How the structured credit revolution started
“The very first credit derivatives that I wrote, we didn’t even call them credit derivatives as the name hadn’t even been invented then!” says Andrew Donaldson, former deputy treasurer of the European Bank for Reconstruction and Development, who went on to work at JPMorgan before forming hedge fund Credaris last year as CEO.
Triple-A institutions such as the EBRD were excellent counterparties for such transactions because their liabilities attracted zero capital risk weighting. But they could only play in triple-A and double-A space, not an attractive option because such corporates were very expensive to buy, often with sub-Libor spreads. Furthermore, there wasn’t much paper to buy anyway because double-A corporate credits rarely need to borrow much on the capital markets.
But it was several years before credit derivatives developed properly. What really got the wider sector going was JPMorgan’s execution of synthetic balance sheet collateralized debt obligations on its own behalf in 1997. It spawned a number of technologies and its impact was quite remarkable. The structured credit sector was born out of a unique culture at the bank where young officials were given immense responsibilities and serious issues to tackle.
In the mid 1990s Peter Hancock, the fixed income head at JPMorgan, was giving a lot of responsibility to a young swaps specialist, Bill Demchak. Demchak had joined JPMorgan in the late 1980s. Demchak, although only in his early thirties, was given responsibility for structured finance and securitization, credit derivatives, and hybrid and exotic derivatives. He built around him a young and very bright team of people set up to do everything that wasn’t flow business. Then in 1997 Demchak took control of credit portfolio/lending at JPMorgan.
This was to prove a pivotal moment because once Demchak got control of Morgan’s credit portfolio he charged Blythe Masters and Andrew Feldstein with finding a way to release regulatory capital from the credit portfolio. Demchak’s team had been working with KMV, the credit risk management specialist firm, on credit portfolio risk. The aim was to advise the bank’s clients but the techniques were quickly turned onto Morgan’s own portfolio.
At that time Morgan was in a tricky situation. It had an excellent list of clients that it lent to, the crème de la crème of US corporates. However, under Basle I the bank was at a disadvantage compared with other lenders with weaker names in their portfolios. One main faults of that regulatory regime was that exposures to high-quality corporate names attracted the same regulatory capital hit as lending to more feeble credits. Under this perverse system lending to well-rated corporates, which paid relatively low spreads, hit JPMorgan hard.
The young team constructed by Demchak came up with a unique response to the question of how to free up substantial amounts of regulatory capital. The answer was Bistro (Broad Index Secured Trust Offering).
“There is nothing like being long and wrong in terms of credit risk to give you an inventory to start a market,” says a former senior JPMorgan official. “We put $25 billion of credit risk out into the market in securitizations in the form of Bistro and single-name credit derivatives. There were two Bistros in 1997 for approximately $10 billion each, the first synthetic CDOs.”
Using this technology allowed the bank to retain long-standing client relationships but shift regulatory and economic risk like never before. Suddenly JPMorgan had a new business model. As JPMorgan transformed itself, shedding credit risk and being more efficient in the risk capital it had allocated to the credit portfolio, the institution changed. No longer were bankers quite so cavalier in taking credit risk into the institution and they had a much better pricing metric. By the end of the 1990s Morgan had done some fantastic things in terms of transference of credit risk into the market. At the turn of the century JPMorgan, alongside Morgan Stanley and Goldman Sachs, was arguably one of the three best investment banks in the world.
There were several spin-offs from Bistro. One of the most obvious was the business of managing credit portfolios – using securitization and credit derivatives to control credit portfolio risk. The less obvious by-product was the first correlation model.
Before Bistro, traditional balance sheet CLOs were full-blown securitizations and therefore expensive for originators to fund. The new technique used credit default swaps to transfer tranched risk into the capital markets, the expected loss on the portfolio was collateralized by US treasuries. The portion above the triple A tranche – which became known as super senior – had a zero theoretical value at risk. JPMorgan would own this top 85% of the capital structure and hold it within Morgan.
Once it started to conduct these synthetic balance sheet CDOs for clients, it was forced to build an analytical model that would value the various tranches. The correlation smile was an attempt to value the residual risk piece.
From there Demchak’s team took that correlation model and used it to develop arbitrage, as opposed to balance sheet, synthetic CDOs and then single-tranche CDO technology emerged.
A senior JPMorgan official explains: “We ended up doing a deal for a European guy who wanted to sell equity and we quickly decided that what we should be doing is shorting the equity tranche ourselves. And not worry about the rest of the structure. That then led us to ask ourselves, ‘if we short it then how do we capture the value?’ and then that led us to delta hedging the individual tranches.”
The final stage of the structured credit sector’s boom was industrialization – a move from a high-margin but low volume bespoke business into large-scale production.
Because of a unique mix of circumstances, such as a constrained balance sheet and a young talented team, JPMorgan had started the structured credit industry. A young group of smart individuals were given free rein to solve a series of problems facing the bank and came up with a set of solutions that was to transform the bank and the financial markets.
Meeting JPMorgan officials around the turn of the century, one could not help but be struck by how they loved the institution.
It welcomed the erudite. It was the perfect breeding ground for smart individuals to flourish in. It also had a strong international flavour – the first thing senior JP Morgan officials would boast of is the fact that it was the first US bank to have an office in Paris some 139 years ago. This international profile was to prove important for building a structured credit franchise because many advances took place in Europe.
Then in 2002 Demchak departed. He was a casualty of Chase’s takeover. A larger firm meant more politics, bureaucracy and a change in culture. Demchak was still young at 38 – most of his immediate team were far younger and destined to go their separate ways. They were entrepreneurial and full of vitality. It was impossible to hold that structure together under the circumstances of a transformational merger.
“The truth is that when people got into that larger firm a lot of us had made pretty good money in the sale of Morgan to Chase and it gave us the opportunity to open our eyes and look at other things. There were a lot of talented people and everyone has gone on to do remarkable things,” says one senior ex-Morgan banker.