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How the Exxon Valdez Spill Created the Credit Default Swap

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When Exxon Mobil borrowed billions from JPMorgan to pay damages in the case, the risk needed be managed somehow.

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It was reported yesterday that the Associated Press obtained a witness statement from one Truitt Crawford, an employee of Transocean (RIG) -- the company that leased the now-infamous Deepwater Horizon drilling platform to BP (BP).

"I overheard upper management talking saying that BP was taking shortcuts by displacing the well with saltwater instead of mud without sealing the well with cement plugs, this is why it blew out," Crawford told Coast Guard investigators.

Eleven people died on April 20. The various methods BP has tried in its increasingly desperate attempt to stanch the gusher of oil currently turning the Gulf of Mexico toxic -- the "Top Hat," the "Top Kill," and so forth -- haven't worked. What we don't yet know is the extent of the contamination caused.

Trial attorney W. Mark Lanier, founder and lead litigation counsel at The Lanier Law Firm, who has extensive expertise in maritime law and has filed a class action suit on behalf of Louisiana residents affected by the spill, wrote that "some estimates of the flow of oil exploding from the sea floor put the volume equal to the Exxon Valdez spill -- every four days."

Lanier noted that "It is sobering to realize that oil still remains from the Exxon Valdez spill, a spill that occurred over 20 years ago."

While the Exxon Valdez spill created environmental havoc, it also ended up inadvertently creating something else that, years later, created a bit of havoc in the financial markets:

The credit default swap.

After a jury ruled that Exxon Mobil (XOM) was responsible for paying $5 billion in punitive damages -- equivalent to one year's worth of Exxon profits at the time -- the US Court of Appeals for the 9th Circuit later reduced the amount to $2.5 billion. That ruling was overturned in 2008 by the United States Supreme Court, which ruled 5-to-3 to limit Exxon Mobil's liability to $507.5 million, the amount of actual economic losses suffered by fishermen, landowners, and others affected by the spill.

Years earlier, in 1994, to protect the company in case the $5 billion award was affirmed, Exxon Mobil obtained a $4.8 billion credit line from JPMorgan (JPM).

JPMorgan, knowing that the Basel rules required banks to hold 8% of their capital in reserve against outstanding loans, wasn't thrilled about tying up $384 million in the event the loan went bad. All sorts of swaps already existed at that time -- currency swaps, interest rate swaps -- but according to Gillian Tett's 2008 book Fool's Gold, Blythe Masters, a member of JPMorgan's swaps team, hit upon the idea of the credit default swap as a way to allow the bank to sell the credit risk associated with the Exxon loan to the European Bank of Reconstruction and Development. The EBRD stood to gain a substantial return for taking on the risk of Exxon defaulting, while JPMorgan was able to keep more cash available for other things and greatly reduce its own risk by laying it off on someone else -- in essence, insurance to cover its loan to Exxon.

"Interesting -- I didn't know that," was the first thing Cato Institute senior fellow Jerry Taylor said when told of the Exxon Valdez/CDS connection in an interview with Minyanville.

Taylor, who has testified frequently on Capitol Hill regarding assorted energy and environmental policy matters and is an adjunct scholar at the Institute for Energy Research, asserts, as do most financial professionals, that there's nothing inherently "evil" about credit default swaps, a claim that has lately become rather fashionable to bounce around at dinner parties when discussing the economic meltdown.

"Credit default swaps are simply a creative means of managing risk," he explained. "That's all they are. There are lots of ways to do it; a CDS is just one method."

The problems begin when banks stray from the tight risk models JPMorgan had in place at the time of the Exxon Valdez deal.

"I don't mean to steal a line from the NRA, but it's not the gun that kills someone else, it's the person pulling the trigger," Taylor said.
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