Free Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

could make this idea work, this thing could be huge!” Demchak told his team.
    But could it be made to work? Over at Merrill Lynch, Connie Volstadt’s team had already been playing around with similar ideas for ayear. And at Bankers Trust innovative traders named Peter Freund and John Crystal had actually cut a couple of deals using these concepts as early as 1991. That made Freund and Crystal the true “inventors” or pioneers of credit derivatives. However, perhaps ironically, Bankers Trust itself never tried to turn its brainchild into a large-scale business. The bank was beset with management upheaval at the time. Moreover, the credit derivatives concept did not seem sufficiently profitable, relative to other business lines, to tempt Bankers Trust traders to devote enough time and energy to create a mass-market credit derivatives business.
    Hancock’s group, though, operated with different incentives. At J.P. Morgan, generally pay was also tied to profits personally accounted for. But Hancock had impressed on the IDM bankers that they were supposed to chase ideas with long-term value, even at the expense of the quick buck. Moreover, the team knew that if they “cracked” the credit derivatives puzzle, they would solve a big problem for the bank, which would win them considerable acclaim, thereby boosting their careers. “They say necessity is the mother of invention,” Feldstein later said, smiling. “In the case of credit derivatives, we all knew there was a real need, a problem that had to be solved. So we all looked for ways to do that.”
     
    Blythe Masters fervently hunted for a way to make credit derivatives work, and eventually she spotted an opportunity at Exxon. In 1993, after Exxon was threatened with a $5 billion fine as a result of the Valdez oil tanker spill, the company had taken out a $4.8 billion credit line from J.P. Morgan and Barclays. When Exxon first asked for the credit line—which is a commitment to provide a loan, if needed—J.P. Morgan was reluctant to say no because Exxon was a long-standing client. The loan epitomized the twin problem of capital requirements and internal credit limits. Like so many of J.P. Morgan’s corporate loans, it would produce little, if any profit, yet would gobble up credit, pushing the limits, and would require a large amount of capital reserve. In theory, the bank could have dealt with that headache by selling the loan to a third party, since a market forselling such loans did exist. But that would have violated its commitment to client loyalty.
    Masters thought she could see a solution. In the autumn of 1994, she contacted officials at the European Bank for Reconstruction and Development (EBRD) in London to see if she could find a way to off-load the credit risk of the Exxon deal, but without selling the loan. The EBRD might be interested, she figured, because it had complementary needs; it had a large amount of credit available for extending to companies with high credit ratings. The bank was also eager to find ways to earn more money on its investments, as it was rigorously restrained from high-risk activity, so generally earned low returns.
    Masters proposed that J.P. Morgan pay the EBRD a fee each year in exchange for the EBRD assuming the risk of the Exxon credit line, effectively insuring J.P. Morgan for the risk of the loan. If Exxon defaulted, the EBRD would be on the hook to compensate J.P. Morgan for the loss; but if Exxon did not default, then the EBRD would be making a good profit in fees. The EBRD might well be interested, Masters figured, because the chances that Exxon would default were so slim. True to the derivatives formula, the loan would not actually move from J.P. Morgan’s books to EBRD, so Morgan would be respecting its client relationship without eating up its internal credit lines.
    Andrew Donaldson, the EBRD’s director, liked the idea. He agreed that it was highly unlikely Exxon would default, and he was impressed by the