Fool's Gold

4 ideas

1. J.P. Morgan's BISTRO and Exxon credit swap

   In 1994 a young J.P. Morgan team led by Blythe Masters and Peter Hancock arranged a swap that moved the default risk on a roughly $4.8 billion credit line to Exxon, drawn after the Exxon Valdez disaster, over to the European Bank for Reconstruction and Development. Morgan kept the loan and the client relationship but paid to transfer the credit risk. In 1997 the team scaled the idea into BISTRO, which pooled hundreds of corporate loans and sold synthetic slices of their risk to investors. This freed regulatory capital while leaving the risk measurable, because the underlying borrowers had long default histories.

2. Copied innovations shed their original safeguards

   J.P. Morgan applied credit-derivative structures only to corporate debt with decades of default data, and it declined to extend them to mortgages because it could not model how home loans would correlate. Rivals copied the form and applied it to subprime mortgages, where no such data existed. They also dropped the internal controls that had made the tool safe. An innovation's safety lived in its inventors' judgment and discipline, and that judgment did not transfer when others copied the technique.

3. Finance examined as an anthropological tribe

   Financiers should be studied the way an anthropologist studies a tribe: through their rituals, specialised language, social silos and shared blind spots, not only through their models. Areas that insiders treat as too technical or boring to discuss are exactly where unexamined power and risk build up. Outsiders such as regulators, journalists and even bank CEOs stopped looking at credit derivatives because the field seemed arcane.

4. Super-senior risk as illusory safety

   The highest tranches of CDOs, called super-senior, were modelled as almost impossible to default, so banks such as UBS and Citigroup held tens of billions of them on their own books. They treated these holdings as nearly riskless and gave them almost no capital. Because the models assumed mortgage defaults were largely uncorrelated, a nationwide housing downturn made the 'safest' paper the source of catastrophic losses. When a ratings-driven label of safety becomes the reason to accumulate an asset, it concentrates risk instead of dispersing it.

Save and mark ideas in the app