Risky Business
Sunday Times 12th October 2008
TERRI DUHON could not believe her ears. It was 1994 and the 22-year-old graduate trainee was among hundreds of JP Morgan traders called to a meeting in the bank’s then headquarters at 60 Wall Street.
Peter Hancock, a British banker who headed the bank’s fixed-income and trading division, had just explained that in spite of a record year in the trading department no-one at JP Morgan was going to receive a bonus.
The high-flying maths and science graduates who had just been lured to Wall Street felt they had been short-changed.
“I’ll never forget sitting in that room,” said Duhon. “The message was: ‘great year guys, but sadly no-one’s getting paid’. And the problem was the loan book.”
JP Morgan had hundreds of billions of dollars outstanding in loans to multinational corporations. The bank was having to tie up large amounts of capital to support these loans — just holding them on its balance sheet was costing huge amounts of money.
It was time to find a solution, and a group of senior executives came up with the idea for credit-default swaps — a financial instrument banks could use to sell to other institutions the risk that their loans would blow up.
Over the next 14 years that idea ballooned into an industry now worth more than $55 trillion (£32.3 trillion) worldwide. For many analysts these credit derivatives are to blame for the credit crunch.
“Credit derivatives are a tool,” said Duhon, who now runs B&B Structured Products, a London-based consultancy that trains directors and fund managers on the risks of dealing with derivatives. “Like any tool it can be used for good or bad.”
It was Duhon who was charged with pulling together the world’s first credit derivative, which was sold to investors in 1997. It was linked to the fortunes of 300 loans JP Morgan had made to big US corporates, worth a combined sum of $10 billion.
By shipping the risk off to pension funds and other institutional investors, JP Morgan was free to lend that money again without raising any more capital.
A year after that first trade Duhon became the world’s first “exotic credit-derivatives trader” and the success of those early transactions saw every bank on Wall Street wanting a piece of the action.
Over time derivatives grew more complex and involved more and more debt. Derivatives started to be created around mortgages as well as corporate debt.
“With hindsight it’s obvious that all this would happen,” said Duhan. “But while you’re in the middle of it everybody’s dancing, everybody’s making money, the global economy’s going great, China’s expanding — it’s the new paradigm.
“Then you realise the greed and demand for returns caused people to take on more leverage than they should, more risk than they understood. It saw them buy homes they couldn’t afford, to speculate the price would rise and they would be able to afford it in the future.
“Everyone was happy to take more risk to make more money. Did they fully understand those risks? In some cases no. Did they use too much debt? In some cases yes. Did derivatives facilitate overstructuring and over-leverage? Yes.”
For the full Sunday Times report please click here
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