Credit derivatives: Fitch says AIG dominates protection

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Market dismisses concentration risk claims.

Fitch’s latest annual survey of the leading players in the credit derivatives market revealed a 40% increase in the amount of credit protection bought by banks in 2004. AIG Financial Products drove an increase in net protection selling by insurance companies.

Banks were net buyers of $427 billion of credit protection. Insurers and financial guarantors sold $556 billion of protection. The global insurance industry sold $319 billion net, with AIG contributing $269 billion, just over 84%, of that total.

“Being late to the table has worked in AIG’s favour,” says Ian Linnell, managing director, Fitch Ratings. “Lots of insurers moved in just at the wrong time and were exposed to the record US defaults of 2001 to 2003. AIG has sold when spreads were high, and now spreads have come in 60%.” This suggests that other insurers and reinsurers could be ready to return to the market. “AIG made a lot of money,” says Linnell. “Swiss Re and others exited. Will they come back?”

Because Fitch doesn’t rate hedge funds, they are not included in its survey. Nevertheless, the gap between the net protection bought and sold, together with feedback from broker-dealers, suggests that hedge funds and high net-worth individuals bought in the region of $120 billion of credit protection.

Increasingly, banks transfer risk less through single-name CDS, where bought and sold positions are large (up to $3.5 trillion) but broadly cancel each other out, and more through portfolio products. When Fitch looked at the ratings breakdown of the $1.1 trillion gross volume of synthetic CDOs sold in 2004, 14% was unrated.

The top 15 global banks and broker dealers held 75% of gross sold and 81% of gross bought positions at year-end 2004. The top four counterparties were Deutsche Bank, Goldman Sachs, Morgan Stanley and JPMorgan.

Fitch annoyed some market participants when it released its report by saying that concentration risk is high and by failing to acknowledge the progress the industry has made on settlement risk.

“You should be worried if there were 40 banks all actively making markets in complex credit derivatives products,” says Marcus Schüler, head of credit marketing at Deutsche Bank. “It is good to know that the relevant players that capture most of the market share are big ones that put adequate resources into pricing and risk management tools, not small banks that are capturing 2.5% of the market each.”

Linnell concedes that, if there is concentration risk in credit derivatives, there is concentration risk throughout the capital markets. “These guys are big players no matter what product you pick, be it FX, bonds, or anything else,” he says. “The survey shows that this is another market where cost of failure is big and it is increasing all the time, but probability of failure is decreasing all the time.”

Russia replaced Deutsche Telekom in the list of the five most frequently cited reference entities, which now reads: General Motors, Ford, DaimlerChrysler, Russia and France Telecom.

Of the $427 billion net protection bought by banks, $123 billion was bought by North American banks, $294 billion by European banks and $10 billion by Asian banks. German banks shifted from being net sellers to net buyers, although of the nine Landesbanken that took part in the survey, seven were still net sellers.