This book tracks the history of credit derivatives market from their roots in J.P.Morgan to their eventual role in Wall Street collapse in 2008.
ABS and MBS have been around for sometime that allowed banks to offload credit risk to other investors. However J.P.Morgan had a peculiar problem with their corporate lending. They needed a way to keep the loans on their books yet find a way to offload the risk. Out of this need are born Bistro instruments which allowed banks keep the loans on books yet remove the risk. Better still, they could reduce the capital charge required by regulators against such loans and thus free up capital.
This concept is later borrowed by other investment banks and used to create derivative products on residential mortgages. Thus we have CDOs (Collaterized Debt Obligations) that are born with a premise that risk will be spread across the system instead of concentrating with a few banks.
Soon banks set-up assembly lines and started churning out CDOs in various forms worth $billions of dollars. In the then low interest rate environment, investors are too happy to snap up the instruments offering higher return. Eventually the supply of underlying mortgages is not enough to meet the demand. Thus are born CDO derivatives and CDS that allowed investors speculate on the prices of mortgages.
All is well until interest rates are low and the default rates on mortgages are minimal. Both have changed to worse by mid 2007. Banks and brokerages who themselves held a few super-senior CDOs on their books hoping for higher return were staring at huge losses. To make matters worse the ABCP market that supplies short term funding for brokerages dried up. A panic took hold that finally altered the westeren financial system permanently.
As the book describes, derivative instruments – used for the right purpose – are never meant to be harmful. However once the greed is mixed it became potent weapon.
Read this book if you are keen to know the history behind the collapse of our lifetime.