Paul M. Barrett: J.P. Morgan's bankers invented dangerous ways of dispersing risk





[Paul M. Barrett is an assistant managing editor of BusinessWeek.]

To understand the calamity on Wall Street, we need erudite financial analysis and good old-fashioned stories about human fallibility. Gillian Tett, who oversees global market coverage for The Financial Times, offers some of each. In “Fool’s Gold,” she describes how a small group of bankers at storied J. P. Morgan built a monster that got out of control and helped destroy much of their industry. Tett’s tale doesn’t explain all of the recent mayhem, but it is one place to start.

She shows us the financial world through the eyes of her talented but short-sighted subjects: geniuses at math and marketing, they thought they had discovered how to defy the laws of nature. The old rules didn’t apply.

Beginning in the mid-1990s, the wizards at Morgan decided they could defeat the banker’s oldest foe — the danger that borrowers will not repay their loans. If that sounds as audacious as bringing the dead to life, it’s not far off. The Morgan team thought they could combine esoteric financial instruments so cleverly that repayment risk would simply disappear, or at least become so diluted as no longer to matter. Relieved of risk, banks would lend more money, corporations would grow more quickly and capitalism would blossom.

Accomplishing this “bold dream,” as Tett puts it, required arduous toil in the financial laboratory — accompanied, at times, by after-hours antics of “Animal House” proportions. The author excels at recreating this fevered environment. She also deciphers Wall Street mumbo-jumbo in terms that a lay reader, or at least a determined lay reader, can understand....

The Morganites sold the notion that financial gravity had been overcome—that risk had been vanquished and that lending could proliferate endlessly. That some would take this to absurd extremes seems entirely foreseeable. The retrospective shock that Tett’s subjects express in interviews rings hollow, especially when we learn that some of them, although not Blythe Masters, left Morgan and personally imported derivatives know-how to institutions that behaved more rashly.

Morgan’s culpability doesn’t end there, either. Tett notes that Morgan provided key manpower and initiative in a ferocious Wall Street lobbying campaign that persuaded Congress, the Securities and Exchange Commission, and the Clinton and Bush administrations to back off from regulating derivatives trading in any meaningful way. Industry advocates received vital backing from the high priest of free market ideology, Alan Greenspan, then the chairman of the Federal Reserve.

The argument that persuaded Washington to allow manic derivatives trading to go unchecked boiled down to the myth that financiers had a powerful self-interest in keeping one another honest. Wrong. As Tett reports, Greenspan went before Congress last October to admit that “he had made a ‘mistake’ in believing that banks would do what was necessary to protect their shareholders and institutions. ‘[That was] a flaw in the model . . . that defines how the world works,’ ” Greenspan confessed belatedly....

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