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May 1, 2009 7:16 pm

Genesis of the debt disaster

By Gillian Tett

n the 1990s, a young team at Wall Street

investment bank JP Morgan pioneered a new way
of making money credit derivatives. Within a
decade, the market for these exotic securities had
exploded to more than $12,000bn and some
people later blamed them for fuelling the global
financial fiasco. In the first of two extracts from her
book, Fools Gold, the FTs Gillian Tett reveals how
the innovation genie was first let out of the bottle
and eventually devoured the system, to the horror
of its creators.
The first sign that there might be a structural problem with
the innovative bundles of credit derivatives that bankers at JP Morgan had dreamed up
emerged in the second half of 1998. In the preceding months, Blythe Masters and Bill
Demchak key members of JP Morgans credit derivatives team had been pestering
financial regulators. They believed that by using the new credit derivative products they
had helped create, JP Morgan could better manage the risks in its portfolio of loans to
companies, and thereby reduce the amount of capital it needed to put aside to cover
possible defaults. The question was by how much. (Though these bundles of credit
derivatives later went under other names, such as collateralised debt obligations [CDOs],
at that time these pioneering structures were known as Bistro deals, short for Broad
Index Secured Trust Offering). Masters and Demchak had done the first couple of Bistro
deals on behalf of their own bank without knowing the answer to their question for sure.
But when they were doing these deals for other banks, the question of reserve capital
became more important the others were mainly interested in cutting their reserve
requirements.
The regulators werent sure. When officials at the Office of the Comptroller of the Currency
and the Federal Reserve had first heard about credit derivatives and CDOs, they had
warmed to the idea that banks were trying to manage their risk. But they were also uneasy
because the new derivatives didnt fit neatly under any existing regulations. And they were
particularly uncertain over what to make of the unusually low level of capital available to
cover losses on the derivatives.
When the team did their first Bistro deal, they pooled more
than 300 of JP Morgans loans, worth a total of $9.7bn, and
issued securities based on the income streams from these loans. The lure of the idea was

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clear: the team had calculated that they only needed to set aside $700m a strikingly
small sum against the risk of defaults among the 300-plus loans. After much debate, the
credit rating agencies had agreed with the teams assessment of the risks, and the deal had
gone ahead on the basis that if financial Armageddon wiped out the $700m funding
cushion, JP Morgan would absorb the additional losses itself. To Masters and Demchak,
the chance that losses would ever eat through $700m were minuscule.
That argument didnt wash with European regulators, and some of their US counterparts
were uneasy, too. Christine Cumming, a senior Fed official, indicated to Masters and
Demchak that JP Morgan should look for a way to insure the rest of the risk the
missing $9bn in their original Bistro scheme if the bank wanted to gain approval to cut
its capital reserves. So Masters and her team set out to find a solution. They started by
giving the bundle of uninsured risk a name. Masters liked to refer to it as more than
triple-A, since it was deemed even safer than triple A-rated securities. But that was too
clumsy to market, so they came up with super-senior. The next step was to explore who,
if anyone, might want to buy or insure it.
The task did not look easy. As far as JP Morgan was concerned, this risk was not really
risky at all, so there was no point paying anything other than a token amount to insure it.
On top of that, whoever stepped up to acquire or insure the super-senior risk had to be
brave enough to step into an unfamiliar world.
...
The seeds of AIGs destruction
Masters eventually spotted one solution to the super-senior
headache. In the past, one of JP Morgans longstanding
blue-chip clients had been the mighty insurance company
American International Group. Like JP Morgan, AIG was a
pillar of the American financial establishment. It had risen
to prominence by building a formidable franchise in the
Asian markets during the early-20th century. That business
was later extended to the US, making the company a
powerful force in the American economy after the second
world war. AIG was considered a weighty and utterly reliable
market player, and like JP Morgan, it basked in the sun of a
triple-A credit rating.
But within AIG, an upstart entrepreneurial subsidiary was
booming. In the late 1980s the company hired a group of
traders who had previously worked for Drexel Burnham
Lambert, the infamous and now defunct champion of the junk-bond business under
Michael Milken in the mid-1980s. These traders had developed a capital markets business,
known as AIG Financial Products and based in London, where the regulatory regime was
less restrictive. It was run by Joseph Cassano, a tough-talking trader from Brooklyn.

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Cassano was creative, bold and highly ambitious. More important, he knew that, as an
insurance company, AIG was not subject to the same burdensome rules on capital reserves
as banks. That meant it would not need to set aside anything but a tiny sliver of capital at
most if it insured the super-senior risk. Nor was the insurer likely to face hard questions
from its own regulators because AIG Financial Products had largely fallen through the
cracks of oversight. It was regulated by the US Office for Thrift Supervision, whose officials
had scant expertise in the field of cutting-edge financial products.
Masters pitched to Cassano that AIG take over JP Morgans super-senior risk, and Cassano
happily agreed. It was a watershed event, or so Cassano later observed. JP Morgan came
to us, who were somebody we worked with a great deal, and asked us to participate in
some of what they called Bistro trades [which] were the precursors to what [became] the
CDO market, he explained. It seemed good business for AIG.
AIG would earn a relatively paltry fee for providing this service just 0.02 cents per dollar
insured per year. But if 0.02 cents is multiplied a few billion times, it adds up to an
appreciable income stream, particularly if no reserves are required to cover the risk. Once
again, the magic of derivatives had produced a winwin solution. Only many years later
did it become clear that Cassanos trade had set AIG on the path to ruin.
With the AIG deal in hand, the JP Morgan team returned to the regulators and pointed out
that a way had been found to remove the rest of the credit risk from their Bistro deals.
They started plotting other sales of super-senior risk to other insurance and reinsurance
companies, which snapped it up, not just from JP Morgan but from other banks too.
Then, ironically, just as this business was taking off, the US regulators weighed in again.
Officials at the Office of the Comptroller of the Currency and the Fed indicated to JP
Morgan that after due reflection they thought that banks did not need to remove supersenior risk from their books after all. The lobbying by Masters and others had seemingly
paid off. The regulators were not willing to let the banks get off scot-free. If they held the
super-senior risk on their books, they would need to post reserves one-fifth the size of the
usual amount (20 per cent of 8 per cent, meaning $1.60 for every $100 that lay on the
books). There were also some conditions. Banks could only cut their capital reserves in this
way if they could prove that the risk of default on the super-senior portion of the deals was
truly negligible, and if the securities being issued via a Bistro-style structure carried a triple
A credit rating from a nationally recognised credit rating agency. Those were strict terms,
but JP Morgan was meeting them.
The implications were huge. Banks had typically been forced to hold $800m reserves for
every $10bn of corporate loans on their books. Now that sum could fall to just $160m. The
Bistro concept had pulled off a dance around the international banking rules.
For a while, Demchaks team stopped transferring super-senior risk from JP Morgans
books. But then Demchak became uneasy. The super-senior risk was ballooning to a
staggering figure, because when the bank arranged these credit derivatives transactions for
clients, it typically put the super-senior risk in the deal on its own balance sheet. In theory,

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there was no reason to worry. But by 1999, the total pipeline of future deals had swelled
towards $100bn. Something about that mountain of risk started to offend Demchaks
common sense. If you have got $60bn, $100bn or however many billions of something on
your balance sheet, that is a very big number, he remarked to his team. I dont think you
should ignore a big number, no matter what it is.
...
The problem with correlation
Demchak was acutely aware that modelling the risks involved in credit derivatives deals
had its limits. One of the trickiest problems revolved around the issue of correlation, or
the degree to which defaults in any given pool of loans might be interconnected. Trying to
predict correlation is a little like working out how many apples in a bag might go rotten. If
you watch what happens to hundreds of different disconnected apples over several weeks,
you might guess the chance that one apple might go rotten or not. But what if they are
sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so,
how many and how fast?
Similar doubts dogged the corporate world. JP Morgan statisticians knew that company
debt defaults are connected. If a car company goes into default, its suppliers may go bust,
too. Conversely, if a big retailer collapses, other retail groups may benefit. Correlations
could go both ways, and working out how they might develop among any basket of
companies is fiendishly complex. So what the statisticians did, essentially, was to study
past correlations in corporate default and equity prices and program their models to
assume the same pattern in the present. This assumption wasnt deemed particularly risky,
as corporate defaults were rare, at least in the pool of companies that JP Morgan was
dealing with. When Moodys had done its own modelling of the basket of companies in the
first Bistro deal, for example, it had predicted that just 0.82 per cent of the companies
would default each year. If those defaults were uncorrelated, or just slightly correlated,
then the chance of defaults occurring on 10 per cent of the pool the amount that might
eat up the $700m of capital raised to cover losses was tiny. That was why JP Morgan
could declare super-senior risk so safe, and why Moodys had rated so many of these
securities triple-A.
The fact was, however, that the assumption about correlation was just that: guesswork.
And Demchak and his colleagues knew perfectly well that if the correlation rate ever
turned out to be appreciably higher than the statisticians had assumed, serious losses
might result. What if a situation transpired in which, when a few companies defaulted,
numerous others followed? The number of defaults required to set off such a chain
reaction was a vexing unknown. Demchak had never seen it happen, and the odds seemed
extremely long, but even if there was just a minute chance of such a scenario, he didnt
want to find himself sitting on $100bn of assets that could conceivably go bust. So he
decided to play it safe, and told his team to look for ways to cut their super-senior liabilities
again, irrespective of what the regulators were saying.
That stance cost JP Morgan a fair amount of money, because it had to pay AIG and others

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to insure the super-senior risk, and those fees rose steadily as the decade wore on. In the
first such deals with AIG, the fee had been just 0.02 cents for every dollar of risk insured
each year. By 1999, the price was nearer 0.11 cents per dollar. But Demchak was
determined that the team must be prudent.
...
The mortgage time bomb
Around the same time, the JP Morgan team stumbled on a
second, potentially bigger problem. As the innovation cycle
turned and earnings declined from the early Bistro deals
based on pools of corporate loans, Demchak asked his team
to explore new uses for Bistro-style deals, either by
modifying the structure or by putting new kinds of loans or
other assets into the mix. They decided to experiment with
mortgages. Terri Duhon was at the heart of the endeavour.
Only 10 years earlier, Duhon had been a high-school student
in Louisiana. When she told her relatives she was going to
work in a bank, they had assumed she was going to be a
teller. Now she was managing tens of billions of dollars. She
was trained as a mathematician, and she thrived on
adrenaline, riding motorbikes in her spare time. Even so, she
found the thought of being in charge of all those zeros
awe-inspiring. It was just an extraordinary, intense
experience, she later recalled.
A year after Duhon took on the post, she got word that Bayerische Landesbank, a large
German bank, wanted to use the credit derivatives structure to remove the risk from $14bn
of US mortgage loans it had extended. She debated with her team whether to accept the
assignment; working with mortgage debt wasnt a natural move for JP Morgan. But Duhon
knew that some of the banks rivals were starting to conduct credit derivatives deals with
mortgage risk, so the team decided to take it on.
As soon as Duhon talked to the quantitative analysts, she encountered a problem. When JP
Morgan had offered the first Bistro deals in late 1997, it had access to extensive data about
all the loans it had pooled together. So did the investors who bought the resulting credit
derivatives, since the bank had deliberately named all of the 307 companies whose loans
were included. In addition, many of these companies had been in business for decades, so
extensive data were available on how they had performed over many business cycles. That
gave JP Morgans statisticians, and investors, great confidence in predicting the likelihood
of defaults. But the mortgage world was very different. For one thing, when banks sold
bundles of mortgage loans to outside investors, they almost never revealed the names and
credit histories of the individual borrowers. Worse, when Duhon went looking for data to
track mortgage defaults over several business cycles, she discovered it was in short supply.
While Americas corporate world had suffered several booms and recessions in the later

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20th century, the housing market had followed a steady path of growth. Some specific
regions had suffered downturns: prices in Texas, for example, fell during the Savings and
Loans debacle of the late 1980s. But since the second world war, there had never been a
nationwide house-price slump. The last time house prices had fallen significantly en
masse, in fact, was way back in the 1930s, during the Great Depression. The lack of data
made Duhon nervous. When bankers assembled models to predict defaults, they wanted
data on what normally happened in both booms and busts. Without that, it was impossible
to know whether defaults tended to be correlated or not, in what circumstances they were
isolated to particular urban centres or regions, and when they might go national. Duhon
could see no way to obtain such information for mortgages. That meant she would either
have to rely on data from just one region and extrapolate it across the US, or make even
more assumptions than normal about how defaults were correlated. She discussed what to
do with Krishna Varikooty and the other quantitative experts. Varikooty was renowned on
the team for taking a sober approach to risk. He was a stickler for detail and that
scrupulousness sometimes infuriated colleagues who were itching to make deals. But
Demchak always defended Varikooty. His judgment on the mortgage debt was clear: he
could not see a way to track the potential correlation of defaults with any confidence.
Without that, he declared, no precise estimate could be made of the risks of default in a
pool of mortgages. If defaults on mortgages were uncorrelated, then the Bistro structure
should be safe for mortgage risk, but if they were highly correlated, it might be
catastrophically dangerous. Nobody could know.
Duhon and her colleagues were reluctant simply to turn down Bayerische Landesbanks
request. The German bank was keen to go ahead, even after the uncertainty in the
modelling was explained, and so Duhon came up with the best estimates she could to
structure the deal. To cope with the uncertainties the team stipulated that a biggerthan-normal funding cushion be raised, which made the deal less lucrative for JP Morgan.
The bank also hedged its risk. That was the only prudent thing to do, and Duhon couldnt
see herself doing many more such deals. Mortgage risk was just too uncharted. We just
could not get comfortable, Masters later said.
In subsequent months, Duhon heard through the grapevine that other banks were starting
to do credit derivatives deals with mortgage debt, and she wondered how they had coped
with the lack of data that so worried her and Varikooty. Had they found a better way to
track the correlation issue? Did they have more experience of dealing with mortgages? She
had no way of finding out. Because the credit derivatives market was unregulated, details
of the deals werent available.
The team at JP Morgan did only one more Bistro deal with mortgage debt, a few months
later, worth $10bn. Then, as other banks ramped up their mortgage-backed business, JP
Morgan largely dropped out. Eight years later, the unquantified mortgage risk that had
frightened off Duhon, Varikooty and the JP Morgan team had reached vast proportions.
And it was spread throughout the western worlds financial system.
Gillian Tett is an assistant editor at the FT. In March, she was named Journalist of the
Year at the British Press Awards

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This is an edited extract from Fools Gold: How Unrestrained Greed Corrupted a Dream,
Shattered Global Markets and Unleashed a Catastrophe by Gillian Tett. It is published
this week by Little, Brown, 18.99, and in mid-May by Simon & Schuster in the US. To
buy the book for 13.99, call the FT ordering service on 0870 429 5884 or go to
www.ft.com/bookshop
To read the second Fools Gold extract, How greed turned to panic, click here.

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