In Fool's Gold, Gillian Tett, a reporter for the Financial Times, tells the story of how esoteric credit derivatives were developed and championed by a small group of independent thinkers at J. P. Morgan and how these derivatives came to ran amok among other banks causing the financial crisis from which we currently suffer. She details how a small close-knit group at J. P. Morgan developed and championed credit derivative swaps (CDS). J. P. Morgan was quite careful with these derivatives. It is interesting to note that they looked into the possibility of creating similar instruments backed by residential mortgages, but thought it too risky.
When J. P. Morgan merged with Chase Manhattan, the change in culture led many of the team to leave JP Morgan Chase for other banks or hedge funds. Those that stayed watched as the credit derivatives they invented took off, sometimes baffled by the risks other banks seemed to be taking. Did those banks know more than they did?
Another merger, this time between JPMorgan Chase and Bank One, brings in Jaimie Dimon who was the head of Bank One. He soon took over as JP Morgan Chase. The previous derivatives team had been conservative, but Dimon, with his "fortress balance sheet" idea really drove home the possible dangers of credit derivatives. Other banks, however, continued increased their CDO outputs, leveraging themselves with increasing ratios to do so. Then the bottom fell out. Two hedge funds at Bear Stearns collapsed due to their heavy investment in CDOs. Downgrades by the rating agencies forced many banks to write down their derivative assets, leading to billions in losses. Mortgage lenders like Countrywide failed, then commercial banks like Northern Rock. Bear Stearns blew up, with J.P. Morgan swooping in the buy them for a song. More write downs led Lehman Brothers bankruptcy and AIGs government rescue. The original team watched in horror as all this unfolded, but retained a belief that the instruments themselves were a useful way to manage risk, even if their abuse led to a financial crisis.
If you are at all interested in the how we got into this current financial mess, Tett's book is a good place to start. Earlier this year, I read William Cohan's account of Bear Stearns fall, The House of Cards. I found this a much more readable book.