FT.com / Weekend / Reportage - Genesis of the debt disaster
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Saved by 6 people (0 private), first by anonymouse user on 2009-05-02
- Bmaclean on 2009-11-01 - Tags Tett , derivatives , origin , cap v cap
- Ignitesrini on 2009-06-22 - Tags no_tag
- Ahughes2 on 2009-05-24 - Tags finance-derivatives , recession , history , finance , rank5
- Andrewcrook on 2009-05-03 - Tags no_tag
- Rlieberman on 2009-05-03 - Tags no_tag
Public Sticky notes
Genesis of the debt disaster
Highlighted by tonycurzonprice
In the 1990s, a young team at Wall Street investment bank JP Morgan pioneered a new way of making money – credit derivatives.
Highlighted by bmaclean
The first sign that there might be a structural problem with the innovative bundles of credit derivatives that bankers at JP Morgan had dreamed up emerged in the second half of 1998.
Highlighted by bmaclean
But when they were doing these deals for other banks, the question of reserve capital became more important – the others were mainly interested in cutting their reserve requirements.
Highlighted by bmaclean
The regulators weren’t sure. When officials at the Office of the Comptroller of the Currency and the Federal Reserve had first heard about credit derivatives and CDOs, they had warmed to the idea that banks were trying to manage their risk.
Highlighted by bmaclean
When the team did their first Bistro deal, they pooled more than 300 of JP Morgan’s loans, worth a total of $9.7bn, and issued securities based on the income streams from these loans.
Highlighted by bmaclean
After much debate, the credit rating agencies had agreed with the team’s assessment of the risks, and the deal had gone ahead on the basis that if financial Armageddon wiped out the $700m funding cushion, JP Morgan would absorb the additional losses itself.
Highlighted by bmaclean
But within AIG, an upstart entrepreneurial subsidiary was booming. In the late 1980s the company hired a group of traders who had previously worked for Drexel Burnham Lambert, the infamous – and now defunct – champion of the junk-bond business
Highlighted by bmaclean
Cassano was creative, bold and highly ambitious. More important, he knew that, as an insurance company, AIG was not subject to the same burdensome rules on capital reserves as banks.
Highlighted by bmaclean
It was regulated by the US Office for Thrift Supervision, whose officials had scant expertise in the field of cutting-edge financial products.
Highlighted by bmaclean
AIG would earn a relatively paltry fee for providing this service – just 0.02 cents per dollar insured per year. But if 0.02 cents is multiplied a few billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the risk. Once again, the magic of derivatives had produced a “win–win” solution. Only many years later did it become clear that Cassano’s trade had set AIG on the path to ruin.
Highlighted by bmaclean
She discussed what to do with Krishna Varikooty and the other quantitative experts. Varikooty was renowned on the team for taking a sober approach to risk. He was a stickler for detail and that scrupulousness sometimes infuriated colleagues who were itching to make deals. But Demchak always defended Varikooty. His judgment on the mortgage debt was clear: he could not see a way to track the potential correlation of defaults with any confidence. Without that, he declared, no precise estimate could be made of the risks of default in a pool of mortgages. If defaults on mortgages were uncorrelated, then the Bistro structure should be safe for mortgage risk, but if they were highly correlated, it might be catastrophically dangerous. Nobody could kn
Highlighted by ignitesrini
In subsequent months, Duhon heard through the grapevine that other banks were starting to do credit derivatives deals with mortgage debt, and she wondered how they had coped with the lack of data that so worried her and Varikooty. Had they found a better way to track the correlation issue? Did they have more experience of dealing with mortgages? She had no way of finding out. Because the credit derivatives market was unregulated, details of the deals weren’t available.
Highlighted by ignitesrini
The team at JP Morgan did only one more Bistro deal with mortgage debt, a few months later, worth $10bn. Then, as other banks ramped up their mortgage-backed business, JP Morgan largely dropped out. Eight years later, the unquantified mortgage risk that had frightened off Duhon, Varikooty and the JP Morgan team had reached vast proportions. And it was spread throughout the western world’s financial system.
Highlighted by ignitesrini
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