The credit crunch unveiled itself as an accelerating series of ever-heavier bumps. The first was probably HSBC's warning in February 2007 that its US sub-prime lender, Household Finance, had run into difficulties. Big bank: small problem. Not abnormal.
It was three months before the next bump: in May 2007 a Bear Sterns hedge fund called - what a wonderful name - the High-Grade Structured Credit Strategies Enhanced Leverage Fund, said it had lost 6 per cent in a month. Then, two weeks later, this is more or less what they said: "Sorry… make that 19 per cent… not a further 13 per cent... the 6 per cent was simply wrong. The one-month loss was actually 19 per cent."
This set the tone. It wasn't the absurd name. It was the fact that the arithmetic was so difficult. Within a week, it was clear that there were a lot of investments in a lot of funds that could not be valued, because nobody would buy them, despite the fact that they had triple-A ratings. What did that mean? It meant 'Get out of here!'
The rest is history...
Northern Rock collapsed. Citibank attempted to rally fellow banks into launching a rescue fund for the triple-A derivatives that were strangling it. UBS announced shock losses. Bear Stearns was marched into JPMorgan, with a $30bn (£19.6bn) US government guarantee. By late last year, the bumps had become carnage, the pace sickening. In a month, Lehman, Merrill Lynch and AIG were eviscerated. Even proud Goldman Sachs took government money. Over here, Royal Bank of Scotland and HBOS turned out to have been playing the same game as Northern Rock. This sorry tale occupies the second half of the book.
...and this is how we got there
The first half begins in 1994 at a JPMorgan meeting where its 50 top derivatives people were challenged by their boss - a Brit called Peter Hancock - to come up with some new ideas. That session launched the credit default swap (CDS), which would be counter-intuitive to most people. If banks want to free up capital, they can sell loans they have made - this is a tame concept. But the idea of the credit default swap was that banks could achieve the same objective without selling the loans. They only needed to sell the - wait for it - risk that the loan would not be repaid.
JPMorgan's first CDS involved a prestigious client, Exxon, which unexpectedly sought a large loan facility (about $3bn) at a very low rate. Under traditional rules, this would require JPMorgan to tie up $240m of its free capital. JPMorgan didn't want to tie up so much money for so little return. Yet it could not refuse Exxon, and nor was it willing to sell down a loan to such a key client. So it asked a gentle giant - the European Bank for Reconstruction and Development (EBRD), which had more capital than customers - if, in return for a fee, it would care to assume the very slight risk that Exxon might go bust. The European Bank said yes. This left JPMorgan with just a sliver of income from the loan, but zero capital risk… and very little of its precious free capital tied up in the name of Exxon. It was ingenious, and it was not toxic. Ms Tett records that one senior US regulator told JPMorgan "it was one of the best innovations I have ever seen. It was just a wonderful idea".
It took another three years for JPMorgan to industrialise the process, creating a tame structured investment vehicle (SIV) in the place of the EBRD and "collateralised debt obligations" as a currency by which its loans could be passed in small parcels to investors of every hue. By 1999, JPMorgan had thus "sliced and diced" hundreds of billions of dollars of loans made to thousands of clients. And kept more than a sliver.
But as JPMorgan's competitors leapt on the bandwagon, and grew that figure to trillions, it all became very unwonderful. They created dubious SIVs, loaded them up with loans to customers of dubious creditworthiness, and created collateralised debt out of collateralised debt.
