News reports on a Fitch study on credit default swaps came out yesterday, and I saw it reported in the Financial Times and decided to pass, but other elements of the report have been picked up elsewhere, and I changed my mind.
Basically (surprise!) leverage cuts both ways. The FT cited the results of a survey conducted by Fitch:
Credit derivative market participants are increasingly concerned about how the markets would deal with a downturn, even as growth continues in the sector, a new survey suggests.
All of the 65 financial institutions – 44 banks and broker-dealers, 13 insurance and reinsurance companies and eight financial guarantors – that responded to a survey by Fitch ratings expressed concern over how smoothly the credit derivatives market would deal with a turn in the credit cycle.
“Specifically, some of these worries included liquidity in the event of a downturn, the impact that unwinding of system leverage can have on volatility, and settlement following a credit event,” Fitch will say in its fifth annual Global Credit Derivatives report, published today.
In recent weeks, credit markets have been rattled by a spate of defaults in the US subprime mortgage market, which has dented sentiment and risk appetite.
Respondents to the survey may have anticipated this upheaval: 18 of the institutions polled forecast either an increase in spread volatility, an unexpected rise in credit events or spread widening.
“A small minority of market participants expect either a major default or a general increase in defaults in the near-term, while certain other investors have concerns that liquidity may suffer or disappear in an eventual downturn of the market,” the report said. “Yet other participants are concerned that an unwinding of system leverage will only serve to exacerbate this situation.”
In spite of the concerns expressed in the report, respondents to the survey expect continued growth – of anywhere from 11 to 50 per cent – in the credit derivatives market. The report cited collateralised debt obligations (CDOs), loan-only credit default swaps, which are swaps on loans rather than bonds, and the traded indices as the products expected to have the most robust levels of growth.
I’m amused at the disconnect. The participants recognized that credit derivatives can increase systemic risk in market declines, yet are bullish on the products. Maybe we need to start thinking of systemic risk as an externality and try to figure out how to have financial products reflect their true costs (I don’t pretend to have an answer, but it would be useful to have some discussion along these lines. In the past, regulation was the main way of dampening down on the possible adverse effects of financial innovation, but the innovations have now gotten way ahead of the powers that be’s ability to assess their full impact).
Let’s say we have either pronounced inflation or a serious financial meltdown and credit derivatives contributed to the crisis, just as program trading (a supposed form of insurance) did in the 1987 crash. Events like that impose costs on people who had nothing to do with these products, so the notion that they can create externalities seems valid.
A few other factoids: it appears these products are often used for speculation, rather than mere hedging. When Delphi Corp. went bankrupt, the amount of credit default swaps outstanding was 10 times the amount of debt. The Bloomberg story continues:
A scarcity of bonds to settle credit-default swap contracts after Delphi’s bankruptcy drove the price of the Troy, Michigan- based company’s notes to 70 cents on the dollar on Oct. 31 from 57 cents two weeks earlier.
The bond price returned to below 60 cents after ISDA held an auction that enabled investors who bought Delphi credit-default swaps as part of a benchmark debt insurance index to settle their contracts with cash instead of bonds.
If I read that correctly, that was a fix. I suppose now that the precedent has been set, other swaps that call for delivery of bonds may also be cash settled. But what good is a contract if you can renegotiate it if you stuffed up? That isn’t how the rough and tumble world of trading is supposed to work.
Accordingly, the UK Telegraph’s commentary on the report focused on the role of hedge funds:
Ian Linnell, a managing director at Fitch, said: “There is a growing perception that the credit cycle may be turning, which would lead to an up-tick in corporate defaults.”….
Due to their growing investment in credit derivatives, hedge funds’ influence on “key segments of the credit markets” has continued to “grow at a dramatic pace”, the study found.
Fitch cites recent research from Greenwich Associates that showed that hedge funds are responsible for nearly 60pc of all trading volume in credit-default swaps and one-third of volume in collateralized debt obligations, another type of structured credit product.
Mr Linnell said: “Hedge funds love credit derivatives because they can go long or short on credit positions and it’s yet another instrument to use in their strategies, alongside equities, foreign exchange and interest rates.”
But while hedge funds have helped to boost liquidity in the credit markets, their influence is not all benign.
The Fitch report, which was based on interviews with 65 banks and other financial institutions, concluded that because hedge funds are borrowing so much money to invest in credit derivatives, they might find it hard to offload these substantial positions in any downturn.
“The uncertain outlook for credit markets, combined with the large positions taken by hedge funds – which is magnified by the leverage strategies adopted by many of them, may well result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,” the study said.
Mr Linnell added: “Should something happen in the hedge fund sector that causes them to unwind their credit derivative positions, liquidity would dry up and credit markets would become more volatile.”
And Bloomberg highlighted concentration among counterparties:
Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., Fitch said. The top 10 firms accounted for 89 percent of credit derivatives bought and sold in 2006, up from 86 percent in the previous year, Fitch said.
“For better or worse, counterparty concentration appears to remain a feature of this market,” Fitch analysts wrote.
I have to wonder if the same thing that happened to Delphi is happening right now to ABX.HE.
Everybody is assuming that the ABX.HE indices are good barometers for the net present value of baskets of subprime mortgage ABS.
What makes us think that there is not enough speculation in the CDS market that ABX.HE performance has become completely uncoupled from the underlying bond performance?