All the Devils Are Here [40]
The consequence of this new approach was obvious. Banks were going to stuff their balance sheets with mortgage products because they required less capital. Because highly rated securitized tranches required less capital, it made more sense for financial institutions to hold the securities rather than the original loans. The banks also kept pushing to change the rules in their favor. Starting in the mid-1990s, for instance, bank lobbyists repeatedly tried to get the regulators to lower the capital requirement on highly rated private-label securities to 20 percent, so their securities would be on equal footing with Fannie and Freddie’s. (Fannie objected, of course.) In 2001 they finally succeeded, at which point banks had even more incentive to hold highly rated mortgage-backed securities.
Finally, banks searched for ways to game the Basel rules. For instance, under Basel I, banks could set up an off-balance-sheet investment vehicle, and so long as the duration of its credit line was less than one year, the bank didn’t have to hold any capital against that vehicle. So, theoretically, a bank could sell a risky slice of a mortgage-backed security to such a vehicle, set the credit line to last one day short of a year, and hold no capital against it.
Once this risk-based methodology took hold, banks had an enormous incentive to move into assets that would require less capital—or to invent new products that would have the same effect.
Lo and behold, along came the product that would soon be the greatest capital reducer of them all: the credit default swap.
In simplest terms, a credit default swap is designed to accomplish the same task as an interest rate or currency swap—move risk from a party that doesn’t want it to one that does. The risk in this case, however, is credit risk. A credit default swap is essentially an insurance policy against the possibility of default—credit protection, it came to be called. One party—a bank—would buy credit default swaps to protect against a default in its loan portfolio. A counterparty would sell the bank the credit default swap in return for a fee. So long as there was no default, the counterparty would keep collecting fees. But in the event of a default, the counterparty would have to pay the full amount of the loss to the bank. The loan itself remained on the books of the original lender.
There were a number of rationales behind J.P. Morgan’s push to create credit default swaps. The first had to do with the bank’s obsession with risk management. The one area where the bank’s modern risk management approach had not taken hold was commercial lending. Over the years, big corporate loans had become increasingly less profitable as corporations turned to other funding mechanisms, like commercial paper. More and more, companies were using banks for inexpensive lines of credit that they needed only in emergencies—which is precisely when a bank doesn’t want to extend credit. Yet banks were afraid to end these lines of credit because they didn’t want to alienate their big corporate customers, who used many of their other, more profitable services.
What’s more, although Basel may have viewed all commercial loans as equally risky, J.P. Morgan certainly did not. Was a loan to Walmart really as risky as a loan to Kmart? Yet the bank had no real way to distinguish the relative risk between the two. J.P. Morgan was reduced to making educated guesses. “We were extending credit,” says one member of the credit derivative team, “and nobody was putting a price on it.”
A tradable market for credit default swaps would change that. Traders buying and selling credit protection would allow the market to gauge the riskiness of a loan. If the cost of the credit default swap increased, that meant the chance of a default was rising; if it decreased, then the odds were decreasing. Even before a tradable market existed, J.P. Morgan’s quants began using credit default swaps