After graduating from the London School of Economics in 1994 with a degree in Government and History, I spent three years with Credit Suisse Financial Products in London and Tokyo before studying Shipping, Trade and Finance for a year at business school. I first traded credit at Chase Manhattan (before the merger with JP Morgan) and then at JP Morgan (after the merger with Chase Manhattan) with a brief interlude trading energy derivatives with Enron. The Enron experience was fascinating. The company was innovative in the products traded (e.g. bandwidth and weather derivatives), but the approach to risk management was alien to someone from an investment banking background (this was borne out by the company’s eventual demise – some time after I left!). After scratching the itch to trade commodities one could see and touch (which I ascribe to growing up on a farm in the north east of Scotland), I returned to credit trading at JP Morgan just in time for the merger with the company I had left the year before – Chase Manhattan.
The marriage of JP Morgan’s trading nous with Chase Manhattan’s balance sheet heft went well; it was exciting to move to the top of the credit league tables in the early years of the combined firm. This was also a period of rapid innovation in the credit markets. When I joined Morgan’s credit trading desk in 2000 the vast majority of our business was in cash bonds. When I left in 2005, credit default swaps dominated. Our market had also become increasingly ‘technical’ with credit spreads driven by activity in Collateralized Debt Obligation (CDOs). CDOs can comprise a wide variety of underlying instruments (such as mortgages, credit card receivables, and auto loans). In our case, the ‘financial weapons of mass destruction’ referred to by Warren Buffett involved Special Purpose Vehicles selling credit default swaps (essentially insurance contracts on corporate defaults) and using the cash flows to fund different tranches of bonds that were sold to investors depending on their appetite for risk. For a lucid account of how this was all supposed to work, and what went wrong, please see: www.lrb.co.uk/v30/n09/donald-mackenzie/end-of-the-world-trade
I had a front row seat as the global financial crisis unfolded with my next job managing Cairn Capital’s corporate CDO business. Many people now insist they saw the crisis coming. We at Cairn made no such claim but it was clear when I joined in 2005 that the market was due a major correction. But as Keynes remarked, ‘the market can stay irrational longer than you can stay solvent’, and we had salaries and rent to pay. So we continued structuring deals albeit with larger ‘short buckets’. This meant diverting a portion of the income from the CDO to be deployed in hedges when the market eventually turned. One particular trade from the time stands out – selling a Royal Bank of Scotland default swap for 4 basis points (0.04 per cent) because it fitted with the structure of a particular CDO. Using standard recovery rate assumptions, this implied that the probability of RBS defaulting within five years was 0.06%. RBS did not default in the end, but only because it was taken into public ownership.