That is a widely accepted view of the impact of CDs in the financial markets – and it is wildly wrong. In fact, the new and volatile credit derivatives markets often misprice risk and banks could be paying way over the odds to transfer it off their balance sheets. While the major banks that trade credit derivatives daily are mostly on top of the game, smaller banks coming in to the market to hedge portfolios are in danger of being fooled.
The winners could be the investors and not the banks. The investors in any case are not only or even mainly insurance companies – they are a wide range of protection sellers including many hedge funds.
The fact that banks have not suffered more is because, outside of the major players, the use of CDs by banks is quite limited. Indeed, the market is currently too small and illiquid to take anything but investment grade risks. But as it expands and brings more names into the credit derivatives universe, the bulk of the world’s banks will start to use these instruments. Those that fail to understand their pricing volatility better will suffer.
Says a spokesman for the Bank of Spain, which has closely monitored credit derivatives use by Spanish banks: “We do not think that CDs played any significant role in protecting banks from the downturn in Argentina.”
“It seems that spreads in CDs overshoot when tensions appear in financial markets. That was very clear for some of the banks operating in Brazil at the time that country suffered a significant widening of sovereign spreads. Neither the risk there or the relative weight of the activities in Brazil explained the huge swing in CDs spreads.”
This is serious news for banks which believe, wrongly it seems, that CDs are their strongest risk management weapon. The outcome may be that risk management fundamentals have to be rethought once again, even as the approach ofBasel II is already causing upheaval.
Facing reality may be difficult, however, since the opposing case is largely being made by outspoken investors such as Warren Buffet who are complaining about toxic waste being transferred off bank balance sheets and into the arms of unsuspecting insurers. Mr Buffet, for example, describes CDs as being like hell – easy to get into but difficult to get out of.
Official words of support
At the same time huge support is being given to the instruments by senior regulators such as US Federal Reserve Chairman Alan Greenspan and Sir Andrew Large, Deputy Governor of the Bank Of England. Mr Greenspan has spoken out on several occasions about the useful role credit derivatives have played in protecting banks and their customers against adverse movements in the credit markets.
Speaking at the London School of Economics in January, Sir Andrew said: “Risk transfer processes have mushroomed. The consequences of these developments, whose impact took off in the 1980s, have been quite dramatic. Assets can be disposed of, packaged, securitised, and sold. In size. And fast. So risk can be, and is, dispersed across the system globally.”
Could it be that a vociferous and rather shrill opposition has got it more right than the detached and sober regulators?
The debate has recently been stoked up by two reports from rating agencies, one from Fitch claiming that credit derivatives are too volatile to be useful as risk measures and one from Standard & Poor’s suggesting that they had done little to effect the transfer of risk away from the banking system.
Fitch’s report, “Credit derivatives: A case of mixed signals?”, argues that in addition to being quite volatile, credit derivatives have sent many “false positives” to the market. Fitch analyst Robert Grossman says that investors following the lead of the credit derivative market would have purchased protection at levels much higher than the credits’ intrinsic risks, or would have sold bond positions at the most inopportune time only to see prices improve dramatically over a subsequent period.
Fitch points to the example of France Telecom whose credit default swaps widened to their highest point of 730 basis points in June last year, but which did not default.
Bertrand Pinel: ‘development of CD market truly remarkable’
Colin Fan: ‘more trading in small and medium credits’
Limited protection
The S&P report contended that of the whopping $3,000bn total notional amount of credit derivatives outstanding, only about $100bn represented a true transfer of credit risk from banks’ lending and trading activities to other market participants. As a result, the author claimed that the instruments could not possibly have played a meaningful role in helping banks escape the ills of credit cycles.
Tanya Azarchs, a credit analyst at S&P in New York, and the report’s author, explains: “The report was not meant to be controversial, the controversy really comes from the conflicting statements that have been made about the market elsewhere.
“While some have talked about how credit derivatives have improved risk management, others have talked about weapons of mass destruction. There are lots of different views. Ours is in the middle – the point is that they haven’t proved to have done or to be any of the aforementioned.”
Although Ms Azarchs admits she was surprised by the “underwhelming” figure of $100bn, she says that when she set out to measure the amount of true risk transfer she did not believe that it would have been enough to have protected banks against the downturn, as others had suggested.
She adds: “In future I would expect the $3,000bn to $100bn ratio to change as more banks use credit derivatives in loan portfolio management, but it won’t change that much. There seems to be an underlying assumption that credit risk is bad and ought to be gotten rid of, but banks are in the business of holding risk. On the whole they are the best at holding and managing it, and it would be absurd and costly if they were to transfer it wholesale.”
The two rating agency reports have evoked a sharp response from bankers who realise the charges are in some ways more serious than the “toxic waste” type of criticism.
Marcus Schueler, head of credit derivative flow marketing Europe, at JP Morgan, says: “Like its peers, Fitch has an interest in proving that rating agencies are useful and that they are providing value, even though they have been sometimes slow on some rating actions. Hence they are keen to stress that it is not sufficient just to look at CDs.”
Rating agency deficiencies
Another banker claims that Fitch is selective in the numbers it chooses and the information it gives on the rating actions. She says: “While Fitch had pointed out that its ratings were stable on France Telecom while the CDs prices were volatile, it ignored the fact that the ratings on WorldCom were stable, while the CDs had actually anticipated the eventual default.”
Matt King, head of European quantitative credit research at Citigroup in London, says that the handful of examples Fitch cited are “not a very rigorous or quantitative test of whether CDs predict default rates better than the agencies”. He also challenged the notion that market participants would wait to buy protection until they see evidence of spreads widening.
He agrees with S&P’s numbers, however: “S&P’s numbers appear realistic. To some extent the large discrepancy we see between the $100bn and $3,000bn figures will always be there. Even if banks wanted to, they would find it close to impossible to hedge their large loan positions, as the liquidity simply won’t be there – and moreover the costs would prove prohibitive. More to the point, banks are in the business of extending credit and if they hedged all of it, they would have to find an alternative means of generating income.”
However, Stuart Lewis, a managing director in the Loan Exposure Management Group at Deutsche Bank in London, says he was surprised by the $100bn, and that his expectation was that it would have been “substantially higher”.
He says: “The reports seem to suggest that the agencies do not fully understand how banks are using credit derivatives. The S&P article underestimates the amount of risk that is actually being shifted by credit derivatives, and underestimates the value the instruments can create for banks in pricing the risk up. That is key for banks – making sure we are properly awarded for the risks that we hold.”
Commenting on Ms Azarch’s assertion that the credit derivative markets have not helped banks escape the ills of credit cycles, Bertrand Pinel, head of portfolio management at DrKW in London, says: “It is an unfair statement in that it is being made in respect of a market that is still very much in the early stages of maturity. Given that the underlying cash market is relatively limited, the development of the CDs market has been truly remarkable.”
Chris Cloke-Browne, head of credit portfolio advisory, at DrKW in London, adds: “The statement is somewhat unjust in respect of banks. In fact, they are increasingly using CDs to manage their loan books despite existing constraints such as P&L implications of loan and derivative accounting rules or regulatory capital treatment for derivative transactions.”
Although Mr Pinel concedes the report accurately describes a number of facts in terms of the current market situation, he says even these have to be put in perspective. “There are some high profile examples where banks mitigated wide-scale losses through the CDs market – just look at some of the banks involved with Enron, WorldCom and Global Crossing.”
Robert Reoch, founder of Reoch Consulting, a London-based credit derivative advisory firm, agrees: “Despite the high levels of corporate failures over the last few years we have seen little evidence of bank weakness. This would not have been the case 10 years ago. The difference can be attributed to better credit portfolio management and an important tool for such risk management is the credit derivative.”
Guy America: ‘idea that CDs are mis-sold is misleading’
Jonathan Davies: ‘investors lack mechanism to monitor credit risk’
Keeping up with market expansion
So many bankers are relatively unperturbed by the charges that firstly, CDs are mispriced and secondly, they represent much less of a revolution in financial markets than previously believed. But they could be knocked out of their complacency if the market continues to grow, bringing within its grasp a much wider range of credits and risks. And insurance companies and other investors, whether they currently do or do not understand the risks they are buying from banks, will need to improve their analysis if they are to keep up with the market’s expansion.
Citigroup’s Mr King believes that the proportion of loans hedged by CDs will increase in the future, but even so he estimates it will never account for more than 10%-20% of the total amount of CDs outstanding. Explaining why the percentage is so much lower now, he says: “Because the credit default swap market only really became liquid in the late 1990s after most of the loans had already been built up, and by which time spreads were too wide for hedges to be economical – banks would have been locking in losses upfront if they had engaged in widescale hedging at that point.” Now the CDs market is more liquid and spreads have tightened, and the difference between loan rates and CDs spreads is smaller, he says, there is more incentive for banks to hedge. “As a result, next time round we will find that more banks have hedged a higher proportion of their loans.”
Although he disputes S&P’s figures, Deutsche’s Mr Lewis has another explanation for the low amount of risk transfer. He says it is because banks tend to focus on their concentration risks closely when looking to transfer credit risk, and most large banks find that the greatest concentration is closely skewed to the top 100-200 names. Wholesale loan portfolios may have as much as a third to a half of their exposures and commitments concentrated with their largest names, but they will use CDs to off-load only a portion of that concentration risk.
He says: “This is for three reasons: first, because most of the banks are chasing the same kind of protection and there is not always sufficient liquidity for them all to do so at an economical price; second, because banks actually want to hold on to a measured portion of the risk, and third, because using CDs can create accounting volatility in their P&Ls.”
Market-regulator disconnect
DrKW’s Mr Pinel meanwhile points the finger at regulators. This is because most focused on market risk during the last decade, when the credit risk transfer market grew up. Many are still having difficulty keeping up with the speed of market development, which is understandable, he says. “There is a disconnect between the market and regulators at this point, but they are now closing the gap. However, one of the key challenges going forward will be how to embed such market innovations in the regulators framework, in particular Basel II.
“As the report correctly suggests, the market is still linked to investment grade names. But the maturation process taking place is ongoing and includes trading in weaker names, building up yield curves, further developing index and option products. All this will help increase both the market’s liquidity and the number of participants,” he says.
Colin Fan, head of emerging market credit derivatives at Deutsche Bank, adds: “We need more users from a broader base to trade more names further and deeper into the credit spectrum. We need more trading in small and medium credits. We need to see hedging by local and regional banks against their aggregate credit portfolios. We need a variety of end users – from trade and project finance to loan syndicates and sovereign agencies – to accept CDs as the currency of credit risk transfer. Only then can the breadth and depth of tradeable credits increase alongside the notional volumes.”
In the meantime, Mr Fan says the speed and direction of change have been encouraging. Although there were only some 20 sovereign and 80 corporate names traded in the emerging market universe three years ago, today, there are over 40 sovereign and 300 corporate names.
The number of users has ballooned to include banks, insurance companies, non-emerging market funds, corporates, and supranationals. It is now down to the dealers to facilitate this market’s development by committing their own capital to provide liquidity to and mitigate basic risks for end users.
However, as the market matures insurance companies and other investors need to ensure they are not themselves deceived by mispricing. Sir Andrew Large raised the concern in his speech at the LSE when he said that new holders of such risks may not have the same understanding of what the risks consist of, as those who generate them.
He added: “Risk transfer contracts straddling different areas may engender expectations that in practice may harbour surprises; with unexpected outcomes and adverse behaviour.”
A recent McKinsey article by Léo Grépin, associate principal, also questioned whether insurers had the means of properly measuring the risks they were taking on when buying collateralised debt obligations (CDOs) – pools of assets that often include credit derivatives. As the portfolios and risks of the insurers grew to embrace the new risks, Mr Grépin said that few of them updated their systems and management processes to oversee the potential downside of the new investment strategies. “Many of these companies resemble little more than hedge funds with insurance business on the side,” he said.
As well as outside observers, many within the industry have agreed with some of the arguments. Jacob de Wit, head of fixed income, SNS Asset Management in Holland, says that many of those buying structured credit products are not using the right technology and lack the understanding to be able to fully model what they are doing to their portfolios.
Jonathan Davies, a consultant at Reoch Consulting agrees: “Investors have bought heavily into credit products attracted by the returns on CDO products. However, they often buy in, without the mechanism to monitor and model the credit risk.”
But not everyone shares the view that insurance companies are out of their depth or even the main player on the investing side of the market. Guy America, managing director, head of flow credit trading Europe, at JPMorgan, says: “The idea that insurance companies have mis-sold CDs or that they are unable to value them is misleading. Over the last five years, many investors have used synthetic credit for the first time to gain diversified exposure to the asset class quickly, in size, and tailored exactly to their needs.”
Although Mr America concedes that some lost money on their positions in 2002, he says that was to be expected given the widening in credit spreads. He adds: “And you shouldn’t forget that these deals have performed very well in the spread tightening of the last one-and-a-half years.”
S&P’s Ms Azarchs says: “Everyone assumes that the risky portions went to the insurance industry, but in fact the insurers only bought the AAA tranches – which are practically risk free. It is very difficult to track where the riskier, subordinated tranches have gone – it doesn’t seem to be in the banking system to any large degree, but we don’t see it in the insurance industry, so by default it must be in the hedge fund industry.”
Perhaps the banks, the insurance companies and others are getting carried away with CDs, rather than seeing them as just one more risk management tool. Tim Davies, a director in the audit and assurance group at Deloitte, specialising in credit risk management, believes that anything that gives another frame of reference to the loan market is good.
He says: “Tools like CDs highlight different market perceptions – and that to me is the important point. Credit risk managers can do more due diligence and credit surveys, but there are limits to the value of these – a credit review is only ever a snapshot in time, CDs are far more live indicators.”
Michael Fuhrman, a credit market specialist at GFI Group, adds: “I think the point [Fitch] was trying to make is that these contracts aren’t the best predictors of default – and that had you purchased protection at the height of the France Telecom problem you would have overpaid for it, as there has not been a subsequent credit event. That is true but you don’t wait till the tide is up around your waist to buy a pair of waders.”
Mr Fuhrman also believes that the Fitch report misses the point. Although the instruments are called credit “default” swaps, he says default protection is not their only raison d’ętre. “Many people use them to take a view on the widening and tightening of credit spreads, just as another investor might use cash instruments or equity derivatives to express a view on an issuer’s future situation.”
Marcus Schueler: ‘agencies can be slow on some rating actions’
Tim Davies: ‘CDs highlight different market perceptions’
The importance of diversification
Nearly all the bankers were quick to point out that the instruments should never be used in isolation. Mr Cloke-Browne says: “To expect CDs to be the ultimate all-singing-all-dancing indicator with which all risk can be measured is of course wrong. CDs are one of many instruments.”
For an industry as young as it is, CDs have come in for an unprecedented amount of attention – and flak. Burgeoning volumes, legal wrangles and reports of vast salaries and bonus payouts for bankers have only added to the controversy surrounding them. For as long as the market remains fast-growing and lucrative, it is a safe bet that it will continue to grab headlines and set off fiery discussions. Bankers themselves need to be taking a more scientific view of the market if they are not to find themselves outwitted.