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 Page A

steady stream of income from the fees. It was much higher than anything else he could earn on a highly rated bond or loan. “It seemed like a win-win situation,” Donaldson later recalled. Just as Salomon Brothers’ early interest-rate swaps deal between IBM and the World Bank had met two sets of needs, the Exxon deal was brilliantly transferring risk in a way that suited both parties.
    For several weeks, Masters made endless phone calls to London from New York as she and Donaldson—together with a phalanx of lawyers—worked out legal terms for the deal. In most sectors of finance, well-established rules governed deals. But the credit derivatives concept was so new that they had to be crafted on the fly; Masters was making history as she went. Nobody quite knew what the fees paid to the EBRD shouldbe or even quite what to call this “product.” Eventually though, the deal was done, and it was dubbed a “credit default swap,” which, as the business spread, was shortened to CDS.
    Hancock and the team were jubilant. The Exxon deal showed that a substantial credit derivatives contract could be made to work. And it was not the only one. As Masters was cutting her deal with the EBRD, Robert Reoch, a British banker who worked on Winters’s team in London, cut a deal with Citibank asset management that transferred the risk attached to Belgian, Italian, and Swedish government bonds. However, it was one thing for a bank to arrange a few isolated deals; it was quite another to turn those deals into a full-blown business as lucrative as Hancock was aiming for. So, as 1995 got under way, the group went into overdrive to attack the key obstacles to making the concept fly on a large scale.
    One of those was convincing their internal commercial lending team, as well as regulators, that the concept was sound. This would open up a wide pool of loans on the bank’s books to use for making swaps. They also had to figure out a way to “industrialize” CDS deals, so that they could do many more of them much faster. One other key thing the team wanted to investigate was if, by removing the risk of its loans in this way, the bank would be allowed to lower its capital reserves. That was one of the most important potential payoffs, as a good deal of reserve cash would then be freed up for use in making profits. That was the dream: credit derivatives would allow J.P. Morgan—and in due course all other banks, too—to exquisitely fine-tune risk burdens, releasing banks from age-old constraints and freeing up vast amounts of capital, turbo-charging not only banking but the economy as a whole.
    Behind the scenes, Masters and Demchak started visiting US regulators. Two main institutions held responsibility for monitoring this activity: the US Federal Reserve, in New York and in Washington, and the Officer of the Comptroller of the Currency (OCC), in Washington. Neither of them had spent much time studying the idea of credit derivatives. After all, the concept had not even been invented when the Basel Accord, or any American financial rules, had been written. But that didn’t mean they wouldn’t weigh in with strict views if J.P. Morgan started doing lots of deals. Masters and Demchak posed the crucial question: if banks usedcredit derivatives to shift their default risk, would the regulators let them cut their capital reserves?
    The signs looked promising. At the start of the decade, regulators had grappled with the savings and loan disaster and had learned firsthand the dangers of banks concentrating loan risk, one of the big mistakes the S&Ls had made. Many regulators were consequently thrilled to learn that tools could be developed to disperse risk. Indeed, one senior American regulator was so enamored of the idea that when he heard about what Masters was doing, he telephoned her to learn more. “When I read the details, it seemed to me this was one of the best innovations I had ever seen. It was just a wonderful idea!” he later