Book review: Fool's Gold

Tait Simpson is entertained by how complex derivative products contributed to the financial crisis

There are a few hard and fast rules in finance. One is that the higher an interest rate you can earn on an investment, the higher the risk inherent in that investment. Your local bank will pay you about one percent interest on your savings account; in return you can rest assured that unless your bank collapses, that interest will be paid. A group of mortgages bundled together that pay nine percent interest; well, that would be considerably more likely to have an unhappy ending. This rule, while simple in practice, got lost on both bankers and investors for much of this decade until it abruptly came back as a reminder in the bank collapses of 2008.

As capital markets editor for The Financial Times, Gillian Tett watched the growth in sophisticated financial products that paid investors ever more in interest, earning investment banks ever more in profits, between 1998 and 2008. Fool's Gold tells the story of how a group of whip-smart financiers at J.P. Morgan helped create a vast array of derivatives products with the aim of reducing the level of risk their clients had in their portfolios. What ensued was a runway train of ever more complex financial products which finally imploded last year.

Derivatives are financial products, like stocks or bonds, that investors can purchase. Mostly they are purchased by large companies or pension funds. While there are dozens of different kinds of derivatives, their common attribute it that their value is based on some other financial entity. Derivatives, such as an interest rate swap (where one party agrees to exchange their interest for that of another party's interest), are designed as an insurance against unlikely, unforeseen and unwanted events. The mortgage backed security (MBS) is the derivative which features most heavily in the book. Think of an MBS as a group of 100 mortgages of identical value bundled together, each paying 6 per cent interest. You purchase the bundle and receive the interest payments, which would be equal to 6 per cent of the bundle. If one of your 100 mortgagees defaults and doesn't make their payment, it's no big deal because there are 99 other people who did so you still get close to your 6 per cent. Now, if 20 of those 100 don't make their mortgage payments, well, you can say goodbye to your 6 per cent interest. Few people predicted many mortgage payments would default as the United States hadn't had a sustained decrease in house prices since the 1930s.

Tett traces the origins of derivatives back to a rambunctious gathering of J.P. Morgan financiers at an offsite meeting at a glitzy Florida hotel in 1994. After the previous night's party, in which the boss got a broken nose and a golf cart found its way into the swimming pool, J.P. Morgan empowered a group of young traders to come up with more ways to put derivatives to work. As Tett makes clear, derivatives were a relatively benign part of the financial world until they collided with the mortgage industry after the internet boom ended in 2000.

The book's central character is J.P. Morgan Chase's CEO, Jamie Dimon. Prior to Dimon's arrival at the firm in 2004, midway through the book, the narrative reads much like a long newspaper story as Tett tells how the derivatives team evolved, packing ever more and ever riskier mortgages into MBS. Dimon is a compelling protagonist; fiercely determined to succeed and not disposed to playing nice.

While J.P. Morgan's offices are arguably where the MBS security and all of its hybrids originated, nearly all banks partook in bundling mortgages into sellable securities. One rather comical scene involved a ratings agency who made public how they valued MBS, thereby enabling bankers to put the absolute maximum number of risky mortgages into a security while still achieving the desired AAA rating.

Tett sets up Dimon and the derivative creators at J.P. Morgan before the predictable troubles arise. Aptly, the last three chapters in sequence are named "Bank Run, Bear Blows Up, Freefall." While J.P. Morgan was one of the first into MBS and other derivatives, its institutional knowledge of the products, combined with its unorthodox CEO, allowed for them to emerge as one of the winners of the crash of 2008. It bought investment bank Bear Stearns for nearly nothing and grew many of its divisions' revenues while rivals disappeared.

Many other authors have written about the financial crash of 2008 and new books are being produced weekly. Tett assumes a fairly advanced level of understanding about derivatives, therefore the book can be overwhelming, especially in the early stages. It does however lead to a rollercoaster finish that would be rather funny - if it weren't all true.