Last night, Cerise and I were dining at Citronelle in Georgetown – or, at least, we were about to, when Dalrymple sidled up to our table.
“Tom,” he exulted, “what a surprise to see you here!”
“Cerise,” I said, by way of introduction, “this is Aloysius Dalrymple. His friends call him Scooter. He’s a senior financial analyst with the Federal Open Market Committee here in Washington.”
“It’s a pleasure to meet you, Scooter,” Cerise smiled as she extended her hand.
“Likewise,” Scooter replied with a slick grin. “Mind if I join you?”
“Uh, well, certainly,” Cerise allowed, betraying just the slightest note of apprehension in her voice.
“Thanks,” Scooter murmured as he slid into a chair at our table. “You know, Tom, there’s something I’ve been wanting to discuss with you.”
“My appointment calendar has some openings next Tuesday,” I pointedly remarked. “If you call, I’m sure Gretchen can…”
“Oh, no, no, no,” Scooter interrupted. “I’ve got far too many foreign financial reporters following me around these days. I couldn’t possibly be seen visiting your office. And besides, Chairman Bernanke’s been on a budget control kick lately, anyhow, and you know how he complains about your rates.”
“In this town,” I shrugged, “you get what you pay for. And the Federal Reserve has more money that God. It’s not like they’re the Red Cross or something.”
“I know, I know,” Scooter agreed. “But we can’t expect everything to make sense around this place, now can we?”
“Oh, all right,” I relented, in hopes of getting things over with quickly, “what’s on your mind?”
“You will,” Scooter whispered conspiratorially to Cerise, “be… discreet, I assume?”
“’Loose lips sinks ships,’ as my grandpa used to say,” Cerise shot back with a wink.
“Good, good,” Scooter softly cackled, rubbing his hands together in satisfaction. “Tom, I’m sure you’re familiar with this Dimon business?”
“Diamonds?” Cerise wondered aloud. “I thought the farthest the Fed got into that sort of thing was gold.”
“He’s referring to Jamie Dimon,” I clarified. “The Chief Executive Officer of JP Morgan. He’s in Washington this week, testifying before Congress.”
“Oh, him,” Cerise sighed wearily, “that rat bastard.”
“Well now,” Scooter cooed in a conciliatory tone, “it’s true he’s very well paid for his work, but Wall Street bankers provide a very valuable service to society by…”
“Stealing from widows and orphans,” Cerise interjected indignantly.
“By supplying capital,” Scooter protested.
“By foreclosing mortgages and throwing families out on the street,” Cerise countered.
“By providing consumer credit,” Scooter doggedly continued.
“By bankrupting working people with sky-high interest rates that amount to nothing by pure, unadulterated Shylock usury,” Cerise insisted.
“By making financial markets,” Scooter stubbornly declared. “Tom, I never would have expected you to have an ardent Socialist for a lady friend.”
“She’s hardly that,” I dryly informed him. “It just seems that you’ve been inside the Beltway so long, you’ve lost contact with what the typical American thinks of bankers these days. So – what about Dimon and JP Morgan, anyway?”
“Well, I must admit,” Scooter began with smarmy smile at Cerise, “that the Fed is – quite rightly, I might add – somewhat concerned about what happened at JP Morgan and…”
“And what, exactly,” Cerise broke in, “was it that happened at JP Morgan, if I may be so bold as to ask?”
“Oh, um… yes…” Scooter stammered, collecting his thoughts. “Well, you see, it was, ah, a very large derivatives structure that…”
“Derivatives?” Cerise demanded. “Meaning what?”
“Uh… okay, well,” Scooter fumbled, “derivatives are financial instruments which are called that because they derive their value from the underlying value of the actual assets or liabilities to which they are related.”
“Related?” Cerise prodded skeptically.
“There are… um… forward contracts,” Scooter explained, “for example, where the buyer and seller agree to trade a security or other asset or liability at some future date. Then, there are futures, which are a specialized kind of forward contract that is standardized and traded on a commodity exchange. Then there are options, which consist of the right to buy or sell a security, commodity or other asset. And then there are IO and PO securities – which stand for ‘interest only’ or ‘principal only’ payments. They’re based on mortgages. If you own an interest only security, then you get the interest portion of a bundle of mortgage payments, and likewise you get only the principal portion with a PO. Then there’s structured notes – they’re liabilities, debt, that sort of thing, bonds, basically, where the interest rate paid depends on something like the price of oil or what the London Inter Bank Offered Rate is. And then there are swaps, of course, and there are all kinds of them. You can bet against higher interest rates with an interest rate swap where you exchange payments for a bundle of adjustable rate mortgage loans that your bank owns with another bank that owns a bundle of fixed rate mortgages that were created at no more than current rates. Or your bank can use swaps to bet on currency exchange rates, credit defaults or any number of other things and hedge those bets by combining their swaps with options to get things called ‘swaptions’ or…”
“Excuse me,” Cerise nailed him tartly, “did I hear you say ‘bet’?”
“Well, yes,” Scooter acknowledged.
“And the difference,” Cerise asked, “between degenerate gamblers betting on craps in Las Vegas and the horses at Pimlico and Wall Street bankers betting on derivatives is what?”
“Why, ah, um,” Scooter stammered, “there’s all the difference in the world!”
“Really?” Cerise challenged. “The only difference I can see is that at the casino or the race track, the degenerate gamblers make bets with their own money, and on Wall Street the degenerate bankers make bets with other peoples’ money.”
“But Cerise,” Scooter objected, “don’t you see? If you put your money in a bank, and the banker loans it out to somebody else, that banker is betting that person will repay that loan. So bankers are always making bets with other peoples’ money, whether they deal in financial derivatives or not.”
“And I suppose,” Cerise sniffed, “that the odds on all of those bets are comparable?”
“Er, well, not exactly,” Scooter confessed. “But the idea with a properly constructed derivatives portfolio is to reduce risk overall.”
“The distinction,” I chimed in, “is primarily which other peoples’ money the bank is betting with. The bank can place bets either with its depositors’ money – that’s called ‘hedging,’ when the bank dabbles in derivatives and such to reduce overall risk to the depositors’ wealth – or it can place bets with its own money, which is known as ‘proprietary trading,’ when the bank dabbles in derivatives and such to make a good, old-fashioned captialist profit from good, old-fashioned capitalist speculation.”
“So which one was it,” Cerise wondered, “that lost JP Morgan that two or three billion dollars everyone’s talking about?”
“Ah yes. That’s the sixty-four thousand dollar – or perhaps I should say, two or three billion dollar question,” I observed. “JP Morgan’s supporters say the deal that went sour was hedging, while the bank’s detractors insist it was a proprietary trade carried out with depositors’ money. Of course, the definition of a ‘hedge’ is ‘an investment which is structured such that it cannot sustain a loss in one of its components without a corresponding gain in another.’ And so consequently, JP Morgan’s supporters are having a difficult time explaining how a hedge could lose two or three billion dollars.”
“Has anyone considered the possibility,” Cerise mused, “that maybe JP Morgan is, in fact, run by a bunch of incompetent ninnies whose talent and efforts scarcely merit payment of the minimum wage, much less their obscenely bloated compensation packages?”
“That would,” I conceded, “explain a lot. But nobody in Congress has the intestinal fortitude to think such thoughts, much less voice them. And Jamie Dimon does, after all, wear extremely expensive suits and have truly awesome hair, and, in the final analysis, those are the things that really count, both on Wall Street and in Washington’s corridors of power.”
“Hear, hear,” Scooter enthusiastically agreed. “If the images of Wall Street executives like Jamie Dimon didn’t inspire confidence, the entire system would collapse. Economics is, after all, a psychological discipline.”
“Okay,” Cerise relented. “As you say, then. So regardless of whether it was the depositors’ or the shareholders’ money that went down the drain, can either of you tell me what the hell happened?”
“There was a kind of derivative called an Investment Grade Series 9 10-year Indexed Credit Default Swap,” Scooter began.
“They were constructed,” I elaborated, “such that they would rise in value as the degree of risk on a group of corporate bonds increased.”
“And Bruno Iskil,” Scooter continued, “at JP Morgan in London, kept selling them, and selling them, and selling them.”
“And a guy named Boaz Weinstein, in New York,” I added, “kept buying them, and buying them and buying them.”
“Using a basis trade, Iskil was attempting to construct a second-order hedge,” Scooter told her, “in order to offset volatility associated with a first-order hedge of JP Morgan’s credit risks constructed through purchase of another kind of derivative called a Credit Default Swap Index.”
“Iskil,” I concluded, “was betting the gap between the Credit Default Swaps and the Index that tracked them would continue to widen, while Weinstein was betting it would narrow.”
“That’s one interpretation,” Scooter opined, “another is that the two components of Iskil’s hedge were imperfectly constructed due to a lack of understanding, on JP Morgan’s part, of the underlying market correlations. Therefore, the legs of JP Morgan’s position moved in a contrary juxtaposition, and consequently, Weinstein collected two or three billion dollars of JP Morgan’s money.”
“As clear as mud,” Cerise huffed as she returned her attention to her raspberry cosmopolitan.
“Well,” Scooter muttered as he turned to me with a dismissive wave of his hands, “we tried, anyway.”
“So what’s on your mind?” I inquired.
“Um, well, it seems now that Dimon’s got Congress pretty much bought off and snowed under,” Scooter confided, “the geniuses at JP Morgan have invented a brand new derivative, and to tell you the truth, it scares the hell out of us down at the Fed.”
“What’s so frightening about it?” I queried.
“They had a team of quantum physicists and fractal mathematicians cook it up using the world’s fastest super-computer,” Scooter revealed. “It’s a freakin’ monster, I tell you. And if your friend Cerise here is concerned about indigent widows, penniless orphans, bankrupt consumers, rampant unemployment and ubiquitous family evictions, she ain’t seen nothing yet.”
“Really?” I pondered. “Has it got a name?”
“They call it,” he sagely intoned, “a Justified Asset Certificate Of Financial Funding.”
“The JACOFF?” I gasped. “How does it work?”
“That’s the point,” Scooter shuddered. “JACOFFs are so complicated, absolutely nobody, anywhere, no matter how smart they are, can possibly understand them.”
“So at last, Wall Street has finally devised the ultimate derivative,” I concluded.
“That’s affirmative,” Scooter complained. “And you can see our dilemma – how can we regulate something if we aren’t smart enough to comprehend how it works?”
“Scooter, my friend,” I admonished as I shook my head sadly, “I don’t know how you missed noticing it, but every regulatory agency in this town does precisely that every damn day of the week and now, if you and your colleagues at the Fed can’t figure out how to do it too, then frankly, you just don’t deserve to work in Washington.”
“What… where,” Scooter mumbled as he stared at me blankly. “I mean, who should we ask?”
“Okay,” I suggested, “in that case, why don’t you start with the FDA, the FCC, the EPA and the NRC? After you’re done talking to them, I’ll suggest some others.”
“Good evening,” our waiter cheerfully chirped. “Will the three of you be dining together?”
“He,” Cerise snapped as she indicated Scooter, “was just leaving.”