A Hybrid That Converts Junk Bonds To Triple A?

Unshakable Belief

More than four decades later, index-based mutual funds and exchange-traded funds hold $10 trillion in assets, according to Statista Inc., a New York–based research group.

The project left McQuown with an unshakable belief that financial engineering could make investing more efficient and less risky.

It could also prove quite lucrative, as he found when he shifted into credit analysis in the 1990s and formed a firm in San Francisco called KMV with Stephen Kealhofer, a University of California at Berkeley finance professor, and Oldrich Vasicek, a Czech mathematician.

The trio recognized that credit ratings often don’t accurately reflect a company’s likelihood of defaulting on its liabilities. So they developed complex mathematical formulas based on a company’s stock option pricing to calculate this probability with greater depth than can be found in conventional credit reports.

Clear Thread

As an entrepreneur, McQuown savored exploiting such inefficiencies. In 2004, at the age of 70, he co-founded DCI with Kealhofer to profit by predicting and managing the default risk in corporate bonds and CDSs.

Yet McQuown was also driven by an engineer’s desire to replace a flawed machine with a better one. For years, McQuown and MacWilliams had kvetched about how antiquated the bond market seemed compared with stocks, futures and other securities.

MacWilliams had gotten to know McQuown in the early 1990s, when he headed EJV Partners LP, a bond data provider that did business with KMV. In the aftermath of the 2008 crash, the two men rapped by phone daily about how to take advantage of the restructuring of Wall Street.

“There is a clear thread from Wells Fargo to the eBonds concept,” says David Coulter, the vice chairman of Warburg Pincus LLC, the New York–based private-equity firm, and an adviser to eBond Advisors. “Once again, Mac’s asking ‘How do markets function? Are they efficient? And if not, what can we do about it?’”

Maligned Derivative

When President Obama signed Dodd-Frank in July 2010, McQuown and MacWilliams found their opening in Title VII of the 848-page law. Credit-default swaps, developed in 1994 by Blythe Masters, an economist then working on JPMorgan’s derivatives desk, were originally designed to help banks cover losses in the event their borrowers failed. Within 14 years, the instrument’s purpose had become warped as banks and insurers sold unsecured swaps supposedly to guarantee subprime mortgage-backed bonds.

Now, McQuown and MacWilliams are wagering that this maligned derivative will ultimately justify its usefulness. They point out that the junk bond, another innovation that was once viewed as a financial weapon of mass destruction, has become an uncontroversial tool.

With investors required to trade and clear swaps in an open and accountable marketplace, “We can return credit-default swaps to their original purpose—to transfer risk,” MacWilliams says.

Biggest Challenge

To create the new instrument, eBond Advisors’ lawyers added three sections to the standard contract that bond issuers provide to bond buyers.

Even so, McQuown and his partners may have difficulty finding investors willing to sell the swaps to embed in the eBond because the market has yet to fully recover from the crash. In the second week of January, investors traded $86 billion worth of contracts, a 37 percent drop from the same week in 2011.