Rise of Credit Derivatives: A Boon to the US Market - Until It's Not

by: Michael Panzner

In recent days, contrasting views have been put forth about the derivatives market. On the one hand, according to a report in the Financial Times, the rise of credit derivatives has been a "boon" to the U.S.

The explosive growth of credit derivatives has strengthened the US financial system, making it more efficient and more resilient, two Federal Reserve governors declared on Thursday.

Their comments suggest the Fed believes the financial system is in better shape than in the past to withstand shocks and might absorb losses from the subprime mortgage market.

One of the governors suggested that the Fed would be wary about drawing conclusions about what movements in stock and bond prices say about the economy.

Don Kohn, Fed vice-chairman, said: “As these markets develop and become more complete, they facilitate risk transfer and diversification, thus increasing the resilience of the financial system.

“Credit derivatives, like all derivatives, are in zero net supply and, abstracting from the important issue of counterparty credit risk, they neither add to nor subtract from the stock of financial risk in the economy.”

Mr Kohn added: “[Credit derivatives] do, though, provide new and more efficient ways for sharing and hedging the risks that do exist and they facilitate the transfer of those risks to those who are most willing to evaluate and bear them.”

Randall Kroszner, a Fed governor, said: “These developments have greatly enhanced the efficiency and stability of the credit markets and the broader financial system.”

He added that many concerns about the development of credit derivatives were ill-founded and that 70 per cent of outstanding credit derivatives were not complex products at all, but single-name credit default swaps – simple products that insure against the likelihood that a particular borrower will default.

Even so, their support for these modern day wonders is not exactly unequivocal.

Most derivative contracts entered into by banks with unregulated entities such as hedge funds were backed by collateral, Mr Kroszner said. But creditors should exert effective discipline on hedge funds to ensure they did not take ill-judged risks.

Both governors flagged up the risk that defaults on credits embedded in complex derivative portfolios could be more closely correlated than banks believed, resulting in potential for higher-than-anticipated losses in bad times.

Indeed, another report suggests that there is far less there than meets the eye when it comes to understanding the many dangers associated with modern financial alchemy. According to the FT, the risk of derivatives has "not [been] fully evaluated."

Fewer than half of global financial institutions account sufficiently for complex financial and commodity exposures in assessing the riskiness of their holdings, according to a survey by Deloitte.

The results suggest that much of the industry may "lag behind the explosive growth of credit derivatives and their attendant risks", the firm said. Risks in energy and other commodity derivatives were also not fully evaluated by most institutions, the survey found.

"The bar on what constitutes effective risk management is constantly being raised. Most institutions have an unfinished agenda," said Owen Ryan, head of Deloitte's capital markets practice.

The firm's risk management survey involved 130 mostly global institutions, primarily commercial and retail banks and diversified groups, with total assets of $21,000bn.

The report comes as regulators stress the need for prudent risk management, and in spite of intensive industry efforts to improve the sophistication of risk analysis.

Timothy Geithner, president of the Federal Reserve Bank of New York, said on Friday that recent innovations should make financial markets "more efficient and more resilient" but that the complexity of new credit instruments could present unforeseen challenges in times of stress.

"Even the most sophisticated participants in the markets find the risk management challenges associated with these instruments daunting. This raises the prospect of unanticipated losses," he said.

The Deloitte survey showed that only 41 per cent of executives reported using value-at-risk (VaR) models to cover credit derivatives, with fewer than half of them using VaR analysis extensively. VaR is a measure of the probable losses on a portfolio if historically big – but not extreme – market moves occur.

Fewer than half of respondents regularly used "stress-testing", a technique recommended in reports on systemic risk. Stress-testing aims to estimate losses in a severe stock market crash.

Overall, then, it sounds to me like things will be OK...until they're not.