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Fool’s Gold Part I

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:

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Fool’s Gold Part I

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  1. Fool’s Gold Part I

  2. 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

  3. 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 Libor+5.5% B A 9.95% (fixed)

  4. 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.

  5. 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

  6. 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

  7. 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

  8. 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.”

  9. 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?

  10. 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.

  11. 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

  12. 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 CDS Fee J.P. Morgan EBRD If Exxon defaults, make up loss

  13. 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

  14. 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 Piece of paper J.P. Morgan Clients $100 Million

  15. 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

  16. 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? Fees Bonds Bank Investors SPV Default Insurance on $9.7 Billion in Loans $700 Million

  17. 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.

  18. 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

  19. Correlation • 1999: BayerischeLandesbank – 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 BayerischeLandesbank • Did one more mortgage Bistro • Then backed out of doing Mortgage Bistros all together.

  20. 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-Steagallreplealed (Bill Clinton) • “The financial world was becoming “flat”, morphing into one seething, interlinked arena for increasingly free and fierce competition.

  21. 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

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