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 B

said.
    Sure enough, in August 1996, the Fed issued a statement suggesting that banks would be allowed to reduce capital reserves by using credit derivatives. Masters, Demchak, and Hancock were thrilled.
    Even as that battle was being waged, Demchak and others on the team threw themselves into an internal lobbying campaign to sell the concept to their colleagues, particularly the loan officers. In some respects, that proved harder than dealing with the regulators. During the late 1980s and early 1990s, the wild antics of the swaps team had provoked unease among the older members of the bank’s commercial lending arm. Those more traditional bankers now reacted with even more horror when Demchak declared he wanted to overhaul the way that commercial lending was done.
    To bolster his case, Demchak unveiled a flood of supportive data. It was drawn from a crucial new twist on the original VaR idea that Weatherstone had developed. During the early 1990s, the quantitative experts inside J.P. Morgan had refined their tools. The first version of VaR was concerned primarily with measuring market risk. However, by the mid-1990s, J.P. Morgan analysts were using similar ideas to analyze the risk of untraded loans, too, and then compare those numbers to the risks attached to bonds and other assets. The basic idea was to look at all the assets that a bank held on its books and work out which parts of the bank were producing good returns, relative to the risks—and which were not. The implications of this analysis looked alarming. By 1995 it seemed four fifths of the bank’s capital was tied up in activities that typically earnedless than 10 basis points of return for the bank each year, meaning just 0.1 cent for each dollar used. Areas of the business that generated much higher profits, such as derivatives, were often short of capital. The bank’s capital simply wasn’t being used as profitably as it should be, let alone in a manner that would enable the bank to hit a self-imposed target of a 20 percent annual return on equity. “We have to change the way we do business!” Hancock declared over and over again, convinced that if the bank didn’t make this change, it faced a slow death.
    The harder Demchak and Hancock pressed the case for reform, though, the more recalcitrant some of the commercial loan officers became. They had spent their careers evaluating loan risks, and they still highly valued the merits of relying on relationships with firms and reputations, in addition to the math Demchak was relying on to produce his data. Demchak’s fervor didn’t help. Though he was most often easygoing, he found it hard to suffer fools. The more they refuted his arguments, the more biting Demchak’s comments became. “These guys are dinosaurs !” he wailed to his team in fury. The loan officers retaliated by dubbing Demchak “The Prince of Darkness,” because he seemed so intent on launching otherworldly schemes. Hancock was considered the king of these dark plans.
    For months, they were at an impasse. Finally, in July 1997, an unexpected twist broke the deadlock. In the middle of that year, a financial crisis erupted in Asia, and the commercial lending group suffered painful losses on loans across the region. That raised the pressure on the bank’s new CEO, Douglas A. “Sandy” Warner, who had replaced Weatherstone in 1995, to take some decisive action to improve the bank’s profits. It was becoming increasingly clear—just as Hancock and Demchak had long complained—that the bank’s level of profitability was lagging behind its rivals’, and these losses were a body blow. Warner decided to throw his weight behind the value of credit derivatives business.
    He gave Hancock responsibility for managing not just the fixed-income business, but the commercial lending department, too. That was a radical move for staid J.P. Morgan, since almost no other Western bank had ever tried to combine lending, bonds, and derivatives into a