Recounting credit risk

Fitch Ratings’ latest survey of the credit derivatives market has received a mixed response from the market. Alan McNee looks at the findings of the survey and assesses its consequences

Credit rating agency Fitch has updated its survey of the global credit derivatives markets, giving a picture of the market’s growth and evolution. But not everyone in the market agrees with the concerns Fitch has raised about possible dangers inherent in credit derivatives.

Fitch’s original survey, entitled Global Credit Derivatives: Risk Management or Risk?, was published in March. The updated version largely reinforces the conclusions of the March survey, with data gathered from extra institutions, including broker-dealers. Fitch also tried to expand the report to include hedge funds, but without success (see box on page 46).

The updated report estimates the outstanding value for global credit derivatives at $1.7 trillion – rising to $1.8 trillion if cash CDOs are taken into account. This compares with a figure of $1.2 trillion in March this year (or $1.3 trillion including cash CDOs).

However, Fitch also flags up some concerns about potential risks in the credit protection market. In particular, the agency raises the issues of transparency, information asymmetry and moral hazard. And the report also makes clear that while on an aggregate basis, the banking industry has been a net buyer of credit protection, this picture can be misleading.

Once the bank data is broken down further, it becomes clear that it is the global banks who are the net buyers of protection. Smaller, regional banks – particularly in Europe – are actually net sellers, with banks in Germany and the Benelux states particularly active. The larger banks have net purchases of $296 bn, while the smaller, regional institutions are net sellers of credit derivatives and CDOs (having sold $67 bn) as a way of originating credit they would not otherwise have access to.

The Fitch report also raises worries about how credit risk is being dealt with in the derivatives markets. Overall, Fitch regards the growth of credit derivatives activity as a positive development, which has allowed “enhanced risk transfer and dispersion”. But it warns that the risks include low financial transparency and “informational asymmetries”. The market remains “very opaque”, warns Fitch, and there is also a degree of moral hazard as “the linkage between origination and management of credit risk becomes more attenuated”.

On the question of informational asymmetry, Fitch claims there is a “real risk of unanticipated concentration of risk if credit derivatives are not managed properly and adequately disclosed”. Ian Linnell, MD of credit policy at Fitch Ratings and one of the report’s authors, says that while such asymmetries exist in all markets, the potential risk in the credit derivatives market is higher.

“A bank has a relationship with a client, which it probably knows well, and it then repackages the counterparty risk it faces from that client and sells it off to a third party which does not have a relationship with the client,” explains Linnell. “In theory, at least, it could be because they are aware of problems with that client’s credit quality. In practice, of course, there could be many other reasons for the bank to sell off that credit risk – it may be for portfolio reasons, for regulatory capital reasons and so on. But in theory the risk of asymmetric information is higher in credit derivatives markets for this reason.”

Not all credit derivatives professionals agree. John Tierney is director of US credit strategy and credit derivatives research at Deutsche Bank in New York. He says concerns about information asymmetry have been around for as long as the credit derivatives market has been in existence, but are probably already priced in by the market where necessary. “Most trades involve big, S&P 500-type companies with stock and debt outstanding and lots of information in the public domain. The likelihood that banks would have access to materially more information that the rest of the market is small,” says Tierney.

“Once you get down into the middle market,” he adds, “the firms involved may not be public, or if they are public they may not be widely followed. But you see very few of these middle-market names in the credit default swap market. If they do trade, it tends to be in synthetic CDO form, and both the rating agencies and capital markets investors are quite conservative in the way they price such structures – especially having come through such a brutal time for the credit markets.”

However, Fitch’s Linnell says the agency has heard some US fund managers say they are not interested in getting involved with credit derivatives “because they see no reason to buy credit risk that banks are offloading, and expose themselves to companies the banks know much better than they do”. He does concede that worries about information asymmetry are offset by the fact that this is still largely an investment-grade market, but predicts that “as the market pushes further down the credit curve, that risk becomes harder to assess, price correctly and manage”.

Some people in the market believe it is this factor which is stopping a genuine high-yield market from developing, says Linnell. It is also the case that information asymmetry may be more of a concern outside the US, since the North American credit default swap (CDS) market is generally based more on the bond market than on bank loans. In Europe, loans are more likely to be the underlying.

The report also cites concerns about moral hazard – the danger that credit derivatives may “inadvertently foster a lending culture based less on sound underwriting and more on volume, since banks are able to separate originations from the ‘buy and hold’ credit decision”. But Merrill Lynch’s head of international credit research, Chris Francis, is sceptical that this is a real problem. “I’d be very surprised if you could find a single example of a loan having a higher coupon than the CDS market. If you make a five-year loan at 50bp over Libor, and buy a credit default swap at 100bp over, you have given yourself a way out that’s a bit less painful than a default but which still remains painful. So there’s very little incentive to cut corners on due diligence when originating loans,” says Francis.

Fitch’s worries about transparency in the market generally meet with a cool response from those involved in CDS trading. Michael Pohly, head of credit derivatives trading at Morgan Stanley in New York, says transparency has been the biggest area of improvement in the past couple of years. “You now have multiple dealers quoting liquid markets in credit derivatives, with a degree of transparency akin to that in the corporate bond markets. Buyers can call up dealers and get consistent quotes.” And Merrill Lynch’s Francis adds that the credit markets in general are not notably transparent. “The corporate bond market isn’t transparent. The loan market may be at the time of new issues, but these are then often traded on in the secondary markets. So credit derivatives are not uniquely opaque by any means,” he says.

Nonetheless, Fitch concludes in its report that disclosure “is one of the key issues for the market’s healthy development”. It says that “traditional measures of financial strength and performance are at risk of becoming increasingly distorted in the absence of a minimum standard of disclosure vis-à-vis credit derivatives”. And the report concludes that enhanced disclosure would allow capital markets participants to assess the inevitable losses in their proper context and respond accordingly.

The survey in brief Banks reported gross sold positions of $1.324bn, compared with $800bn in the March survey. This $444bn increase is largely attributable to the inclusion of five broker-dealers in the updated survey. Overall, banks and broker-dealers are net buyers of credit protection, with $229bn purchased ($97bn in March). The insurance sector, meanwhile, remains the biggest seller of credit protection, with insurers and reinsurers showing a net sold position of $303bn (up from $283bn in March). Ten more insurers and reinsurers are included in the new survey. Financial guarantors continue to make up the biggest proportion of insurance sellers, with a net sold position of $166bn (unchanged since March). The latest version of the survey was based on responses by 113 banks, of which 77 were European or Asian and 36 North American, and 68 insurance groups, 54 of them North American and 14 European or Asian. The updated data since March adds a total of 34 institutions, including the 10 extra insurers.

The case of the missing hedge funds Fitch Ratings tried to add data on the involvement of hedge funds to its latest survey, but was thwarted by the secretive nature of the industry. Of the top hedge funds, 50 were approached and asked to supply basic information on a voluntary basis. All 50 declined. So how important are hedge funds to the credit derivatives market? And does it matter that they don’t want to go public on the extent of their involvement? Ian Linnell, managing director of credit policy at Fitch, says he has come across estimates as high as $100 billion of net sales attributable to hedge funds. “We had a lot of funds ringing us up to discuss the report when it was first published,” he says. Those working in the market agree that hedge funds are increasingly important players, although not everyone is concerned about their lack of transparency. “Hedge funds have become a significant part of the market, both as buyers and sellers of credit protection,” says Michael Pohly head of credit derivatives trading at Morgan Stanley. “I don’t share the view that hedge fund participation is a cause for concern because of lack of transparency. I’m a great believer in the market as a self-regulating mechanism.” John Tierney, director of US credit strategy and credit derivatives research at Deutsche Bank, also accepts that there is no real quantitative information on how big hedge funds’ participation in the market is, but does not believe they add significant risk to the market. “They are an increasingly important part of the market, and while the notional amount of their outstandings is probably smaller than many people believe, they are quite active in terms of numbers of trades,” says Tierney. However, hedge funds are not a generic category, he points out. “Each type approaches the market differently,” he says. “These include convertible arbitrage funds, credit-oriented relative value funds, and funds that concentrate on credit versus equity, for example, all focusing on distinct market sectors and strategies. In that sense, hedge funds are a much more heterogeneous group than, say, reinsurers. That diversity should help to offset any risks posed by the lack of data about their involvement in the market.” Others question whether the involvement of hedge funds in credit derivatives is much different from their involvement in other markets. Chris Francis of Merrill Lynch points out that hedge funds are, after all, also involved in bonds and equities. “Most fixed-income trading is not carried out on exchanges, and hedge funds are involved in that on a leveraged basis, so there’s nothing unique about their involvement in credit derivatives,” he says. Francis also believes that the hedge funds are predominantly buyers, not sellers, of credit protection. Ultimately, hedge funds are absent from the report because they can afford to be. As unrated entities, they simply have no obligation to supply data to Fitch or any other rating agency. When a rating agency asks rated firms for information, the threat of a ratings withdrawal or other action is always implicit should the company decline to provide the data. Fitch’s Ian Linnell says that while no ratings have so far been changed as a direct result of credit derivatives activities, the agency would not rule out withdrawing ratings from some companies if it cannot get satisfactory data from them. Given this potential threat, it’s not surprising that so many institutions agreed to participate in the survey. And if some of the banks, insurers and other firms who cooperated with the survey had not been rated by Fitch, it’s quite possible that more institutions than just hedge funds would be missing from the survey.