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Tuesday, 12 December 2017

1997: JP Morgan’s US$700m Bistro bond: the first CDO

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Start of something big - About a week before Christmas 1997, JP Morgan launched the rather clunkily named Broad Index Secured Trust Offering, a US$700m bond issue referencing a portfolio of more than 300 corporate and public finance credits across Europe and North America.

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About a week before Christmas 1997, JP Morgan launched the rather clunkily named Broad Index Secured Trust Offering, a US$700m bond issue referencing a portfolio of more than 300 corporate and public finance credits across Europe and North America.

When it comes to trades that have changed the face of finance, Bistro ranks right up there. The structure’s popularity and later bastardisation, which involved some originators injecting dubious assets such as sub-prime mortgages into underlying reference pools, has ensured it remains one of the most controversial capital market inventions ever devised.

It was also one of the most important. Hailed as a landmark at its inception, Bistro was the first time a bank succeeded in hedging economic risk while simultaneously releasing regulatory capital. To this day, it remains the template for bank balance-sheet hedging.

“The over-arching motivation for Bistro wasn’t to open up a new market or sell some funky product, but for JP Morgan to hedge its credit risk,” Bill Winters, former co-chief executive of JP Morgan’s investment bank, told IFR in a recent interview. “It was extremely effective in accomplishing that. It also had the effect of spawning a new industry.”

At the same time as a more liquid credit default swap market was being built in the mid-1990s, JP Morgan began examining ways to hedge its loan and bond books. The project was led from JP Morgan’s New York office, where Blythe Masters was a senior member of the credit team.

After fine-tuning the structure over the summer months, the first Bistro deal came to market in December 1997. A special purpose vehicle sponsored by the bank entered into a CDS with a notional of US$9.8bn referencing a JP Morgan portfolio of 307 commercial loans, corporate and municipal bonds.

The SPV then sold some US$700m of notes backed by the CDS to investors: a US$460m Aaa/AAA tranche and a US$237m Ba2 tranche. A block of US Treasuries was inserted to collateralise the deal over the first five years of its life.

Investors snapped up the bonds and Bistro looked set to supersede the cash-based collateralised loan obligation market and earlier synthetic deals – such as SBC Warburg Dillon Reed’s Glacier Finance vehicle – as the weapon of choice for loan portfolio managers.

But it was in the summer of 1998 that its place in history was cemented, shortly after JP Morgan printed its second Bistro transaction of US$346m of notes referencing a US$4.8bn CDS. After painstaking talks with the US Federal Reserve, the regulator permitted JP Morgan to apply a model-based approach to calculating the risk capital on its trading book. This meant the bank could secure regulatory capital relief for its first two deals.

A new era was born and the bank was justifiably proud of its achievement. JP Morgan printed five Bistro deals in less than a year: US$2.7bn of securities amounting to a total risk transfer of US$29bn.

“Bistro was originally put together as a vehicle that we saw value in as an originator of loan and bond transactions,” Masters told IFR in 1998.

The bank began to market the technology to other institutions, which soon developed copycat structures.

“Bistro was very important for changing the mindset around risk management. It was the major catalyst for credit portfolio management,” Winters recently told IFR.

Volumes mushroomed. Synthetically funded collateralised debt obligations rocketed from US$10bn outstanding at the turn of the millennium to a peak of US$105bn in 2007.

But the market was swerving out of control. Convinced of the infallibility of their mathematical models, structurers embraced complexity for complexity’s sake. Fatally, some inserted real estate assets including sub-prime mortgages into the reference pools.

Many banks failed to shift the super-senior risk of the portfolios off their books, or bought what would become largely worthless protection from monoline insurers. In short, the market had strayed far from its roots.

Those firms that faltered as a result would have done well to heed the rather prescient words of Peter Hancock, JP Morgan’s global head of fixed income when the Bistro was executed, shortly after the trade first came to market.

“We work in a cyclical industry, in which issues of risk control are vitally important. Short-term profitability is no substitute for sustainable performance over the long run,” Hancock told IFR in early 1998.

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