Rating agencies debunk credit derivatives misconceptions

Separate research by two rating agencies has sought to shed more light on the credit derivatives market. A report from Fitch Ratings suggests investors who rely too much on credit default swap (CDS) spread data as a leading indicator of default risk are playing a dangerous game. Meanwhile, Standard & Poor’s (S&P) says credit derivatives have not helped banks avoid meaningful amounts of losses in the current credit cycle.

During recent years, the paradigm that CDS spread data can presage defaults has emerged among some on the buy side. In response to this, Fitch decided to broach the matter in a paper entitled Credit Derivatives: A Case of Mixed Signals?, released in December.

“Despite a number of successes, market-based measures can also give misleading false signals, particularly when the market is feeling negative towards a sector,” says Mariarosa Verde, an analyst in New York at Fitch Ratings.

Proponents of market-based indicators pointed to CDS spread widening among certain credits in the months prior to their default in 2002 as evidence of the predictive power of market-based measures. But Fitch says that while this is true, CDS spreads also widened dramatically for many other investment-grade companies in 2002 before tightening up last year.

According to Verde, the CDS market has been a coincident indicator of default risk, rather than a leading indicator. “By relying on spread data as a [sole] leading indicator of credit-worthiness, there is the potential for investors to add stress to the market as a whole,” Verde says.

Ineffective hedging

In a separate report, S&P says credit derivatives are not yet helping banks to hedge their risks effectively, despite a rapid increase in both innovation and trading volumes. The claim is made in the report, Demystifying Bank’s Use of Credit Derivatives, by Tanya Azarchs, a credit analyst in New York.

“As promising as the credit derivatives technology is, it is not yet a panacea for credit problems of banking systems around the world,” says Azarchs. “It has not, as is commonly believed, helped banks avoid meaningful losses in the current credit cycle.”

One reason is that most activity takes place between dealers, the report says. The rating agency estimates that of the $3 trillion total notional amount of credit derivatives outstanding, only $100 billion represents transference of credit risk from banks’ lending and trading activities to other market participants such as insurers and hedge funds. By comparison, the aggregate loan and bond portfolios of the global banking system stand at $29 trillion and $5.5 trillion respectively, according to S&P.

Another factor that has limited the amount of risk transferred away from banks is that most of the available credit protection is for the lowest-risk names. “This appears to have the effect of shifting the remaining risks in the banking system further towards the riskier, non-investment-grade range of the spectrum,” says Azarchs.