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By Root 3658 0

in having a deep, ongoing understanding of the risks FP took. It was a point of pride among FP’s executives that although they were derivatives traders, they were unusually careful ones. The problem for AIG when it began building deals around credit default swaps was that the risk models they used seemed to suggest that they came with virtually no risk at all. Which ultimately caused FP to let down its guard. The traders and executives didn’t do the constant calibrating, didn’t bring the skepticism, didn’t do the worst-case-scenario modeling or put on the hedges that they might have if they’d sensed danger lurking. Their internal models told them that there was a 99.85 percent chance that they would never have to pay out a penny. “The different nature of those trades from any other trades FP had done opened the door to all the problems that came about,” Savage told the Washington Post.

It was J.P. Morgan that lured AIG into the credit default swap business. The bank’s initial 1994 swap deal—the one that insured against an Exxon default—had gone off without a hitch. Since then, J.P. Morgan had done a handful of similar deals, while at the same time using credit default swaps internally to better evaluate its loan portfolio. In 1997, after the bank lost millions in bad loans during the Asian financial crisis, the credit derivatives team was put in charge of the bank’s commercial lending department, much to the horror of the old-time commercial lenders. They began using swaps to perform risk analysis on the loan portfolio. Credit default swaps were truly becoming central to the way the bank did business.

As for the regulators, once they began to understand what credit default swaps did, they warmed up to them. Bank regulators, it turned out, liked the idea of banks off-loading some of their default risk to other entities; in theory, it meant that banks were less likely to fail if they made bad loans. In fact, by 1996, the Federal Reserve agreed with J.P. Morgan that a bank should get some capital relief if it used credit derivatives. It put out a statement saying that if a bank used credit default swaps to move a borrower’s default risk off its balance sheet, it would be allowed it hold less capital.

What J.P. Morgan had not been able to create was a tradable market for credit default swaps. Such a market was important to the bank for several reasons. First, it would give the bank a new line of securities to create, market, and trade. Second, if a tradable market existed for credit derivatives, the market itself could be used to establish a company’s default risk. This would give J.P. Morgan a better way of measuring the risks in its own commercial loan portfolio, while also giving speculators the means to bet on the possibility of a company’s default, even if they had no economic interest in the company.

In the late 1990s, the bank—again, with Blythe Masters leading the way—found a way to create a credit product that investors loved. It did so by ingeniously combining credit derivatives with securitization. Instead of having a credit default swap reference a single company like Exxon, J.P. Morgan bundled together a large, diversified basket of credit derivatives that referenced hundreds of corporate credits. It was different from other kinds of securitizations in one critical way. Investors in mortgage-backed securities owned pieces of actual mortgages. But those who invested in J.P. Morgan’s invention didn’t own a piece of the actual corporate loans. Instead, they owned credit default swaps—the performance of which was determined by the performance of the underlying corporate credits. The credit default swaps referenced the actual loans, which were owned by others. Because securities like these were built out of credit derivatives rather than real assets, they came to be called synthetics.

Just as with mortgage-backed securities, synthetic securities were tranched, usually into three slices. The first, and smallest, was called the equity portion; it produced the heftiest return because it came with the most risk. In