Explosive growth of credit products
There has been such rapid growth in the market of credit derivatives, it is surely an area that investors are looking at, if not already investing in. The market for these products began in earnest in the mid-1990s. Less than one decade later, it is expected to exceed $4trn (E6trn) in 2004, according to the British Bankers’ Association.
The credit derivatives sector began as novel means for banks to pass their credit risk from certain borrowers on to an entity which wanted it, be that another bank or insurance company and so on. In essence, it still is a market for credit risk transfer. Although credit risk transfer is by no means a new process, the fact that it could now be achieved via the use of derivatives and without having to buy or sell the assets themselves clearly was novel.
Those entities wishing to shift credit risk away, that is the ‘buyers’ of credit protection, are primarily the lending banks, while ‘sellers’ might be insurers as well as other banks. Increasingly, however, other participants are becoming increasingly active in particular the insurers and re-insurers as well as hedge funds and pension funds.
The array and diversity of derivatives already available is vast and growing. At the core of the majority of them is the ‘credit default swap’ (CDS), which is a swap where one counterparty receives a premium at set intervals in consideration for guaranteeing to make a specific payment should a negative credit event take place, for example a downgrade in the credit status of a specific entity. Single name credit default swaps remain the most used instrument in the credit derivative world, with a 72.5% share according to Risk Magazine.
In the excellent primer on credit derivatives from Lehman Brothers, author Dominic O’Kane describes the meteoric rise in the use of credit derivatives and how the trading of credit risk has been revolutionised by their development. He outlines some of the many differing products, such as credit linked notes, total return swaps, spread options and portfolio default swaps, and the more established collateralised debt obligation (CDO) instruments.
O’Kane describes how the simplification and standardisation of the credit derivative documentation has been a key part of the success of these instruments, allowing a far greater degree of homogeneity, and thus liquidity and depth to the market’s trading. The ISDA (International Swaps and Derivatives Association) has been the principal mover behind these developments.
Equally important for the banks is their regulatory environment and here too there have had to be changes. As credit derivatives did not exist when the 1988 Basel Accord was agreed, there is currently no common internationally agreed approach on how banks ought to treat them. The updated rules, Basel II, are expected some time this year and, according to the ISDA and other participants, the proposed treatment of credit derivatives is to be welcomed.
As well as needing a clear definition of the instrument, the investor also needs clarity from his/her own regulatory bodies. Marie-Anne Allier, in charge of the Credit Management team at SGAM, is well versed in the area of credit derivatives. She explains, “When we started trading CDS in 2000, the legal environment was not as clear as it is now. Here in France, for example, the COB had not yet defined the status of these instruments and so we at SGAM were very cautious at that time. By 2003, however, agreement was reached and we can now invest in these products for our French UCITS.”
Today, SGAM are active investors in credit derivatives in general. “For us, there are several straightforward reasons for entering into the market. We might want to short (the credit of) a name if we have a negative view on a specific issue, with a CDS we can buy ourselves protection. Alternatively we might want to get exposure to an issuer but perhaps there are no bonds, or poor liquidity or the wrong maturity and so we can use a CDS to gain credit exposure. Or if we do not want the yield/interest rate risk of an existing bond, CDS is a good means of getting exposure without taking the interest rate risk.”
Many investors remain unsure as to the true nature of these beasts. Alexander van der Speld of Dutch group Insinger de Beaufort, for example, has been closely following this domain for the past year but has yet to invest. He says: “CBOs and CLOs are very interesting instruments and, in the right environment very appropriate investments with reasonable liquidity too. But now may not be the right time to invest, with credit spreads so tight I for one do not see that they are attractive. With today’s narrow spreads, these instruments have to use leverage to multiply those margins. If we have another crisis like Russia in 1998, then all credit everywhere widens, if you factor in leverage of 8x, 9x or 10x and the unwinding of all those CDOs could be explosive.”
The leverage and the fact that these securities are ‘off-balance sheet’ (read ‘invisible’) for the banks does cause concern among many. Fitch Ratings published a special report last year entitled ‘Global credit derivatives: risk management or risk?’. They agree that the credit derivatives market has the potential to benefit the global financial system by promoting greater diversification and diffusion of risk but that the market’s rapid expansion, immaturity, and relative lack of transparency presents risks.
SGAM’s Allier states that they aren’t huge investors in CDOs and other credit derivatives, but that they are sufficiently sure they have done their due diligence very thoroughly and have a very clear notion of the risks they have taken on board. Allier points to the way the market coped in the aftermath of the Parmalat revelations, commenting: “There were plenty of CDS trades involved and there did not seem to be a problem as they were unwound. It was re-assuring and there weren’t any significant dark surprises.”