Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

some vague rhetoric that stressed the value of derivatives for the financial system as a whole. But it then laid out, in exhaustive detail, thebest norms for running the business. One section urged all banks to adopt VaR tools. Another demanded that banks’ senior managers learn in detail how derivatives products worked. Another section urged banks to use ISDA’s legal documents for cutting deals. The report also demanded that banks record the value of their derivatives activity each day, according to real-time market prices, following the principles of what’s become known as “mark-to-market.” This would bring consistency in valuations where before banks had been accounting the values of the derivatives deals in a host of ways. It also underscored the assumption that market prices were the “best” guide to value.
    Equally important was what the G30 report did not say. The tome did not suggest the government should intervene in the market, in any way. Nor did it drop any hint that the derivatives world might benefit from a centralized clearing system, like that for commodities derivatives and the New York Stock Exchange, to settle its trades. These clearing systems not only recorded the volume of trades, providing a valuable barometer of activity that signaled signs of trouble, but also protected investors from the eventuality that the party on the other side of the trade—the counterparty—might fall through on a deal, leaving the trade in limbo. Without a clearinghouse, derivatives traders faced this so-called counterparty risk.
    Brickell and the other members of ISDA were opposed to setting up a clearing system because they feared it would be the thin edge of a wedge of further regulations. They insisted that counterparty risk could be handled perfectly well by following the ISDA guidelines, posing some collateral against the risk of default, and just good smart trading. “The swap [market] framework is a model of market discipline,” Brickell argued. “Within it, every participant scrutinizes the reputation and credit quality of his counterparties and adjusts the flow of his business accordingly.”
    As regulators and central bankers digested the weighty G30 report, a few commentators expressed concern that the report simply did not go far enough. Brian Quinn, an executive director of the Bank of England, said the G30 report “struck me as somewhat complacent” in regard to the risks posed by the derivatives world. But, just as Dennis Weatherstone had hoped, regulators generally appeared impressed by the detailed nature of the guidelines. “If the market players continue forward in the spirit of the G30 study, then regulators will have much less to do,” observed J. Carter Beese, a Securities and Exchange commissioner, in November 1993. Hancock, Brickell, and the rest of the swaps market heaved a sigh of relief.
    Then disaster struck. By early 1994, Fed chair Alan Greenspan was starting to fear that the US economy was overheating after several years of loose monetary policy. On February 4, 1994, he suddenly raised the federal funds rates by 25 basis points from 3 to 3.25 percent. The move, which came amid other unexpected economic data, stunned the markets, triggering a sharp fall in bond prices. It also caused carnage in the derivatives world. So many of the derivatives deals made in 1992 and 1993 were premised on rates continuing to fall, and with the sudden hike, these deals produced enormous losses.
    An early victim was Procter & Gamble. The company had made a deal with Bankers Trust, with a face value of $200 million, that promised to reduce its medium-term financing costs, but only if interest rates kept falling. With the rate increase, the company was forced instead to book a pretax $157 million loss. Then more shocks emerged. Gibson Greetings, a medium-sized card company, announced a loss of $23 million; the Mead Corporation, another small American company, revealed similar losses; and Paine