What is a B.I.S.T.R.O?

Instead of jumping right into the advanced structured credit stuff, I decided to write up a little post to both paint a picture and to give an explanation of the early days of the world of credit derivatives. I am sure that most of you that are reading this blog are somewhat familiar with credit derivatives, if you are familiar with the world of structured credit, read on! (Cuz if not, you will find this article sounding like chinese...)

Did you know that, in the early 90s, the initial CDOs were all actually imitations of the MBS structure? They were basically all just a bunch of CLOs. Banks took their loans to corporate clients and sold them to a SPV, the SPV then issued debt in the capital markets, then the money raised was used to pay for the loans.

A few years gone by, something changed in 1997 with the invention of the famous BISTRO, short for (Broad Index Secured Trust Offering). It was a deal that was lead by a team under the famous M.Cassano at JP Morgan that allowed the bank to sell about 9.722$ USD Billion of credit risk with only 700$ USD million set aside to protect against the risk of default. These guys were the pioneers of financial engineering. In 1997, the regulators were more than confused with the risk involved. Cassano and his team pooled more than 300 loans at JP Morgan to create this first BISTRO and issued securities based on the income streams from these loans.

This gets a bit confusing, but this is how it works: The BISTRO first sold trenched bonds with attractive yields to investors, the proceeds from the sales was kept in a cash reserve which was used to collateralise the BISTRO, the bankers then wrote credit default swaps against the bond and the other assets on JP Morgan’s own balance sheet. These Synthetic CDOs worked because the banks saved on capital with the use of CDS rather than asset ownership! They also sweetened the returns to the investors and dealers for helping them do the capital shuffle. So, if part of the loans started to default, imagine what would happen… Talk about credit crisis 2008... VaR of 99% confidence level? Its always the last 1% that count...