Credit risk and its management raise a paradox

Derivatives can be used to hedge risk, to speculate or, unacceptably, to cook the books. That those involved in the financial markets can simultaneously fear credit risk and the use of instruments to allay it suggests that they need to identify derivative users’ intentions more clearly.

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Lex Maldutis

A report on financial risk based on a survey answered by 175 bankers, regulators and corporate users was published last month by the Centre for the Study of Financial Innovation. They were asked to list the top-10 risks to the financial system. The results are paradoxical: high up were both credit risk (at number one) and, at four, the financial instruments banks have designed to cope with it.

Racing up the league of perceived big risks was complex financial instruments, which went from tenth place last year to the fourth-biggest risk this year. Bankers are worried by companies' use of structured finance techniques such as swaps and synthetic CDOs to hide debt and manipulate revenues. One respondent to the survey says: "Financial derivatives are largely unregulated, untransparent and misunderstood." Another, Chris Sutton of IT company Logica, says derivatives are mainly used as a way of "circumventing regulations".

Their anxiety is shared by regulators. New measures are being considered in the US that could seriously affect both the credit derivative and securitization markets - just about the only financial markets that are booming at the moment, thanks to synthetic CDOs - by bringing special purpose vehicles back on balance sheet. In the UK, the Financial Service Authority's Howard Davies said in a speech earlier this year: "One investment banker recently described synthetic CDOs to me as 'the most toxic element of the financial markets today'. When an investment banker talks of toxicity, a regulator is bound to take a heightened interest."

The tough talk from regulators has been prompted by a sudden epidemic of financial puritanism in the US and Europe. One banker complains of the difficulty of convincing companies of the need to use legitimate derivatives in this atmosphere of suspicion. His bank has just underwritten a convertible bond for an issuer with an interest rate derivative attached. The bank suggested the company use a swaption to extend the interest rate derivative if the shares underperform and bonds do not convert into shares by the dates it expects. But the board refuses to sign off on it. It all looked too complex. So the company is potentially left with interest rate exposure its finance director doesn't want.

The number-one risk to banks, though, according to CSFI's survey, is credit risk - in other words banks and companies are worried that they are exposed to too many potential bankruptcies through bonds and loans. Paradoxically, the solution to this would be to hedge the credit risk with credit derivatives.

So credit derivatives are either the problem or the solution, the evil underminer of the financial markets or the only thing sustaining them, depending on how you look at it.

Enron was a leading user of credit derivatives, and of other types of derivatives such as telecom capacity swaps and commodity derivatives. It went from merely hedging itself through these instruments to speculating in them, to becoming a market maker in them, before finally tripping over its own complex network of subsidiaries and collapsing. That collapse is bound to make people suspicious of derivatives, which have always struck members of the public as simply a way of irresponsibly betting, of making something from nothing. Derivatives has been a dirty word since the scandals of Gibson Greetings and Procter&Gamble in the early 1990s.

But there's reason to believe that the effect of Enron on the world economy, as well as the effect of the default of Argentina, could have been far worse had credit derivatives and synthetic CDOs not spread the risk exposure to these two credit events.

Lex Maldutis, director of structured credit products at CSFB, says: "If you look at the US banking crisis of a decade ago, it was driven mainly by overexposure to high-yield bond portfolios and real-estate loans. Substantial defaults in those portfolios led to some banks' capital being wiped out, precipitating the crisis. By the time the banks realized the danger it was too late."

He continues: "It illustrates how in the past, before there were ways of hedging credit risk, there wasn't much you could do if there was a problem - you just hoped to ride it out. If credit derivatives didn't exist now, I'm pretty sure the combination of recent credit events would have led to some sort of banking crisis. The fact that this has not happened is at least partly due to the availability of credit derivatives."

And it's not just banks that stand to benefit from the use of credit derivatives. A research note sent out last month by the Goldman Sachs credit derivatives team says companies could learn a lot from banks' use of credit derivatives. It gave the example of two unnamed energy companies that had exposure to Enron. One, a small independent energy company, had an exposure of around $10 million. When Enron went bankrupt, the company reported its exposure and its share price fell 40%. It is now struggling to obtain new financing. Another company, described as a large provider of electricity, had to terminate several commodity futures contracts with Enron and was made to mark the futures contracts to market. The note says: "As Enron declined into bankruptcy, the market capitalization of the power company fell from about $300 million on October 1 2001 to $100 million on December 3 2001." Goldman Sachs points out that the companies are based on real examples. As the note says: "Failure to hedge credit exposures has resulted in significant earnings volatility and a substantial decline in shareholder value." These risks could have been mitigated by buying a single-name credit default swap on Enron.

Others have been rallying to the credit derivatives cause. William Harrison, the chairman of JPMorgan Chase, told 800 of the bank's clients at a special meeting in January that JPMorgan Chase was protected from being more seriously hit by Argentina and Enron because it had hedged its risk through credit derivatives. "Credit derivatives," he said, "are one of the must-haves for a global full-scale investment bank."
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Cash management poll 2008:

Abigail Hofman:

Credit risk and its management raise a paradox

Derivatives can be used to hedge risk, to speculate or, unacceptably, to cook the books. That those involved in the financial markets can simultaneously fear credit risk and the use of instruments to allay it suggests that they need to identify derivative users’ intentions more clearly.

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