Credit Crash?
“Credit derivative dealers talk about their market in much the same way spotty teenagers talk about sex. A lot of people profess to be accomplished experts, but when it really boils down to it, most of them are still fumbling in the dark.” Anonymous credit derivative dealer.
There have been profound changes in the nature of debt markets. The major developments are the use of credit default swap contracts (CDS) (indemnities against the loss upon default) and collateralised debt obligations (CDOs) (securitisations of credit portfolios) to transfer risk to investors, including hedge funds. The former Chairman of the Fed, Alan Greenspan, has welcomed the new “Structured Credit Markets”: “The CDS is probably the most important instrument in finance. … What CDS did is lay-off all the risk of highly leveraged institutions – and that’s what banks are, highly leveraged – on stable American and international institutions.”
The true dynamics of the structured credit market is misunderstood. The structured credit market and its role in credit risk transfer while significant is overstated.
CDS contracts suffer from a number of problems: ? The documentation of CDS contract is highly technical. It can and has led to serious problems; e.g. settlement of the contract requires delivery of defaulted debt but in most cases the volume of CDS exceeds outstanding bonds by a large margin making it difficult to settle the contracts and distorting the value of the protection against default. ? The number of names that are traded is limited to around 600 (liquidity is concentrated in maybe 100-150). ? Liquidity in CDS markets is illusory. Trading and re-balancing of dealer positions drives it. End user participation is limited.
The CDO market also suffers from a number of issues: ? The limited supply of underlying credit and diminishing credit spreads is leading to increased leverage (CDO2) being used to increase return. ? There are substantial problems in credit modeling that a market event (e.g. GM/ Ford downgrades in May 2005) is likely to expose quickly. ? Few credit investors are equipped to deal with the complex products and accurately value the structures.
The structured credit market operates to: ? Channel credit risk to investors, especially hedge funds, and allow credit risk to be traded like other assets. ? Allow increased leverage of credit positions.
The structured credit markets have increased leverage within credit and debt markets very significantly. Since 2003, credit markets have been benign. This has led to very high returns for some investors. When market conditions change and default rates rise, the factors identified will lead to: ? A rapid unwinding of the credit markets affecting availability and pricing of credit to healthy companies. ? Potentially large losses in hedge funds and the dealers.
The advantage of the structured credit market, most often cited, is that it allows banks to transfer credit risk to better capitalised and less leveraged investors. In reality, much of the risk is transferred to hedge funds that are more not less leveraged than banks. In addition, banks remain heavily exposed to credit risk they have theoretically transferred. This is through their direct and indirect exposure to hedge funds in the following form: ? Funding hedge funds. ? Investment in hedge funds. ? The bank’s own proprietary trading where they take identical positions to hedge funds internally.
An informed analysis of the structured credit markets shows that risk is not better spread but more leveraged and (arguably) more concentrated amongst hedge fund and a small group of dealers. This does not improve the overall stability and security of the financial system but exposes it to increased risk of a “crash” during a credit downturn.
In the attached paper I have set out a critical analysis of the new credit markets and the risk of a credit crash.
Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.
