Blythe Masters

So let me try to boil it down to English that I understand. You had a business that basically had to keep capital on the side in a kind of conservative way because there were requirements about it, it was sort of core business, and it wasn't making as much money as you want it to. So there were new things that you guys knew about and that the market knew about that let you operate a little freer, a little more profitably, whatever phrase you want to use.

Maybe a good place to start is to explain what were the products that came out of that era. And then it'll be a little easier to understand how you use them to improve performance.

A credit derivative at its core is actually a very simple concept. … The simplest way to think of a credit derivative is it is analogous to insurance against the risk of a credit default by your counterparty, your business counterpart. One party, who's essentially buying insurance, pays a fee to the other so that in the eventuality that the referenced credit were to have a credit event, so if it were to go bankrupt, for example, then the seller of insurance would essentially make a payment to the buyer insurance to reflect the potential for loss that could be incurred in the event that that company failed.

There are important legal differences between these contracts and insurance. For example, the buyer does not have to prove loss in order to be paid under this contract. Rather, there is an objective decision made as to whether this event occurred, and if it occurred then the payment is made. It's as simple as that.

Now, why is this useful? In the era before credit derivatives were invented, credit markets were well developed. They were very large. Multiple trillions of dollars were deployed in the form of loans, bonds, contracts, receivables on corporate balance sheets, many different forms of credit risk.

But what was common across that entire asset class was that it was very, very difficult to change or to manage your credit risk profile after the fact. If you lent some money to someone, you were going to live with that decision for the five years until the contract says that they have to repay you the loan.

And that illiquidity essentially meant that credit risk was a very imperfect market. It meant that it was concentrated. So typically, you would find large amounts of credit risk residing on the balance sheets of traditional lenders, banks, most notably. And their ability to subsequently modify their strategy to manage down risk really was very limited. You either had to destroy your relationship with the borrower and sell down the loan, or refuse to lend any more in the future, or you had to live with the consequences.

That meant that pricing of credit risk was not transparent. There were not ready markets where one could see buyers and sellers of credit risk interacting on an arm's-length basis at a transparent price that would give you information about the market's view of the creditworthiness of the underlying obligor. There was none of that information at the time.

And so typically, the pattern would be the credit risk was a hidden risk, and generally you would see behaviors where everything was fine until it wasn't fine. And when it wasn't fine, you had a crisis on your hands, meaning that a credit failure had occurred, but up until that point, there had been no market indication that things might have been deteriorating and there had been nothing that one could have done as a manager of that credit risk to avoid it at all.

So along comes this idea, and the idea is simple: What if we could create a market where people were able to buy and sell freely on an arm's-length basis, independently of the companies themselves, the risk associated with lending to those companies, so that there would evolve a market where you could see transparently pricing for the credit risk, and where those that had that risk could pay those that wanted that risk to assume it on their behalf, and vice versa?

That, in essence, was the core of the idea. Very, very simple idea. It would make it easier and safer for people to lend, and easier and more attractively priced for people to invest, to take on credit risk and be paid for that access without having to necessarily be engaged in the direct lending business themselves.

How does that idea come forward? Are you excited? Is it a eureka kind of a moment, or is it incremental in its bits and pieces; you already had thought about it and it isn't a moment of invention at all?

People are always disappointed to hear it, but really this wasn't a eureka moment. It was, as you've suggested, very much an iterative process. It was over time, a coalition of people working together whose ideas were coalescing and they built upon each other.

The essence of the idea of a credit derivative in and of itself is intellectually compelling, and one can imagine instantly if you say, "Well, if I could buy credit insurance, then I could use it to free up risk, I could use it to improve returns on capital deployed, I could use it to create investment vehicles for investors." But unless you actually have a market in which all of these things can occur with reasonable liquidity and transparency, the idea in and of itself is not that significant.

What was significant was the work that began in the early '90s and continued throughout that decade to create a market for the ready transfer of credit risk in derivative form. And that took many years to evolve, and it was a function of many different things occurring cumulatively.

It was the initial ideas, of course, but it was then the discussion around those ideas, the introduction of those ideas to clients and customers and other competitors. It was creating documentation so that whenever you thought about doing a transaction, you didn't have to make up the terms of that transaction from scratch and imagine them and write them down. Rather, you could refer continuously to a template that other people were familiar with.

That took many years of negotiation and work and industry forums, working with ISDA, the International Swap Derivative Association, in order to standardize documentation. It meant working with regulators to establish, is this a permissible activity? And if so, how would that activity be accounted for from a regulatory point of view, from a capital requirement point of view?

It meant working with ratings agencies. If a rating agency is able to assign a rating to a company and say, "This is an A-rated company," then how would they create a credit derivative referencing that company? And all of these dialogues, many, many steps along the way, together cumulatively created eventually a market for the free transfer of credit risk.

Initially [it was a] transfer of credit risk referencing individual companies, so Ford Motor Company, or XYZ Corp., each individual transaction referencing one company. Over time, that too evolved so that just as in the equity markets you see index transactions, so you can buy a stock or you can buy an index, the S&P 500, for example, which is a basket of stocks.

In just the same way, in credit markets we saw indices referencing multiple companies at once evolve, so that now transactions could occur where, for example, you defined the investment grade corporate credit universe and transacted on several hundred names in that universe at once.

So the same tools that you saw in other markets began to be deployed in credit markets as part of a natural progression, and that really was the process of innovation. It was all of those small steps incrementally adding up to the creation of an entire marketplace, so it wasn't any longer just an idea in a room in Florida, it was transactions that had a reasonable likelihood of being able to be transacted in a transparent fashion on an arm's length basis between sophisticated counterparties.

I should emphasize, there was never any retail dimension to this whole market. It was always sophisticated counterparties, so banks and financial institutions and major corporations transacting amongst themselves rather than individuals on the street.

And indeed, that is one of the reasons why when subsequently, in later years, credit derivatives became entangled in the recent financial crisis, your man on the street was so shocked and surprised. There was this large market that he had no familiarity with.

Well, the reason for that is because individuals at a retail level, unlike in the equity markets, were never really involved in transacting in these transactions because by their very nature they were designed for large, sophisticated institutional activity rather than retail investment. …

[What did your team do in Boca Raton?]

Boca Raton was a gathering of people that were part of the then global derivatives group at JPMorgan. That group was run by Peter Hancock, and in some shape or form, all of us worked for him or with him and/or had been hired by him over the previous three to five years I would say.

One of the core philosophies that Peter used in running his business was that he believed that innovation was really the key to success over the long run, and that innovation naturally occurred when you encouraged interactions between people that were informal but business-oriented.

Peter brought us together in part as a celebration, in part as an opportunity to relax, but perhaps much more importantly, as an opportunity to get creative, innovative people together in a room to discuss a whole variety of different topics.

They ranged from risk management challenges to capital optimization to the issue of credit risk management, all sorts of different topics. Credit derivatives was just one of the many topics that was discussed at those sessions.

… So what actually happened at Boca Raton? What happened in those meeting rooms that was exciting enough that people comment on it as a sort of ground zero moment?

I don't see it as a ground zero moment. But what was notable about those meetings and the era that followed was that it was a very unique group of people who were brought together by a management structure that was visionary, and which explicitly was seeking to promote innovation along a number of dimensions. Again, credit derivatives only being one of quite a number of different angles of investigation. And what occurred subsequently was those efforts, those endeavors, became successful. So if you trace them back, you do see them having roots at that time. …

Financial innovation, by the way, is something that has happened repeatedly over the years. And if you think about credit derivatives, they share many characteristics with other financial innovations that happened many years before that. … Interest rate derivatives, for example, were precursors. The credit derivative market would never have evolved but for the preexistence of the derivative markets because so much of the technology was borrowed.

Subsequently, as credit derivatives expanded into forms of synthetic securitization, … that step in the evolutionary process came because the derivative technology borrowed from the securitization market's technology.

The thing about innovation in financial markets is they're always building on what has come before. It's a natural process. And the way great innovators and great innovating organizations arrange themselves, organize themselves, is so that we try to socialize the knowledge of what has come before in the hope that it will spawn new ideas that come from that application of similar concepts to new contexts. And it's those new contexts and new challenges or new problems that really create the solutions.

I think that was what was important about what was going on at Boca Raton, is here are some problems, let's use the tools that we have in our tool kit to think about how one might solve these problems. And in particular, one of the challenges was look at the credit markets. They're a real challenge. There's huge inefficiency, huge lack of transparency. What is different about credit markets than other markets? And it was simple. There was no risk-transfer mechanism.

[What was the effect of credit derivatives on JPMorgan's business?]

I think the most important thing to understand about credit derivatives and their use at JPMorgan is they served a number of different purposes. First and foremost, they were a tool which initially was seen as being useful in managing the bank's own risk management challenges. …

At the same time, to the extent that this idea applied logically to JPMorgan, obviously there were applications to JPMorgan's clients. So we took the same tools and discussed them with clients predominantly in a risk management context as it related to other financial institutions.

A typical dialogue would involve us talking to a bank about managing their credit exposures in their own loan portfolio, where we would offer them the ability to lay off or reduce risk in their credit portfolio, and our role would be as an intermediary. We would then turn to this newly evolving credit derivative market and find takers of that risk who would take the risk from us.

Acting essentially as the middleman?

As the middleman, exactly. Taking risk along the way and intermediating and sometimes managing differences in the risk, managing a portfolio. Nonetheless, the objective was not to build up a gigantic portfolio of credit derivatives risks. It was to buy and sell, to be in the originate and distribute business as opposed to the warehousing business. And that was always an important feature of this business.

There's a big difference between being a credit investor and being a credit intermediary. One requires a completely different set of skills, an orientation, than the other. And I think subsequently, in recent years where problems have evolved in the course of this credit crisis was where that distinction between investing, or taking on or warehousing risks for the longer run, versus intermediating and repackaging and being very careful about residual risks, that became blurred in many people's business model. And I think that subsequently led to many of the problems that eroded.

Let's take Exxon as a case. You were involved directly in that idea. That was one of the first, or the first?

One of the firsts. Exxon was the client at the bank, and we had credit exposure associated with that relationship in conjunction with a letter of credit that had been issued by JPMorgan on behalf of the company. And a letter of credit creates credit risk. If Exxon were to fail on their obligations, then JPMorgan would have to step in and make good on those obligations on their behalf. It was a large amount of exposure, and there was a significant amount of risk associated with that.

The idea was that we wished to purchase protection from others. In this case, the example that was made public was from the EBRD, which is the European Bank for Reconstruction and Development. So we paid them a fee in return for their assuming the credit riskiness of Exxon in this case. That was it, very simple concept.

And why did JPMorgan do that? Because we wanted to free up our capacity to do more business for Exxon. Why did EBRD do that? Because they felt that Exxon was a strong company whose business model they understood. I believe it was AAA rated at the time. They would receive compensation from JPMorgan from taking on or assuming credit risk to Exxon and felt that that was a good risk/reward proposition. They took on a modest amount of risk, we reduced our risk. They didn't create a significant concentration in their case, and so risk was essentially dispersed.

And if you imagine that example multiplied by hundreds of different examples, you can see how concentrated risks on the balance sheet of one bank, in this case JPMorgan, begin to make their way into the hands of investors at prices that those investors are comfortable with and pleased with.

In many cases, this represents credit risk that those investors could not themselves have originated directly. Exxon was not issuing large amounts of corporate debt at the time, so the existence of this letter of credit, which was a bank market product, meant that that credit asset, if you will, was really not available to an institutional investor like the EBRD was at the time.

So tell me how people make money? In that deal, how did JPMorgan make money?

In that particular example, it would have been essentially between the price at which we originated the credit and the price in which we laid it off. Or alternatively, imagine that that was a flat proposition, meaning that they were the same prices. The opportunity that was created was the opportunity to do more business with our customer and to get paid by the fees associated with that incremental business.

Had we not laid off this risk, we would have been full up with that credit risk and unable to do more business. So the future revenue-generating opportunity would have been curtailed.

So capital requirements … would ordinarily lock you into holding a bunch of money on the side?

Correct.

The fact that you can lay that risk off on somebody else means you can free your capital to do other things for Exxon or do other things.

Or another client, indeed. That's exactly right.

So that's how you make your money. How does EBRD make their money?

They're acting as an investor. … Their job was to take credit risk, to make investments. But they were constrained as to the availability as to what they could do. There wasn't another way to take on Exxon credit risk in this form at the time, so that was the opportunity for them.

They had capital to deploy. If they didn't deploy it, they'd earn no return on it. Their job was to deploy it, but they had limited choices. This was a way of expanding their choices.

Importantly, they made the decision as to whether or not they were comfortable at this pricing with Exxon's credit risk, because they're a major, sophisticated, institutional investor in this context. That wasn't an act of persuasion on JPMorgan's part. What we were providing them was a means to an end where the end was defined by them.

Their end was they had an investment objective, and we achieved it for them. We weren't marketing the merits per se of the company in question and had no inside information as to its respective strengths and weaknesses, or at least not in the area that was working on these transactions. Rather we were, on the basis of publicly available information, transacting that risk on an arm's length basis at a transparent price.

Consenting adults?

Correct.

Everybody knows what's going on.

Correct.

… Do you have a boss you have to sell this to? Is it complicated to get it done? Are people kind of excited about the innovation of this?

I think through time this process evolved from being a very bespoke, highly negotiated invention process at the beginning to becoming a very liquid, very transparent, very routine, very standardized market transaction several years later.

So in the case of this example of Exxon and EBRD, we're talking about the very, very earliest transactions, everything had to be made up as we were going along. Five years later, the act of inventing -- what did we mean when we say a "credit event" of Exxon, how do we define that -- five years later, all of that work had been done. …

In terms of how to develop this business within the context of a major global diversified financial institution, I think the important thing to understand is that we were leveraging preexisting capabilities of the bank. Remember that JPMorgan was a big global bank servicing major investors and corporations all around the world already. So for every one of those clients, there was a salesperson or a banker who was servicing those clients needs on a day-to-day basis.

So my job was to articulate this new capability, or opportunity, to those people who were relationship managers. … Actually the way these opportunities evolved more often than not was a buyer process of reverse engineering, meaning that you would have a client who would approach the bank with a problem, and listening to the nature of the problem, you would go away and think about a potential solution and then revert with an idea that could often involve the use of a derivative to tailor a solution to the needs of that particular client. And that's typically how the derivative business evolves.

Because derivatives themselves are in some respects standardized, there are certain elements of them that are repeatable and look the same from transaction to transaction. But in many respects, [they] are tailored to meet the needs of the individual.

So the particular maturity, the particular payment dates, the size of the transaction, various features of it will be changed from deal to deal. That indeed is one of the inherently important strengths of the over-the-counter derivative markets is the fact that you don't have to have a one-size-fits-all solution.

Many of the risks in the financial world differ from moment to moment and problem to problem and company to company. Over-the-counter derivatives are designed to fit those needs on a case-by-case basis, and then the residual or portfolio effect of those risks is managed on a portfolio basis by the big financial intermediaries like a JPMorgan.

Was it exciting?

Yes, very exciting. It was amazing feeling to be able to be involved in invention -- but not just invention, the creating of a marketplace that had real value to add. What in the long run this all meant was that credit, which is a vital part of the lifeblood of any economy, global economy, became a more readily available asset, more readily risk distributed. And the thinking behind that was [it] would be an unambiguously positive thing because credit helps drive growth, helps companies deploy capital, helps employment, etc.

Now the irony is that credit became too loose. …

Were you worried about the potential for harm in those early days?

No. And I think the most important way to understand why that's the case is if you look back through history and look at mishaps in financial markets, many of them have at their root credit origination standards slipping for some reason or another.

So lending in the Latin American debt markets, or crisis in the oil patch, the bursting of the tech bubble. Many of these events have had to do with the deployment of leverage, excess leverage, and the decline of risk-management standards often associated with competitive pressure.

Credit derivatives per se didn't change any of that. It didn't increase or reduce the propensity for people to make unwise underlying credit decisions. Or at least that was the thinking at the time.

It was really more that you created a transparent pricing mechanism for credit risk and fill the void, rather that it really influenced the propensity of people to make unwise lending decisions in the first place. Obviously, subsequently, some of that evolved along a different path and that proved to be wrong.

… What happened?

I think one of the defining characteristics of the business that we ran at JPMorgan was that we were, from the very beginning, very focused on insuring that the risks that we assumed were very carefully managed. …

We were always very focused on if we assume a risk, how do we distribute it, and obviously making sure we were distributing in an appropriate fashion to people who understood what they were doing and why. That goes without saying.

Consenting adults?

Yeah, exactly. And we did see many opportunities to take on risks indefinitely that at least in theory one could have argued to oneself, "Gosh, that's a very attractive risk. Why would I need to lay it off? Why not just keep it and earn the return associated with that?"

And we explicitly turned away from those paths because of a number of reasons, but primarily because we knew there were scenarios -- they were hard to imagine -- but we knew that the were scenarios where that risk accumulation could be extremely dangerous. And we were not in the business of assuming risks that subsequently could put our franchise, our company, our shareholders at risk. We were in an intermediation business. We were about making markets more efficient. We were not about investing in credit risk over the long run.

So what subsequently happened? I described the evolution of this single-name credit derivative product, buying and selling risk on individual companies. That evolved to buying and selling risk on portfolios of credit risk.

So you take a loan portfolio -- initially portfolios of corporate credit risk, so large, investment-grade corporations to whom a bank had lent -- and transactions occurred where those risks were transferred in the form of synthetic securitization or credit derivatives, which took on an entire tranche or slice of the risk of that portfolio and paid an investor to assume that risk.

Corporate credit portfolios have a characteristic of being relatively diverse, meaning that the event that can deteriorate the credit equality of one corporation often don't correlate with the events that can lead to a credit deterioration of another corporation. They're in different industries, different areas of the country. They might be operating overseas of not. They're fundamentally in different businesses. And so when you look at those portfolios of risk, it's reasonable to assume a high degree of diversification.

The next application of this same technology was to portfolios of consumer credit risk, and in particular mortgage-related credit risk. A big difference between mortgages and corporate loans is this diversification difference.

And it turns out that even if a portfolio of underlying mortgages is diverse from a geographic perspective, for example, it still has systematic risk in it which makes it vulnerable to certain events and makes all of those loans in that portfolio vulnerable to the same events, specifically a deterioration in house prices caused by a recession, an increase in interest rates caused by macroeconomic developments, a rise in unemployment caused by a recession, for example.

If those things occur on a severe enough basis, then an entire portfolio previously deemed diversified in fact will turn down all at once. And it was essentially the application of the credit derivative technology to this situation that led to problems.

And the bank, JPMorgan, walked away from all of this?

We did.

When did that happen? Take me there. You guys all looked at it and just said, "Whoa, I don't like where this is headed?"

Somewhere around 2002 to 2004, 2006 it really accelerated. And during that time, we were active in the mortgage markets ourselves; we were active in the derivative markets. We saw the opportunities here, but we could not get comfortable with the idea that the diversification in these portfolios was sufficient to justify the treatment of the risks.

So we steered away from assuming or warehousing those risks, or doing lots of business with other companies that themselves were predominantly in the business of assuming or warehousing those risks. And that meant that we missed a revenue opportunity, but that was okay because we couldn't get comfortable with it. And indeed, that's why we shied away from it.

Others did not. Why not?

Well, I think a number of reasons. I can't speak for obviously the actions of others, but I can speculate.

I think that first of all, typically the structures that became very problematic for people were structures where the nature of the risk that was being assumed was so-called "catastrophic," meaning that it was risk associated only with extreme losses in portfolios of underlying assets.

And to visualize or to imagine losses of that severity required one to make some very significant assumptions about the path of the economy, which were just not in people's minds. It required things like assuming that house prices in the United States fell by 25 percent.

Now we all know because it's happened that that was a realistic scenario. But on an a priori basis, people weren't thinking that way in 2006 or '07. And so I would say that lulled people into a false sense of security.

Secondly, the apparent compensation for risk on the face of it, if you didn't have in mind those types of scenarios, look very attractive indeed, meaning that you could get "well paid," in inverted commas, for assuming and carrying that risk, and the risk return proposition appeared better than the proposition of paying someone else to take it away.

I think that there was also an element of an assumption that conditions would just continue in the way that they were.

The value of an American house has never gone down, right?

As long as house prices never fell, these risks would never come home to roost. And that ultimately was obviously very flawed logic. …

When some of the subsequent facts came to light and it became clear what the risk management practices of others were and had been, it was very surprising not just to me, but to others who I had worked with both in the past and who were still at the company, it was very surprising to see tens and tens, if not hundreds in some cases, of billion of dollars of this risk being warehoused on the balance sheets of leveraged financial institutions. …

[Critics say that] so many of these deals seem to happen, from their point of view, in secret. They keep saying black box, black box, it was impossible to know who were the counterparties. …

I think that point is correct. The fact is that the regulatory framework in the United States … was designed for an era that ended decades ago and is one that is very much defined by either products or corporate entity charters.

So even though your activity may look the same irrespective of whether you're an insurance company, a banker, a broker/dealer, hedge fund, a private equity company, your regulatory framework, your restrictions, your legal powers are utterly different depending on what your corporate charter looked like. And that's wrong, because the essence of intelligent and effective regulation needs to be that similar activities should be subject to similar regulation, indeed, the same regulation for lots of good reasons, one being the efficacy of the regulation, the other being the leveling of the competitive playing field, incidentally, which is another topic. …

I think that the thinking that got people comfortable erroneously, with hindsight, with that outdated framework was that somewhere there was an overriding commercial incentive that would govern the behavior of all of these outfits and cause them to defend their own positions, their own shareholders, their own capital, and that that was an adequate incentive for insuring that people did not engage in self-destructive behavior. That, at the end of the day, only matters if the self-destruction brings down others.

Unfortunately, what became clear is that either because people didn't understand the risks that they were engaged in, or because they were under such competitive pressures that they were unable to react wisely to them, self-destructive behavior actually occurred. And that self-destructive behavior, which under normal circumstances one should let it flow and the destruction should occur, became systemically consequential because of the linkages between all of these companies.

They all became "too big to fail."

Not necessarily "too big to fail," but too interconnected. …

When all of it starts to cascade, what were you thinking when you were watching it go? Did you have a sense of how vulnerable everything was over Labor Day weekend in 2008? Were you personally concerned?

Extremely, yes. It was a very, very scary time. I think up until that Labor Day weekend, we were in just another financial crisis. Those aren't pleasant occurrences, but they repeat, and they have patterns that one can recognize, and over the course of a 20-year career, you learn to recognize them. Up until that point, I think we were in one of those situations.

At that point, we were in totally new territory. The notion that a Lehman Brothers could be filing for bankruptcy and AIG could be at risk of the same fate -- and it was very uncertain what would happen to the rest of the broker/dealer community that week -- was absolutely unprecedented. And thinking through the implications of that for the health of not just the U.S. economy but the world, it wasn't really conceivable to do that. I couldn't get my mind around it. I know others couldn't.

The extraordinary actions that were subsequently taken by governments to intervene were absolutely necessary, because the consequences of an interconnected failure by all of those institutions simultaneously would have been unimaginably terrible in terms of impact not on the shareholders of those corporations who suffered terribly anyway, but on the man on the street.

We know that credit conditions are tight today; they would be nonexistent had those events unfolded. Absolutely nonexistent. The Great Depression would have looked like a small event by comparison to what I think would have happened had that process continued unrestricted.

And one of the great tragedies of understanding, or misunderstanding, it through all of this is the notion that somehow banks and/or Wall Street were bailed out at the expense of the taxpayer. What has been lost in translation is that it is for the sake of the man on the street that the financial system needed to be stabilized, and it was unambiguously in the interests of the taxpayer that that system be stabilized.

And let us not forget that the shareholders and many, many employees of these financial institutions that did make major mistakes have paid dearly in terms of their own personal net worth and the value of their companies. The bailing out aspect was keeping them afloat through the presence of government backstops and capital so that credit markets could go through a process of un-seizing themselves without abject panic. And that was what we were looking at then.

This wasn't about credit derivatives, this was a much more complex situation. It had at its core credit conditions that were easy and had been that way for many years; it had the low savings rate in the United States, the high savings rates in the emerging economies, particularly China and India, the growth in the emerging markets.

All of these things had conspired to create an environment that essentially became a bubble. The consuming habits of United States citizens driven, in part, by the housing bubble led to a lot of this buoyancy and lack of fear of risk in financial markets. And there was a significant deployment of leverage, leverage in the form of balance sheets that were running with very little capital against large volumes of assets which all looked fine, except when the music stopped in a correlated fashion, they deteriorated.

That, at its essence, was the root cause of this financial crisis. The derivatives, in a sense, are a manifestation of people's risk appetite. How they used derivatives reflected their lack of fear of the consequences of market behavior, lending in particular in mortgage markets. …