Credit derivatives: You ain't seen nothin' yet
Credit derivatives will transform the way banks manage their balance sheets. Once banks adopt a true portfolio approach, they will create a fully liquid secondary market in credit risk. Before then, demand for loans, asset swaps and credit derivatives will surge as proprietary traders and hedge funds cut up the credit curve. Mark Parsley reports.
"There is a common misconception that banks are using credit derivatives because they are worried about the borrower; in fact it's completely the opposite. Most banks would rather liquidate the cash position than buy a default swap in that situation." Hermann Watzinger, vice president, credit derivatives at Citibank in London, is keen to dispel the image of the credit derivatives market as a way for banks to dump the toxic legacy of poor lending decisions onto unsuspecting institutional investors. "The most important use will be in loan portfolio management and we already use credit derivatives very extensively as an end-user in our own portfolio. We have done deals from $10 million to $1.1 billion."
Citibank, in common with other commercial banks, says that it would not lay off risks on a credit that it thought might default. Instead it would liquidate the position or hand the exposure to a specialist work-out team within the bank. Another banker agrees: "We don't want to sell a default swap and then collect on the default.