This book review appeared in The New Sunday Express, August 23, 2009

"FOOL'S GOLD" - Gillian Tett
Trapped in a vast, opaque spider’s web
E K Santha

The global downturn, the worst since the Great Depression of the 1930s, has affected Europe and the United States; and Asia, Africa and Latin America as well. With investors pulling back globally, the unemployment rate swelling across Europe and the US, steep GDP contractions and large numbers of people filing for bankruptcy, governments in Europe and USA are desperately cooking up economic stimulus plans to fire up the economy. Some economists predict a deepening of the recession, including a further fall in the GDP in the euro zone.

Fool’s Gold by Gillian Tett, a Financial Times journalist who followed the innovations in the investment banking sector since the 1990s, is an enquiry into the economic catastrophe caused by these innovations. Tett’s work unravels what went wrong, why and who was responsible.

In a narrower sense, it is an account of JP Morgan Bank and a young, super-savvy group of employees who were responsible for the new derivatives. Indeed, they became the model for other banks. The story begins at a private beach in Boca Raton, Florida, where they met to have fun and also gather ideas on CDs in 1994. Despite the stock market crash in 1987, when the banks lost fortunes in derivatives, they went ahead. Their ideas changed the derivatives worlds of America and Europe. There was no dearth of regulations — national and international — or regulatory bodies in the commercial banking sector to see that banks maintained a reserve equivalent to 8 per cent of the value of their assets to be adjusted against risk. Indeed, the colossal growth of derivatives so rapidly invited the attention of regulators; they insisted on the extension of rules for investment banking, especially on CDSs (Credit Default Swaps) and like products.

JP Morgan, along with the banks involved in large-scale credit derivatives, formed the International Swaps and Derivatives Association. ISDA furiously lobbied, in the UK and the US, for a self control mechanism rather than regulations. The regulatory bodies succumbed. All the four anti-derivatives bills were shelved in the US. Tett brings this out clearly to show where the fault lies.

Some of these regulations would have averted disaster. The Congressional Watchdog Government Accountability Office conducted a study on the derivative world and had commented in 1994 on the weakness in risk management that might create wider systemic risk. But it did not find any takers, as “market derivatives had grown overnight from a cottage industry into a bazaar where tens of billions of dollars of risk was changing hands.” Insurance giants like the American International Group galloped in to insure the risks.

The one thing the inventors of the derivatives had never imagined was the scale of disaster that their brainchild would unleash. It not only devastated Wall Street but shook the world as well.

Investors, who relied on the rating agencies, were riding for a fall because the agencies had no idea how to assess or assign risk for the CDOs (Collateralised Debt Obligations). Even bankers had a tough time understanding these complex instruments, but the ratings agencies nevertheless gave triple ‘A’s to many of these instruments.

Investment banking grew manifold in these magical years, the large banks by 14 per cent in fiscal 2003-04, earning a profit of $61 billion. Most of this came from the frenetic appetite for sub-prime loans repackaged into CDOs. Soon, the bubbles began to pop all over the place. Repeated shocks, such as the collapse of the Asian market, Enron Corporation, the Internet bust, the fallout of 9/11 and the collapse of some huge hedge funds exposed the system. By early 2007, “most of the Western policy makers were convinced that the credit cycle had been so extreme that it would inevitably turn soon” says Tett.

The inevitable did happen; prices of houses (yet another huge mortgage sector) started sliding and many banks suffered huge losses on the mortgages. In April 2008, total mortgages lost were approximately $400 billion. Big banks and brokers were collapsing and governments were trying desperately for bailouts. JP Morgan was forced to buy Bear Stearns, which was on the verge of collapse. AIG was sold to JP Morgan. Lehman and Washington Mutual Fund collapsed. Bradford and Bingley (UK) was nationalised.

“The CDs market had turned in to a vast, opaque spider’s web; linking together banks shadow banks and brokers alike with unfath­omable trades and fear”. And Tett’s book conveys to us, that as in the case of Mackenna’s Gold,that Hollywood classic, the rush for riches in this case was Fool’s Gold.

This is a must-read book for the simple and catchy narrative of a complex credit derivative world and about how unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe.