Credit Derivatives Role In Crash

Image: Phillip Toledano

1 of 5 NEXT

At a time when the reputation of bankers has been shredded, Bill Demchak is a throwback. The day I meet him, the financial world is once again poised on the brink of destruction. The Dow Jones Industrial Average lost 358 points the day before and is already down another 150 this morning. Yet the green-eyed Demchak, in pleated khakis hiked up unfashionably high onhis waist, seems preternaturally calm—especially for a man who, unwittingly, has had a hand in bringing Wall Street to its knees.

Demchak, now the vice chairman of PNC Financial in Pittsburgh, returned to his hometown in 2002 to help rescue the bank after it became mired in an accounting scandal. Under Demchak and the rest of its new management team, PNC has avoided most of the terrible mistakes of its Wall Street peers by spurning bad mortgages, dubious off-balance-sheet deals, and questionable corporate loans. It’s now one of the best-performing banks in the country.

But before he had this life, Demchak had another, as the leader of a small group at J.P. Morgan in New York that pioneered the kind of financial instruments that eventually led to this autumn’s wreckage on Wall Street. The J.P. Morgan team created and then industrialized credit derivatives, which have enveloped the global markets, growing to a mind-numbing $58 trillion worth of credit contracts. They have spread and morphed in ways that Demchak never intended but always feared.

Long celebrated as a way for banks to diffuse their risks, the credit derivatives invented by Demchak’s team have instead multiplied them. The new credit vehicles encouraged banks and other financial firms to take on riskier loans than they should have; helped increase leverage in the global financial system; and exposed a much wider array of financial firms to the risk of default. (View an interactive timeline of derivatives.)

Credit derivatives aren’t, of course, solely to blame for the pandemic that has helped bring down Wall Street. They didn’t single-handedly force Bear Stearns and Lehman Brothers to bulk up on toxic debt, dooming them to collapse. But they made the financial world more complex and more opaque. Ultimately, they have exacerbated the market panic, as financial firms and regulators have belatedly come to grips with the enormity of the problems. Merrill Lynch ultimately capitulated to a sale because investors had no confidence that the firm had a handle on what its problems were. When the federal government took over A.I.G. in September, it was largely because of the insurance behemoth’s exposure to credit-default swaps, a type of derivative that flourished in the wake of Demchak and his team’s creations. By mid-September, Treasury Secretary Hank Paulson was forced into proposing the largest bailout in U.S. history. Securities and Exchange Commission chairman Christopher Cox (S.E.C. No Evil, October) called for regulating credit derivatives.

Morgan’s derivatives project began in the wake of the Asian financial crisis in 1997 as an attempt to protect the bank from bad loans. Demchak’s innovations worked—for his bank. Morgan came to dominate this corner of the financial world while preserving a culture of prudence. Morgan—deemed to be so safe that it snagged two of the victims of the financial-system collapse, Bear Stearns and Washington Mutual—is still swimming in credit derivatives, far more than any other firm on Wall Street, though the bank says it’s hedged. As of the second quarter of 2008, the bank had written derivatives contracts backing credit valued at $10.2 trillion, roughly three-quarters the size of the U.S. economy.

But Demchak’s innovation has a more troubling legacy. J.P. Morgan, rather than being inoculated, was actually becoming the Patient Zero of Wall Street, eventually carrying the credit virus to the far corners of the global financial system. The structure of the first derivatives deal wasn’t as solid as Demchak’s team had intended. That initial, flawed financial instrument was later replicated thousands of times by J.P. Morgan and other banks, with the same defects repeated and magnified over and over again.

The creation of credit derivatives, only a decade ago, is more responsible than anything else for binding the global financial world together more closely. Now some of the trailblazers are puzzling over what has been wrought. “How can we have a financial system so precariously balanced after such an extraordinarily profitable period?” asks Andrew Donaldson, a former colleague of Demchak’s who runs an asset management firm in London.

1 of 5 NEXT