The very first CDS

June 10, 2010 in Finance

Yes, conspiracy theorists, thereĀ is a link between environmental disasters and financial meltdowns.

In the wake of the Exxon Valdez disaster, Exxon was faced with $5B in fines. The company turned to its banking partner, J.P. Morgan, and asked for a line of credit in that amount. J.P. Morgan was reluctant to grant the loan for two reasons: Basel regulations would require them to keep 8% of the capital on their balance sheet, and there was a chance that Exxon would go bankrupt before the money was repaid. However, Exxon was a good client and the bank wanted to maintain that relationship. J.P. Morgan's swaps team reasoned that if they could find a way to transfer Exxon's credit risk to a third party, they could kill two birds with one financial innovation, getting around the capital restrictions and alleviating the repayment risk.

And so it was that in 1994, the largest American oil spill led directly to the creation of the first credit default swap.

Isn't history fun?

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