Derivatives

Banks make money by making loans so the more loans they make the more money they make. The government requires that banks retain 10% in reserve so if a bank has $100 they can loan $90 but must keep $10. Say a bank loans a large oil company $100 million dollars. They must retain $10 million in reserve. They can put the money in the federal reserve bank and earn the going interest rate. Between 2008 and 2016 the fed rate was less than one percent. So the bank is sitting on $10 million dollars earning less than one percent. The bank looked for way to get around the reserve requirement and came up with what are called credit default swaps(CDS). The bank went to another financial entity such as an insurance company and said we would like you to cover any loss we may have on our $10 million in reserves and we will pay you 2% of the principal amount for your service. The bank could then loan out the $10 million at 4% and share the profits. The first such arrangement was with Exon who after the Exon Valdez accident took out a letter of credit with JP Morgan to deal with the cost of any future accidents. This letter guaranteed that Morgan would pay for damages caused by accidents. It was worth hundreds of millions and Morgan would charge a fee. They used their newly released reserves to back up the letter. This demonstrated the risk could be off loaded and capital freed up for more loans. The next step was to bundle many loans together and use CDS for the bundle as opposed to just one loan like the Exon. On the first one they put together loans on 300 companies in Morgans portfolio. The bank then offered investors an opportunity to invest in this portfolio of CDS's. They further refined the investment by dividing up the companies based on risk and the higher the risk the higher the return. These divisions were called tranches. These then became known as synthetic collateralized debt obligations and they were in fact derivatives of derivatives. This was a private market out of the view of regulators and that was in the end its downfall.