World - How credit defauly swaps became a timebomb

Mathew Philips

They're called "Off-Site Weekends"—rituals of the high-finance world in which teams of bankers gather someplace sunny to blow off steam and celebrate their successes as Masters of the Universe. Think yacht parties, bikini models, $1,000 bottles of Cristal. One 1994 trip by a group of JPMorgan bankers to the tony Boca Raton Resort & Club in Florida has become the stuff of Wall Street legend—though not for the raucous partying (although there was plenty of that, too). Holed up for most of the weekend in a conference room at the pink, Spanish-style resort, the JPMorgan bankers were trying to get their heads around a question as old as banking itself: how do you mitigate your risk when you loan money to someone? By the mid-'90s, JPMorgan's books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital?
What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices. While the concept had been floating around the markets for a couple of years, JPMorgan was the first bank to make a big bet on credit default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments. Within a few years, the credit default swap (CDS) became the hot financial instrument, the safest way to parse out risk while maintaining a steady return. "I've known people who worked on the Manhattan Project," says Mark Brickell, who at the time was a 40-year-old managing director at JPMorgan. "And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important."
Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn't realize they were creating a monster. Today, the economy is teetering and Wall Street is in ruins, thanks in no small part to the beast they unleashed 14 years ago. The country's biggest insurance company, AIG, had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and scores of other entities. So much of what's gone wrong with the financial system in the past year can be traced back to credit default swaps, which ballooned into a $62 trillion market before ratcheting down to $55 trillion last week—nearly four times the value of all stocks traded on the New York Stock Exchange. There's a reason Warren Buffett called these instruments "financial weapons of mass destruction." Since credit default swaps are privately negotiated contracts between two parties and aren't regulated by the government, there's no central reporting mechanism to determine their value. That has clouded up the markets with billions of dollars' worth of opaque "dark matter," as some economists like to say. Like rogue nukes, they've proliferated around the world and now lie hiding, waiting to blow up the balance sheets of countless other financial institutions.
It didn't start out that way. One of the earliest CDS deals came out of JPMorgan in December 1997, when the firm put into place the idea hatched in Boca Raton. It essentially took 300 different loans, totaling $9.7 billion, that had been made to a variety of big companies like Ford, Wal-Mart and IBM, and cut them up into pieces known as "tranches" (that's French for "slices"). The bank then identified the riskiest 10 percent tranche and sold it to investors in what was called the Broad Index Securitized Trust Offering, or Bistro for short. The Bistro was put together by Terri Duhon, at the time a 25-year-old MIT graduate working on JPMorgan's credit swaps desk in New York—a division that would eventually earn the name the Morgan Mafia for the number of former members who went on to senior positions at global banks and hedge funds. "We made it possible for banks to get their credit risk off their books and into nonfinancial institutions like insurance companies and pension funds," says Duhon, who now heads her own derivatives consulting business in London.
Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions, and credit default swaps proved just the tool. By then, the CDS market was more than doubling every year, surpassing $100 billion in 2000 and totaling $6.4 trillion by 2004.
And then came the housing boom. As the Federal Reserve cut interest rates and Americans started buying homes in record numbers, mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought by just about every financial institution imaginable: investment banks, commercial banks, hedge funds, pension funds. For many of those mortgage-backed securities, credit default swaps were taken out to protect against default. "These structures were such a great deal, everyone and their dog decided to jump in, which led to massive growth in the CDS market," says Rohan Douglas, who ran Salomon Brothers and Citigroup's global credit swaps research division through the 1990s.
Soon, companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps. AIG's fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn't necessarily increase your risk of getting into one. But with bonds, it's a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit.
The problem was exacerbated by the fact that so many institutions were tethered to one another through these deals. For example, Lehman Brothers had itself made more than $700 billion worth of swaps, and many of them were backed by AIG. And when mortgage-backed securities started going bad, AIG had to make good on billions of dollars of credit default swaps. Soon it became clear it wasn't going to be able to cover its losses. And since AIG's stock was one of the components of the Dow Jones industrial average, the plunge in its share price pulled down the entire average, contributing to the panic.
The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS business—buying and trading them and thus offsetting whatever losses they took—AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who'd bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they hadpurchased, causing them their own credit problems.
Given the CDSs' role in this mess, it's likely that the federal government will start regulating them; New York state has already said it will begin doing so in January. "Sadly, they've been vilified," says Duhon, who helped get the whole thing started with that Bistro deal a decade ago. "It's like saying it's the gun's fault when someone gets shot." But just as one might want to regulate street sales of AK-47s, there's an argument to be made that credit default swaps can be dangerous in the wrong hands. "It made it a lot easier for some people to get into trouble," says Darrell Duffie, an economist at Stanford. Although he believes credit default swaps have been "dramatically misused," Duffie says he still believes they're a very effective tool and shouldn't be done away with entirely. Besides, he says, "if you outlaw them, then the financial engineers will just come up with something else that gets around the regulation." As Wall Street and Washington wring their hands over how to prevent future financial crises, we can only hope they re-read Mary Shelley's "Frankenstein."