JP Morgan

Image via WikipediaFortune cover story:

It was the second week of October 2006. William King, then J.P. Morgan's chief of securitized products, was vacationing in Rwanda, visiting remote coffee plantations he was helping to finance. One evening CEO Jamie Dimon tracked him down to fire a red alert. "Billy, I really want you to watch out for subprime!" Dimon's voice crackled over King's hotel phone. "We need to sell a lot of our positions. I've seen it before. This stuff could go up in smoke!"

A classic Dimon manic moment, the call is significant for two reasons. First, it marked the beginning of a remarkable strategic shift that helped J.P. Morgan, virtually alone among the big diversified banks, sidestep the worst of a historic credit crisis.

Dimon and his team are on top today because they took a daring stance at the height of the credit bubble. J.P. Morgan mostly exited the business of securitizing subprime mortgages when it was still booming, shunning now notorious instruments such as SIVs (structured investment vehicles) and CDOs (collateralized debt obligations). With the notable exception of Goldman Sachs, J.P. Morgan's main competitors - including Citigroup, UBS, and Merrill Lynch - ignored the danger signs and piled into those products in a feeding frenzy.

Remember the October 2006 "ditch subprime" call? What set Dimon off?

Every month, recall, Dimon reviews every aspect of the business in great detail ("Appendix 3" is not a joke). And in October 2006, during the regular monthly review of the retail bank's operations, the head of mortgage servicing said that late payments on subprime loans were rising at an alarming rate. Moreover, data showed that loans originated by competitors like First Franklin and American Home were performing three times worse than J.P. Morgan's subprime mortgages. "We concluded that underwriting standards were deteriorating across the industry," says Dimon.

But what about the CDO's the bank still held? Weren't they all AAA rated?

Yes, they were, but the price of credit default swaps on even AAA-rated CDO's told a different story:

Winters and Black [investment bank co-heads] saw that once they bought credit default swaps to hedge the AAA CDO paper J.P. Morgan would have to hold, the fees from creating CDOs would vanish. "We saw no profit, and lots of risk, in holding subprime paper on our balance sheet," says Winters.

The combined weight of that data triggered Dimon's call to King in Africa. "It was Jamie who saw all the pieces," says Winters.

Not only did Dimon instruct the bank to start selling its CDO's (including more than $12-billion subprime mortgages that JP Morgan had originated), he took action across the entire institution. Trading desks were ordered to dump loans on their books, and to stop making markets in subprime loans for customers. The private bank, that manages money for wealthy clients, started advising them to sell. The corporate treasury department started hedging and placing bets that credit spreads would widen (profiting by hundreds of millions of dollars when that turned out to be precisely the case).

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