J.P. Morgan's monster

(Via CJR's Ryan Chittum)

Jessee Eisenger details the frightening evolution of Credit Default Swaps.

The big instigators of the CDS market was a team at J.P. Morgan under the leadership of a man named Bill Demchak:

Securitization has been around since the 1970s. In such a transaction, a group of loans—for example, mortgage, credit card, or corporate loans—is bundled together and sliced up into pieces called tranches. The lowest portion, called the equity, is exposed to the first losses. The next slice up is exposed to the following losses, and so on, until you get to the top. The slices are usually rated by the rating agencies. (Often, the media and even some on Wall Street colloquially refer to tranches of securitizations as derivatives; they aren’t. Tranches are securities backed by a pool of cash-producing assets.)

The Demchak group’s breakthrough was to inject a little magic into standard securitizations. Instead of putting a particular loan into the sliced-up instrument—say, a 30-year loan to I.B.M.—it put a piece of J.P. Morgan’s exposure to I.B.M. into it. For this, the team used credit-default swaps, a burgeoning form of credit derivative. In a C.D.S. transaction, the buyer is protected against a default. These contracts had been floating around in small, experimental form for several years, having been created by Bankers Trust, a scrappy cowboy investment bank.

Bill Demchak’s team was the first to take them wholesale, using credit-default swaps in a huge deal. They mashed up J.P. Morgan’s exposure to more than 300 giant corporations, created an off-balance-sheet vehicle, then sold slices of that to investors. The vehicle then protected J.P. Morgan from defaults. In effect, Morgan was paying insurance premiums to investors who now were on the hook if one of Morgan’s clients went belly-up. “The innovation of not being tied to specific loans or bonds is what made the credit-derivatives market what it is today,” says Romita Shetty, who was part of Demchak’s team at J.P. Morgan.

[snip]

J.P. Morgan would go on to launch a credit-­derivatives assembly line, becoming the Henry Ford of the new financial market. Throughout the 1990s, the bank was a major player in persuading lawmakers to allow the derivatives markets to remain unregulated—a move regulators are now reevaluating. [J.P. Morgan's first CDS, called] Bistro helped [their] traders in London kick-start the expansion of the “single-name” C.D.S. market, where individual contracts that cover just one company or entity trade hands. This market became liquid and deep by the early 2000s. “We had 100 people,” Demchak recalls. “We helped create the regulatory framework, the legal and accounting framework, and we did billions. We industrialized the product.”

Bistro “was the most sublime piece of financial engineering that was ever developed. It was breathtaking in terms of beauty and elegance,” says Satyajit Das, a risk consultant and the author of Traders, Guns, and Money, a financial history. But “in many ways,” Das adds, “J.P. Morgan created Frankenstein’s monster.”

Turning your own debt into the debt of others is a pretty interesting exploit of the CDS structure.

How would that conversation go, I wonder...

J.P. Morgan: We're going to pay you money every year, in exchange for you assuming our liability if we default on this billion dollar loan.

Investor: Where do I sign?

Obviously, it was more complicated than that, but you have a kind of financial judo move taking place - but basicially J.P. Morgan is selling its future payments on a CDS to investors. The investors would be liable for Morgan's loan but-

I imagine they could sell a CDS to someone else to net out the risk.

...and that someone will sell a CDS to someone, and that some will sell a CDS to someone.

And so on and so on and so on.