How the structured credit revolution started
Tony Best faces a daunting task. As European head of investor client management at JPMorgan, he is one of a select band of managers charged with putting the bank back in what it still considers its rightful place – at the very pinnacle of the structured credit business.
The task is made all the more challenging by the ghosts of JPMorgan past – a gilded generation of investment bankers who can take credit not only for making JPMorgan enormously profitable but, also, for the creation of an entire market. In recent years, most of that group have left the bank.
There was a halcyon period when the name JPMorgan was almost synonymous with capital markets innovation. In the years before and after the turn of the century the bank was responsible for a series of advances using credit derivatives and traditional securitization technologies that culminated in the creation of the structured credit sector. And that was arguably the biggest product market development in the financial services industry in the past 20 years.
JPMorgan is approaching the end of its second large integration since the turn of the century. Its transformation from niche derivatives-led investment bank into a universal bank following the mergers with Chase and Banc One was painful, resulting in its losing its stranglehold over the structured credit world, which had been a function of first-mover advantage. It had spent years developing the information and technology needed to originate, structure, execute and distribute structured credit product.
“We hated using the term ‘dominate’ when talking about our position in the market since it had negative connotations of unfair practices. But it’s fair to say that there was a payback period for all the research and development that JPMorgan did.” says former senior executive Andy Brindle.
Brindle was global head of credit derivatives at a time when JPMorgan’s market share in exotic and structured credit derivatives was widely estimated as close to 50%, although Deutsche Bank would no doubt dispute that number. In its heyday, JPMorgan also accounted for some 20% to 25% of the vanilla flow credit derivatives sector.
Many would argue that, in investment banking, R&D resides in human capital. When people walk out of the door so can the franchise. Just as the structured credit business was taking off in a big way the merged bank was hit by the downturn in credit. If that was not enough, there was litigation over Enron – fines from the regulators for helping fraudulent activity were followed by multi-million dollar lawsuits from various disgruntled parties. Consequently JPMorgan was not able to pay many of its bankers the going rate between 2003 and 2005. Structured credit experts, especially JPMorgan’s, were in demand – not just from competitors but also from hedge funds.
According to detractors, the bank’s personnel losses are a signal that its unique culture, which culminated in the creation of the structured credit revolution, is no more. Not so, argue the bank’s senior managers. In the past year there has been little turmoil and recent management changes appear well founded. And the bank is addressing areas of weakness. If the argument is franchise or rainmakers, the franchise has won, they say. Despite well-publicized departures in 2005 the bank’s structured credit business enjoyed a good year.
“We can promote outstanding people quickly here. That is what supports the business when people decide to leave – these very smart young people coming through. There’s a deep bench in these places,” says Best.
Have they been missed?
It is amazing to think that over the past five years JPMorgan has lost talent of the calibre of Bill Demchak, Andrew Feldstein, Andy Brindle, Andrew Palmer, Andrew Donaldson, Betsy Gile, Jonathan Laredo, Fawzi Kryiakos-Saad, Chris French, Jeremy Barnum, Bertrand des Pallieres, Charles Pardue, Romati Shetty, Jeff Herlyn, Mike Rosenburg, Geoff Sherry, Tim Frost, Paul Horvath, Mark Stainton, Malcolm Perry, David Peacock and Jeremy Barnum – to name but a few — and yet is still a leading player in structured credit.
| Bill Demchak |  |
Only one member of the original team, the pioneers behind the very first Bistro deal [see How the structured credit revolution started, this issue] remains – Blythe Masters now, at the tender age of 35, the CFO of JPMorgan investment bank. Demchak is CEO of PNC, Feldstein is now president of BlueMountain Capital Partners. As for the other Morgan leaders of the structured credit world, the rest now populate credit hedge funds or to a lesser extent JPMorgan’s competitors. Pardue founded the Prytania Group, Frost went into start-up Cairn Capital, Donaldson is CEO at Credaris, Laredo has a similar role at Solent Capital. Other above-mentioned former JPMorgan officials now at hedge funds include Sherry (Caxton), Barnum (BlueMountain), Stainton (Citadel) and Peacock (Cheyne). So how important is it to JPMorgan that many of the well-known characters formed by its transformation from an old-fashioned commercial bank into investment banking have been scattered around the marketplace? The bank’s insiders accept that while the departures were noteworthy, although the franchise is bigger than any individual. JPMorgan officials make a cogent argument that the effect of these departures has not been that debilitating.
Talk to outside people who are still close to the bank and they will say that JPMorgan is doing fine. The investment bank’s structured credit/credit derivatives division continues to make lots of cash and it is not paying out massive bonuses to certain high-profile names. And if the truth be told some of those that headed for the exit are not being missed.
While JPMorgan has coped with these departures, the wider structured credit market has positively thrived as a result. It is unlikely that the sector would have grown at such a pace had it not been for the sheer number of ex-Morgan market participants that are now employed elsewhere. And when these ex-employees join credit funds they say that they are more than happy to put business JPMorgan’s way.
“Over the years we have been a source of talent for the hedge fund market,” says Best. “It’s both good news and bad news. It’s good news because we’ve got a number of new clients as they tend to come back and do a lot of business with us. We are often the largest counterparty for these people, so that’s great from a revenue perspective. It’s bad news because obviously you don’t like seeing good people leave. But at least they’re leaving in a more productive way than going to work at competitors.”
Furthermore, there was little of the public outpouring of rancour suffered by Morgan Stanley a year ago, or even a sudden mass walkout of top bankers of the sort seen at CSFB and Deutsche several years ago. Only time will tell whether there has been permanent damage to the franchise.
JPMorgan has a reputation for being at the forefront of innovation. According to those close to the firm, that is not going to change. The legacy has not evaporated just because well-known individuals have left. But it is hard to argue with those that say Deutsche Bank is now regarded as the leading house in structured credit/credit derivatives. The support for this business line goes right to the top, with co-head of investment banking Anshu Jain known to be keen for the bank to keep ahead of the pack. In the correlation, exotic and hybrid credit derivatives businesses JPMorgan is still a leading player but its market share is no longer overwhelmingly dominant in the way it once was.
In the early days of this industry the leading players were earning extremely fat margins, and those fat margins attracted competition. JPMorgan responded to the increased competition by addressing its cost structure. The fact that Dimon concentrates on tight cost controls has been well publicized. But he has stated that compensation is now under control and this was borne out in the 2006 bonus round, which was well received – in marked contrast to the previous two years.
Growing up fast
The structured credit business has matured rapidly. Three or four years ago there were only a handful of serious players in structured credit in terms of large-scale correlation books. Deutsche and JPMorgan dominated the market, with Morgan Stanley and other banks gradually getting involved. Moving forward to the spring of last year, when the General Motors meltdown took place, the number of correlation books estimated in London was an amazing 23.
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“As hedge funds become more sophisticated and institutionalized, we believe that the capital-raising will be augmented by a large amount of structured product” Tony Best, JPMorgan |
The good news is that the correlation debacle of May 2005 shook out a number of the players. JPMorgan views the structured credit world differently to the way it did four or five years back. Competition is red-hot and there are fewer innovations. It’s a mature business, and that requires a different approach. “While the structured credit business is a very profitable business, if you’re a market leader, it’s not as profitable as it used to be, which is unsurprising given its rapid growth,” says Best. “I think the market has moved towards a vast increase in index trading, which again has been an innovation that we have participated in.”
Customized risk profiles
Banks such as JPMorgan are increasingly playing a different role in the provision of credit product. The techniques used to provide investors’ portfolios with a particular risk profile are now commonly understood. JPMorgan has played a key role in developing investors’ understanding of these methods. It also helped drive the process of merging banks’ proprietary credit indices. The result was a massive increase in liquidity and opening up the credit world in a way few could have imagined possible a few years back.
Best says: “Our view of structured credit is that it has become a business where investors are asking: ‘Why would I pay significant money as an investor to a manager to give me a triple A tranche of a CDO? I’m paying for management fees when, frankly, I can pretty much replicate the triple A tranche through the index market and pay 5 cent bid-offer spreads.’”
According to Best the days of executing the full capital structure of a synthetic CDO are numbered because investors have cheaper alternatives. That type of synthetic market activity is also moving into a new phase because of the brain drain from banks to credit hedge funds. The introduction of iTraxx has provided credit players to easily trade and construct different types of risk themselves.
One fresh development in the structured credit space that JPMorgan points, for instance, is investors’ embrace of constant proportion portfolio insurance (CPPI) techniques. These offer principal protection on synthetic credit portfolios and have moved from a retail oriented product into the institutional market. A couple of months ago JPMorgan conducted a CPPI trade for German bank LBBW. Although this development is highly notable, it seems as if the pace of change in the synthetic arena is now incremental rather than revolutionary.
JPMorgan is also seeing a trend towards deals for single-strategy hedge funds. Last year it executed an innovative synthetic transaction with Cheyne Capital, which was a long/short credit strategy on CDS. The structure incorporated features used in CPPI to protect capital in the portfolio. It was targeted at typical credit investors but also alternative investment accounts. Perhaps the alternative investments space is where the pace of change is rather more dramatic.
Best says: “In our pipeline of products we are seeing a range of single-manager, single-strategy structured products that are CLO-like in their nature and are bringing institutional investment dollars into a managed product. The next new thing is essentially investment banks wrapping and doing structured products around what we broadly call SAI [Structured Alternative Investments].
“To my mind this is the next evolution. People who naturally have been involved in capital-raising for the hedge fund and alternative [investment] space, used to be the prime brokers with capital introduction services. Capital introduction was an activity that was more relevant in the early phases of hedge funds. But as the hedge funds have become more sophisticated and institutionalized, we believe that the capital-raising will be augmented by a large amount of structured product.”
If Best’s predictions prove true JPMorgan will be well placed to take full advantage, especially given how many former colleagues work at or own credit funds.
| Andrew Palmer |  |
But JPMorgan still faces challenges. Like all large banks, it has struggled to find the right structure or model. Many commentators have said that it is increasingly looking like Citigroup, an analogy easy to make given Dimon’s history as Sandy Weill’s right-hand man. But Citi’s corporate and investment banking division regularly turns in 20% return on equity. In the fourth quarter of 2005, JPMorgan’s investment bank returned a paltry 13%, according to consultants Fox-Pitt Kelton. Jamie Dimon said earlier this year at the Citigroup Financial Services Conference that JPMorgan should also strive to hit 20% return on equity through the business cycle. In 2005 it was just 18%.
Volatile trading
A key reason for this is the fact that JPMorgan’s results have regularly featured significant trading losses. The $6 billion trading volume is extremely volatile, far more than that experienced in other investment banking operations. This year the bank has altered its infrastructure to address this volatility.
“I believe that changing the risk and infrastructure on global lines is an entirely sensible thing to do,” says a recently departed senior JPMorgan official. JPMorgan needs consistency in risk-taking and, because there’s a lot of correlation in the markets, having a simplified risk-taking structure on a global basis is best. The bank now has four product heads for equities, rates, credit and currencies, commodities and emerging markets.
“I’ve been in this business for 25 years and think there is always a bit of a pendulum that swings between regional and global in our industry,” says Best. “If you take the view that this is about scale and efficiency in some of our core businesses, I think it’s hard to conclude that you do not want to be global, because global means common platforms, technology and infrastructure, fundamentally building efficiencies. The most local part of the business is obviously around clients, because clients are local.”
So in contrast to the global product lines, the client business has a regional basis. Best now runs the investor client business in Europe. “One thing that we’ve overlaid on top of this is our retail structured products business where again we need to globalize that platform of products,” he says.
The reorganization involves more than just new structures. One recently departed JPMorgan insider admits that “during 2001 and 2002 we were preoccupied with the merger”. The bank was making plenty of cash in structured credit but because of mergers it wasn’t able to find the effort needed to invest in mortgages, prime brokerage, principal investments and commodities.
More from mortgages
These are areas that have experienced significant growth and highly profitable returns for other investment banks, such as Lehman Brothers, Bear Stearns and Goldman Sachs. So, like every other investment bank that was not already a major player, in the past year JPMorgan has started investing heavily in commodities. According to insiders it is already making good returns despite the standing start. It is also seeking to get more out of the mortgages business. Given the profile of JPMorgan as an institution steeped in structured finance, it really is surprising that the bank failed to hitch a ride on the great US remortgaging wave.
The reasons for this are quite simple. Neither the old JPMorgan nor the old Chase had great product capability in mortgages. And after the merger the home equity business was separated from the trading and structuring mortgages business and both of those kept separate from the old Chase Home Finance business. Those decisions didn’t play to any of the merged institution’s strengths.
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Tim Frost |
So despite being one of the biggest US loan mortgage originators through Chase Home Finance, JPMorgan has not been a serious player in distributing that product into the capital markets. That is about to change. In future the mandates will flow directly to the investment bank instead of to rivals like Lehman and Bear Stearns. Already this strategy is starting to bear fruit in the CMBS market where the bank has jumped from number 14 to number one simply by plugging the gap between the mortgage origination company and the distribution. Another anomaly has been corporate securitzation in Europe. JPMorgan has been a player in the consumer ABS asset classes but on the corporate risk side it has been absolutely nowhere including CMBS – a booming asset class in Europe.
“Something that we are investing in is securitization in general, so we’ve moved Oldrich Masek to head up the securitized business,” says Best. Masek’s former role was co-head of structured credit. He is a JP Morgan stalwart and led some of the most innovative CDO trades in Europe during his time at the bank.
Structured credit now sits with Don McRee, who is global head of credit. JPMorgan had co-heads of global structured credit until mid-March; Masek based in London and Brian Zeitlin in North America. Zeitlin came over from Deutsche Bank at the end of 2004 and is now in sole charge of structured credit. David Puth is head of currencies, commodities and emerging markets, Carlos Hernandez runs equities, Patrick Edsparr looks after rates. Bill Winters – a longstanding derivatives veteran – and Steve Black remain co-heads of the investment bank.
Stretching people to perform
“One practice that differentiates JPMorgan is talent management,” says Best. “We have a legacy of stretching our best people by asking them to build businesses. Securitization may be relatively small today but over the next three to five years it’s going to be big along with securitized products in EMEA and global pensions.”
JPMorgan thinks that the pensions business has growth potential so Ed Giera, until the reorganization head of debt capital markets in Europe, is now looking after this division.
JPMorgan is also moving Patrick Edsparr to Europe. He not only heads the global rates business but heads principal and proprietary business globally. The bank believes that having the ability to warehouse, structure and distribute, or keep parts of the capital structure, is very important to playing in the corporate and pensions space.
Following a trend that is well in place at various other investment banks, JPMorgan has merged management of debt and equity origination. That way it hopes to extract greater value from its corporate finance dialogues with companies. Viswas Raghavan, the former head of European equity capital markets, is the new head of capital markets for the region.
