Credit due

The credit default swap market has been rocked by a series of stinging accusations over the past year. David Watts says it’s right to raise questions about the market but that doesn’t mean the alarmists are right

In the past 10 months, the credit derivatives market has been the target of a succession of damaging allegations from some of the biggest players in the American financial markets.

In October last year, Chris Dialynas, a managing director at Pimco, went public with the claim that banks were in a position to exploit the privileged information they receive when extending a corporate loan in the credit default market.

Then last March, Warren Buffett, the chief executive of Berkshire Hathaway, expressed concerns about derivatives in his company’s 2002 annual report, saying: “We view them as time bombs, both for the parties that deal in them and the economic system.” He added that “particularly credit risk [has] become concentrated in the banks of relatively few derivatives dealers.”

These comments have led to a polarization in the debate over credit default swaps. On one side, doom-peddlers have pointed to the comments as proof that the end is nigh. On the other side, supporters of the market have rejected the arguments as representing vested interests.

Indeed both men’s comments do have a faint whiff of ulterior motives. As the largest investor in bonds in the world, Pimco’s fund managers are used to knowing as much about what is happening in the tradable debt markets as anyone. Now that banks are able to trade their exposure to corporate debt in the open market, Pimco’s dominance could be at risk.

In the same vein, Warren Buffett has a bee in his bonnet about derivatives. In 1998, Berkshire Hathaway acquired General Re, the world’s fourth largest reinsurance company. Along with General Re, came General Re Securities, a loss-making derivatives trading house that Buffett has been trying to sell – without success. Instead it is being slowly closed down.

But neither of the above necessarily means that the comments of Dialynas and Buffett should be ignored. Dialynas’s remarks, for example, raise interesting questions about the information banks can pass internally. Take the following scenario: a bank is about to extend a loan and news of the deal is slipped to someone in the bank’s loan portfolio department. That person can then hedge the loan in the CDS market before other participants know about the new loan.

So Dialynas’s question is a fair one: the markets do need to be reassured that the Chinese walls between the lending department and the loan portfolio managers is as impervious as, say, that between lending and bond origination.

In response to Dialynas’s comments, four New York-based trade associations, representing the biggest participants in the credit default market, published a statement of best practice for consultation in May.

This recommends that information that isn’t available to the public and could be useful in making an investment decision should be considered “material non-public information”. Banks should then set themselves up with a private side – the lending department that would have access to this information – and a public side – the loan portfolio managers and credit default swap traders that would not have access. The recommendation looks likely to be accepted by regulators and market participants in late August.

Buffett’s comments on derivatives were more about the proliferation of derivatives and the inability to value them accurately. His only comments that related directly to credit derivatives were on the increasing concentration of credit risk in the hands of relatively few banks. This allegation is not new and Buffett is by no means alone in being alarmed by it: Alan Greenspan, chairman of the Federal Reserve, voiced similar concerns in May this year.

But it is difficult to tell the extent to which this concern is justified. Credit default swap contracts are agreed in private between two counterparties that may be located in different countries and subject to different regulations and disclosure requirements.

According to Blythe Masters, global head of loan portfolio management at JPMorgan in New York: “Generally, the statistics cited to support this argument are inaccurate.” The reason, says Masters, is the statistics are usually taken from regulatory call report filings on the outstanding credit derivatives in the US. But these exclude all CDS transactions by non-commercial banks and all activity booked outside of US branches, which probably account for about half of the actual market.

The result is that participants such as JPMorgan can be portrayed as having a disproportionately large market share – more than 50% – when according to Masters the reality is closer to 20%. While 20% of a market is still a large chunk, and while the largest participants – the large commercial banks – are likely to conduct a disproportionately large share of the trades, they are nevertheless net buyers of credit default swap protection, not sellers. Despite banks making strong profits from credit default swap trading, the primary reason for banks using them is to remove credit risk from their balance sheet.

This very notion of passing on risk is perhaps one of the reasons investors and their clients have been wary about credit default swaps. As Dick Blewitt, a member of Banc of America Securities’ global synthetic products team in New York, says: “Investors sometimes think, ‘if you’re looking to sell it to me then there must be a problem with it.’”

There may be some truth in investors’ suspicions, but there is a more obviously tangible reason for banks to want to remove credit risk from their balance sheet. As Simon Harris, a London-based bank analyst at financial services consultancy Mercer Oliver Wyman, says: “One of the great ironies is that banks are not very efficient instruments for lending money.”

Banks tend to have poorly diversified loan portfolios in terms of the geographical and industrial breakdown compared with an ordinary bond portfolio. And because banks use deposits to lend money rather than allocating capital on clients’ behalf, they are heavily regulated and must hold large amounts of regulatory capital. They also frequently extend loans to companies at inefficient rates to win business. If they are able to remove the risk of that loan at a more realistic market rate, they can reduce their exposure while still making a profit across the whole bank.

Credit risk is often called the last, great unhedged risk. It is only with the advent of credit derivatives, and particularly credit default swaps, that the managing of credit exposure has become possible.

Furthermore, though the growth in the credit default swap market appears to be steady, it has in reality grown in bursts coinciding with major credit events. The Asian crisis in 1997, Russia’s default and the failure of Long Term Capital Management in 1998, Enron’s bankruptcy and Argentina’s default in 2001, and the default by WorldCom on its debts last year, all caused spikes in participation.

And rather than bringing the market to its knees, each crisis succeeded in proving its resilience. As Greenspan said in May: “Even the largest corporate defaults in history – WorldCom and Enron – and the largest sovereign default in history – Argentina – have not significantly impaired the capital of any major financial intermediary.”

This is not to suggest that credit default swaps do not have the ability to cause problems for individual market participants – all financial investments come with inherent risks. But credit default swaps appear to have brought greater stability to the financial system by allowing those best suited to analyzing, pricing and holding credit risk to buy it.