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. Mortgage debts were bundled up and sold in slices. Available mortgage money thus ballooned and a housing bubble followed. The frenzy gave birth to plenty of bad lending; especially because of U. S. legislation outlawing lending discrimination against ethnic minorities.

The bubble was filled with explosive gas. But only a few bankers spotted the dangers. Gillian Tett tells us who the wise ones were, and who went blindly on into the minefield. J. P. Morgan, under the leadership of Jamie Dimon, understood the danger and steered clear; which is why it is one of the few banks in good shape today.

The tale gets worse. The top-quality slice of securitised mortgage debt, known as the super senior tranche, got AAA ratings, and the Basle bank regulators thought the credit quality was so safe that they required banks to hold only a minute slice of capital by way of support. Thus many banks, seeing profitable business without needing much capital, held on to their super senior tranches, selling only the rest. The amounts rapidly became truly staggering. When the bubble burst all were sellers and prices collapsed. Citibank alone had $43 billion of super senior risk on its books. The saddest thing is that central banks and regulators knew all about it, gave speeches warning of the risks, but took no effective action.

However Tett’s tale is not simply an exercise in attributing blame. She is an anthropologist turned journalist with a balanced view of human nature. Most of the managers were clever people, trying to do a good and profitable but nevertheless useful job. Few were completely warped by greed. The trouble was that they were infected by the herd instinct. They lacked the wisdom to stand back and realise what was really happening.

Regulators everywhere did badly and this alerts us, especially now, to the dangers of over reliance on regulation. They should have acted in time to prevent disaster, especially as some banks became too big to manage, as well as being too big to fail. However regulation is never a satisfactory or complete answer.

Gillian Tett has been writing on this subject in the Financial Times for a few years and her analytical and penetrating articles have been read eagerly by those who follow the credit markets. This book is for a much wider public. It is a page-turner; a gripping tale of how the tragedy has unfolded, bringing disgrace for some and misery to many. It is a ‘must’ for anyone who wants to understand precisely how it came about.