Terri Duhon joined JPMorgan as a derivatives trader in 1994 after graduating from MIT. Four years later she was tapped to develop JPMorgan’s credit derivatives business. She is managing partner of B&B Structured Finance. This is the edited transcript of an interview conducted by producer Martin Smith on Feb. 6, 2012.
Terri Duhon
JPMorgan (1994-02)
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The JPMorgan exotic trading book I was asked to develop was the first of its kind
So you're not at [the offsite weekend meeting in] Boca [Raton, Fla.]; you're in training. But then when do you join up with that team?
Well, I went into the JPMorgan training program in '94, and then at the end of '94 -- because I graduated from MIT in May '94 -- I believe my start date was sometime in October, probably on one of the crash dates, you know. (Laughs.) But I started in October '94, went into the training program through to early '95, and then I joined the interest rates swaps trading desk, and I traded interest rate swaps for three years, and then I was asked to move to the credit derivative business and build their exotic credit derivative trading book.
And that trading book was the first of its kind, certainly, anywhere on -- with any of the banks. We had just gotten approval from the Fed to be able to put [together] that trading book and create that new trading book. So I was asked to be the trader for that book.
DerivativesFinancial innovations
Single-name credit derivatives were not new anymore. But portfolios of derivatives were.
Now, JPMorgan had been involved in sort of test runs of writing credit derivatives prior to '98.
Test runs.
You had not -- they weren't --
They had actually traded.
Right. They had traded on a smaller scale.
Yes. They had certainly traded what we call single-name credit derivatives, a few of them. So the transaction on Exxon, or they had traded, you know -- so, for example, a credit derivative on IBM or a credit derivative on Wal-Mart, they would have traded, certainly, single-name credit derivatives before that.
And the trading book that I was asked to build was the exotic trading book. It wasn't about transacting single-name credit derivatives; it was transacting portfolio credit derivatives, in particular tranches of portfolios. So it was a very different risk from just a single-name credit risk.
Financial innovationsDerivatives
Derivatives trading was developed so that banks could take credit risk off their books
So I want to get into that in a second, but let's go back and explain the Exxon deal, for instance, how that worked, how it functioned. What was the utility of the credit default swap in that case?
Well, the basic concept or the original driver of credit derivatives was for banks to be able to transfer credit risk off of their balance sheet without transferring the loan itself. Say, for example, Exxon has come to JPMorgan and said, "Can we borrow X billion dollars?" JPMorgan says: "You've been a client for a long time; we certainly want to help you out with this. We want to give you this loan, but it's a big number. You need to borrow a big number. And for our risk management purposes, that's a lot of risk to take on our books and for us to hold for whatever -- five, 10 years, whatever the majority is going to be. So in order for us to give you this loan, I think we're probably going to have to transfer some of the credit risk."
Now, they probably didn't have that conversation with Exxon, but they probably had that conversation internally, which was: "We want to service the client, but this is a big risk for us to take. What can we do with it? How can we manage it?" And so the best way to manage it is to buy protection, or like buying insurance from another party.
We have to manage our risk
Now, Exxon is a big company. It's not like they're not going to pay on their line of credit. Was it really -- I mean, wasn't it more about regulatory capital and not so much about protecting against the risk?
But you can never say today who's going to be around in five years' time. You know, before 2008 we would have all said, sure, you can lend as much as you want to Lehman Brothers; you can lend as much as you want to Fannie Mae or Freddie Mac. You can lend as much as you want to. They all look like great credits. They're going to be around forever.
But that's not the way that the world of credit risk works. The fact is that today, there is always a chance that within the next five years, there's always the probability that they may not be able to pay that money back. And it's a small probability, but that's the risk that a bank manages, which is, you know, it should be a small probability.
Hopefully we're not lending money to someone that we're expecting to default, by any means, but the probability exists. So we need to transfer that risk. And, yes, we did have regulatory capital against that loan as well. Every--
In other words you had to hold less debt on the-- I'm sorry. Yes, you had to hold less debt on the balance sheet because you had a letter of credit extended to, or a line of credit extended to Exxon Mobile. The regulations required that you not be so that there be less debt. There [would] be more equity in the company.
Sorry, I don't understand the question.
How banks determine the amount of capital they need to retain on their books
In other words, on the bank's balance sheet, on JP Morgan's balance sheet, by extending that line of credit to Exxon Mobile, you were therefore-- having to hold more capital.
Equity. More capital.
More equity.
More equity. That's right.
Less debt.
Well, more equity in--
Okay. But it's the same thing, right? It's the flipside of the same thing.
Well, so imagine a scenario where you don't have any loans on your books and the first thing you do is give out a loan for a billion dollars. Well, you're gonna need to go and borrow the billion to do it in the first place, because you need to find that cash somewhere.
The next step, very simply, is that the regulator says, "You must hold some capital against the loan." Let's say originally the minimum capital number was eight percent, let's say now it's it's higher. Let's make it ten percent. That's equity. That's shares.
We issue shares against that capital because we don't have to pay those shares back. The money we've borrowed, the billion we've borrowed to lend to Exxon in the first place, we have to pay that money back. But the shares we don't have to pay that money back.
And let's say that number's ten percent, the concept is that if I have a huge portfolio of loans that I've given out to hundreds of different borrowers, is that I'm not expecting to lose more than ten percent of that portfolio. So I can borrow 90 percent to lend 90 percent of the cash, but the other ten percent I need to issue shares because it's money I never have to pay back.
And so in the world of banking we have two different calculations of capital. The first is regulatory capital. What does the regulator say is the minimum amount of capital we have to hold against this risk? And the second is what we call economic capital. That's our determination of what the risk is. And that might be four percent. So it's four percent capital compared to the ten percent that the regulator requires, or it might be 12 percent compared to what the regulator requires.
And in 1990, you know, in the 1990s, the regulators required a flat number. They didn't look at the credit quality of your portfolio. And so if your portfolio had on average a lower credit quality than what a lot of, you know, than what the regulators considered the average, then you should, in theory, have been holding more regulatory, more economic capital than the regulatory capital. Whereas if you had a portfolio that was higher credit quality than the average.
Like a loan to Exxon.
Like a loan to Exxon. Or like, at the time, JP Morgan's portfolio, we primarily dealt with very highly rated investment grade companies. Blue chip, you know, we had a blue chip client list for the lending activities that we did. And so we looked at our loan portfolio and we looked at the minimum regulatory capital, and we felt that the economic capital was lower than the regulatory capital that we were required to hold. And so--
For the high quality of loans we had, we shouldn't be required to hold as much capital.
You thought you could do business effectively by holding less -- you know, economically, you could do business with less capital than what the regulators were requiring.
I think the idea was that we looked at the credit risk of the portfolio of loans we had, and it was very, very high quality compared to what the regulators considered an average portfolio. And we felt that the risk capital that we should have held was less than what the regulators might have said.
Now, again, in the '90s, the regulators had a very, very simple regulatory capital model. So there were lots of banks who looked at their own portfolio and said, "It's very different from what the regulators see as an average portfolio."
And these are not conversations that we considered secret. We certainly had direct conversations with the regulators: "Look at the credit quality of what we have in this portfolio. Look at the types of borrowers that we have." You know, we are holding a huge amount of regulatory capital against what we consider to be very low credit risk on average.
And you felt, therefore -- correct me if I'm wrong -- that you could effectively put more money to work for the bank.
Yeah, I think the concept was we wanted to be more efficient with our capital use. Now, just to put it into context, we as an institution were rated AAA in '94, and in '95 one of the decisions we made as a bank -- and I say "we" as if I were involved in these decisions. I was a new hire; I was very junior. But one of the decisions we made in -- that JPMorgan made in '95 was that they didn't need to be a AAA institution; that, from a competitive landscape, most of the other banks with whom they were competing weren't AAA institutions. And what that meant is that they held less capital against the risk that they had. They were slightly more risky institutions. And we, JPMorgan, must have needed -- you know, must have looked at the competitive landscape and said: "OK, we need to be more competitive. We need to have a better return on capital for our shareholders, and to do that we need to be more efficient with our usage of capital...."
Credit Rating Agencies
We never tried to hide our risk management practices from regulators
And so the deal was done. What effect does having that credit default swap deal made have on the books of JPMorgan?
What it allows JPMorgan to do is to say to the regulator, "Look, we have transferred the credit risk from our books to a third party via this contract, and as a result, against this particular loan, we should not be required to hold the capital -- whatever the number is, 8 percent, 10 percent -- that we've had to hold in the past against that loan." So if that was a billion-dollar loan, and we had 10 percent regulatory capital against it, we were able to release $100 million of regulatory capital by virtue of transferring the risk to someone else.
And so that money was therefore freed up, right?
That capital was then freed up to be able to --
Do more business.
Do more business, lend to other entities. Or it could have even been that the decision was, "Look, we actually don't have the capital to lend the full amount that Exxon needs, so in order for us to even lend this, give this loan in the first place, you know, based on our capital restrictions, we're going to need to distribute some of the risk." And we had very open and frank conversations with the regulators. There was certainly -- we were not looking, by any means, to hide the risk management practice that we were putting in place.
This was incredibly new stuff
And give me some sense of -- I mean, this was pretty new stuff.
(Laughs.) This was incredibly new stuff. And now, certainly, I think, depending on who you talk to, you can always find a banker who will tell you that they were the -- you know, "I traded the first credit default swap in 1980," something. Or some other guy will tell you: "I traded the first credit default swap in 19--, you know. I have the contract in my desk."
But there were a handful of them traded. The concept existed long before 1997 or '98 when the market really -- [where] JPMorgan really stood -- started to take off. The contract certainly existed already. The concept existed And there were banks who were looking at employing it on their own books. But JPMorgan made the decision in '94 to put some effort behind it and really try to standardize the documentation, try and engage other dealers and get them to transact, to educate the sales force, to educate the investors, to build a sensible risk management framework around the product. And that was part of my job, was to come in as a trader and look at the more exotic version of the credit derivative and to build [an] exotic credit derivative trading book including all the risk management around the more exotic products. That was what I was brought in to do....
DerivativesCredit Default Swaps
It was a huge amount of work, but it was also very fun
Given that you were breaking new ground in the work that you were doing, how exciting was it to be there? (Laughs.) What was it like?
You know, with hindsight, everything seems more exciting -- (laughs) -- because at the time, it was a huge amount of work. It was a lot of fun. It was a great team of people. We had some really very clever and very interesting people that we were working with, and people who had really thought about credit risk and who had really, really spent a lot of time thinking about the dynamics of credit risk and portfolio risk as a whole.
And we worked with some great -- some fun people. It was a global team, so we had some fascinating personality clashes every now and then, but a lot of fun. And the JPMorgan work environment was very much a team-player environment when I was there, certainly. And it may have changed.
But the idea was that we weren't looking for stars. Being a superstar wasn't -- if you wanted to be a superstar, if you wanted to be the star trader, or, you know, if you wanted to be a superstar on the trading floor, you were in the wrong place, because our approach was we were looking at -- we worked as a team.
So everybody -- we weren't trying to hide anything from the next guy down the desk from us. We were all trying to make this happen. And it required a team of people to make this happen. It was a big project. It was a big deal. And we had a lot of fun, but we worked hard. (Laughs,) There were some --
You worked hard.
There were some long nights and some all-nighters and some weekends and -- many weekends. And we certainly felt more like we were, you know, investment bankers, and we were working on the trading floor at parts during some of those times.
Every year the actual growth of derivatives far surpassed any our estimates. There was a need.
And give me some sense of how this part of the business grew.
Well, certainly the single-name credit derivative business was becoming more and more popular. It was clearly a product that was much easier to understand, which is -- look, if you're comfortable investing in Exxon's debt, you should be comfortable selling protection on an Exxon credit default swap, because they have the same risk-return profile. They have almost the same cash flows -- not exactly, but very similar cash flows.
So the idea is that when you talk to investors about credit derivatives, although it has the term "derivative" -- and even in the '90s, we certainly had a lot of reticence to touch anything that said "derivatives." Derivatives have always had a little bit of an edge associated with them. They've always seemed a little bit more risky than what everybody's prepared to invest in.
But we talked to a number of asset managers who were comfortable with derivatives generally and as a result who became comfortable with credit derivatives. And those single-name credit derivatives, certainly they grew exponentially well beyond anyone's expectation.
Every year the BBA, the British Bankers' Association, would do a survey of what did different individuals within the credit derivative market anticipate that the growth of the credit derivatives could be the next year. And every year the actual growth far surpassed any of the numbers that we talked about. It was amazing. It was clearly a product that was in need. We had identified a need. There were banks who wanted to better manage their regulatory and risk capital. They wanted to manage their credit risk. They wanted to better service their clients by being able to give them loans, but they needed to free up some capital in order to do that, or they needed to be able to manage the risk.
And there were investors who were able to invest in some entities that they had not had access to before, entities who had previously only borrowed via the loan market. So they weren't necessarily in the bond market, so you had a bunch of investors who were very happy to be able to diversify their portfolios.
"Once the seed was planted, there wasn't any stopping it."
By buying a credit default swap.
By investing in a credit default swap, because it was a name that they hadn't previously had access to. So there was a lot of very positive reinforcement of the market, and it just -- it grew. It grew very naturally.
Once the seed was planted, there wasn't any stopping it. Just going back to what was going on on the loan portfolios, you have to remember that prior to credit derivatives, there was really no way for a bank to manage credit risk.
So you say on day one, "Well, aren't you happy giving Exxon a loan?" Well, sure, but we would have been happy giving Enron a loan or giving Ford a loan -- (laughs) -- giving Lehman Brothers a loan, giving all of these entities loans that at that time seemed like fine and credible risk decisions to make. And yet, five years down the line, they're not all going to be there. And previously in the loan market, you were stuck with that loan.
It created a liquid market for credit and allowed banks to manage risk
In other words, if you made a loan to Exxon, you couldn't make one to Ford and IBM because your regulatory capital requirements were such that you were maxed out.
Well, you might have maxed out your regulatory capital requirements, but over and above regulatory capital -- forget regulatory capital for a second. Selling loans was hard. There wasn't a secondary market in loans, really. And people say, "Oh, sure, they were -- " There was no liquidity in the loan market.
So once you made the loan --
Once you made it, you were stuck.
You sat on it.
You sat on it. So if you weren't happy with it, in four years' time, there wasn't a lot you could do. And credit derivatives gave you the ability to manage that risk.
So they made a liquid market for these --
It made a liquid market for credit, far more liquid than had existed before. So forget regulatory capital and capital efficiency; it allows banks to manage risk. And if you think that fundamentally that banks are there to be doing -- they are there to intermediate the market for borrowers, they need to be able to manage that risk at the same time.
I mean, you say forget regulatory capital, but that was -- just to be clear -- that was also a factor.
That absolutely was a factor. But it wasn't the only factor, right?
Soon every bank started up a credit derivatives team
Fair enough. So this is growing and becoming a larger and larger part of JPMorgan's overall business.
Yes, and the markets in general. Every bank --
And the markets -- every bank.
Every bank has started up a credit derivatives team, and in fact, a lot of the business, I guess a lot of the banks, were educated by JPMorgan. In 1999 we had a huge conference where we mostly had banks and other asset managers and other financial institutions where we were talking about credit derivatives.
It was our first credit derivative conference, and it was held at -- I think it was 23 Wall Street. That was where the first JPMorgan building ever was. And we had this huge conference. There must have been hundreds of people, and we had several different presentations running all day.
And I gave two of the presentations. One of the presentations was on valuing credit derivatives, exotic credit derivatives, and another presentation was on counterparty credit risk, which we haven't talked about, but is a huge risk in the marketplace and one that is today still a big discussion.
But those presentations, because they talked about risk management, were the best attended presentations by far. There were 500 people in one of the presentations that I gave. And I must have given it over and over and over. I must have given it three times that day. There was so much interest in risk management. ...
We could only see positives coming out of derivatives trading
You thought you were doing, at that time -- I mean, now there's a lot of criticism, but at that time, you -- it was a net good. ...
Yes, it was absolutely a net good. I mean, we saw a huge number of positives. We saw that our loan portfolio was suddenly able to manage credit risk. We didn't have to give out a loan and just pray that over the next five years or however long the loan was that the borrower wouldn't default. We were able to manage that risk.
We were also able to give out loans to our clients when we had some capital constraints. And capital constraints come in a number of ways. It's not just that we had a certain amount of capital that we could no longer give out, you know; we had used it all, and we couldn't give out any more loans.
Another way to think about capital constraints is that when you look at the portfolio of loans you have, you don't want any big outliers. You don't want a portfolio of 100 loans for $10 million and then one loan for a billion, because that one loan for a billion dwarfs the rest of your portfolio, and there's no benefit from the diversification that you should be getting from dealing with hundreds of different borrowers. So a borrower who comes to you and says, "I need a huge size," if it stands out in its size compared to the rest of the portfolio that you have, then it is a capital constraint, because you're going to have to put way too much capital against one name in that scenario, and it doesn't make sense.
So it's about using capital efficiently and using capital wisely. And we looked at our investors and we said, look, there's investors over here, they're getting access to, in the single names; they're getting access to names they hadn't previously had access to, and they're able to diversify their portfolio. They are also able to buy protection on their portfolio to the extent that they're looking to risk manage.
And in the more exotic products, or the portfolio products that we were selling, the tranches of portfolios, they were getting a new product. It was diversified. They were participating in a way with us and our loan portfolio activity. We could only see positives.
Everything we did ... was done with the knowledge of our regulator ... the Fed
And there's a lot made about the lack of regulation for this sector. It was important to the banks that this sector not be regulated.
Well, I don't -- that's an interesting statement, because everything we did off the loan portfolio was done, certainly, with the knowledge of our regulator. There was no hiding what we were doing. And in fact, the regulator was certainly very well aware of what we were looking to do in the loan portfolio with the usage of credit derivatives, and it was one of the drivers of a change in the regulatory capital rules globally. So we were initially talking about Basel I or ball one, and then we moved to ball two almost -- really as a direct result of the discussions we were having about managing the capital in our loan portfolios.
So you were regulated as a bank by --
Absolutely. We were regulated by the Fed.
By the Fed, and the OCC [Office of the Comptroller of the Currency].
I think we were regulated by everybody -- (laughs) -- because I'm pretty sure that the activities we did, every regulator was involved with [these] activities. I think that's the case with the larger major dealers. Every regulator has a hand in some activity that they're doing. ...
I don't know actually. I've always assumed that everything's absolutely a secret, and you're not supposed to say anything. It was a German institution. It was a German bank, a very big German bank.
German banks bought a lot of loans.
Mortgage-backed securities, yes.
Right. From the United States.
From the U.S., that's right.
We traded $14 billion of AAA mortgage-backed securities
So this bank came to you and said they want to get a credit default swap on this.
I don't know the origin of the conversation, whether we went to them and introduced the concept of risk management or whether they came to us. But the discussion transpired, and they needed to do a large transaction.
And them doing a large transaction meant that they needed to pass through my trading book this $14 billion portfolio of AAA mortgage-backed securities. And then we would turn around and sell pieces of it out of my trading book to investors, and --
You would tranche it up.
We were going to tranche it up and distribute it. And it was complicated, because prior to that, we had only done portfolios of corporate risk, entities to whom we had lent ourselves, entities that we were comfortable [with]. We knew the names; we understood them. We had teams of credit analysts looking at them. We absolutely, you know, for, as I said, 100-plus years we had been looking at credit portfolios. We knew -- we understood that risk.
So here you get a mortgage portfolio, and you're like --
And so suddenly we've got a mortgage portfolio. And we had -- we traded mortgages. We had some mortgages on our books. We certainly understood the mortgage-backed security market, but we had a lot of trouble getting comfortable with that risk.
We didn't feel that we had enough data to analyze that risk. You know, we had years and years of historical data about how corporates performed during business cycles, but we didn't have that much data about how retail mortgages borrowers, you know, individual borrowers, how they performed during different business cycles. ...
Our quant guy said, "I can give you a model…but we don't have enough data to support it."
And in the middle of the table you had a $14 billion loan portfolio.
And we had a $14 billion mortgage portfolio. And we also had salespeople represented, because they of course had to go and distribute the product. And we sat around, and the ideas, you know: Can we quantify the risk we're about to take? Can we model it? Can we book it? Can we manage it over its life? Do we have the operations to do it? How do we feel about the market risk? How do we feel about the credit risk? Can we distribute this? How do we feel about our reputation if we are distributing this? Those were the discussions we had.
And we had those discussions because this was a new product for us. We would have gone through what's called a new product approval process, and it involves a whole -- every element of the trade life cycle needs to be analyzed and discussed.
And, you know, the big hang-up for us really was data. Our quant guys said: "Look, you know, you the trader, you tell me what you think the price is, and I can give you a model that, when you hit F9, that's the price that pops up. But we don't have enough data to support it." So -- (laughs) -- we were nervous about the data.
And the issue was we had data about the '80s savings and loan housing crisis and what happened in a tri-state area -- I think it was Texas; I forget exactly, but it was around Texas. We had some data about some bad mortgage performance then.
We didn't have anything that was nationwide. We didn't have anything that was global, because there were a lot of mortgages from around the world in that portfolio as well. They weren't just U.S. mortgages. We didn't have anything on credit cards; we didn't have anything on auto loans; we didn't have anything on student loans. We just didn't have the data.
We did the deal anyway, but JPMorgan only did two or three more CDOs after that
And so?
And so we decided to do the trade. There was a number of things we did, you know, off the back of that conversation that got us comfortable with the trade. You know, the first --
So you wrote the swap.
We did the transaction. The big risk that we were concerned about is what we call tail risk. Tail risk is that these mortgages [have], you know, 30-to-40-year lives. And while we could get comfortable with what might happen in the market for the next three to four years, 30 to 40 years was the tail. That was way so far out there, we couldn't imagine what could possibly happen in the market in that length of time.
But you did the deal.
We did the deal. ...
So -- but generally, going forward, with CDOs [collateralized debt obligations] --
We didn't do any more.
You didn't do any more?
We -- no, that's not true. We did two or three other CDOs of mortgages.
The first CDO of mortgages, there were no subprime mortgages there. But that changed.
They started getting riskier. So, as I was saying, one of the original -- the first product that we had, this CDO of mortgages, they were AAA tranches of mortgage-backed portfolios. They were prime mortgages. There were certainly no subprime mortgages in them. We did the trade only for a three-year time period. The way we --
So the insurance was only good for three years.
It was, yes. It was a short-term trade. And we got comfortable with that. And then [there] were a number of other structural features within the transaction that we got comfortable with. And then --
So it was a profitable deal for you.
Remember, we couldn't retain the risk in our trading book; we had to distribute it. So the way that we priced it was, we were very transparent about what it cost us to distribute and what the risk that we would retain and what price we put on that risk.
I would say, from the perspective of we had no losses and as a result the money that we put on the risk that we retained ultimately became profit. But it was against risk that we had on our books. So it was a profitable transaction for us at the end of the day, but it could have just as easily been a loss, because we retained quite a bit of risk.
JPMorgan stopped doing these deals because the products got more and more risky.
So it takes rocket science to -- I mean, -- (laughs) -- these are very complex deals, correct?
They are complicated. But for someone who is well versed in fixed income products or who has been looking at portfolios of fixed income products for a long time, it's not that much of a leap from what they're currently looking at. So if you're looking at individual bonds and loans, already thinking about them on a portfolio basis, and then thinking about the tranches of risk isn't that much of a leap.
OK. But by that argument, why did other banks go forward when your bank and your team decided to stop? So if it's not so complicated, why did so many others keep going, marching toward the cliff?
Look, very simply, there are certainly some investors, some banks, some borrowers who are a bit greedier than they should be. And we decided to stop because the products just got more and more risky. The risk became something that we weren't comfortable with.
Credit Default SwapsWall Street CultureSubprime Mortgages & the Housing Bubble
In 2001 we pulled the plug on a deal at the last minute.
Was there a moment in time when you saw a deal that you said, "That just stinks"?
Absolutely. Absolutely.
When was that?
It was 2000 and -- must have been 2000. No, maybe it was 2001. 2001, we had gone down the road of originating a bunch of deals that were similar to the deal that we had done with the German bank in 1999. And they were much smaller deals. They weren't $14 billion. I think they were each about a billion. And we started looking at all these portfolios and thinking, hang on, these portfolios aren't all portfolios of entirely AAA risk, nor are they portfolios of prime mortgages. There's a lot of stuff that we're not comfortable with. And, you know, there was maybe some overeager originators, some overeager salespeople, some --
Who was bringing these bundles to you?
We had set it all in motion ourselves because we had introduced to the corporate finance relationship guys, to the bankers, that this was a really good way for their clients to manage risk, so if they saw any portfolios sitting on their clients' balance sheets that their client wants to manage the risk or manage the regulatory capital, then --
Come to us.
Then come and let's have a conversation. But every other bank started doing the same thing. ...
And then along came mortgages.
And then along came mortgages. And we did one transaction, and we just about -- I mean, we got ourselves comfortable with it. We'd have certainly never done it had we not gotten ourselves comfortable.
That was the German bank.
That was the German bank. And then we got a few other requests for other mortgage portfolios. But every other bank was looking to do this business as well. Lots of the other major dealers were looking to do this business as well. So slowly, what we started to notice is that the high-quality portfolios had been already managed; they had been risk-managed already, and suddenly we were starting to look at a lot lower-quality portfolios. It wasn't portfolios of investment grade; it was portfolios of high-yield risk.
Subprime Mortgages & the Housing Bubble
Someone on the call said, "I'm nervous."
So let me get this straight: You were first to the party. You developed this tranching of stuff --
That's right.
-- and writing credit default swaps on it. But now, by 2000, everybody else has jumped into the game.
Everybody wants to do it. So suddenly the market became a lot more competitive, and the risk we were being asked to retain as a bank became a lot more, and we --
2001, we were just about to say "Done" on a transaction. We had a global phone call. I was sitting in London, and we had a global phone call, and we were discussing the risk that we were about to do, and we had discussed it over and over and over.
And finally someone on that phone call said, "I'm nervous." And everybody said: "We're all nervous. What are we doing?" We've just -- we almost had stopped thinking and stopped reassessing the risk as we went along. It was almost not that we had become automatons, but we had done it so many times, and it was just a little bit different from the last trade, and a little bit different and a little bit different, and suddenly we found ourselves with a product that was vastly different from where we started. And every little tweak along the way, we had all said, "Oh, that's OK, that's OK, that's OK," until suddenly we all looked up and said: "Hang on. It's not OK. It's so different from where we started. What are we doing?"
And other banks didn't have that valve. We had that valve because we had a very, very open relationship with our risk management department. There we are on the trading floor; we're gearing to go; we want to do this trade. We're going to make money. We've got fees; we've got client relationships; we've got investors over here. We want to do this trade. And we're on the line with a bunch of risk managers that we've worked with all the way along the way, and they finally said: "Hang on. Something's not right. This doesn't work."
And it was 2001, and I remember the shock where I sat back, and I thought -- I was angry originally. I thought, this is, you know -- I know that we weren't 100 percent comfortable, but we got ourselves there, so what's different? And you sort of follow the path, and then you think, hang on, we can't be doing this. What are we doing?
We were worried we would no longer be competitive, but the risk was too great
But you were worried that you were going to start losing business now.
Now we're worried that we're not going to be competitive anymore, certainly. But we also had a very strong risk management culture, very strong.
So who's running -- who's making the final determination here? Who was that?
There were a lot of boxes that had to be checked for these trades to happen. There wasn't one individual who said "Go" or not. A lot of different individuals had to say "Go" because every trade was slightly different. As I said, every trade was almost like a new trade.
Who said, "I'm nervous," first?
I don't remember. I think it was this trader in the New York office who said it, and he had vast[ly] more experience with mortgages than the rest of us. So he was on the call because of that experience. And I think he might have been the first one who raised his hand. But it caused an uproar. I mean, we had to go to the client and say, "Look, I don't think we can do this." And --
Who made that call?
I was the unlucky person to -- I called them up, and I said, "We need a meeting." And we went, and we had a meeting, and they kicked us out of the building. (Laughs.)
Who was that?
It was a UK bank, and they said, "Look, you're going to have to figure out how to do this trade, because you told us you could do this trade." And, you know, these are the pressures that exist within a bank.
I was the one who had to call the client to tell them we couldn't do the deal
So put me there. You went to the bank and you said, "I've got to have a meeting."
It was awful. In our parlance, we had gotten ourselves pregnant with a trade that we couldn't do. And we sat down, and we said: "Look, we can't do this trade. It just doesn't work." And we did. We figured out a way to do the trade, and we stopped. We just -- we couldn't do any more. We were done. And we knew we were not going to be as competitive in these conversations with our clients. We knew that, but we made the decision that it was a risk we were not comfortable with.
So --
And we made that decision. I mean, it was a tough decision. But here's the thing: Banks have natural tensions within them, and those tensions have to exist, you know. You've got to have people on the trading floor who are sitting there pulling the bank toward making deals that make money, but then you have to have someone on the other side that's saying, "You're making money, but it's too much risk." And you have to have that natural tension.
And in a lot of institutions you have the guys on the trading floor that are being paid a huge amount of money, almost too much money, because they're in a very privileged position. They're making money because they're leveraging a huge operation. They're leveraging a big balance sheet. They're leveraging a bunch of salespeople.
You know, it's not necessarily because they're superstars. It's -- they're sitting in a good seat. But they're paid a lot of money, and they're seen as superstars. And if they say, "I want to do a trade," they do a trade. The risk manager sitting over here says: "Hang on. You can't do that. That's not acceptable risk." And the trader overrules him.
I'm sitting there saying, "I think the world's gone a bit mad."
You were a trader.
I was a trader.
So you were one of those that was saying, "Let's go."
Yeah. We didn't have the superstar system at JPMorgan. We did not have that system when I was there, so I --
But you were, on the other hand, paid to seek out risk and insure it.
Yes, I was. But I was also responsible for explaining why that trade made sense to senior management, and if I couldn't explain that clearly, or if I couldn't articulate it, if I couldn't show numbers that made sense, if I couldn't work with a whole team of people and get them all to agree with me, then the trade didn't happen. ...
But in 2005, you go to a conference, a derivatives conference in Nice --
-- and you made a statement there.
Yes. So I was chairing a panel of other exotic credit derivative traders, and I think I had a hedge fund guy there, maybe two hedge fund guys and some bank guys there. And 2005 -- at this point, I was overwhelmed with the interest in credit derivatives and in particular in structured credit derivatives. And what I saw was a huge wave of demand from the investor base ... in structured credit..., exotic credit derivative products. What I could see was a huge wave of demand. And the business I was in at the time was in training, and I was getting phone calls into our business all day long: "Can you come and tell us what these products are? We're investing."
In fact, I was getting phone calls, and this is what was really nerve-racking, I was getting phone calls from risk management departments of investors who were saying: "We've got a billion dollars of this stuff. Can you come and tell us what they are?"
And I remember thinking, why are you calling me now? Why didn't you call me before you made the decision to buy a billion dollars of this stuff? How can you, as a risk manager, hold your head up and say that you've done your job if you don't understand what these products are in the first place? Where were you when the decision was made?
And so I'm sitting there saying, "I think the world's gone a bit mad." And I look at the panel, and I turn to them, and I said, "Look, I think we've got some irrational exuberance going on in the credit department," to, you know, take a leaf from [former Fed Chair Alan] Greenspan's book.
And they all -- "Oh no, of course not. You know, of course we don't." But they weren't interested in saying that we had irrational exuberance in the credit markets because they were profiting from all of these investors who were interested in the product. And the next day, you know, the front page of the FT [Financial Times], "Terri Duhon says irrational exuberance in the credit markets." And I got phone calls from some of my clients saying: "What are you saying? How can you say something like that? You're going to scare our investors." And I said: "Hang on. I think your investors need to be thinking -- (laughs) -- spreads look really tight. What are we doing here? What's going on?" One, you know, do these prices really represent fair risk and credit right now? And two, do people really understand what they're investing in? I'm not so sure. In fact, I know they don't. And --
Not all banks understood credit derivatives
Did top management at JPMorgan understand credit derivatives?
Yes, they did. Absolutely they did.
Did they at other banks?
No, not at all other banks. Certainly not. And that was part of the problem we had.
Did the buyers of credit default swaps in many cases -- I mean, how many of them actually understood the products they were buying?
I think, for the more basic product, for the simple product, the vanilla product, most of them absolutely understood, and they still do understand. You know, if they invested -- as I said, if they invest in a bond, the credit default swap in the bond is the same thing, is the same risk.
But there are some differences and some nuances that need to be understood. They're not fungible, so you do need to understand that the use of cash and the use of capital and the counterparty credit risk that comes along with it, they are different. ...
Credit Default SwapsDerivatives
I was shocked at how widely distributed such a risky product this had become
When the mortgage market began to deteriorate, what was going through your mind as you watched this?
I was simply amazed. I was not aware of the scale of distribution of subprime mortgages to the world. I was amazed at the interest on the part of investors to invest in a product that was highly complex and very risky on top of it. So not only were we talking about a very complicated product, a securitization of a securitization of mortgages -- (laughs) -- and sometimes a securitization of a securitization of a securitization of mortgages, it just --
And then a bet on a bet on a bet.
A bet on a bet on a bet on a bet on a bet. It was much more complexity than made sense to me. And over and above that, it was on the most risky piece of the pie. So you can sort of follow it all the way through and you can look at the mortgage market, and there are pieces of the mortgage market that make sense to invest in. They are fundamentally sound investments. The prime mortgage market, there are lots of good reasons to invest in that product. You go further down the scale, and you get a much more risky subprime product.
And that is for a specialist investor, because that is a lot more risk. It requires a lot more analysis. And suddenly that product went from the specialist investor to being repackaged, repackaged, repackaged and distributed to a bunch of investors who weren't necessarily specialists in that particular type of risk. And the shock for me was how widely distributed such a risky and complex product had become. ...
We've come a long way from the Exxon.
We've moved way far away from Exxon asking for a loan and JPMorgan trying to manage its credit risk. We have moved to, you know, subprime borrowers being leveraged and leveraged and leveraged and leveraged and distributed to an investor that has never invested in mortgages before.
Subprime Mortgages & the Housing BubbleDerivatives
We never saw what people would do with credit derivatives coming. Maybe I was idealistic.
I'm going to ask a hard question here, but I don't want you to take it wrong, but you were a person there at the beginning of all of this. And as you watched this all come down, what did you feel personally?
I was disappointed, just hugely disappointed. I just -- you know, I did feel personally not responsible, but I was part of a market that I believed was doing the right thing. And maybe I was idealistic, maybe I was young, maybe I didn't fully appreciate where we were going, but I absolutely -- you know, even to this day I say, look, the credit derivative itself fundamentally is a good product, because if you want banks to give out loans, you need them to be able to manage that credit risk. And prior to credit derivatives, we didn't have a mechanism for really managing credit risk. So credit derivatives have done a fabulous thing. But on the other side, you see what happened, and you think, we never saw it coming. We never saw that coming.
And I was disappointed, hugely disappointed. I mean, as I said, I work in some -- the business I run, we act as experts in some of the litigation that's happening. And some of the e-mail traffic around some of these deals, both on the investor and the banker side, it's appalling behavior. Some of it is just absolutely appalling behavior. And it's very disappointing. ...