Credit Derivatives Role In Crash

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Demchak spends his days in an unassuming office in PNC’s headquarters, situated amid a slightly seedy collection of streets in downtown Pittsburgh. Demchak warned for years about excesses in lending and is now baffled by, and even somewhat contemptuous of, his peers’ disastrous mistakes: “At the end of the day, I’m never going to be—knock on wood—a guy you see in the paper and say, ‘Look at this stupid, self-serving decision.’ ”

Later, as he thinks back to 1997 and the days in New York when his team helped get the derivatives market off the ground, he lights up. “Oh, God,” Demchak says. “It was absolutely the best time ever in my life.”

In the mid-1990s, Demchak, along with his boss, Peter Hancock, an effervescent Briton, became converts to the closest thing the banking industry has had to a religious reformation. Back then, relationships drove the commercial-banking business. Glad-handing bankers with tight connections to corporate boardrooms made the rain.

These guys never met a loan from a corporate client they would turn down, even if they weren’t sure it would be profitable in the long run.

Hancock and Demchak’s creed was simple: Banks should know whether their loans were going to make money. The pair insisted that loans be priced to their current value in the market. Because of the legacy of the old relationship bankers, J.P. Morgan was struggling. The problem, in the view of the stock market, was that the bank had the wrong clients. They were sleepy American icons, some of whom John Pierpont Morgan himself had lent to and even helped build. Though bank officials were promising Wall Street that it could generate returns of 20 percent, the return on many of its loans was much lower, forcing the bank to run the race while dragging lead weights on its ankles.

The Asian financial crisis highlighted the problem. Morgan lost money on loans to Asian companies. That prompted the bank to take a look at all of its corporate lending practices, abroad as well as at home. When it did, top executives came to a sobering realization: Not only was J.P. Morgan not making nearly enough profit on these blue-chip corporate loans, the bank had also made far too many of them. Most weren’t loans at all but lines of credit promising funds at some later date. Hancock and Demchak realized that in a crisis, many of these companies would probably ask J.P. Morgan for access to the money they were promised. Worse, they wouldn’t do it unless they were on the brink of collapse—exactly the wrong time for a banker to make a loan. The bankers who made those loans thought the odds of that happening were too small to even consider. “The old banking mentality viewed them as riskless,” Demchak says. But the mentality was wrong.

Morgan realized it needed to act quickly to reduce its exposure. It had to free up capital for more profitable business. But it couldn’t sell the loans without alienating its longtime, blue-chip customers.

Demchak put the new religion into action. “Demchak was the first person I know of who had the vision that the credit-derivatives market could be anything like it is today,” says Charles Pardue, who worked for Demchak at J.P. Morgan before moving to a hedge fund in London.

Over the coming months, Demchak would put his assault team of math whizzes and marketers to work on fixing the problem. Within the bank, the project was called the Credit Transformation.

Demchak received crucial help from his lieutenant, Blythe Masters, a rising star and formidable presence at the bank. She interned at Morgan while still in college at Cambridge, in Britain, and joined the bank after graduating. Ultracompetitive and driven with a passion for debate, she would give talks and seminars proselytizing about the promise and power of credit derivatives, ultimately becoming their “poster child,” according to credit-­markets consultant Eileen Murphy.

“When you are doing something new, it gets done only by imposing your force of will,” says a former colleague of Masters’. “She was that person.”

Wall Street likes to call its innovations “technologies” to convey a weighty sense of importance. What Demchak and Masters did was combine two of these technologies—securitization and credit derivatives—for the first time.

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