All the Devils Are Here [41]
And the second reason the bank wanted to make credit default swaps a reality? If a tradable market developed, J.P. Morgan would certainly be a dominant player. It stood to make a lot of money. Commercial loans represented the stodgy past; credit derivatives represented the turbocharged future.
As for capital requirements, there is no doubt, when talking to people who were there at the creation, that the J.P. Morgan team always understood the potential for credit default swaps to reduce the need for banks to hold capital. After all, if a bank pays a counterparty to accept the default risk of its loan portfolio, doesn’t that mean its credit risk has been reduced? And therefore, shouldn’t it get capital relief? If the government went along, every big bank in the world would clamor to buy credit protection on its loan portfolio. The market wouldn’t just be big; it would be huge. But for that to happen, the Federal Reserve would have to agree that credit default swaps did indeed transfer default risk. And who could say when, or even if, that would happen?
In 1994, J.P. Morgan put together its first credit default swap. It came about as a result of the Exxon Valdez oil spill. The oil giant, facing the possibility of a $5 billion fine, drew down a $4.8 billion line of credit from J.P. Morgan. This put the bank in exactly the kind of position it didn’t want to be in. It couldn’t say no, because that would alienate Exxon. Yet the loan wasn’t going to make the bank much money, and it was going to tie up hundreds of millions of dollars in capital that would have to be placed in reserve.
The woman who came up with the idea of using a credit default swap to deal with this situation was Blythe Masters. Though she was not the head of the derivatives group, she was a key member of the team, a superb saleswoman who in later years would become the person most closely associated with J.P. Morgan’s entrée into swaps. After Exxon drew down its $4.8 billion line of credit, she convinced the European Bank for Reconstruction and Development (EBRD) in London to participate in a swap deal where it assumed the default risk for the loan, with J.P. Morgan paying it steady fees for doing so. The loan stayed on J.P. Morgan’s books.
Compared to what would come later, the deal was simplicity itself. J.P. Morgan was transferring the credit risk of a single loan to a single entity. Why was the EBRD willing to assume that credit risk? In truth, the reason was that the risk was minimal. Potential fine or no, Exxon was one of the strongest companies in the world, with 1994 revenues of close to $100 billion. It ranked third on the Fortune 500. Yet J.P. Morgan was going to pay the European bank substantial fees to assume the risk of an Exxon default. It seemed like free money.
And why was J.P. Morgan willing to pay those fees? Because even if it couldn’t reduce its government capital, it was still removing a risk it did not want to bear, one that was weighing down its commercial lending risk profile. It had its own internal capital requirements, which would be reduced with this swap deal. And besides, the Exxon deal served as proof of a concept, and might help convince the government that swap deals merited capital relief. But that was still a ways off.
Just like mortgage-backed securities in the 1980s, the derivatives business needed government help in order to really take off. For instance, the industry needed Congress to tweak the bankruptcy laws, so that derivatives contracts could be “netted out” in case of a default. Without that change, if a bankrupt company owed its counterparties $500 million in swap deals, while the counterparties owed the company $300 million, the derivatives dealers would have to stand in line for its $500 million—while paying the company the $300 million. After Congress passed the “netting out” provision, the counterparties would then be