The Financial Times columnist offers a history of the development of the credit default swap (CDS), the derivative financial instrument that cost so many banks so much in losses as to bring on the financial collapse of 2008. Gillian Tett focuses on the derivatives team at JP Morgan while tracing developments at other banks to create new financial instruments.
Along the way, Ms. Tett points to the pieces of the history that combined to make the disaster. She recounts the efforts by the Wall Street banks to leave the derivatives business essentially unregulated (or, at most, self-regulated.) She covers the work by industry committees to draft ISDA rules, including avoiding creating a third-party clearinghouse, as a way to put off regulation by the Federal Reserve and their further work to lobby against four separate bills in Congress in the 1990s to regulate derivatives trading.
The other great problem was how to keep these instruments from impairing the balance sheet: if they carried any risk for the bank, the bank would have to maintain adequate reserves behind them. By breaking the CDS into separate tranches according to the risk implicit in the underlying securities, it would be possible to find buyers who matched the level of risk of each tranche with their own preferences for a balance between yield and risk tolerance. There was, however, a particular problem with the "riskless" tranche, the most senior and lowest risk tranche since it was difficult to imagine that this tranche would ever be at risk. Fortunately, the insurance giant AIG was willing to take on this instrument as an asset. The return would be small, but with sufficient scaling up, the total would be significant. Eventually, lobbying by the industry convinced regulators that the senior tranche was sufficiently safe that it didn't need to leave the balance sheet or impair operations by requiring reserves behind it. Since there was much to be made by selling CDS, the banks went into it fully and this meant they were accumulating a lot of the senior tranche. Thus both AIG and the banks were set up to take on risks they could not measure.
The key problem was whether the underlying logic of the instruments was correct; there was no way to be sure. The assumption was that each security (mortgage) had an independent probability of failure. Even if they were not perfectly independent, the correlation among the constituent securities was assumed to be low. Experience with corporate failures made the assumption seem safe; the assumption was on far shakier ground when new instruments were designed to use only mortgages. It was difficult to calculate the probability of general collapse in real estate. The problem was ignored or assumed away.
The collapse came, quietly at first, but with increasing fury as derivatives began to melt on the balance sheet. When it was over, few banks were left standing firmly. Although there were heroes whose rationality and ability to avoid jumping in to the risk pool saved their banks much grief (and Jamie Dimon appears to be one of Ms. Tett's heroes), most banks were caught by the very instruments that had been paying them so well. The cost in wiped out value reverberated throughout the markets and into the real economy. The recovery continues eight years later.
This book is highly recommended.
