by Calculated Risk on 3/11/2007 03:35:00 PM

From the Financial Times (hat tip Name): The dream machine: invention of credit derivatives. A short except on Bistro:

By 1997, Demchak and Masters came up with their Big Idea: a product known as Bistro, short for Broad Index Secured Trust Offering. ... What Bistro did was to use credit derivatives to “clean up” a bank’s balance sheet. The scheme started by taking a basket of bank loans and separating out - in accounting terms - the theoretical risk that these loans would turn sour from the loans themselves. This default risk was usually then sold to a “paper” company, known as a special purpose vehicle, which then issued bonds that investors could buy. ... And as long as the deal was structured in a way that made the bonds look cheap, relative to the risk of default, then investors would think they had got a good deal. The pricing itself was based on what had happened to banks’ loan books in recent years (together with some complex number crunching).

The deal looked even better for the original bank. For the act of selling the default risk on to new investors had crucial regulatory implications. International banking rules say that banks have to hold a certain level of spare funds (or reserves) to protect themselves from the danger that their loans might turn bad. However, since the banks had sold the risk of default on to somebody else, they could now argue that they did not need to hold these funds.

To anybody outside the world of finance, this might look odd (after all, the banks were still making loans); but the regulators accepted this argument, since the risk had moved, in accounting terms. And that let the banks free up funds to make even more loans. It was the financial equivalent of calorie-free chocolate: almost too good to be true.