Fool’s Gold Part I
Feb 12, 2016
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:
Bretton-Woods system of fixed exchange rates broke down Oil Shocks Dramatic inflation High interest rates
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
A B9.95% (fixed)
Libor+5.5%
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.
LIBOR Rate3% 4% 5% 6%
Floating Cash Flow $85,000 $95,000 $105,000 $115,000Fixed Cash Flow -$95,000 -$95,000 -$95,000 -$95,000Difference -$10,000 $0 $10,000 $20,000
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
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
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
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.”
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?
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.
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
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 CDSEBRDJ.P. Morgan
Fee
If Exxon defaults, make up loss
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
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
J.P. Morgan ClientsPiece of paper
$100 Million
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
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?
Bank SPV
Fees
Default Insurance on$9.7 Billion in Loans
Bonds
$700 Million
Investors
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.
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
Correlation 1999: Bayerische Landesbank – 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 Bayerische Landesbank Did one more mortgage Bistro Then backed out of doing Mortgage Bistros all
together.
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-Steagall replealed (Bill Clinton)
“The financial world was becoming “flat”, morphing into one seething, interlinked arena for increasingly free and fierce competition.
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