The complex issues of derivatives
K. SUBRAMANIAN
|
Explores the making of ingredients that contributed to the crisis unbeknown to the team which created them
|
FOOL’S GOLD: Gillian Tett; Little, Brown, 100 Victoria Embankment, London EV4Y ODY. £ 12.99.
Journalists, economists, and bankers are churning out studies month after month on the financial crisis. Not many can match the credentials of Gillian Tett to write on it. She started working on credit markets in the early years of this century. Soon, she was to head the financial markets desk at the Financial Times. Her special surveys/reports on credit derivatives have made waves. Along her way, she bagged several prestigious awards for her work as a f
inancial journalist and the book under review was named the Financial Book of the year 2009.
Fool’s Gold explores the making of ingredients that contributed to the crisis unbeknown to the team which created them. They are a new class of derivatives and the team that created them was from J.P Morgan (JPM) or the ‘Morgan mafia.’
This book may fall short of the expectations of those who have followed the writings of Gillian Tett. By design or accident, it limits its gaze to the role of JPM in crafting derivatives and the extraordinary efforts it made to package them and get them lifted from regulatory scanners. For that reason, it fails the ‘holistic’ test which she herself lays down in the Epilogue.
Complex derivatives
The early chapters provide details of the efforts of the ‘mafia’ to rework the derivatives and they are traced to the team which assembled and worked at Boca Raton, Florida, in 1994. Its endeavour was to work out a new generation of complex derivatives to replace swaps and which could not be copied by others. Truly, a dream.
The product that finally evolved was named Broad Index Secured Trust Offering, or Bistro for short. Tett takes us along the road to this discovery explaining the complex issues, dilemmas, and alternatives which the modellers had to grapple with. She does it without using any jargon.
Bistro, in short, is a way of bundling bank loans and separating out the theoretical risk, that these loans would turn sour from the loans themselves. This default risk was then sold to a ‘paper’ company known as Special Purpose Vehicle (SPV). SPVs would issue bonds that investors could buy. If loans went into default the value of bonds would fall. The assumption was that it depended on the pricing of the bonds and, if the structuring was so done that the bonds appeared attractive relative to the risk of default, investors would be lured even if they do not understand the mathematics.
As Tett explains, “They [the team] felt they had stumbled on a financial Holy Grail.” “At a stroke they had managed to remove credit risk from the bank’s books on an enormous scale.” It would enable JPM to remove pressure on credit limits. More importantly, it would help get around the Basel rules.
JPM’s battles with the Fed to get clearance are captured at length. It could win over Gerald Corrigan, Chairman of New York Reserve. It worked with the ‘Group of 30’ to lobby with Congress. When Clinton took over as the new President, they secured the support of Mr. Rubin who had become Chairman of Economic Advisory Council.
Risks
The zeitgeist was wholly in favour of “free market” and “competition.” Alan Greenspan and Bernanke were votaries of innovations and efficient credit allocation. They could even water down the views of the critics from the BIS. Tett handles these with the panache of an anthropologist — she holds a doctorate in that discipline.
The risks attached to new forms of derivatives (CDOs and CDOs of ABS), as also the staggering increase in their volumes and value, were known for some years. Tett herself had warned over these time and again. There was the inevitability of credit destruction.
Fall of giants
In later chapters, she gives an account of the fall of giants one by one: a roll call of dishonour. She rushes through the episodes. Her accounts about Bear Stearns, Merrill Lynch and AIG are sketchy. Treasury’s efforts to bail out Bear Stearns and Merrill — as disclosed in the recent Senate hearings — are more convoluted and murkier than what has been described in the book. Finally, her admiration for JPM needs correction. Yes, JPM has escaped the crisis thus far. It may be due to their conservatism and culture. There are other reasons. The mafia was aware of the limitations of its models, especially counter party risk which could not be built in for want of historical data. Thus, JPM avoided mortgage risk where others rushed in. But it has avoided only the first round of the crisis.
Many foresee a second round when other risks — for example, over-the-counter derivatives (OTC) — would be in trouble. These are valued at $760,000 bn. Reports of SEC suggest that they are highly concentrated. Fitch Ratings reports that 80 per cent of this risk is held by just five banks and JPM is one of them. Further, JPM is more exposed to commercial real estate and business lending than others. It will stand to lose heavily if OTC is abolished or when the next bevy of birds comes home to roost. No wonder JPM is working hard to stall Treasury’s proposal to regulate OTCs.
Notwithstanding these caveats, Tett’s book is a valuable addition to the literature on the financial crisis.
Printer friendly
page
Send this article to Friends by
E-Mail
Book Review
