How J.P. Morgan escaped the squeeze

Was CEO Jamie Dimon a brilliant risk manager, or just not as dumb and greedy as everyone else on Wall Street?


Andrew Leonard
September 3, 2008 11:01PM (UTC)

How did J.P. Morgan escape the credit crunch with mere flesh wounds, while other investment banks were getting eviscerated left and right? An embarrassingly gushy Fortune Magazine profile of J.P. CEO Jamie Dimon and "the best team on Wall Street," tells the story, and Portfolio blogger Felix Salmon acutely highlights the crucial passage.

While other banks were rushing to get a piece of lucrative subprime CDO action, Dimon and his crew were hearing warning bells.

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In 2006... the market seemed to be saying that the bonds were solid. But Black and Winters concluded otherwise. Their yardstick, once again, was credit default swaps -- insurance against bond failures. By late 2006 the cost of default swaps on subprime CDOs had jumped sharply. Winters and Black saw that once they bought credit default swaps to hedge the AAA CDO paper J.P. Morgan would have to hold, the fees from creating CDOs would vanish. "We saw no profit, and lots of risk, in holding subprime paper on our balance sheet," says Winters.

In other words, the cost of insuring against default would negate the profits gained by making and selling the paper.

Salmon writes: "This is genuinely impressive: Dimon and his lieutenants saw clearly in late 2006 two risks which wouldn't crystallize for most of us until the summer of 2007."

"Most of us" is probably the correct formulation, but Dimon and his crack risk management team were not the only people paying attention to the rising cost of credit default swaps tied to subprime CDOs in 2006.

In April 2006, How the World Works took a close look at an article published four months earlier by ace Wall Street Journal reporter Mark Whitehouse. Whitehouse reported that between September and December of 2005, the price of "credit default swaps on subprime ARM pools" had doubled. The clear implication was that savvy hedge fund operators were beginning to bet on a housing bust, and they were focusing on what would prove to be the weakest link -- securities tied to subprime mortgages.

Here's what I wrote then:

So here's the deal: The smartest players on Wall Street see the housing market about to implode. So they're loading up on cutting-edge financial instruments that will theoretically protect the buyer from exposure to millions of homeowners suddenly beginning to default on their loans. And for the moment, they're making money hand over fist as the value of those derivatives rises with every new data point about slumping housing sales, slow housing starts and rising interest rates.

But what happens if the defaults do start rolling in, and the sellers of those derivatives have to make good on their obligations with cold, hard cash? Will there be enough liquidity in the system to handle the shock? Will state-of-the-art capitalism work as advertised? As Whitehouse reports, the market for credit-default swaps that could be applied to pools of home mortgage loans is new -- it's only been around since last June. Again, no one knows how it will play out.

The warning signs were there for everyone to see, well before Jamie Dimon started running scared. The question I come away with after reading Shawn Tully's Fortune article is not: How was Dimon able to be so smart? It's how come everybody else was so amazingly dumb?

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Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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