The following is an excellent excerpt from the book “FOOL’S GOLD: The Inside Story of J.P. Morgan and How Wall St. Greed Corrupted It’s Bold Dream and Created a Financial Catastrophe” by Gillian Tett from Chapter Three on page 53 and I quote: “Those who invested in the senior-level securities would almost surely never suffer losses, because the chances of so many defaults happening at the same time were extremely slim. Just as in a flooding house, where the water floods the cellar first while the roof stays safe, losses from defaults would flood the junior and mezzanine levels—erasing those bondholders’ expected earnings—and the senior bonds would always be safe, except, that is, in the event of a truly major cataclysm. Due to their higher risk of loss, the junior and mezzanine notes paid proportionately higher returns, while, due to their extremely low risk, the senior notes paid quite low returns.
The key attraction of this bundling, multitiered approach was that investors could choose the level of risk they wanted. And since investors were usually willing to pay a little more for the sheer convenience of someone else tailoring their level of risk, banks could often sell the complete set of notes for more than the total value of the mortgage loans. The concept was akin to a pizzeria that takes an $8 pizza, cuts it into eight pieces, and sells each piece for $1.25. Customers will sometimes pay more to buy just the amount and flavor they want, whether of pizza or of risk.
In the 1980s, bankers took the idea that had been used to “slice and dice” mortgages and applied it to corporate bonds and loans. Demchak and his team, though, then took this a step further and applied it to credit derivatives. The idea was that, instead of grabbing a portfolio of different mortgages and selling investors a stake in it, they would instead sell a bundle of credit derivatives (CDS) contracts that insured somebody else against the risk of default. In financial terms this was equivalent to taking thirty different home insurance contracts, bundling them together, and persuading a bigger consortium of outside investors to underwrite the risk that losses might affect those thirty homes.
As with the early mortgage bond deals, though, the investors who were underwriting that “insurance”–or that pool of CDS contracts—could choose their level of risk. Investors who wanted to roll the dice could agree to pay out the first wave of claims that might hit if, say, a few contracts went bad. Investors who wanted more safety might underwrite the mezzanine—or in-between—level of risk. That was similar to paying up on a collective insurance scheme when losses got bigger than, say, $5,000 but not higher than $100,000. The “safest” part of the scheme was the senior tier, where investors would be forced to pay the cost of defaults only after the claims—or losses—had become so widespread that all the other investors had been wiped out. There were thus different tranches of risk.
To complete its scheme, the team also decided to borrow another trick from the domain of mortgage securitization. One widespread practice banks had engaged in was to create shell companies specifically for buying bundles of mortgages and selling the securities made from them. These companies were generally referred to as special purpose vehicles (SPVs), and they were usually located in offshore jurisdictions, such as the Cayman Islands and Bermuda, to ensure that they did not incur US tax. Demchak’s team decided to set up such an SPV to play the role that EBRD had filled in the Exxon swap. The shell company would “insure” J.P. Morgan for the risk of the entire bundle of loans, with Morgan paying a stream of fees to the SPV and the SPV agreeing to pay Morgan for any losses from defaults. Meanwhile, the SPV would turn around and sell smaller chunks of that risk to investors, in synthetically sliced-out junior, mezzanine, and senior notes.
The really beautiful part of the scheme was that Demchak’s team calculated that the SPV would need to sell only a relatively small number of notes to outside investors in order to raise the money to insure all of that risk. Normally, the SPV would be expected to be “fully funded,’”meaning that it would have to sell notes totaling the complete amount of risk that it was insuring. But the J.P. Morgan team reckoned full funding just wasn’t necessary; the number of defaults would be so low that so much capital wouldn’t ever be needed for covering losses.
Demchak’s team furtively worked on putting that theory into practice. Right from the start, they decided to shoot for the stars. “Let’s do ten billion dollars!” Demchak and the J.P. Morgan team declared; he liked big, round numbers. The team identified 307 companies for which J.P. Morgan was carrying risk on its books that amounted to a total of $9.7 billion. Then they set up a shell company, and they calculated that the company would need to sell only $700 million of notes to cover any payouts to J.P. Morgan it might need to make—less than 8 percent of all the risk insured. This was akin to an insurance company offering insurance on a home worth $1 million, when it holds just $75,000 in its kitty.
Just to be safe, though, Demchak decided that the SPV would invest the $700 million pot in AAA-rated Treasury bonds, so that if it were ever needed, there would be no doubt the money would be there. That ultra-safe investment plan would also help assure investors that the scheme was sound.
The team then approached officials at Moody’s credit rating to get their stamp of approval, which would be needed to convince investors. For several months, Demchak’s team held intensive debates with the ratings agencies, just as banks at NatWest, Swiss Bank Corporation, and Chase had previously done over their own earlier securitization schemes. Some ratings officials worried that $700 million was not enough to insure the entire pot of $10 billion-odd loans, and suggested ways of potentially tweaking the scheme. The J.P. Morgan officials, though, pointed out that the ratings agencies’ own data indicated that the chance of any widespread default was laughably small. In essence, all that J.P. Morgan had done was to use the default models created by Moody’s—and take them to the logical extreme. So, finally, after much back-and-forth, they decided to accept J.P. Morgan’s arguments and out of the pool of $700 million in notes, two thirds were given the all-important AAA tag. The rest were stamped Ba2.
In December 1997, just as most of the New York financial world was packing up for the Christmas holidays, Demchak’s team finally unveiled its creation. They had given it the ugly name “broad index secured trust offering,” shortened to BISTRO. With great hopes, the group set out to sell the notes. Some investors were dumbfounded. “It looks like a science experiment, with all those arrows!” one baffled fund manager quipped. Masters, however, was formidably good at marketing. Over and over again, she explained to potential investors how the scheme worked with a near-evangelical passion. She got results. Within a matter of days, the team had sold all the $700 million of notes. Indeed, the appetite was so strong that Masters concluded there was scope to conduct plenty more such deals.
The team was jubilant. They felt they had stumbled on a financial version o the Holy Grail. At a stroke, they had managed to remove credit risk from the bank’s books on an enormous scale. That wold immediately enable J.P. Morgan to relieve some of the pressure on its internal credit limits. The team also hoped that once regulators had a chance to examine the scheme, they would agree to let the bank reduce its capital reserves. But there were wider economic implications too, not just for J.P. Morgan but for the financial system as a whole.
If it was now so easy to shift large volumes of credit risk off the bank’s books, banks would be able to truly fine-tune their loan portfolios. “Five years hence, commentators will look back to the birth of the credit derivatives market as a watershed development,” Masters earnestly declared. “Credit derivatives will fundamentally change the way banks price, manage, transact, originate, distribute, and account for risk.” She, like her colleagues, took it as self-evident that these “efficiency gains” from shifting risk this way could only lead to a better financial world, and they pleaded their case with an almost religious zeal.
“When you heard these guys speak, you realized that they really believed this stuff,” Paula Froelich, a journalist from Dow Jones who had extensive contact with the BISTRO team during that period, recalled. “They thought they were the smartest guys on the planet. They had found this brilliant way to get around the [Basel] rules, to play around with all this risk. And they were just so proud of what they had done.””
(A STORY OF MISGUIDED BANKERS AND A BOOK WRITTEN ABOUT THEM. WHILE THIS BOOK WAS WRITTEN EXCLUSIVELY ABOUT ONE BANK, THE BIGGEST BANK INVOLVED IN THE DERIVATIVE MARKET, EVEN THOUGH THERE WERE OTHERS THAT TRADED CONTRACTS WITH ONE ANOTHER TO MAKE IT LOOK LIKE THEY WERE REALLY DOING BUSINESS AND GROWING. ONLY LATER TO FIND OUT, THE BANKS WERE LYING TO ONE ANOTHER, AS WELL AS THE CUSTOMERS. ALL IT WAS IS A PYRAMID SCHEME BUILT ON LIES AND MORE LIES AND ENOUGH BOOKS WRITTEN TO FILL A LIBRARY BY INVESTIGATIVE REPORTERS, WHO TOOK TIME TO TRACK DOWN WHAT WAS REALLY GOING ON. THE SADDEST PART OF THE WHOLE ISSUE WAS EVERY TIME AN ELECTED OFFICIAL CAME TO TOWN OR I CALLED THEM ON THE TELEPHONE, I ASKED THEM IF THEY TOOK TIME TO READ A PARTICULAR BOOK, AND THAT THEY SHOULD DO SO BUT THEY SAID THEY NEVER HAD THE TIME TO DO SO. THAT’S WHY, ON MY BLOG SITES, I’VE PUT MANY EXCERPTS OF THE HIGHLIGHTS OF THESE BOOKS SO THE ELECTED OFFICIALS COULD ZERO IN ON JUST EXACTLY WHAT THE REAL PROBLEMS WERE AND THIS BOOK “FOOL’S GOLD: THE INSIDE STORY OF J.P. MORGAN AND HOW WALL ST. GREED CORRUPTED ITS BOLD DREAM AND CREATED A FINANCIAL CATASTROPHE” BY GILLIAN TETT, ZEROED IN ON JUST EXACTLY HOW HARD THE DREAM TEAM WORKED TO CONFUSE THE TAXPAYER AND TOOK ONE OF THE BIGGEST BANKS IN USING ONE OF THE MANY TACTICS THAT ALL THE BANKS WERE TAKING OF DEFRAUDING THE PUBLIC. SAD TO SAY, THERE ARE ONLY A FEW LEGISLATORS, SUCH AS SENATOR ELIZABETH WARREN, SENATOR BERNIE SANDERS, AND SENATOR SHERROD BROWN, TRYING TO BRING THIS VERY, VERY SERIOUS PROBLEM TO THE ATTENTION OF THE MEDIA, AS WELL AS OTHER POLITICIANS. UNLESS WE PAY ATTENTION, THIS WHOLE CATASTROPHE COULD HAPPEN ON A BIGGER SCALE THAN THE 2008 BUBBLE.
LaVern Isely, Overtaxed Independent Middle Class Taxpayer & Public Citizen & AARP Members