The Devil's Derivatives
How the swaps trade worked and why AIG sold it
Summary
Nicholas Dunbar, who covered derivatives for Risk magazine, traces the development of the credit derivatives and structured finance markets from the 1990s through the 2008 crisis. His organising device is a distinction between two types of market participant, whom he calls those who hate to lose money and those who love to make it.
The first group, principally commercial banks and insurers, buy protection and structure products so as to appear risk-free while accumulating exposure that is hidden rather than absent. The second group, principally hedge funds and proprietary traders, take positions they understand to be risky and are paid for doing so. Dunbar argues that most of the losses of 2008 were concentrated in the first group, because their structures concealed the risk from themselves as well as from others.
The technical narrative covers the development of the credit default swap at JPMorgan, the regulatory capital arbitrage that drove much early issuance, the collateralised debt obligation and the correlation modelling that priced its tranches, the role of the monoline insurers and of AIG's financial products unit in writing protection they did not hedge, and the mechanics by which triple-A rated tranches produced enormous losses. Dunbar is technically precise and writes for readers willing to follow structural detail. The book covers ground also treated by Gillian Tett and Michael Lewis, with considerably more attention to how the instruments actually worked.
Key takeaways 7
- Institutions that structured exposures to appear risk-free concentrated the losses, because the structures concealed risk from their own management.
- Credit default swaps were developed partly to reduce regulatory capital requirements rather than to transfer economic risk.
- Collateralised debt obligation tranche pricing depended on correlation assumptions that no data supported.
- AIG and the monoline insurers wrote protection without hedging it, on the basis that the underlying events would not occur.
- A triple-A rating on a structured tranche describes expected loss under a model rather than the security's resemblance to a government bond.
- Dunbar argues that participants who understood themselves to be taking risk managed it better than those who believed they had eliminated it.
- Regulatory capital rules shaped the instruments the market created more than economic demand did.
Who should read it
Investors and risk professionals who want the technical development of credit derivatives and structured credit explained by someone who covered the market throughout.
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