Bistro: some history of synthetic CDOs

…Demchak’s team was the first to take them wholesale, using credit-default swaps in a huge deal. They mashed up J.P. Morgan’s exposure to more than 300 giant corporations, created an off-balance-sheet vehicle, then sold slices of that to investors. The vehicle then protected J.P. Morgan from defaults. In effect, Morgan was paying insurance premiums to investors who now were on the hook if one of Morgan’s clients went belly-up. “The innovation of not being tied to specific loans or bonds is what made the credit-derivatives market what it is today,” says Romita Shetty, who was part of Demchak’s team at J.P. Morgan.

Development on the project continued slowly through the second half of 1997, involving painstaking and tedious legal and accounting work, quantitative analysis, and hand-holding and persuasion of banking regulators and credit-rating agencies. Demchak and Masters wanted their first deal to hit the market by the end of the year so that Morgan could get credit for it when the bank reported its earnings. The period was so intense that Masters, an avid equestrienne, at one point took a conference call from atop her horse.

Finally, in December 1997, Demchak’s team closed on this first big credit-derivatives deal, the Broad Indexed Secured Trust Offering, or Bistro for short. Insurance companies and banks, the initial customers, were enthusiastic, snapping it up in just two weeks. The deal was enormous for the time, off-loading more than $9.7 billion of J.P. Morgan’s exposure. Morgan had succeeded in reducing its balance-sheet risk and was able to free up capital to buy its stock back.

J.P. Morgan would go on to launch a credit- derivatives assembly line, becoming the Henry Ford of the new financial market. Throughout the 1990s, the bank was a major player in persuading lawmakers to allow the derivatives markets to remain unregulated—a move regulators are now reevaluating. Bistro helped J.P. Morgan traders in London kick-start the expansion of the “single-name” C.D.S. market, where individual contracts that cover just one company or entity trade hands. This market became liquid and deep by the early 2000s. “We had 100 people,” Demchak recalls. “We helped create the regulatory framework, the legal and accounting framework, and we did billions. We industrialized the product.”

J.P. Morgan continues to dominate the world of derivatives. It has derivatives contracts tied to $90 trillion of underlying securities. Of that, $10.2 trillion are credit-derivatives contracts. Those mind-boggling totals are somewhat misleading. They reflect what is called the “notional” amount in the world of derivatives, based on the underlying amount of the contract, not its current value. When offsetting contracts are taken into account, that figure is whittled down to a much smaller—though still enormous—$109 billion of derivatives, of which $26 billion are credit derivatives. That’s the amount the bank could lose if all its trading partners went out of business, an extremely remote event. But the exposure is climbing, up 17.4 percent from the end of 2007. That’s equal to 20 percent of the bank’s net worth.

Bistro “was the most sublime piece of financial engineering that was ever developed. It was breathtaking in terms of beauty and elegance,” says Satyajit Das, a risk consultant and the author of Traders, Guns, and Money, a financial history. But “in many ways,” Das adds, “J.P. Morgan created Frankenstein’s monster.”

For J.P. Morgan, Bistro worked wonderfully. But even in that first deal, the weaknesses in structured finance and credit derivatives that would come to the fore in the 2007 credit-market crash were already there.

Despite its blue-chip assets, Bistro didn’t perform pristinely. The initial slice, the equity layer that Morgan retained as a cushion against trouble, was so thin that it couldn’t weather even one default from one of the bigger companies in the bundle. That ultimately happened, wiping the slice out entirely. The investors who were one notch up, in what’s called the mezzanine layer, lost money as well. Even the buyers of the top-rated tranches, which were thought to be rock solid, had to endure bumpy periods before they got their money back.

During that first major deal, the credit-rating agencies, which were supposed to be impartial, were already deeply enmeshed in the give-and-take of the process. A former Morgan banker who helped create Bistro recalls that Standard & Poor’s was giving the bank a tough time. The rating firm would run the deal through its models, and “each time, it came up with disastrous results. We did some tinkering and all of a sudden, it could rate the deal,” the banker says.

The pattern was set. The rating agencies would become integral to the creation of the structures. Standard & Poor’s says questioning that first deal was appropriate and stands by its original rating. It further says it doesn’t get involved in structuring deals. But the close relationships between the rating agencies and the Wall Street firms were heavily criticized following widespread mortgage-related securities failures after the housing bubble burst.

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