In Boca Raton, Florida, during the early 1990s, a group of JP Morgan bankers gathered for an “offsite” weekend. Have some fun, get some sun, do some brainstorming. They had hoped to create a new product.
And they did.
Their new product involved selling the risk that a bond might default. For example, if JP Morgan owned an Italian bond, it could pay an investor to take over the risk that Italy would default. No default? Then JP Morgan pays the investor a fee. Default? Then the investor pays JP Morgan. As one journalist said, “…it was a win-win deal: JP Morgan reduced its risk, and the investors could earn nice returns.” They called it a “first to default” swap.
Just like silly putty, the aircast or the Model-T, in finance also, someone has an idea that becomes a product. At one time, the junk bond, the money market fund, checking accounts, futures options, hedge funds and adjustable rate mortgages (ARMs) were all innovations. We could go on and on. Someone invented each new financial product.
And that takes me back to JP Morgan–now JPMorgan Chase. Reporting the bank’s unexpected investment losses, yesterday, the Washington Post indicated heavy investments in an index of credit default swaps (descendants of those “first to default swaps) might have been related.
Our Bottom Line: Especially with the controversy surrounding complex financial products, we should remember that financial innovation can fuel economic growth when it moves money and credit productively.
For more about that JP Morgan Florida weekend, the evolution of credit default swaps and the source of my quote, this FT article by Gillian Tett is excellent. And, for more about financial innovation, you might want to look at this Brookings article.