect market. It meant that it was concentrated. So typically, you would find large amounts of credit risk residing on the balance sheets of traditional lenders, banks, most notably. And their ability to subsequently modify their strategy to manage down risk really was very limited. You either had to destroy your relationship with the borrower and sell down the loan, or refuse to lend any more in the future, or you had to live with the consequences.

That meant that pricing of credit risk was not transparent. There were not ready markets where one could see buyers and sellers of credit risk interacting on an arm's-length basis at a transparent price that would give you information about the market's view of the creditworthiness of the underlying obligor. There was none of that information at the time.

And so typically, the pattern would be the credit risk was a hidden risk, and generally you would see behaviors where everything was fine until it wasn't fine. And when it wasn't fine, you had a crisis on your hands, meaning that a credit failure had occurred, but up until that point, there had been no market indication that things might have been deteriorating and there had been nothing that one could have done as a manager of that credit risk to avoid it at all.

So along comes this idea, and the idea is simple: What if we could create a market where people were able to buy and sell freely on an arm's-length basis, independently of the companies themselves, the risk associated with lending to those companies, so that there would evolve a market where you could see transparently pricing for the credit risk, and where those that had that risk could pay those that wanted that risk to assume it on their behalf, and vice versa?

That, in essence, was the core of the idea. Very, very simple idea. It would make it easier and safer for people to lend, and easier and more attractively priced for people to invest, to take on credit risk and be paid for that access without having to necessarily be engaged in the direct lending business themselves.

... You had a number of meetings throughout this period of time. One that's gotten a lot of attention is a weekend in Boca [Raton, Fla.] What was happening there? ...

... We had the idea that it would make sense -- in fact, it had been going on for several years -- to take a couple of days over a weekend once a year, go someplace that's out of the office so the phones aren't ringing, the clients aren't knocking on the door, it's a weekend, so you're not distracted by market activity, and just think. And you sign out tasks before you go for different people to focus on different themes that may be interesting or relevant and then discuss it in groups.

The Boca Raton meeting was one of those, probably notorious more for some of the antics that were happening on the sidelines than for the main event, but it was like all of the conferences that we had from year to year. ...

There's a famous story about you getting your nose broken as you fell into the pool.

You can see this glorious nose that you're looking at right now did not always look like that. I used to have a cute little button nose, and after Boca Raton, it's now big and crooked. ...

So there was a lot of carousing.

I tell you, it was 85 percent real thinking. ... I can't remember how many people there were, maybe 60 people, 80, something like that -- a large number of people, not a small group around a table.

But at 8:30 in the morning, everybody was there, and we had session after session after session in a conference room, while the parrots were chirping outside in Boca Raton. Then sometime around 4:00 in the afternoon or 5:00 in the afternoon, things broke up. People went off in small groups. And some people drank; some people didn't. And I'm happy to say that most people stayed reasonably sober.

But the important part of the event, of course, was that people were thinking all day, and I think generally the relaxation time, whether it was on a tennis court or a sailboat or the bar, was an extension of that. I think people tended to talk about business and how we could develop business and how we could address some of the issues the clients had, etc.

But of course, when you get a group of 60 people together outside of their normal environment, there will be some excess as well.

In their mid- to late 20s or early 30s.

Yeah, in their 30s, and yes, things will happen. So yes, I went into the pool fully clothed, as did my boss in that session. And I think it made everyone feel good.

What was the idea that came out of that weekend in Boca Raton?

Honestly, I don't recall some sort of a cathartic realization that there was a great opportunity. ... The usefulness of something like the Boca Raton conference for JPMorgan was that it gave everybody a chance to sort of vet each other's ideas to a degree.

Some of them really resonated with people, and as a result, it became something that you were actually -- if it was a big enough idea, important enough -- you would take somebody and say: "This is now your job. Go make this happen." ...

... What is the sort of defining problem that you're dealing with there [in Boca]?

I think there was a defining problem and a defining opportunity. The defining problem was that banks were unable to adequately deal with their own credit risks. So for centuries, perhaps, the job of a bank was to lend money and then manage those loans. Then the derivatives markets came along, and at the outset, it was the same thing. Now it's to lend money in loan form, but also to take credit risk in derivative form. ...

What department are you in [at JPMorgan] in 1992?

I was sent over from New York to run the European swaps business, as it was called at the time.

And your primary concern is risk?

Primary concern was risk, but at that point a number of the markets that we were dealing in were still relatively young. So credit derivatives hadn't been invented yet. That was a risk category that just didn't exist in derivative form. It was primarily an interest rate and currency derivative business. ...

So how do you get from there to actually inventing credit derivatives?

I don't know who invented credit derivatives, but it was clear as we developed in our own thinking at JPMorgan through the 1990s that there were risks that we wanted to deal with ourselves that were difficult for us to deal with. So, for example, in our derivate transactions, we ended up taking what is called counterparty risk.

This is the risk in a derivative transaction where the guy on the other side goes bankrupt himself or herself sometime during the life of the transaction, and you're left with a credit risk that itself is a function of what's happened to markets. So they could end up owing us; we could end up owing them.

As the derivative markets became bigger and more valuable, this counterparty risk became bigger, and that was a risk that was very difficult -- in fact, it was impossible for anybody to manage at that point. You just took the risk, and if you were able to get some collateral against a transaction, you might be able to diminish the risk a bit. But for the most part, it was an open-ended, uncertain risk.

So as we sat around meeting rooms and conference rooms, thinking about on the one hand this good business that we were doing, helping our clients manage their risk on an ongoing basis, generating some profits for the bank along the way in exchange for intermediating these trading flows, we were accumulating outright risk. And we needed to find ways to hedge that risk, to eliminate that risk.

... We thought, well, if we could find a way to transfer credit risk the same way we transfer interest rate risk or currency risk or oil price risk, which were things that we had already become very active in, then we can reduce the riskiness to ourselves and therefore do more business with our clients.

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.

So the brakes were off. They could now do whatever they want, and it's off balance. What happens next?

Well, not surprisingly, if it's dark, bad things happen in the dark. And banks started taking on much more risk. They increased the number of off-balance-sheet transactions dramatically. These derivative products became a multi-trillion-dollar market during the 1990s.

And they became much more complicated and much more dangerous, so much so that in early 1994, when Alan Greenspan and the Federal Reserve decided to raise interest rates just a little bit, from 3 percent to 3.25 percent, thinking this couldn't possibly matter that much, there were so many risks on bank balance sheets at the time, that that tiny quarter of a percent increase was catastrophic. It created all kinds of losses throughout the financial system. It ultimately led to the collapse of numerous institutions.

And if we look back to 1994, that was a vicious year in the financial markets. This is when Orange County, Calif. collapsed. You had numerous money market funds and mutual funds nearing collapse. It was devastating because there was all of this risk in the financial system that really no one knew about, even at the very top, at the financial institutions themselves and among our supposedly most sophisticated regulators. They didn't realize that all this risk was buried, because it hadn't been disclosed.

Take me back to the place where you were trading. How did this play out on your trading floor? What was going on?

It was utter pandemonium. People were suddenly losing huge amounts of money on swap transactions, on derivatives. People were suddenly making huge amounts of money. I mean, one of the most amazing things about these derivatives is that they're just two-sided bets. They're called zero-sum bets. So there's a winner and there's a loser.

And so, what we saw in the markets was some people losing their shirts and some people making more money than they had ever dreamed of because they had bet the right way. They had bet on interest rates going up, or they had bet on the Mexican peso collapsing late in 1994.

And so, on the trading floor, you'd have this really weird set of responses, where half of clients would be devastated, maybe near bankruptcy, and then the other half of clients would be incredibly excited, because they had the right bets. …

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.

Were you worried about the potential for harm in those early days?

No. And I think the most important way to understand why that's the case is if you look back through history and look at mishaps in financial markets, many of them have at their root credit origination standards slipping for some reason or another.

So lending in the Latin American debt markets, or crisis in the oil patch, the bursting of the tech bubble. Many of these events have had to do with the deployment of leverage, excess leverage, and the decline of risk-management standards often associated with competitive pressure.

Credit derivatives per se didn't change any of that. It didn't increase or reduce the propensity for people to make unwise underlying credit decisions. Or at least that was the thinking at the time.

It was really more that you created a transparent pricing mechanism for credit risk and fill the void, rather that it really influenced the propensity of people to make unwise lending decisions in the first place. Obviously, subsequently, some of that evolved along a different path and that proved to be wrong.

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 was the effect of credit derivatives on JPMorgan's business?]

I think the most important thing to understand about credit derivatives and their use at JPMorgan is they served a number of different purposes. First and foremost, they were a tool which initially was seen as being useful in managing the bank's own risk management challenges. …

At the same time, to the extent that this idea applied logically to JPMorgan, obviously there were applications to JPMorgan's clients. So we took the same tools and discussed them with clients predominantly in a risk management context as it related to other financial institutions.

A typical dialogue would involve us talking to a bank about managing their credit exposures in their own loan portfolio, where we would offer them the ability to lay off or reduce risk in their credit portfolio, and our role would be as an intermediary. We would then turn to this newly evolving credit derivative market and find takers of that risk who would take the risk from us.

Acting essentially as the middleman?

As the middleman, exactly. Taking risk along the way and intermediating and sometimes managing differences in the risk, managing a portfolio. Nonetheless, the objective was not to build up a gigantic portfolio of credit derivatives risks. It was to buy and sell, to be in the originate and distribute business as opposed to the warehousing business. And that was always an important feature of this business.

There's a big difference between being a credit investor and being a credit intermediary. One requires a completely different set of skills, an orientation, than the other. And I think subsequently, in recent years where problems have evolved in the course of this credit crisis was where that distinction between investing, or taking on or warehousing risks for the longer run, versus intermediating and repackaging and being very careful about residual risks, that became blurred in many people's business model. And I think that subsequently led to many of the problems that eroded.

Do you trust the banks to operate over-the-counter derivatives in a responsible fashion?

I do.

You don't think we need more regulation of derivatives? ...

I think we need tons of regulation of derivatives, but I think an over-the-counter market which is --

That means, to people listening to this conversation, an unregulated, non-transparent --

No, it's not. It never was unregulated.

Well, it's not easily regulated by the regulators. The regulators oversee the banks, but they don't have good visibility.

I think it's relatively straightforward to protect what's best about the over-the-counter derivative market while satisfying all the public policy objectives and the safety and soundness objectives.

For example, banks or any participant in a derivative market can be obliged to record their transaction with, for example, the DTCC [Depository Trust & Clearing Corp.], which is a good old industry consortium, central clearinghouse, regulated and regulatory entity.

So the SEC or the CFTC [U.S. Commodity Futures Trading Commission], when they want to review every trade that's been done in the OTC derivative market, can get it in one place, and they can see where all the risks are concentrated.

There's always a debate around whether big participants in this market are advantaged relative to small participants. So the reason in equity markets that every trade has got to be done on a recognized exchange and made public virtually immediately is because regulators have not wanted to disadvantage the mom-and-pa day trader, saver, IRA holder versus the big institutions that could get some inside information. And that's a very legitimate objective, particularly in equity markets.

When you get into the credit derivative market or the interest rate derivative market, the ma-and-pa [customers] don't trade in those markets. They don't have access to those markets. They shouldn't have access to those markets, and therefore do they need protection in terms of immediate transparency? No. They absolutely don't need that protection.

But we need protection against somebody like AIG taking a lot of one-way bets and then not being able to pay up when the time came that they needed to.

Absolutely.

So we still don't have a regulator looking in on that kind of trading activity to know whether or not there's somebody sitting out there with a lot of one-way bets that gives them a lot of exposure.

First of all, I think the movement to central clearing is different than the movement toward exchange trading. So central clearing makes a lot more sense ... because it concentrates the information. And the AIG one-way bet? If all of their bets are with a clearinghouse, the clearinghouse knows exactly.

But why are we sitting here four years down the road and this could happen again?

... Probably the only thing I could imagine that would be worse than the position that we're in right now, which is that four years later we've made relatively little progress, is if policy-makers had been given the right to do whatever they wanted in the six months after it first became clear what the problem was, because the things that they would have done, we'd be regretting terrifically today.

How is it that we're four years out from this and derivatives are still not being traded in a transparent and open way on exchanges or even clearinghouses?

I think there's been a big migration for the straightforward derivatives into swap execution facilities at least, trading platforms that are easier to monitor for a regulator. And there's been a very large migration toward central clearing. But the most complicated transactions are still not traded in a transparent way and are not centrally cleared. ...

But why aren't we there yet?

I think there's a few reasons. One is it's really complicated technically. Two is there has not been global harmony in terms of the best way to do this. So the Americans passed the Dodd-Frank [Wall Street Reform and Consumer Protection Act], ... which was reasonably specific, but as you know, the rules that are underpinning that law still haven't been clarified. ... They're still writing the rules, and the rules are very complicated, hundreds and hundreds of pages.

The Europeans are going through a separate process that's also quite complicated and on which there's not perfect consensus. And of course where the Europeans and the Americans are coming out is not exactly the same place.

Along the way the folks in Singapore and Hong Kong and Dubai and other places may have a completely different set of ideas, and maybe they're trying to get a little bit of competitive advantage. Maybe they're just not so concerned about some of the issues that America or the Europeans are worried about, but this all drags the process down.

Perhaps the most interesting thing to note was that the number of end users of derivatives, really bona fide risk managers -- so the poor folks at Caterpillar that sell in 180 countries in the world that have some of the most complex currency exposures and interest rate exposures on earth, compounded by complicated tax treaties and other things -- are saying, "Please just let us manage our risk." ...

So the Caterpillars of the world took a little while to weigh in on the debate. But they did, and they said: "Please let us have our over-the-counter derivative market. It's really what we need to operate our business. It's worked very well for us. It's not been abused." And I've got real sympathy for that perspective. So all these things I think are weighing on progress.

Others did not. Why not?

Well, I think a number of reasons. I can't speak for obviously the actions of others, but I can speculate.

I think that first of all, typically the structures that became very problematic for people were structures where the nature of the risk that was being assumed was so-called "catastrophic," meaning that it was risk associated only with extreme losses in portfolios of underlying assets.

And to visualize or to imagine losses of that severity required one to make some very significant assumptions about the path of the economy, which were just not in people's minds. It required things like assuming that house prices in the United States fell by 25 percent.

Now we all know because it's happened that that was a realistic scenario. But on an a priori basis, people weren't thinking that way in 2006 or '07. And so I would say that lulled people into a false sense of security.

Secondly, the apparent compensation for risk on the face of it, if you didn't have in mind those types of scenarios, look very attractive indeed, meaning that you could get "well paid," in inverted commas, for assuming and carrying that risk, and the risk return proposition appeared better than the proposition of paying someone else to take it away.

I think that there was also an element of an assumption that conditions would just continue in the way that they were.

The value of an American house has never gone down, right?

As long as house prices never fell, these risks would never come home to roost. And that ultimately was obviously very flawed logic. …

When some of the subsequent facts came to light and it became clear what the risk management practices of others were and had been, it was very surprising not just to me, but to others who I had worked with both in the past and who were still at the company, it was very surprising to see tens and tens, if not hundreds in some cases, of billion of dollars of this risk being warehoused on the balance sheets of leveraged financial institutions. …

… What happened?

I think one of the defining characteristics of the business that we ran at JPMorgan was that we were, from the very beginning, very focused on insuring that the risks that we assumed were very carefully managed. …

We were always very focused on if we assume a risk, how do we distribute it, and obviously making sure we were distributing in an appropriate fashion to people who understood what they were doing and why. That goes without saying.

Consenting adults?

Yeah, exactly. And we did see many opportunities to take on risks indefinitely that at least in theory one could have argued to oneself, "Gosh, that's a very attractive risk. Why would I need to lay it off? Why not just keep it and earn the return associated with that?"

And we explicitly turned away from those paths because of a number of reasons, but primarily because we knew there were scenarios -- they were hard to imagine -- but we knew that the were scenarios where that risk accumulation could be extremely dangerous. And we were not in the business of assuming risks that subsequently could put our franchise, our company, our shareholders at risk. We were in an intermediation business. We were about making markets more efficient. We were not about investing in credit risk over the long run.

So what subsequently happened? I described the evolution of this single-name credit derivative product, buying and selling risk on individual companies. That evolved to buying and selling risk on portfolios of credit risk.

So you take a loan portfolio -- initially portfolios of corporate credit risk, so large, investment-grade corporations to whom a bank had lent -- and transactions occurred where those risks were transferred in the form of synthetic securitization or credit derivatives, which took on an entire tranche or slice of the risk of that portfolio and paid an investor to assume that risk.

Corporate credit portfolios have a characteristic of being relatively diverse, meaning that the event that can deteriorate the credit equality of one corporation often don't correlate with the events that can lead to a credit deterioration of another corporation. They're in different industries, different areas of the country. They might be operating overseas of not. They're fundamentally in different businesses. And so when you look at those portfolios of risk, it's reasonable to assume a high degree of diversification.

The next application of this same technology was to portfolios of consumer credit risk, and in particular mortgage-related credit risk. A big difference between mortgages and corporate loans is this diversification difference.

And it turns out that even if a portfolio of underlying mortgages is diverse from a geographic perspective, for example, it still has systematic risk in it which makes it vulnerable to certain events and makes all of those loans in that portfolio vulnerable to the same events, specifically a deterioration in house prices caused by a recession, an increase in interest rates caused by macroeconomic developments, a rise in unemployment caused by a recession, for example.

If those things occur on a severe enough basis, then an entire portfolio previously deemed diversified in fact will turn down all at once. And it was essentially the application of the credit derivative technology to this situation that led to problems.

And the bank, JPMorgan, walked away from all of this?

We did.

When did that happen? Take me there. You guys all looked at it and just said, "Whoa, I don't like where this is headed?"

Somewhere around 2002 to 2004, 2006 it really accelerated. And during that time, we were active in the mortgage markets ourselves; we were active in the derivative markets. We saw the opportunities here, but we could not get comfortable with the idea that the diversification in these portfolios was sufficient to justify the treatment of the risks.

So we steered away from assuming or warehousing those risks, or doing lots of business with other companies that themselves were predominantly in the business of assuming or warehousing those risks. And that meant that we missed a revenue opportunity, but that was okay because we couldn't get comfortable with it. And indeed, that's why we shied away from it.

Do you think that was widespread, and that was the abuse of derivatives, right?

There were abuses. In every market there are abuses. There were abuses in the derivative markets because of the opaqueness of derivatives. It was probably easier to abuse in some cases.

What does that say about the profession?

It obviously doesn't cover the profession in glory. And I think when you go through a period like we all did in the 1990s and the 2000s, where really large amounts of money were available to individuals on the condition that they performed well and performed honestly --

We're talking compensation.

We're talking bonuses. The incentive to cheat is very high. It's very high. And as a manager of those organizations, policing of prospective cheating becomes very difficult when there's huge amounts of money at stake. And there were cheaters.

I don't think the industry was full of cheaters. I don't think every firm was riddled with cheaters. In fact, I don't think most of the business that was done was cheating. I don't think most of the mistakes that were made can be chalked up to somebody cheating someplace. I think most of the mistakes that were made can be chalked up to incompetence. ...

But don't the banks have a fiduciary responsibility in this case to advise the governments about what they're getting into?

I think they do. And one of the criteria for any deals that we did with Greece -- would have been before the Goldman Sachs incident or after -- was that anything that they do be outlined specifically and in detail to Eurostat. Eurostat is the EU [European Union] organization that was tasked with determining whether a transaction complied with the European rules. So that would have been one of our requirements.

Another requirement would have been that the minister of finance personally signed off on the transaction and that somebody in a position of responsibility at JPMorgan spoke to the minister of finance and was sure that he understood what he was signing off on.

These are quite burdensome obligations, which meant that lots of times JPMorgan didn't do the business, as it were.

Those were burdensome obligations to make sure that your client understood what they were getting into. Do you think all banks went through that?

No, of course not.

Of course not? But that's a remarkable thing to say.

Well, perhaps. For me it's remarkable, and of course that's why we set the rules that we did. I think somebody else might have said it doesn't have to be the minister of finance. If you'd got somebody that runs the Treasury, that's fine. Doesn't have to be the elected official. It can be --

Or as long as they sign the paper, we're OK with it?

I think some banks might have set that criteria as well. ...

... You're saying that investment banks would sell derivative products to governments, whether it be a municipality or a federal government, that they knew the governments didn't understand?

Yeah.

You knew of deals like that?

I know of deals like that.

Did you ever raise that? Did you ever go to a regulator? ...

Yeah, I did, and so I'll give you a couple of examples. In terms of government entities dealing in derivatives, some of the worst abusers of the product, both on the government side but also in terms of banks dealing with governments, were the municipalities in Italy.

The local authorities in Italy in the '90s dealt very actively in derivative markets. They had no business dealing with derivative markets. They didn't understand the product, and they didn't have the underlying risk. They weren't risk management transactions. They were speculative transactions designed to generate income to fill up the government coffers.

Like interest rate swaps?

Interest rate swaps or currency swaps or commodity swaps or credit derivatives. ...

So the Italian Treasury was concerned enough about [it] that they came to us and other banks that I think they considered to be responsible and said, first of all: "We would be quite disappointed if you were participating in these markets. Confirm to us that you're not." And of course we said we're not.

Were you?

No. No. The transactions that we did with Italian municipalities were entirely bona fide as far as I'm concerned.

You bought Bear Stearns--

Uh-huh. (AFFIRM)

--in 2008. And they had done some famous deals in the town of Cassino, outside of Rome?

Uh-huh. (AFFIRM)

Are you familiar with those?

Yeah.

Was that a clean deal?

I don't know. At the time that the deals were entered into, hard to tell. Would JPMorgan have done those deals? No. No. Too complicated, too small a counterparty.

So in this case you're holding banks responsible for leading less sophisticated municipal officials down the wrong path?

I would hold banks responsible for that.

... 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. ...

... So you're there in Boca Raton figuring out, discussing, "How can we better manage these risks?"

That's right. How can we better manage these risks, and how can other people that have the same risks better manage those risks? ...

Was there a reason for this happening at this point in time? ...

I think there were two realizations in the background that were prompting our thinking. One was that the derivative markets were growing very quickly.

And so ... you had just much more of this risk floating around, correct?

Correct. You had more of the risk, but that risk was less certain. So if you lent somebody $100, you know that you were never going to be owed more than $100 plus interest. That was as much as you could be owed.

If you entered into an interest rate derivative contract with somebody, on the first day he didn't owe you anything at all, and you didn't owe him. But a year from now, he might owe you $5; he might owe you $10; he might owe you $100 if it was a really dramatic move in whatever you were hedging. So you had more risk, and you also had more uncertainty.

So in this way, derivatives spawned the need for more derivatives in the form of credit default swaps [CDS]?

That's right, and I think you'll find as the derivate markets developed over the subsequent 20 years -- and for that matter as the securitization markets developed, the close cousin to derivatives -- a lot of the product that was developed in the second, the third and the fourth generation was only necessary because of the product that had been created in the earlier generations. ... That was one of the motivations.

There was a second motivation as well, which was that banks were getting smarter. And that may sound shocking when we look back at what happened in the subsequent 15 years, but certainly at JPMorgan we did some really quite rigorous analysis to answer the question: "When we lend money to our clients, are we earning a decent return? Are we earning an acceptable return on our capital?"

And the answer was, in a nutshell, no, that the loan business, lending money to large corporations, not the small businesses, was a loss leader business. It's a business that banks were doing at a below-market or a below-cost spread in order to curry favor with the corporation, in order to do other business.

And by doing that you were tying up capital?

... Not only tying it up, but tying it up at a poor return. So banks were looking at ways to deal with this increasing risk from derivatives, this uncertain risk from derivatives, but also ways to just get rid of the risk so that that capital could be recycled into other things. ...

... At the end of that [Boca] weekend, had you made assignments? ...

I think there were a number of areas that we had committed as a group to advance. One was to more actively manage our own portfolio of risk, which was not common in banking circles those days. I mean, the risk management approach of banks in those days was you said yes or no. And if you said yes to the right ones and no to the right ones, you did well at the end of the day. But having said yes or no, you didn't get a chance to change your mind down the road.

I think we realized both as a group but also as a bank that we needed to have the ability to manage the portfolio of credit much more accurately.

... A credit derivative is essentially an insurance policy?

It is an insurance policy.

... So why do you call it a credit default swap?

Because the payout on the insurance policy isn't fixed. If you buy house insurance -- you've got a $200,000 apartment and you buy fire protection and the building burns down, you're going to get $200,000, not $190,000, not $210,000.

If you enter into a credit default swap, the first thing that has to happen is the equivalent of the fire. So the borrower needs to go bust or needs to default. That in and of itself already requires a little bit of contractual fine-tuning. What is actually a default? But we'll leave that aside for the moment.

The payoff, though, is a function of the ultimate payoff from that defaulted borrower to his creditors, the real creditors, and the people that actually lent the money. And typically that's measured shortly after the event of default. ...

JPMorgan loans money to, or at least insures -- writes a letter of credit, a line of credit, if you will -- to a big corporation. They then insure that by writing a credit default swap and getting somebody to buy it. Why would somebody else buy that? What's in it for them?The same reason anybody would write an insurance contract: because they think that the value of the premium is statistically, or actuarially, or from a market perspective, worth more than the likelihood of default.

And why would Exxon or some big corporation want their bank to sell off the risk of default to somebody else?

They didn't always want that, ... because when they held a bank meeting, ... if they did get into trouble, they want to be able to call their bankers together into a room and say, "Ladies and gentlemen, we're going to work through this together." And if the banks have sold the loan to somebody else, then they don't know who's going to show up in the room.

So they were very keen not to have the banks either sell or assign or novate their loans. In the early days of credit derivatives, they may not have been aware that the bank had bought insurance against their loan exposure, or if they were aware, they may not have been terribly concerned. ...

But in some cases they were concerned, and they were concerned for a very simple reason: That the bank was effectively influencing the market value of their debt without them being in control of it. So in some cases they were concerned, and legitimately. ...

Sen. [Carl] Levin [D-Mich.] had an investigation of Goldman Sachs. He revealed in one case that a $38 million subprime mortgage bond created in 2006 ended up in more than 30 separate debt pools and caused roughly $280 million of damage. That sounds like a lot of bets against one reference bond. That strikes me as a huge magnification of risk.

I think that the nature of the derivative markets is it allowed participants, either buying or selling, so on either side of the market, to take their positions without being constrained by the size of the underlying market. ...

... In other words, you could take a bet against a mortgage bond, and you can take the bet, and I can take the bet and --

That's right.

So doesn't that then misalign the market in such a way that you magnify risk on one side of the ledger?

I don't think so.

Why not?

Because for every buyer there's a seller. So in terms of the market as a whole, it nets out. ... I think for the most part, the idea that there were derivatives that were 10 or 20 or 100 times the size of the underlying bond in and of itself doesn't create a big problem in my mind. ...

If it's a risky bond, it creates a big problem for those people who would bet on it. When the mortgage market goes down, you've got many more bets against those bad mortgages.

But almost by definition there's going to be as many bets for it as there are bets against it, because there's another side to every trade. And every German Landesbank that took exposure to falling U.S. house prices were offset by somebody that was benefiting from --

Who were those people on the other side?

... It was relatively savvy hedge funds. It was banks like JPMorgan that tended to have inventory sitting on their books that they hedged, where they were managing their own risk.

In actual fact did this transfer money from the unsuspecting, the naive, suckers, fools, to people that were a lot smarter about the way markets worked?

In some cases, yes, although just pick, you know, two spectacular hedge fund collapses during that period. One was Peloton [Partners], which was a group of very smart Goldman Sachs-trained, mortgage-backed security experts that blew up spectacularly. And the second, perhaps a bit closer to my heart, were the blow up of the two large Bear Stearns hedge funds. ...

So there were some hedge funds that lost.

But really sophisticated. If you think about Bear Stearns, it was one of the leaders in the U.S. mortgage market. It was one of the leaders in the bundling of subprime mortgages. Yet their own hedge funds were the first to blow up, and not a little bit. They blew up spectacularly.

... So my only point is there were some really smart people on both sides of the trade, and there were some really not smart people on both sides of the trade.

When you were selling to the Landesbanks, or when you were cutting deals with various derivatives to governments or municipalities in Europe, did the buyers of those products understand them?

Look, as a rule -- and we were quite bureaucratic about this -- if we couldn't convince ourselves that the buyers understood what they were buying, we didn't sell to them, period, full stop, right? It doesn't mean we got it right 100 percent of the time, but I think we did.

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.

How much [are] derivatives responsible for magnification of the crisis in Europe?

I think it's not only derivatives. Derivatives play a part. The entire sort of transparency, financial instruments, the lack of traction by the supervisors -- as I said, a lot of people were asleep at the wheel. All of that contributed to the European developments.

But all of it originated, in the first place, from the U.S. financial markets being in total disarray as well.

Right. But it's said often that the financial crisis at its root was about subprime mortgages.

Yeah.

In Europe it's about overspending, fiscal irresponsibility.

It's about excess really.

It's about excess credit, but without the magnification and the increased leverage from the use of financial innovations, the crisis would not have been as great as it was.

That's correct.

... 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.

... Had it not been for credit derivatives, how serious would the financial meltdown have been?

It's very hard to say. It's a tough question to answer, because the backdrop for the whole financial crisis was a complicated set of circumstances. One is investors had become very complacent about everything.

I've talked to other of your colleagues who have agreed that that was in part driven by the idea that you could always just sort of write another insurance policy; you could insure yourself. But finally we found out that people that were holding those insurance companies had no capital, couldn't pay up.

You're right. There was real complacency all around. There was a real search for incremental yield or incremental return, and combined with complacency was a very dangerous thing.

How much of that complacency ... was driven by the fact that everybody had laid off the risk through the use of credit default swaps?

I don't think that was a central feature. I think the complacency came about because nobody could imagine house prices dropping by 50 percent or 60 percent. Nobody could imagine interest rates being increased by 3 percent in a short period of time.

But had those things happened and everybody not having been sort of tied together with all these insurance contracts, would the damage have been the same?

I think if for whatever reason derivatives had never existed -- either nobody thought of them, or some regulator at some point in the '80s said, "There will be no derivatives," a little bit like what the Chinese say today -- what would the AIGs of the world had done instead?

What they would have done instead, most likely, is lent a huge amount of money to borrowers in the form of subprime mortgages. And in fact, what they probably would have done was lent the money to owners of this mortgage pool and that 30 percent or 50 percent loan-to-value mortgage.

... When you offered this first bistro deal, you then sliced it into different, what you call "tranches." ... Why slice it?

Because different investors wanted different levels of risk. There were some investors that wanted to earn a big return on really risky stuff, and there were some investors that wanted to earn a little return on stuff that wasn't risky at all. ...

... And that party that takes the higher-risk position is really designating where they stand in line when it comes to payday?

It's all perfectly clear in the contract. So the way that we structured the bistro transactions was the very first losses were for our own account. That way nobody could ever accuse us of flogging something that we weren't standing behind. ...

Why do these if you're not covered?

Because we were shifting ... the bulk of the risk. We retained some of it, which was this first-loss tranche. The next tranche typically went to insurance companies, pension funds, perhaps other banks. The bulk of the risk of the transaction went to other people, but only behind our own loss.

Then what subsequently became known as the super-senior risk, the stuff that was statistically highly unlikely to ever incur a loss at the beginning, we retained ourselves. As we developed this market more and more, we started to shed that risk as well, because there were people that were prepared to buy it.

You talk about also ripping faces off. What was that about, and how did it become a widespread sort of culture?

This was a phrase, "ripping someone's face off," that was used on the trading floor to describe when you sold something to a client who didn't understand it and you were able to extract a massive fee because they didn't understand it. The idea was that this was a good thing, because what you were doing was making more money for the bank.

I think over time, particularly during the 1990s, bankers lost this professional ideal of wanting to service the client. They talk about their long-term reputation, but ultimately, people weren't compensated based on the long-term reputation of the financial institution. They were compensated based on whether they could jam a product down their clients' throats and make a lot of money off of it. …

So maybe as a trader, you're probably looking for the dumbest person in the line?

There's a great set of adages on Wall Street about where risk will flow. If you ask people, they're basically split between two camps: One says that risk will flow to the smartest person, the person who best understands it, and the other says that risk will flow to the dumbest person, the person who least understands it.

And at least based on my experience and my understanding of what has been happening in the derivatives market, it's the latter. It's that risk is frequently flowing to the investor, the institution that has the least capacity to understand the risk.

[Critics say that] so many of these deals seem to happen, from their point of view, in secret. They keep saying black box, black box, it was impossible to know who were the counterparties. …

I think that point is correct. The fact is that the regulatory framework in the United States … was designed for an era that ended decades ago and is one that is very much defined by either products or corporate entity charters.

So even though your activity may look the same irrespective of whether you're an insurance company, a banker, a broker/dealer, hedge fund, a private equity company, your regulatory framework, your restrictions, your legal powers are utterly different depending on what your corporate charter looked like. And that's wrong, because the essence of intelligent and effective regulation needs to be that similar activities should be subject to similar regulation, indeed, the same regulation for lots of good reasons, one being the efficacy of the regulation, the other being the leveling of the competitive playing field, incidentally, which is another topic. …

I think that the thinking that got people comfortable erroneously, with hindsight, with that outdated framework was that somewhere there was an overriding commercial incentive that would govern the behavior of all of these outfits and cause them to defend their own positions, their own shareholders, their own capital, and that that was an adequate incentive for insuring that people did not engage in self-destructive behavior. That, at the end of the day, only matters if the self-destruction brings down others.

Unfortunately, what became clear is that either because people didn't understand the risks that they were engaged in, or because they were under such competitive pressures that they were unable to react wisely to them, self-destructive behavior actually occurred. And that self-destructive behavior, which under normal circumstances one should let it flow and the destruction should occur, became systemically consequential because of the linkages between all of these companies.

They all became "too big to fail."

Not necessarily "too big to fail," but too interconnected. …

What was the set of deregulations that particularly led to the problems that we have now?

... First, in the aftermath of the Great Depressions and the lessons we had to learn, there was a division between investment banks that took money from rich people able to bear risk and invest in high-return, risky activities, and commercial banks that took money from ordinary individuals, supposed to invest it conservatively, lend it to help create new businesses, expand ordinary businesses.

Two very different kinds of financial institutions -- and there were a whole variety of reasons for that separation, but the most important was we'd learned that when you bring these two things together, you have conflicts of interest, very bad behavior. ...

The second aspect was not so much deregulation but not adjusting the regulatory structure to the changing needs of a increasingly more complex financial system. So the other big mistake was that in the '90s these complicated financial products called derivatives -- things that Warren Buffett referred to as "financial weapons of mass destruction" -- had started originating. ...

The repeal of this division between investment banks and commercial banks led to [several] problems. First, the cultures of the two were very different. The investment banks were undertaking risky activities for rich people. The others wanted to be conservative. When you brought the two together, the mentality that prevailed was the risk-taking mentality.

So what we had was banks like Citibank, that used to be a commercial bank, buying all these risky CDOs [collateralized debt obligations] and other risky products which blew up, requiring again a massive bailout. ...

The second [problem] is you have conflicts of interest. When banks are both issuing new securities and lending, you have all kinds of risk to our financial system. You can lend to a company to make sure that it looks good, and you want it to look good because you just issued the shares. ...

The final problem was called "too big to fail," that when you allow these banks to get together you got bigger and bigger banks. ... If you let them fail, it has an enormous effect on our financial and therefore our economic system. ...

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. ...

When all of it starts to cascade, what were you thinking when you were watching it go? Did you have a sense of how vulnerable everything was over Labor Day weekend in 2008? Were you personally concerned?

Extremely, yes. It was a very, very scary time. I think up until that Labor Day weekend, we were in just another financial crisis. Those aren't pleasant occurrences, but they repeat, and they have patterns that one can recognize, and over the course of a 20-year career, you learn to recognize them. Up until that point, I think we were in one of those situations.

At that point, we were in totally new territory. The notion that a Lehman Brothers could be filing for bankruptcy and AIG could be at risk of the same fate -- and it was very uncertain what would happen to the rest of the broker/dealer community that week -- was absolutely unprecedented. And thinking through the implications of that for the health of not just the U.S. economy but the world, it wasn't really conceivable to do that. I couldn't get my mind around it. I know others couldn't.

The extraordinary actions that were subsequently taken by governments to intervene were absolutely necessary, because the consequences of an interconnected failure by all of those institutions simultaneously would have been unimaginably terrible in terms of impact not on the shareholders of those corporations who suffered terribly anyway, but on the man on the street.

We know that credit conditions are tight today; they would be nonexistent had those events unfolded. Absolutely nonexistent. The Great Depression would have looked like a small event by comparison to what I think would have happened had that process continued unrestricted.

And one of the great tragedies of understanding, or misunderstanding, it through all of this is the notion that somehow banks and/or Wall Street were bailed out at the expense of the taxpayer. What has been lost in translation is that it is for the sake of the man on the street that the financial system needed to be stabilized, and it was unambiguously in the interests of the taxpayer that that system be stabilized.

And let us not forget that the shareholders and many, many employees of these financial institutions that did make major mistakes have paid dearly in terms of their own personal net worth and the value of their companies. The bailing out aspect was keeping them afloat through the presence of government backstops and capital so that credit markets could go through a process of un-seizing themselves without abject panic. And that was what we were looking at then.

This wasn't about credit derivatives, this was a much more complex situation. It had at its core credit conditions that were easy and had been that way for many years; it had the low savings rate in the United States, the high savings rates in the emerging economies, particularly China and India, the growth in the emerging markets.

All of these things had conspired to create an environment that essentially became a bubble. The consuming habits of United States citizens driven, in part, by the housing bubble led to a lot of this buoyancy and lack of fear of risk in financial markets. And there was a significant deployment of leverage, leverage in the form of balance sheets that were running with very little capital against large volumes of assets which all looked fine, except when the music stopped in a correlated fashion, they deteriorated.

That, at its essence, was the root cause of this financial crisis. The derivatives, in a sense, are a manifestation of people's risk appetite. How they used derivatives reflected their lack of fear of the consequences of market behavior, lending in particular in mortgage markets. …

What was the role of the New York [Federal Reserve Bank] to begin with, and how did Tim Geithner, as head of the New York Fed, view this? Were they surprised when they saw the hole that existed at Bear?

The New York Fed had only a limited supervisory role over Bear, so I think they were surprised at the depth and the suddenness, even more so the suddenness of the problems.

But I also think that Tim Geithner understood that it was a vulnerable situation. He had only limited ability to take certain actions. And my guess ... is that he was urging even more significant actions than others in Washington wanted.

... Explain that.

I think he was looking for a program or programs whereby the Fed could inject more liquidity into the financial services industry, away from just the banks. He had all sorts of power to inject liquidity with respect to the banks, but less power with respect to the non-bank financial institutions.

It's said that he was fearful or knowledgeable of the problems with derivatives, that he was very involved in trying to clean up the paperwork aspects of it. How much were they concerned about the realities of what the market had become?

... Way ahead, Reserve Bank President Geithner was worried about derivatives. But it was ... focused on the paperwork problem, the clearance problems. It was less focused on the incredible amount of gambling which had been introduced into the market, and the incredible amount of risk which had been introduced.

That is one of the saddest stories of the events leading up to the 2008 crisis, that no regulator, nowhere, had the information necessary to be as responsive as they ideally would have been. Derivatives were the heart of the problem. No one knew who had written them, how much had been written, and who were the recipients.

Why?

There wasn't the mechanism in place at that time. I believe that another clear source of the problem was that some of the biggest writers of derivatives were simply not regulated by the Federal Reserve in any way. These included primarily the so-called insurance monolines -- that's a misnomer, but that's what they were called -- the most egregious example of which being AIGFP [AIG Financial Products], but also was MBIA, Ambac and several others. ...

... Let's talk about Dodd-Frank [Wall Street Reform and Consumer Protection Act]. ... Geithner and Summers are the ones that wrote the original legislation, as opposed to delegating it to Congress, like they did with the stimulus and healthcare. Why is that? And is this bill that was put forward aggressive enough? ...

It's very clear that the Dodd-Frank bill, which was stronger in some ways than the administration's original proposal, does not go far enough, and I think there's almost unanimity among the economics profession on this.

Two issues: One is the "too big to fail" banks. They're still too big to fail. They're even bigger, because part of the process of dealing with the crisis was to consolidate the banks. ...

The second issue is the non-transparent derivatives. [Sen.] Blanche Lincoln's [D-Ark.] committee regulates derivatives, reported out a bill that said that no FDIC-insured institution should be engaged in writing these derivatives. Makes absolute sense. Why should taxpayers be involved in this gambling instrument?

We're not clear whether derivatives ought to be viewed as insurance or gambling. If it's insurance, it should be regulated by state regulators; if it's gambling, it should be regulated by gambling authorities. But neither are banking.

Geithner and Bernanke opposed. Very interesting. Two of the regional presidents of the Fed said this was absolutely essential, wrote a very strong letter.

Bernanke and Geithner won, or to put it more accurately, the American people lost and the New York banks, the derivative-writing banks won, and we are now in a situation where we don't know our exposure to a lot of the risks. ...

They say there's now an ability to, in an organized fashion, dissemble a "too big to fail" bank, that's in the bill. ...

There was what was called resolution authority and living wills, plans for an orderly dissolution.

Two problems with that: One is that the living will describes what you would do in normal times, but in crises, your plan to sell off this asset or that asset or dissolve may not work because there's no buyer on the other side. The markets can actually just disappear. So what does it mean to have a living will when the markets can go into paralysis exactly when you need them?

Even more important was we didn't use the full legal authority before the crisis. The Fed had authority to regulate mortgages, didn't use that authority. The banks scared the American people. They put a gun at their head and said if you don't give us money, we're going to collapse and you'll be sorry, and America blinked. The banks, I think, would do it again.

So even though there's authority to resolve and almost a commitment to resolve, none of us are really sure that it will actually happen if the banks are really too big to fail. ...

Would Congress and would America allow them to bail out the banks again? Is there the political will in this country to allow them to do that again?

... I think there probably isn't. ...