Derivative Doodoo
Although it was nearly three years ago, it seems like only yesterday that former Federal Reserve Chairman Alan Greenspan was waxing lyrical about the wonders of derivatives in a speech entitled "Risk Transfer and Financial Stability."
Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth. The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions, which was so evident during the credit cycle of 2001-02 and which seems to have persisted. Derivatives have permitted the unbundling of financial risks. Because risks can be unbundled, individual financial instruments now can be analyzed in terms of their common underlying risk factors, and risks can be managed on a portfolio basis. Partly because of the proposed Basel II capital requirements, the sophisticated risk-management approaches that derivatives have facilitated are being employed more widely and systematically in the banking and financial services industries.
As is generally acknowledged, the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively. In particular, the largest banks have found single-name credit default swaps a highly attractive mechanism for reducing exposure concentrations in their loan books while allowing them to meet the needs of their largest corporate customers.
Nowadays, of course, it's a different story, as the Financial Times reveals in "Credit Derivatives Turmoil Strikes."
Turmoil in the credit derivatives markets is having an increasingly brutal impact on the wider financial system as a vicious cycle of forced selling drives risk premiums on company debt to new highs.
The trend accelerated on both sides of the Atlantic last week as investors rushed to unwind highly leveraged positions in complex structured products. The cost of protecting US investment grade debt against default soared to a high of 188 basis points, from 80bp in January.
In Europe, the cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe index surged to a new high of 156bp, before closing at 146bp on Friday. A move above 150bp would spark the unwinding of structured trades, according to BNP Paribas.
Institutions that lapped up credit risk products in recent years – many financing their purchases through borrowing – are scrambling to reduce their exposure following heavy losses, traders say.
But many investors fear conditions could worsen as hedge funds, banks and other financial institutions come under pressure to cut their losses before conditions deteriorate further.
Liquidating structured credit instruments requires buying large amounts of protection using credit default swaps. This, in turn, drives the cost of protection higher, potentially triggering a chain reaction.
“There is potential for some wild and possibly inexplicable price movements as the unwinds get bigger,” said Mehernosh Engineer, credit strategist at BNP.
The markets are so illiquid that a few trades can lead to sharp movements, producing violent price swings and knock-on effects.
Tim Bond, head of global asset allocation at Barclays Capital, said: “It’s inflicting heavy losses on the banking system, eroding their capital and reducing their ability to lend. The spread widening is so severe, you’re seeing a rise in borrowing rates across the board for everybody except top-quality governments. It’s affecting both the price and availability of credit.”
Some structured credit vehicles have in-built triggers that force them to be liquidated.
Bank of America estimates that if the cost of US investment grade credit insurance rises above 200bp, the unwinding of structures could trigger a jump towards 220bp.
Jim Sarni, portfolio manager at Payden & Rygel, an investment management firm, said: “The market is very concerned about counterparty risk and how stable positions are as they are marked to market as prices keep falling.”
Suki Mann, credit strategist at Société Générale, said companies and consumers were also suffering because of reduced lending as banks hoarded liquidity.
Today we salute you, Mr. Worldwide Financial Meltdown Causing Federal Reserve Guy.
Posted by: All Your Funds Belong To Us | March 09, 2008 at 10:37 PM
Isn't the unwinding of Structured Products liely to be a good thing if you think that transparency of assets and liabilities is a good idea?
Posted by: dearieme | March 10, 2008 at 08:59 AM