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By Root 3598 0

the event of a default, the equity holders would be the first to be wiped out. The second slice was called the mezzanine tranche; its holders would begin to lose money only after the equity holders had been completely wiped out. The third and largest tranche generated the smallest return, because it was supposed to carry only the tiniest of risks. Modern financial theory suggested that it would take a monstrous financial catastrophe for the defaults to eat through both the equity and the mezzanine tranches and hit the holders of the third tranche. After all, the credits were diversified, which was supposed to ensure a high degree of safety. J.P. Morgan’s models suggested that the possibility that defaults would hit the third tranche was so remote that no capital needed to be held against this final tranche. The bank called this tranche super-senior—so named because it was supposed to be safer than even the senior, triple-A tranche in a typical securitization.

The first such synthetic deal, which J.P. Morgan put together in 1997, was called the Broad Index Secured Trust Offering, or BISTRO. If the name made eyes glaze over, the intricacies of putting it together were even more mind-numbing. The swaps covered $9.7 billion worth of corporate credits spread out among some 307 companies, according to Fool’s Gold, Gillian Tett’s authoritative account of the creation of credit derivatives. Thanks to the diversification of the credits, J.P. Morgan calculated that only $700 million worth of notes would be required to ensure the entire $9.7 billion. So the bank set up a shell company—a so-called special purpose entity, or SPE—to which it would make insurance-like payments. The SPE, in turn, sold $700 million worth of notes to investors, beginning in December 1997. The payments from J.P. Morgan flowed through the shell company to the investors. After much wrangling, the big credit rating agencies agreed that there was very little risk in these securities and rated most of them triple-A. The BISTRO notes were quickly snapped up.

So where did AIG come in? As would so often be the case with credit derivatives, the issue had to do with capital requirements. Despite their enthusiasm for credit derivatives, bank regulators were leery about BISTRO, particularly that “riskless” super-senior tranche. Yes, it would take a genuine financial calamity to get to the point where the entire $700 million would be eaten up by defaults. But what it if happened? Who would be on the hook if there were so many defaults that they reached into the super-seniors, as mathematically improbable as that was? The answer was J.P. Morgan.

For the regulators, that’s all that mattered. The fact that J.P. Morgan was still theoretically on the hook in a worst-case scenario—as unlikely as it might be—meant that the bank had not completely eliminated the default risk on its portfolio. Therefore, the regulators concluded, banks that held the super-seniors got no capital relief—not unless they could truly find a way to off-load every last penny of the default risk.

Thus did J.P. Morgan begin looking for away to buy credit protection for the super-seniors, so it could show regulators that it had indeed gotten rid of that risk. And thus did it find FP, which was almost uniquely positioned to provide such protection. Because it was a derivatives dealer operating inside an insurance company, FP had no capital requirements. It was already doing a lot of derivatives business with J.P. Morgan. And the parent company’s triple-A rating meant that there could be no doubt—could there be?—that FP had the financial wherewithal to back up its promise to insure the super-seniors. In the BISTRO deal, J.P. Morgan bought credit protection from AIG, which took on the risk of a super-senior default. Not that anybody at AIG thought there was any risk; they were every bit as convinced as J.P. Morgan that this was a riskless transaction. “The models suggested that the risk was so remote that the fees were almost free money,” Tom Savage would later tell the Washington Post. “Just put it on