Birth of the Credit Monster

Monday, May 4th, 2009

Gillian Tett, of FT.com has written an in-depth exposé about the birth of innovative securities that gave rise to the markets’ abuse of leverage finance and ultimately, the catastrophic rise of debt. Here is the first excerpt from Tett’s new book, Fool’s Gold provided by FT.com, Genesis of the Debt Disaster, May 1, 2009.

In 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, Fool’s Gold, the FT’s 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 Morgan’s 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 weren’t 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 didn’t 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 Morgan’s loans, worth a total of $9.7bn, and issued securities based on the income streams from these loans. The lure of the idea was 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 team’s 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…

Read the entire article here, or PDF version here.

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The Road to Depression

Monday, December 1st, 2008

Brad DeLong says two big mistakes made the crisis worse:

James Bradford DeLong (b. June 24, 1960, Boston) commonly known as Brad DeLong, is a professor of economics at the University of California, Berkeley and a former Deputy Assistant Secretary of the United States Department of the Treasury in the Clinton Administration. He is also a research associate of the National Bureau of Economic Research, and is a visiting scholar at the Federal Reserve Bank of San Francisco.

The Road to Depression, by Brad DeLong, Project Syndicate: For 15 months, the United States Federal Reserve, assisted by the financial regulators of the US Treasury, have been trying…,

above all, to avoid a deep depression.

They have also had three subsidiary objectives:

• Keep as much economic activity as possible under private-sector control, in order to ensure that what is produced is what consumers really want.
• Prevent the princes of Wall Street … from profiting from the systemic risk that they created.
• Ensure that homeowners and small investors do not absorb too much loss, for their only “crime” was to accept bad risks, which they would not have done in a world of properly diversified portfolios.

Now it is clear that the Fed and the Treasury have lost the game. If a depression is to be avoided, it will have to be the work of other arms of the government, with other tools and powers.

The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. Had the Fed and the Treasury given those two objectives their proper - subsidiary - weight, I suspect that we would not now be in this mess…

The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse… The logic behind that decision was that, previously in the crisis, equity shareholders had been severely punished…

But this was not true of bondholders and counterparties, who were paid in full. The Fed and Treasury feared that the lesson being taught in the last half of 2007 and the first half of 2008 was that the US government guaranteed all the debt and transactions of every bank and bank-like entity that was regarded as too big to fail. That, the Fed and the Treasury believed, could not be healthy.

Lenders to very large overleveraged institutions had to have some incentive to calculate the risks. But that required, at some point, allowing some bank to fail…

In retrospect, this was a major mistake. … With that guarantee broken by Lehman Brothers’ collapse, every financial institution immediately sought to acquire a much greater capital cushion…,

but found it impossible to do so.

The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them - whether they liked it or not - until the crisis passed.

Yes, this is what might be called “lemon socialism,” creating grave dangers for corporate control, posing a threat of large-scale corruption, and establishing a precedent for intervention that could be very dangerous down the road.

But would that have been worse than what we face now? The failure to sacrifice the subsidiary objective of keeping the private sector private meant that the Fed and the Treasury lost their opportunity to attain the principal objective of avoiding depression.

Of course, hindsight is always easy. But if depression is to be avoided, it will be through old-fashioned Keynesian fiscal policy: the government must take a direct hand in boosting spending and deciding what goods and services will be in demand.

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