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May 30, 2008 7:24 pm

Derivative thinking

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Just over a decade ago, a british banker made a small piece of financial history. At the time, Robert Reoch was working as a trader in JPMorgan's London office. Like most of his peers, he spent his days on the phone, surrounded by computer screens, trying to cut deals with clients across Europe. But one day an unusual trade crossed Reoch's desk: one of his clients wanted to buy a contract which would effectively protect him from the chance that any one of three government bonds might turn sour. “It was the first time we had done a transaction like that - I guess you could call it one of the first credit derivatives,” Reoch proudly recalls, noting that the trade was so “cutting edge” that the team only sorted out the legal documentation several weeks later.

Since then, Reoch has left the City dealing floors for the quieter surroundings of a Dorset farmhouse. But his dance with financial innovation continues: he spends part of his time in Mayfair, running a consultancy business that advises clients on how to navigate the “credit derivatives” world that he helped create. This area of finance has exploded at such speed that outstanding trades are now put at more than $60,000bn (or, for comparison, 20 times the aggregate capitalisation of London's equity market).

But Reoch's dance has taken a new twist. Before turmoil took hold of the global credit markets last summer, his consultancy spent most of its time advising clients how to get into credit derivatives. Now he is swamped by investors who want to extricate themselves from derivatives-linked messes, or simply to understand the products that came out of the past few years of intense financial innovation. Reoch intends to take another step: to launch a new hedge fund that would take advantage of trading opportunities created by the market turbulence.

To outsiders, this tale might smack of everything that is dubious about modern finance. In the past 10 years, as an extraordinary wave of innovation has swept through the industry, many bankers have become wealthy by creating ever-more complex products. The idea that some financiers are now profiting again - by helping clients to unravel the complexity, or to trade their way around it - might seem galling. “It's a strange business,” admits one senior banker. “First you make money by creating products no one understands, then you make money by cleaning the mess up.”

But there is another, more positive way to look at what is happening. If you believe in the concept of what Joseph Schumpeter called “creative destruction” - the idea that innovation is best served by letting market forces decide which ideas fail and which ones flourish - then the finance industry is entering a crucial phase. In the past eight months, it has experienced a brutal shake-out that has pushed some hallowed institutions, such as Northern Rock and Bear Stearns, over the edge. This, in turn, has prompted some politicians to call for an overhaul of how finance is practised - an overhaul that would, perhaps, impose greater control.

Yet some in the banking industry argue that restricting innovation is the wrong thing to do. As Reoch's story demonstrates, green shoots of entrepreneurial endeavour are already emerging from the current financial debris. “The markets have a rhythm of their own... and are self-healing,” says Mark Brickell, CEO of swaps trading firm Blackbird and a former chair of the International Swaps and Derivatives Association (ISDA), a trade body. If you believe the bankers, the best response to the current crisis is more innovation, not less.

The issue of innovation in the financial world touches on questions that run far beyond banking alone. It even reaches the problem of whether the state should try to control the animal spirit of entrepreneurs. Reoch's story, for example, really starts a couple of decades ago when some bright young bankers on Wall Street hit upon the idea of derivatives. As the name suggests, derivatives are essentially instruments whose value derives from something else. If you buy an equity derivative, you are not buying shares in a company but instead a contract linked to the level of a share price. Sometimes, this type of contract can be used to help investors protect themselves from risk. If you are a pension fund manager worried about share prices falling, you might, in exchange for a small fee, buy equity market derivatives that allow you to sell shares at an above- market price if the market starts to tumble. In that sense, derivatives act rather like insurance.

However, investors also use derivatives to speculate. If a hedge fund manager thinks the stock market is going to fall, then he might buy equity derivatives contracts that pay out when share prices are low - meaning that they will benefit. And since these contracts can be created electronically, in an instant and in vast size, trading derivatives is often more efficient than buying and selling actual shares.

The first derivatives were created in the 1980s and known as interest-rate swaps or foreign-exchange swaps, since they enabled investors to place bets on movements in interest rates or currencies. Then, in the late 1980s, the business proliferated and became far more complex. There is a bitter irony that stalks the modern investment banking world: while many financial institutions exude vast power, they are highly vulnerable because it is so hard to patent their ideas. Thus, whenever a new product is invented, it tends to be copied quickly. That means that although new instruments - such as interest-rate swaps - typically start out as high-margin, bespoke products, they soon become low-margin, ubiquitous products. The only way that a bank can beat its competitors - other than having more capital or financial muscle - is to be much more creative.

However, in the early 1990s, there was another factor that made the derivatives world boom: interest rates were extremely low. That meant that the level of returns investors could achieve by holding, for example, a government bond were also low. Consequently, bankers hunted for other ways to help investors achieve good returns - such as using derivatives. “The thing to realise about the early 1990s was that you had a falling interest rate environment for several years following the recession of late '89/'90,” recalls T.J. Lim, a Malaysian-born banker who was part of the original group of JPMorgan bankers who developed interest-rate swaps in the mid-1980s, and who went on to become one of the most senior bankers in the derivatives and debt world. “Everyone was looking for yield - it was a period when bankers could do almost anything you could dream of and people would buy it. For example, we had structures [with names] such as Libor squared, Inverse Floater, Power options, Convexity forwards, etc. That drove a lot of innovation.”

However, in an uncanny echo of what has happened over the past year, the boom of the early 1990s ended badly. In 1994, the interest rate climate suddenly changed, unleashing wild market turbulence and causing many of the derivatives contracts to produce huge losses - or “blow up”, as traders call it. For a while everyone hated derivatives - “it became a dirty word,” says Lim. “I was very outspoken then in saying that there is nothing wrong with the product - it's just that the excesses got out of control. But it was a very humbling period. It brought down a number of traders and senior people. There was a lot of soul searching.”

As the turmoil mounted, calls emerged for derivatives to be more tightly controlled. But the International Swaps and Derivatives Association fought back furiously, arguing that a regulatory clampdown would not only run counter to the spirit of capital markets, but also crush creativity. Their aggressive lobbying campaign was effective: by the mid-1990s, regulatory pressure had died away, and the derivatives market was free to innovate - albeit under the close eye of lawyers. “We set out to design a business guided by market discipline because we believed that it should be an even better guide to good behaviour than regulatory proscription,” explains Brickell, a principal architect of ISDA's public policy framework, which helped avert a regulatory clampdown back in the 1990s.

The financial community responded to this new lease of life with a vengeance - but not quite in the way that some had expected. In the years after the 1994 turbulence in the derivatives markets, activity in the swaps world slowly recovered. However, the business had lost much of its earlier glamour, not simply due to the huge losses on derivatives, but also because of a more mundane problem: the innovation cycle. Swaps had started life as a high-margin business, but by the early 1990s they had been copied so widely that they had turned into a mass-market product. Almost as soon as the derivatives scandals had died down, bankers started the hunt for the next big thing.

This was where the story of men such as reoch began. In the mid-1990s, soon after he joined jpmorgan, about 80 other bankers who worked in the company's derivatives business were summoned to a plush hotel in Boca Raton, Florida, for a brainstorming session. The man who ran that team was a British banker called Peter Hancock. Hancock had taken over the derivatives team in the late 1980s, and seen the business become commoditised. For a few days, the young JPMorgan bankers brainstormed ways of overcoming this. Eventually, the group alighted on a potentially fertile new frontier for derivatives: credit. Until that point, banks that made large loans didn't have a way of protecting themselves against the chance of a borrower defaulting. Similarly, investors who held bonds did not have any mechanism to insure against an issuer refusing to pay out. What would happen, the JPMorgan bankers asked, if somebody created a contract that mimicked that credit risk, and then sold that risk to another investor, for a fee?

The group in Boca Raton were certainly not the only ones playing around with these ideas: rival teams at institutions such as Bankers Trust and Credit Suisse were thinking along the same lines. But JPMorgan offered an unusually fertile laboratory for experimentation. One reason was that Hancock had gathered a close-knit team of young, highly creative bankers who were open to sharing ideas. Another was that JPMorgan had a vast pool of loans on its books, thus giving Hancock's team plenty of raw material with which to conduct experiments.

Most important of all, JPMorgan's top management had a compelling reason to innovate. At the time, the bank had so many loans on its books that it was finding it expensive to keep doing business: it needed large “rainy day” reserves to protect against the chance of the loans turning sour. Hancock's team believed that if they found a way to sell this “default risk” to somebody else by repackaging the loans into derivatives, then they could persuade the regulators that they did not need to post such big reserves. “They say necessity is the mother of invention,” recalls Andrew Feldstein, a former lawyer who worked with Hancock. “In this case, JPMorgan had a good reason to look at how it handled credit.”

In the late 1990s, men such as feldstein were trying to develop financial techniques that would turn loans into derivatives they could sell on. They started off doing this on an ad-hoc basis but soon discovered that if they created bundles of derivatives contracts linked to loans, then it was easier to sell these instruments to investors - in the same way that it is easier for banks to sell an investor a stake in a mutual fund than shares in an individual company.

Later generations of bankers would refer to these derivatives bundles by the unwieldy name “synthetic collateral debt obligations”. But JPMorgan christened its brainchild Broad Index Secured Trust Offering - or Bistro. Within a few months, it was feeding a wide range of assets into this financial machine, ranging from corporate debt to student loans, and generating fat profits. “The business we were doing grew exponentially,” recalls Terri Duhon, a young banker from Louisiana who was part of the Bistro team. “We went out and 'Bistro-ed' everything we could.”

But then the vagaries of the innovation cycle kicked in. Soon, the ideas behind Bistro started to leak out. Similar products proliferated across the financial world, with equally odd names: ABN Amro, for example, created structures called “Heineken” and “Amstel”. But, as the copycat process grew more intense, margins started to fall again - spurring the bankers to hunt for even more exotic and creative ways to generate returns. Some banks started to put riskier assets into the mix.

As the new century dawned, the teams that had traditionally handled “subprime mortgage” finance - or loans extended to borrowers with a poor credit history - started talking to the derivatives groups. “One of the crucial points happened in late 1997 - around then credit derivatives structurers started to meet with securitisation structurers,” recalls Reoch, who by this time was working at the Bank of America. “The bingo moment was in the coffee queue of our Chicago office when the two groups met by chance and realised they needed to talk to each other.”

Out of this collision of ideas, a new game was born: bankers began to use subprime loans to create these bundles of loan default risk, now called collateralised debt obligations (CDOs) on an explosively large scale.

Ironically, perhaps, JPMorgan itself never rushed too far down this new path. Indeed, this decade JPMorgan has been notably wary of turning subprime mortgage loans into synthetic CDOs. “We couldn't see how other banks made that business work,” says Bill Winters, formerly a member of Hancock's team, but now co-chief executive officer of the investment bank. “[This] was a good stance to take, in retrospect.”

Other banks had fewer qualms. When the credit turmoil finally erupted last summer, investment banks such as Merrill Lynch and UBS discovered that they were holdings tens of billions of dollars of CDOs, many of which have subsequently led to losses even more devastating than in the derivatives blow-up of 1994.

“It is all about the herd instinct. People do stupid things in search of yield when interest rates are so low without proper risk-reward considerations,” says T.J. Lim, who has been warning for at least three years that the boom in CDOs was heading for disaster - largely because he has always believed there were powerful parallels between this latest leg of the innovation cycle and what happened in the early 1990s.

The bankers who stoked the derivatives market boom are, unsurprisingly, at pains to distance themselves from the current credit turmoil. “This crisis has nothing to do with innovation. It is about excesses in banking,” says Bill Winters, another former member of the pioneering JPMorgan team and now the co- chief executive of its investment bank. “Every four to five years there is a new excess in banking - you had the Asian crisis, then the internet bubble. The problem this time is extraordinary excess in the housing market.” Or, as Hancock says, “a lot of the problems in structured finance have not been due to too much innovation, but a failure to innovate sufficiently... People have just taken the original Bistro idea, say, added zeros and done it over and over again without really thinking about the limits of diversification as a risk management tool. There is a big difference between using this structure for corporate loans, as we did at JPMorgan, and subprime mortgages.”

Meanwhile, the ISDA is now fighting to ensure that regulators do not try again to clamp down on the industry. “This credit crunch gives good evidence that market discipline has guided the derivatives business better than regulation has steered housing finance,” Brickell told a recent conference in Vienna.

Paul Calello, head of the investment bank at Credit Suisse, told the same conference that the derivatives industry needed to engage more fully with regulators. Winters thinks that it is time for banks to think about creating a centralised system for processing credit derivatives trades to make the market more transparent and reliable. “We need to have that debate,” he says.

Hancock, the credit derivatives pioneer, thinks that more innovation is needed in terms of how bankers pay themselves - to prevent them from taking crazy risks in pursuit of fat bonuses. Meanwhile, Reoch recently co-wrote a reform paper for the European Parliament calling for changes in the incentives that drive the financial world. He also thinks it could be time to standardise complex instruments, making it easier for investors to understand them. “There is scope to create a standard CDO product,” he says.

It is an open bet whether any of these ideas for reform will fly. After all, when products become simpler and more transparent, the margins typically fall. Bankers, in other words, have a strong motive to retain complexity and opacity - which is why the innovation cycle keeps turning. “I think in the next year or two, finance may become simpler,” says one senior banker. “But after that we will probably just go back to the old ways again.”

As the debate rumbles on, some bankers are already getting creative. These days Lim works in Mayfair as a consultant in the booming business of helping to restructure CDOs for investment groups suffering losses. Duhon works in another Mayfair consultancy, training lawyers and others to understand how credit derivatives work. Other former members of the JPMorgan team, such as Andrew Feldstein, are running hedge funds.

Meanwhile, JPMorgan itself recently bought Bear Stearns, the Wall Street brokerage felled by the credit turmoil, for a knockdown price. With Bear Stearns, it acquired a vast pile of complex financial instruments it is now trying to restructure. JPMorgan has also recently acquired a huge portfolio of so-called equity-release mortgage loans from Northern Rock and is using these to create a flurry of innovative new derivatives contracts, involving issues such as “longevity” (or placing bets on how long mortgage-borrowers might live).

“The speed at which the market has found opportunities [after this crisis] is impressive,” says Winters. “I suppose you could call that innovation.” Or, at least, creativity in search of another fat profit.

Gillian Tett is capital markets editor of the FT.

How The Products Work

1 Derivative

A financial product whose price is dependent upon - or derived from - underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset.

2 Credit Derivative

Whereas derivatives' most common underlying assets include stocks, bonds, commodities and currencies, a credit derivative's price is driven by the credit risk of either private investors or governments.

3 Credit Default Swap

A financial product designed to transfer between parties fixed-income products' exposure to credit risk. The buyer of a credit swap receives credit protection, whereas the seller guarantees the credit-worthiness of the product.

By doing this, the risk of default is transferred from the holder of the fixed-income security to the seller of the swap.

4 Collateralised Debt Obligation (Cdo)

An investment-grade security backed by a pool of bonds, loans and other assets. CDOs represent different types of debt and credit risk, each of which has a different maturity and risk associated with it.

5 Synthetic Collateralised Debt Obligation

A CDO that invests in credit default swaps or other non- cash assets.

6 Subprime Loan

A type of loan offered to individuals who do not qualify for a lender's best-available (or “prime”) rate. They often do not qualify because of poor credit history. Subprime loans tend to have higher interest rates than traditional loans.

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