Shuffling Risk

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About a week before Christmas 1997, traders on JPMorgan’s New York fixed income desk picked up their phones to pitch a new product. For months, the bank had been working on ways to shed credit risk without sacrificing relationships with borrowers. A few years earlier it had persuaded a third party to insure it against Exxon defaulting, but had struggled to scale the trade. Now, it had an entirely new structure that it was ready to sell to investors.Named Bistro – short for Broad Index Secured Trust Offering – the structure bundled 307 credits from JPMorgan’s balance sheet, spanning corporate loans, bonds, and municipal debt. A special purpose vehicle would insure the portfolio’s risk, funded by selling notes to outside investors. If all went well, investors would earn a steady stream of fees paid for by the bank to compensate them for assuming the risk. If things went badly and defaults occurred, investors would be on the hook. Because defaults were expected to be low – Moody’s estimated 0.82% per year – the vehicle didn’t need to raise so much money. On a portfolio size of $9.7 billion, capital of only $700 million was deemed necessary – enough to cover losses in all but the most dire of scenarios.JPMorgan gave investors a choice. They could sit first in line to take losses in the event of defaults via $237 million of high yielding Ba2 notes, or they could opt for $460 million of safer, though lower-yielding, AAA notes which would only take losses once the Ba2 tranche had been exhausted. The special purpose vehicle invested the proceeds in US Treasuries, guaranteeing the m…