JP Morgan invented credit-default swaps to give Exxon credit line for Valdez liability

Credit-default swaps are widely seen as a major contributor to the recent financial meltdown. But the origin of CDS’s with the Exxon Valdez oil disaster isn’t as widely known.

The New Yorker has a long review of a couple of financial books, including Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe.  It details the history of the CDS, an idea that came out of a June 1994 JP Morgan off-site in Boca Raton (where “binge drinking occurred” and  “a senior colleague’s nose was broken”):

The Boca Raton meeting first bore fruit when Exxon needed to open a line of credit to cover potential damages of five billion dollars resulting from the 1989 Exxon Valdez oil spill. J. P. Morgan was reluctant to turn down Exxon, which was an old client, but the deal would tie up a lot of reserve cash to provide for the risk of the loans going bad. The so-called Basel rules, named for the town in Switzerland where they were formulated, required that the banks hold eight per cent of their capital in reserve against the risk of outstanding loans. That limited the amount of lending bankers could do, the amount of risk they could take on, and therefore the amount of profit they could make. But, if the risk of the loans could be sold, it logically followed that the loans were now risk-free; and, if that were the case, what would have been the reserve cash could now be freely loaned out. No need to suck up useful capital.

In late 1994, Blythe Masters, a member of the J. P. Morgan swaps team, pitched the idea of selling the credit risk to the European Bank of Reconstruction and Development. So, if Exxon defaulted, the E.B.R.D. would be on the hook for it””and, in return for taking on the risk, would receive a fee from J. P. Morgan. Exxon would get its credit line, and J. P. Morgan would get to honor its client relationship but also to keep its credit lines intact for sexier activities. The deal was so new that it didn’t even have a name: eventually, the one settled on was “credit-default swap.”

The story doesn’t have a happy ending for the American economy, of course, but things turned out all right for ExxonMobil.

The oil giant appealed all the way to the Supreme Court and in 2008 the corporate-friendly justices slashed a lower court’s award of punitive damages down to half a billion dollars and ultimately “Exxon recovered a significant portion of clean-up and legal expenses through insurance claims.”

ExxonMobil made $295 billion in profits from 2001-09 and more than $6 billion in the first quarter of 2010.  Who ever said justice delayed is justice denied?

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5 Responses to JP Morgan invented credit-default swaps to give Exxon credit line for Valdez liability

  1. Daniel Ives says:

    Hi Joe,

    Sorry to post off topic, but did you see the latest from Sen. Graham on the American Power Act? I’m afraid it doesn’t look good.

    I’ve really enjoyed your comprehensive coverage of the BP Gulf Disaster and especially your posts relating to analysis of the American Power Act. Thank you so much!


    [JR: Yes, he has continued his incoherent descent into dissent. But sources in the Senate still think he’ll vote for the bill.]

  2. Phillip Huggan says:

    From space the BP logo looks like the Gulf of Mexico. Canadian subs run on diesel. I’m wondering if the Gulf of Mexico can be leased to Canada as a naval base. They should be able to motor right through the Gulf for refuel.
    Louisiana, Texas, Mississippi, Florida, Alabama, South Carolina…all voted for GWB twice. It would be nice if future droughts and civil unrest from AGW could be revisited on these actors instead of innocent 3rd world actors.
    *When* the tailings ponds in Alberta fail it will contaminate a river almost as big as Mississippi. This will devastate Alberta, Saskatchewan (already acid rain recipient), and innocent Northwest Territories.
    So big oil invented pointless derivatives? If they didn’t get that loan they may have never been able to afford to lobby for weak safety regulations.

  3. catman306 says:

    In the spirit of knowing the enemy, I needed to get up to date (as of 2005) on oil company mergers and wikipedia came to the rescue: (Oil corporations are slipperier than those unhappy divers in the Gulf oil plumes.)

    “The Seven Sisters were the following companies:

    Standard Oil of New Jersey (Esso), which merged with Mobil to form ExxonMobil.
    Royal Dutch Shell (Dutch 60% / British 40%). Merged in 2005.
    Anglo-Persian Oil Company (APOC) (British). This later became Anglo-Iranian Oil Company (AIOC), then British Petroleum, and then BP Amoco following a merger with Amoco (which in turn was formerly Standard Oil of Indiana). It is now known solely by the initials BP.
    Standard Oil Co. of New York (“Socony”). This later became Mobil, which merged with Exxon to form ExxonMobil.
    Standard Oil of California (“Socal”). This became Chevron, then, upon merging with Texaco, ChevronTexaco. It has since dropped the ‘Texaco’ suffix, returning to Chevron.
    Gulf Oil. In 1985, most of Gulf became part of Chevron, with smaller parts becoming part of BP and Cumberland Farms, in what was, at that time, the largest merger in world history. A network of stations in the northeastern United States still bears this name.
    Texaco. Merged with Chevron in 2001. The merged company was known for a time as ChevronTexaco, but in 2005, changed its name back to Chevron. Texaco remains a Chevron brand name.
    As of 2005, the surviving companies are ExxonMobil, Chevron, Royal Dutch Shell, and BP, now members of the “supermajors” group.”

  4. Climateer says:

    As Bloomberg reported:
    “Masters, 40, oversees the New York bank’s environmental businesses as the firm’s global head of commodities…”

    So much for Paul Krugman’s “…Oh, and the argument that if you create a market, you’re opening the door for Wall Street evildoers, is bizarre. Emissions permits aren’t subprime mortgages, let alone complex derivatives based on subprime; they’re straightforward rights to do a specific thing. It will truly be a tragedy if people generalize from the financial crisis to block crucially needed environmental policy….”
    From his Dec. 7 post: -Unhelpful Hansen

    If you thought Enron was bad just wait.

    The Senate voted DOWN the Barraso amendment to the financial reform bill, which said simply:

    “Notwithstanding any other provision of law, no person or corporation, limited partnership, trust, or affiliate of any such entity chartered as a for-profit or nonprofit entity shall be eligible to sell, purchase, or trade carbon derivatives as the result of the establishment by the Federal Government of a carbon market.”

    [JR: Not quite sure of your point. Krugman is right.]

  5. sod says:

    it is a travesty.