Book: Fool’s Gold
Author: Gillian Tett
One of the key financial inventions of the past two decades has been credit derivatives. Some of these, namely CDOs got extremely popular in financial press in the aftermath of financial crisis. This book traces the root of creation of these derivatives and their route to popularity. It is interesting to note that the idea was first conceived at JP Morgan and Banker’s Trust (now part of Deutsche Bank)–the two banks that came out of the financial crisis stronger. JPM is the house that popularized the concept, and it was eventually copied across the street.
- The concept of credit derivative is truly innovative: Banks assume many risks when they lend to a client–default, interest rate, currency, inflation, cash-flow, reinvestment and so on. Every risk can technically be hedged away, but credit/default risk is truly hard to get away from. CDS and CDO allows banks to hedge away credit risk, releasing lending from shackles of credit events, and allowing banks to make more loans, super-charging their checkbook and the economy on the way (in the short run), as the risk of default has been lifted away from its books.
- 2008 crisis was not the first time derivatives were involved in havoc: 1992-93 saw a number of derivative related crises, though these were mostly linked to interest rate derivatives. P&G’s $200m loss and following suit with Banker’s Trust, Paine Webber’s $268m loss, Orange County’s bankruptcy are all famous cases of the era when power and risk of derivatives were miscalculated. This led to calls for additional oversight, but by end of 1994, Wall St had managed to roll back the efforts with a supremely successful lobbying campaign. Remember that this was during Clinton administration, and that should give pause to those who think of deregulation as a Republican preserve.
- Like everything, it began benignly: In ’93, Exxon asked JPM for a $5 bn loan, post the Valdez crisis. JPM didn’t want to say no to a long-standing client loan that will generate little interest income, so it sold the default risk of the Exxon loan to EBRD, a European Bank, in exchange for yearly payments from JPM, thus keeping the client happy and moving the loan off its books. This product was called credit default swap or CDS. Soon, the idea was industrialized, where credit risks of several entities were bundled and sold to investors. Securitization and tranches, which had been invented in 60s and 70s for mortgages, were soon applied to corporate bonds and loans. Quickly, this got perverse. JPM started creating SPVs that insured JPM of the risk of the loans, essentially playing the role of EBRD, and then issued tranches of securitized notes. The SPV invested in Treasury notes to keep the “insurance money” safe, and earned AAA rating for most of the tranches from Moody’s. Soon, JPM could sell almost $10 bn of credit risk securitized in this way, and shifted an enormous amount of credit risk off its books, and onto the investors. On face of it, this is indeed brilliant. But, from an investor’s standpoint, this was awful, though no one could tell for sure yet. Capital markets for trade-able securities in developed countries work on arm’s length basis–i.e. details of the operation behind the securities are publicly available. But, securitization on such a large scale obfuscates the complexity. Plus, no investor bothers to even uncover it because it has the all-important appropriate rating from agencies. Leverage meets credit risk meets outsourced judgement (really, professed ignorance).
- Super-senior and AIG: After removing the credit risk from its books, JPM wanted to remove the part of the loan from its books (to make more loans), but regulators wanted them to removed all risk from the books, including the Treasuries held by the SPV. This risk was dubbed as Super-senior, something beyond AAA owing to usage of Treasuries, but there were no natural buyers because the payoff was so low. AIG, the insurance giant emerged to be that buyer, especially because it was not subject to capital reserve requirement as banks were and was regulated by Office of Thrift Supervision, who needed limited expertise in derivatives. AIG earned 2/100th of a cent per dollar on these, and hence it did mega-deals, unregulated. Regulators eventually allowed JPM to remove 80% of the CDS-backed loans from its books, and JPM didn’t need to move the loans to AIG, but it did, because the team knew that the models were just guides, and were wary of large sums of risk lying on B/S. This single decision is perhaps the reason for the rift between post-crisis AIG and JPM.
- SIV: A cousin of SPV, SIV structure was used heavily to move loans off the balance sheet of the banks. Using this, banks got around the Basel rules that said that credit lines of the bank need to be extended to SIVs if the funding commitment were greater than 1 year. These SIVs had funding commitment of 364 days, borrowed on short-term and invested in long-term bonds, earning returns off this carry-trade. Of course, they harbored enormous interest rate spread risk, and some credit risk, even though they invested in only AAA treasuries.
- Others get in: No secret remains so for long on Wall St, especially when it’s so profitable. Particularly, after the 2004 SEC ruling that allowed banks to be in charge of their own risk, all the bank pumped up the leverage on their super-senior loans to make more returns.
- JPM backs out: While every other bank gorged on the CDS/CDO bonanza, JPM backed out because its leaders, including Dimon thought that the business was getting too risky. Dimon made IT and Risk departments more powerful, while instilling the concept of a fortress balance sheet among his lieutenants.
- ..and steeled itself: “The fact is that every five years or so, something bad happens. Nobody ever has a right to not expect the credit cycle to turn.” – Dimon is purported to say again and again. Underwriting standard for mortgages and private investor loans were raised. Macro hedges were put in place.
- Senior at homes: On the other hand, several banks were so busy churning out CDSs and CDOs that they could not find buyers for the residual super-seniors. So, they just put it on their own balance sheet. When the mezzanine tranches started failing, super-seniors also got hit, and fast.
- The rest, is of course, financial history, beginning from Bear Stearns funds to Lehman to AIG and beyond.
As an aside, the following players do a lot of work in the area, which is often under-reported – IIF, Basel Committee, BIS, Group of Thirty
My closing thought: It’s a rare book that talks about why CDS and CDOs were created, and how their use was soon bastardized, to use a technical term. Often books begin by chastising these complex products, which of course, tells less than half the story. The scary thing I took away from the book is that CDS is actually a great financial product which now carries a bad name because of imprudent use, and that pretty much every actor in this trainwreck played within the rules, though not always by the principles.