Professor/Lecturer Ellmann's Course Materials Page

The monster that ate Wall Street
economic thought
MBA/MA - Anglo-American University International Finance
ERASMUS - International Finance
MBA - Money and Financial Markets
ERASMUS Money & Banking
M.A. Public Policy Economic Sociology
On the Origin of Facts

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The Monster That Ate Wall Street

How 'credit default swaps'- an insurance against bad loans- turned from
a smart bet into a killer.
Matthew Philips
From the magazine issue dated Oct 6, 2008

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 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

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

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