Exxon needed to open a line of credit to cover potential damages of five billion dollars... J. P. Morgan was reluctant to turn down Exxon, which was an old client, but the deal would tie up a lot of reserve cash to provide for the risk of the loans going bad. The so-called Basel rules, named for the town in Switzerland where they were formulated, required that the banks hold eight per cent of their capital in reserve against the risk of outstanding loans. That limited the amount of lending bankers could do, the amount of risk they could take on, and therefore the amount of profit they could make. But, if the risk of the loans could be sold, it logically followed that the loans were now risk-free; and, if that were the case, what would have been the reserve cash could now be freely loaned out. No need to suck up useful capital.So the new "credit default swap" allowed Exxon borrow on more attractive terms than it otherwise would have gotten, while J.P. Morgan got to export the risk of the loan to Europe, and free up more of its own money to lend to other borrowers.
In late 1994, Blythe Masters, a member of the J. P. Morgan swaps team, pitched the idea of selling the credit risk to the European Bank of Reconstruction and Development. So, if Exxon defaulted, the E.B.R.D. would be on the hook for it—and, in return for taking on the risk, would receive a fee from J. P. Morgan. Exxon would get its credit line, and J. P. Morgan would get to honor its client relationship but also to keep its credit lines intact for sexier activities. The deal was so new that it didn’t even have a name: eventually, the one settled on was “credit-default swap.”
Wednesday, August 04, 2010
My last post casually mentioned credit default swaps, a fancy financial trick that helped create the credit crisis of 2008 (Planet Money did an amazing reporting series on credit default swaps for NPR back while the crisis was happening).
What I didn't know when I started writing that post was that the Exxon Valdez oil spill actually inspired the invention of credit default swaps. In a way, the loan for restoring Prince William Sound was the first-ever subprime mortgage- the ultimate fixer-upper.
Here's how it happened. In the first court judgment against Exxon Mobil for the 1989 Exxon Valdez oil spill, an Anchorage jury awarded the defendants $5 billion in punitive damages. This was in 1994.
Author Gillian Tett, a financial writer who possesses a valuable background in social anthropology, describes what happened next in her book "Fool's Gold," a detailed history of the financial innovations and machinations that led up to the credit crisis. John Lanchester provides a succinct summary in his June 2009 New Yorker review:
To draw a more familiar analogy, Exxon was like the shady homebuyer who might lose his job at any moment, and J.P. Morgan was the mortgage broker who nevertheless assured him that he was still completely qualified to borrow. And the oil-soaked Prince William Sound was the fixer-upper whose cleanup costs were on the bottom line. Thanks to the credit default swap, the actual responsibility for that mess - like the actual responsibility for millions of underwater mortgages today - wouldn't really be owned by anyone.
The irony is that this first-ever credit default swap actually worked out well for its players: Exxon merged with Mobil and the new company, ExxonMobil, now makes around $40 billion in profits in a typical year. The $5 billion punishment was also recently rejected by the Supreme Court. So needless to say, the risky loan never defaulted, and the European Bank of Reconstruction and Development kept its money.
J.P. Morgan, meanwhile, was able to offer more and more credit default swaps, and merged with Chase bank in 2000. By 2008, when it became evident that many of those credit default swaps were tangled up in a worthless house of cards, the company was one of the nation's four largest banks deemed "too big to fail," and received a $25 billion bailout from the federal government.
Most people would agree that ExxonMobil still hasn't served justice for the Exxon Valdez spill, but look at it this way: the company made $45 billion in profits in 2008, but a year later, it pulled in less than half that amount, thanks in large part to the global financial crisis. By seeking a cheap loan to cover its ass and pass the buck back in 1994, the corporation helped invent the financial device that inadvertently brought the world's economy (and the world's thirst for oil) to its knees. ExxonMobil still cleared almost $20 billion last year, though, so the schadenfreude is admittedly dim.
It's more interesting to think about how BP and the global financial markets will cope with the cleanup bill for the much larger Deepwater Horizon disaster. Suddenly, the multi-trillion dollar business of drilling for oil miles below the surface of the ocean looks a lot riskier. But it's still an extremely lucrative enterprise, which means that the world's bankers will inevitably invent new contortions and pyramid schemes to cover those risks and finance more wells.