How it Happened

Fool's Gold

By Gillian Tett

By Reviewed by Stephen Foley

How the geeks broke the banks

At some point during Gillian Tett's absorbing 15-year gallop across the Wild West of the world's financial markets, the reader will find themselves snapping away from the page and saying, "Hang on a minute. This is nuts."

Would that we had had this narrative in real time. We are familiar enough with the chain reaction of explosions that began two years ago, deep in the credit markets, closing in on the real economy until they blew up our pensions, house prices and job prospects. But the question of when the time- bombs were set - and by whom, and how -remains a subject of bewilderment to victims all around the globe.

In bewilderment and loss, there is the natural inclination to lash out, to rip apart the institutions of capitalism and give in to the temptations of the mob. The employees of collapsed insurer AIG feel the need to hire private security to protect their homes in the US, and the British public smiles a tolerant smile on news that "protestors" had thrown bricks through the window at the home of Fred Goodwin, former boss at Royal Bank of Scotland.

The sub-title of Fool's Gold panders to this, suggesting "unrestrained greed" will be what gives this narrative drive, but thankfully - and unsurprisingly for those who have followed her journalism, or her academic background in anthropology - Tett's book is much more challenging than that. The story is told from the perspective of a tight-knit team of bankers at the US powerhouse JPMorgan, whose pioneering work in the 1990s included the invention of the credit default swap, probably the most important credit derivative. Theirs is the "dream" of Tett's sub-title, that by allowing banks to swap their loan risk to other investors, the business of finance could be made safer, and banks freed up to offer more credit to businesses that needed it.

The bout of excess that their inventions unleashed is different in many ways from the testosterone-dripping 1980s, which spawned Wall Street tell-alls such as Liar's Poker or Barbarians at the Gate, books populated with "big swinging dicks" and "masters of the universe". Tett makes the best of some hi-jinks at a JP Morgan brainstorming retreat (golf buggies raced around the hotel lawn) and wacky "bow-tie days" in the office, but the point about this Wall Street bubble is precisely that it was inflated by geeks operating in the least flashy area of finance.

We are taken back to the mid-1990s, a period of intellectual ferment. For centuries, banks had lent money to clients only after carefully judging the risks and setting aside capital to cover potential losses. Default risk was seen as an inevitable part of banking. But that changed thanks to credit derivatives, which allowed that risk to be turned into a financial product which could be sold as if it were shares, bonds or oil. If that sounds complicated, it was - and trading "risk" was only possible because of computer models that factored in all sorts of assumptions about the economy and the borrowers in order to to come up with a plausible price.

It is somewhere through Tett's patient explanations of each new invention - the CDOs, the CDOs of ABS - that the reader will have their "Hang on a minute" moment. Eventually, the risk of all the loans being made to real businesses and mortgage holders had been sliced and diced so many times that finance had become, literally, detached from reality. Trouble is, the models simply did not predict that so many of underlying loans could go bad all at once. It seems obvious in retrospect, that the lenders cared so much less about the quality of the borrower now that they were selling the risk to someone else. But that wasn't in the models.

Tett was appointed to cover the capital markets for the Financial Times in 2005. With an outsider's eye, she was soon warning that what most people assumed was a backwater was in fact harbouring a profoundly new and bloated kind of finance, whose risks were being dangerously underestimated. Her warnings came too late, of course, but her account of the road to catastrophe has been keenly awaited.

The one downside of her approach is that we are never with those most culpable for the catastrophe. The team at JP Morgan never made CDOs out of mortgages, and are baffled that anyone could even create a model convincing enough to price such a thing. Similarly, JP Morgan decides to insure against losses on the super-safe slices of CDOs that it keeps on its own books, just in case, and everyone if baffled to discover that Citigroup does not take out such insurance.

JP Morgan is the one major bank to have emerged with its reputation actually enhanced. No wonder its executives have been happy to assist Tett's work. Citigroup, once the largest bank in the US, looks like it is about to be effectively nationalised. Its story will also need to be told. The same goes for the credit rating agencies, the "priests in the medieval church", in Tett's fine description, who spoke a financial Latin "which few in their investor congregation understood" but who conferred "guidance and blessings". One suspects that, given a fair hearing, the individuals inside these institutions, too, would have a more complicated tale to tell than one of "unrestrained greed".

Ever the anthropologist, Tett sketches a system in the grip of a great error, emanating outwards from a cadre of elite traders who were able to repel any attempt to monitor, question or restrain them. Greed is in there. Fear, too, of being left behind by the competition. We know there was fraud, and wilful negligence. There was also a lack of inquisitiveness in journalism, and poverty of imagination among regulators. Fool's Gold resists simple answers to a complex disaster - and so should we.

Stephen Foley, 'The Independent''s North American business correspondent, was named Business and Finance Journalist of the Year at the British Press Awards.

Two other realy excellent analyses are A Collossal Failure of Common Sense. It is largely about the failure of Lehman Brothers and it is written by two former execs, Larry McDonald and Patrick Robinson.

Lastly, In Fed We Trust, by David Wessell goes into Bernake and the Fed in great detail. Very good on the inner tensions in the Bush administration.