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Smith
Faculty Opinion Article
The 30
Seconds Outlook
December 1, 2008
“All knowledge resolves
itself into probability.”
— David Hume, Scottish philosopher,
18th Century.
How did the role of
credit default swaps in the current
financial crisis begin? In 1994, JP
Morgan’s “Masters of the
Universe” met in Boca Raton to party
and celebrate, but also to see if
they could figure out how to greatly
limit default risk in their loan
portfolio. Federal law required they
maintain huge amounts of capital as
reserves against losses in their
holdings of billions of dollars in
loans. The work objective of the
meeting was to create a marketable
security that would protect them
against loan defaults, but also a
security that did not require
holding loan reserves, and they
succeeded! While not the first
to come up with the idea, Morgan was
first to actually create and
transact them, which they named a
“credit default swap” (a bit of a
misnomer).
By late 1997, credit default
swaps were transacted in privately
negotiated contracts with
institutional investors. A
designated trading desk was created
solely for these complex securities,
and staffed by technical university
graduates. To create swaps, several
hundred Morgan loans to “blue chip”
corporations (totaling several
billions of dollars) were isolated
and divided into individual
“tranches” (slices). Each slice was
“insured” against default by making
a swap agreement with a second party
that assumed this risk for a fee.
The trading desk was a great
success, and the “buzz” it created
was soon to make credit default
swaps the “darlings of Wall Street,”
ultimately “to the tune” of over $60
trillion!
John A. Haslem
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