Fool’s Gold Part I

Explosion in Derivatives Trading: 1970’s

Derivative: A form of insurance Value is “derived” from some other asset Example: Futures contract

1970’s Technological breakthrough: Black-Scholes option

pricing model Huge volatility in financial markets:

Bretton-Woods system of fixed exchange rates broke down Oil Shocks Dramatic inflation High interest rates

Interest Rate Swaps An agreement between two parties to exchange cash

flows in the future. Cash flows and dates when cash is exchanged are specifically

defined.

Banks often borrow at variable rates, and loan out at fixed rates As interest rates go up, banks lose Can hedge with an interest rate swap

Example: A agrees to pay B the Libor+5.5% rate at the end of each year “B” agrees to give “A” 9.95% Both rates are a percentage of some notional amount

A B9.95% (fixed)

Libor+5.5%

Cash Flows of Floating for Fixed Swap To hedge interest rate risk, a bank could structure

an interest rate swap to pay 9.5% and receive Libor+5.5% on $1 million

When rates go up, the profit from the swap position helps offset losses.

LIBOR Rate3% 4% 5% 6%

Floating Cash Flow $85,000 $95,000 $105,000 $115,000Fixed Cash Flow -$95,000 -$95,000 -$95,000 -$95,000Difference -$10,000 $0 $10,000 $20,000

Should Derivatives be Regulated? American and European Banking through 20th

century: Keep banking private, but swaddle it in rules to ward

against excesses Glass Steagall Act capital requirements International regulation: Basel I Basel II rules

Many rules drafted before explosion in derivatives Regulators Uneasy

“Part of the problem with deciding what to do about derivatives regulation was that there was so little specific data available about the growth of the business.”

Many trade OTC

Derivatives and Exchanges vs OTC Excahanges (CME, CBOE):

Record volumes of trades Force traders to post collateral with the exchange

Insulates traders against “couterparty risk” or default risk.

Deals are standardized

OTC market Allows for customized deals Murky, non-transparant No central data gathering system No protection against counterparty risk

ISDA International Swaps and Derivatives Association

Formed in 1985 Formed by group of bankers from Salomon Brothers, BNP

Paribas, Goldman Sachs, J.P. Morgan, and others. Initial Goal: hash out legal guidelines for OTC deals

Survey of market: 1987, found that total notional value of interest rate and currency swaps at $865 billion

Commodities Futures Trading Commision Regulates commodity derivatives, that largely trade on

exchanges Threatens to intervene swaps trading ISDA lobbies and prevails

Regulators Still Uneasy

1992: Corrigan to New York Banker’s Association: “Given the sheer size of the derivatives market, I have to ask myself how is it possible that so many holders of fixed- or variable-rate obligations want to shift those obligations from one form to the other.”

Group of 30 Group of 30

Highly influential group of economists, academics, and bankers

Set up in 1978 by Rockefeller Foundation Mission: promote better international financial cooperation

Study led by JP Morgan Urged all banks to adopt VAR Urged bank senior managers to learn how derivatives worked Urged banks to use ISDA’s legal documents for OTC deals Urged banks to record value of derivative positions each day

“mark-to-market” Did not suggest government should intervene Did not suggest a centralized clearing system

“could be the thin edge of wedge of further regulations” Does less transparency give banks the upper hand?

Disaster Strikes Greenspan hikes rates February 1994 Causes carnage in markets GAO: derivatives trading marked by “significant

gaps and weaknesses” Four bills introduced in 1994 to regulate derivatives

Bricknell and ISDA leap into lobbying action Clinton cozies up to Wall Street ISDA views in line with Greenspan’s “free market”

thinking Corrigan “Derivatives are like NFL quarterbacks: they get

more credit and blame than they deserve” All four bills are shelved.

J.P. Morgan Inovates June 1994: Hankcock party in Boca Raton Hotel

Idea: Banks can hedge against interest rate risk using swaps. Can we use a similar idea to hedge credit risk? Can we produce credit derivatives on a massive scale?

Why insurance against default might be attractive to banks: Can maintain client relationships, while tailoring exposure to

default risk. May convince regulators to loosen up on capital

requirements

Credit Default Swaps Exxon comes knocking on J.P. Morgan’s door

1993 $5 billion fine for Valdez tanker oil spill Wants $4.8 billion credit line from J.P. Morgan

Exxon a long standing client However:

would make little profit use up a lot of J.P. Morgan’s capital

Solution: Use a CDSEBRDJ.P. Morgan

Fee

If Exxon defaults, make up loss

Mass Production of CDS Fed in August 1996: Green Light

Banks would be allowed to reduce capital requirements by using credit derivatives.

Mass Production: How? CDS are complex – difficult to analyze risk

EBRD could do so for the Exxon deal, but how about other deals?

Winters: Greater transparency Create a liquid market for CDSs, and possibly an exchange

Demcheck: Diversify away risk Pool CDSs together in bundles and sell them

Mass Production of CDSs Securitization

Pool CDSs into a bundle of securities Issue bonds based on the cash flow

Holders of the piece of paper get An interest payment every six months.

The fees J.P. Morgan pays on the CDSs The $100 million principal back at bond maturity If any party in the CDS pool defaults, bond holders make up

losses Get less back in principal and interest

Within the pool, the default risk gets diversified away

J.P. Morgan ClientsPiece of paper

$100 Million

Mass Production of CDSs Synthetic Collateralized Debt Obligations (CDOs) (J.P. Morgan first called them Bistros)

Bonds issued on CDSs pool will come from different traunches

Lowest traunch: first bond holders to suffer losses if any party in the CDS pool defaults

Higher traunches will not suffer any losses until bond holders in the lower traunch get totally wiped out.

Lower traunches get paid a higher interest rate on their bonds

Higher traunches are exposed to lower risk Junior . . . Mezannine . . . . Senior

Mass Production of CDSs Special Purpose Vehicles

Facilitate the packaging and selling of CDO’s Off-shore shell companies

Bonds get rated by rating agencies 2/3 given AAA ratings, 1/3 stamped Ba2

But what about risk that bank losses amount to more than $700 million?

Bank SPV

Fees

Default Insurance on$9.7 Billion in Loans

Bonds

$700 Million

Investors

Mass Production of CDSs “Super Senior Risk”

The risk that losses on defaults exceed the capital raised by the SPV to cover losses.

Hancock: “It was ridiculous to worry about the eventuality of massive defaults. If the corporate sector ever suffered a tidal wave of defaults large enough to eat through the $700 funding cushion, then the disaster probably would have already wiped out half the banking system anyway. There was no point, he argued, in running a bank on the assumption that the financial equivalent of an asteroid would devastate Wall Street.”

Fed: If you want CDOs to loosen capital requirements, then you must insure the super-senior risk.

Mass Production of CDSs AIG – Insurance Company

Insurance Arm regulated by state agencies, not Fed AIGFP (AIG Financial Products) regulated by Office of

Thrift Supervision OTS had little expertise

AIG took on super senior risk for J.P. Morgan Would pay little: $0.02 annually for each dollar insured but multiplied enough times, could pay a lot

Fed Flips: You don’t need to insure super-senior risk after all You just have to hold less in reserves Super Senior Risk must get AAA rating

Correlation 1999: Bayerische Landesbank – wants to use

Bistro structure to remove credit risk of mortgage loans it has extended.

J.P. Morgan had data on corporate defaults They had been making such loans for years Could get some measure of correlation of defaults

Mortgages? No data to measure correlation. J.P. Morgan did deal for Bayerische Landesbank Did one more mortgage Bistro Then backed out of doing Mortgage Bistros all

together.

Era of Deregulation 1989: J.P. Morgan starts underwriting bonds 1990: J.P. Morgan starts underwriting equities

1997: Morgan Stanley Buys Dean Witter 1998: Citibank merges with Travelers, who

had recently purchased Salomon Brothers 1999: Glass-Steagall replealed (Bill Clinton)

“The financial world was becoming “flat”, morphing into one seething, interlinked arena for increasingly free and fierce competition.

Era of Deregulation 1998: LTCM explodes – little effect on policy Greenspan a free-market champion

2000: Commodities Futures Modernization Act Swaps were not futures or securities, and

therefore could not be regulated by the CFTC, or the SEC, or any other single regulator.

2000: J.P. Morgan merges with Chase