Summer 2007
“Jason, doesn’t one of your buddies from Cal work at BNP?” I asked at one of our rare lunches outside the office.
We had just grabbed a couple wraps from Sam’s Falafel Stand one slow afternoon in August. It was usually a quiet month since our MDs were vacationing in the Hamptons or at Martha’s, rather than playing sentry at the office.
“Yeah, Simon’s in their fixed income group. Why?” Jason answered between mouthfuls.
“I heard from that guy Franz, over at Deutsche Bank, that this subprime mess is hitting them hard. He said they might be closing down some of their funds because they can’t tally their losses accurately.”
“No fuckin way.” Jason went on over bites of the falafel, “I’ll ask him about it but I’m sure it’s no big deal.”
A week later, we heard BNP Paribas was indeed shutting down three of its funds that collectively had over $2 billion in assets under management. BNP executives admitted that the extent of the losses they had taken on in the subprime market were unknown and they could no longer accurately value the funds. I saw the news reported on one of the flat-screens while pouring coffee in the break room, and I hoped foolishly that it would all prove to be much ado about nothing, repeating the central banker’s mantra, “it’s all contained.”
When I got settled in at my desk I pinged Eric and Jason.
Rohan: Yo Eric, how is it possible BNP doesn’t know how much money it lost? Aren’t you derivatives guys supposed to ensure that losses can’t exceed a certain amount? That’s what hedging is, right?
Jason: It’s a second rate French outfit. You worry too much, man. Shit happens.
Rohan: Shut up Jason, this is serious.
Eric: Well, to be honest derivatives aren’t really used to “hedge” all that much. I mean they are, but only a small portion. Most of what we do is really to generate alpha.
Rohan: Let me get this straight, rather than using derivatives to reduce risk and limit exposure, you guys are using them to do the opposite?
Eric: Pretty much. Volatility has been too low for the traditional guys to generate enough revenue. We gotta pick up the slack.
Jason: So, what happens when our asses aren’t hedged and shit hits the fan?
Eric: Pray you have a parka handy gentlemen. Anyway, I gotta run. I’ll see you guys at Jenn’s thing on Friday.
I thought that was just Eric being cavalier, until events began to speed up. The Federal Reserve had started hiking rates over a year ago, and the impact on house prices was finally starting to show. By the time Northern Rock had to receive emergency liquidity from the Bank of England due to its aggressive and ill-timed expansion in the years prior, the tension in the office had become unbearable. And yet, when we asked our Associate Rubin about it, he was quick to pat our ruffled feathers.
“Guys, this is JP Morgan, not an upstart bank from the boonies in England inflating its book on British mortgages. They were borrowing like crazy in the short-term money markets and extending junk mortgages. They actually thought they could run that scheme forever.”
Remembering our conversation with Eric, I asked, “How is what we’re doing any different?”
“We’re a lot less dependent on short-term funding for one thing, and our derivatives team hedges our exposure. We’re not amateurs—that’s the difference.”
As we would all learn, it really was just the beginning. The more the Central Banks organized to provide liquidity in markets that seemed to be freezing up, the more investors began to worry that things would spiral out of control. They went after the most over-extended banks first and it was only a matter of time before the dominos started to fall. Bear was next, then Lehman, and finally AIG. Central Banks around the world had built their reputation on claims they could smooth out the business cycle through their interest rate machinations, and it all seemed to work wonderfully as long as rates were being lowered or kept low. When the banks started raising rates, all bets were off. When all was said and done, trillions of dollars were spent and many trillions more in guarantees were made to paper over the cracks in the financial system. Most of the financial institutions and their key investors were saved, like Warren Buffett who lobbied Congress aggressively to save AIG, while individuals who had aspired to the American dream of owning their own home were thrown under the bus. Years later we were still uncertain about exactly what happened, but it seemed to stem from the repeal of Glass-Steagall. Once the big banks were able to use deposits as reserves against bets in the mortgage derivatives game, all bets were off. The flood of new money into the secondary market brought down mortgage rates, leading to a flurry of buying activity in real estate, which in turn sent prices for homes ever higher. New construction, household retail, and other tangential sectors of the economy saw gains across the board too. Packaging the mortgages and reselling them, then buying insurance on them, seemed to eliminate all the risk. We had yet to learn that risk obeyed the law of conservation like energy. It couldn’t be created or destroyed, only transferred. In this case to unwitting parties like savers, pension funds and yet-to-be-born taxpayers.
The following year, JP Morgan Chase began to reduce the number of employees in its mortgage trading group but Jason and I never worried about our jobs since we were clearly on the VP's good side. We did stay later and work a little harder, though nothing like what some of the other analysts were doing, practically living at the office. There were days when we would actually see a new analyst brushing his teeth in the bathroom, bleary-eyed from an all-nighter. We were thankful we never stooped to that level. Though when we were personally called in by our MD along with four other guys from our group, we regretted our lack of worry instantly. In all fairness, he was really nice about it, and told us all how much he regretted letting us go and that under different circumstances we would have worked together for many years to come. Still didn’t change the fact that we were all being let go by our first full-time employer and the humiliation of it stung deeply. In a rare moment of generosity, the powers that be spared us the indignity of being escorted out by security and just let us grab our things and leave unattended. It was a Wednesday, but Eric and Austin stayed out drinking with us until 4am the next morning anyway. We hoped the alcohol and weed would dull the sense of failure we felt, though we knew deep down it wouldn’t. I personally couldn’t get over the fact that we were let go while Joe Gao was retained. That entitled son of a bitch. We carried on drinking and tried to think about our newfound freedom. It was the only thing that cheered us up, which led in turn to shots of celebration. By the end of the night, I was stooped over in one of the legendarily disgusting, graffiti-strewn bathroom stalls at Mars Bar in the East Village, puking my guts out .