Nor all that glisters

Fool’s Gold, by Gillian Tett

Millions of words and scores of official reports on the credit crisis have poured out. There has been no shortage of criticism, especially from political leaders eager to deflect responsibility from themselves.

The catastrophe is a man-made disaster, and in years to come historians will ask how it could possibly have been allowed to happen. Gillian Tett’s Fool’s Gold is the book they will turn to. The story she tells reveals in painful detail how credit derivatives came to be invented and then misused on an unimaginable scale. It is a thriller.

The idea emerged from a wild weekend party of J. P. Morgan ‘rocket scientists’ (as they used to be called) in 1994 at Boca Raton, a Florida resort. The objective was to find ways of making the provision of credit more efficient and profitable at a time of declining interest rates.

Derivatives had been around for ages, but that party was when the idea of a bank using a derivative contract to sell the credit risk of its loans (while keeping to itself the customer relationship) was born. It could limit its own risk and thus make room for more lending. The idea developed into the bank bundling up several of its loans and then selling investors slices of the bundle. The ‘tranches’ each had a defined priority, so that the buyer could choose whatever level of risk suited him. The business, based on J. P. Morgan’s commercial lending, rapidly grew.

In every type of business competitors copy good ideas, and banking is no exception. J. P. Morgan’s business of ‘securitising’ loans was copied by other banks; but they applied the idea to mortgages, not just to commercial loans. This is where it all went wrong.