Credit derivatives: Getting hooked on credit derivatives

The news is gradually filtering down from big banks to small: credit derivatives can be a wonder drug. Widely regarded as a form of Viagra for commercial banks, credit derivatives enable banks to leverage their balance sheets by buying new assets or selling the risk of existing loans. By playing these growing credit markets, banks can diversify their lending risk, hedge or add to existing exposures. The idea is a revelation for banks trapped in a dull and unprofitable cycle of lending to familiar customers at ever-shrinking margins.

German Landesbanken, for instance, enjoyed discovering asset swaps and credit derivatives in the past 18 months. They diversified loan portfolios which concentrated on regional and public-sector borrowers into the thrilling world of emerging-market debt. Earlier this year they withdrew, wounded by heavy losses in Asia and have become more cautious. According to Christian Porath, German credit derivatives specialist at Credit Suisse Financial Products (CSFP), Landesbanken are now taking on risks no lower than double A (except for German corporates). That is about as exciting and lucrative as lending to the city of Düsseldorf.

Buying in new risks through credit derivatives was just the start. Now acquainted with the product, many medium-size banks are ready to graduate to the next stage. Banks all over Europe are now thinking about selling risk too. By using default swaps (the most common form of credit derivative), banks insure themselves against the borrower defaulting.

Such deals can be invigorating: selling risk clears credit lines for more business with the same borrowers, frees up capital to find more lucrative investments, sheds dead-weight loans the bank would rather not manage and may improve the return on non-lucrative loans made to preserve a customer relationship.

Many of the new sellers have plunged in at just the right time. Last autumn offered a brief thrill for many European banks. Bank equity and debt was unpopular with investors, pushing share prices down and spreads up - even on blue-chip European institutions like Deutsche Bank. Balance-sheet difficulties forced banks to give up certain credit lines and to sell the attached risk in the credit derivatives market at spreads which were now high enough to tempt investors.

The buzz didn't last. Since October the banking sector has recovered slightly and investors have drifted away, disappointed at the lack of liquidity and the surfeit of lenders trying to pass on dull debt for unremarkable returns. As in any market, both seller and purchaser need attractive returns, "If it's rich for the investor it's less interesting for the (seller), and vice-versa," says Jorgen Smeby, a managing director at CSFP.

Too safe, too dull

While every product has its price, there are several reasons why credit derivatives offered by rank-and-file European banks are of limited interest. Medium-size banks tend to lend to the local engineering works or town hall rather than to start-up ventures in emerging markets. In many cases, the underlying credit is of such high quality that the default swap or its securitized cousin, the collateralized loan obligation (CLO), offers only a meagre return.

Second, regulation is still making it tricky for banks to use credit derivatives as a means of releasing regulatory capital from their balance sheets. "A major stumbling block for bringing these deals to public markets is the regulator," says Richard Gugliada, a managing director at Standard & Poor's. Often banks fail to get capital relief even after selling the risk on the loans clogging their balance sheets.

In some markets banks cannot be sure of the capital implications until they try a deal. Only in Germany, France and the UK have regulators taken the trouble to lay down a framework for credit derivatives transactions; market-makers suspect that other regulators lack the expertise. The result is that banks in many European countries will have to wait until the International Swaps and Derivatives Association (ISDA) issues guidelines for all credit derivatives; so far only default swaps have been standardized.

That is why Dresdner Kleinwort Benson, one of the leading market-makers for credit derivatives, has just started a drive to try and standardize documentation. Some market-makers even cite the confusing variety of documentation as the reason why many investors have slipped out of the credit derivatives market in recent weeks.

Third, bank treasurers are wary of unfamiliar, illiquid products. All market-makers cite the difficulty - and the danger - of trying to sell a product to a provincial bank treasurer who doesn't really understand it.

Even major banks think hard. Bayerische Landesbank, a major Euromarket borrower with assets of some Dm400 billion ($241 billion), spent months preparing and obtaining the regulator's approval before entering the credit derivatives market in July. Those responsible describe the bank's approach to the business as "buy and hold".

The smaller Landesbank Sachsen, based in Leipzig, has not yet done any credit derivatives deals, one reason being the lengthy approvals procedure demanded by the German regulator BAKred when any new product is introduced. "The question is whether it's worth our time to do that," says Bill Klein, head of treasury and capital markets. Although the credit derivatives market is no longer a collection of one-off deals, true liquidity is still confined to blue-chip risk.

Other kinds of loans - to unlisted, unrated medium-size companies or the public sector - almost never feature as the underlying assets in derivative transactions. There is too little demand from investors. Yet these are exactly the kind of loans regional and local banks would like to divest from their balance sheets to free up credit lines and increase returns.

Theoretically, credit derivatives should be an ideal product from regional banks. These banks' credit exposures tend to be relatively homogenous, concentrated on a single region, and even on a few industries. That should make it easier to package many similar loans with similar credit risks. Regional and local banks are also accustomed to combining volume and spreading risk by sharing lending transactions overcoming difficulties of size. Credit derivatives tend to be worthwhile only for large volumes - at least $10 million.

Medium-size banks are still finding it virtually impossible to sell their risk in the form of default swaps, CLOs or similar credit-backed instruments. That's not because they are smaller, or less well-known than major European players, but because of the kind of exposures they have. Regional and smaller banks have too little exposure to rated blue-chip credits to make them palatable to investors.