Banks are avoiding the downturn as a result of credit risk transfer. But where are the risks ending up? Melvyn Westlake investigates.
Bankers are feeling smug. They are having a surprisingly good recession. Corporate debt defaults may be hitting unprecedented levels, as the credit rating agencies report. But, so far, the rise in bank loan-loss provisions is being reasonably contained. At the bottom of previous credit cycles, in the 1980s and 1990s, the banks were being hung out to dry.
Their loans turned sour in one sector after another, from developing countries to energy companies, from savings and loans institutions to property firms. This time it seems to be different, despite the collapse of the dotcom bubble and high-profile bankruptcies, such as Houston-based energy company Enron, Swissair, telecoms operator Global Crossing, US retailer Kmart and utilities company South California Edison. And this leaves aside Argentina's failure to pay its debts - the biggest ever sovereign default.
"If Enron had collapsed 10 years ago, it would have sent shock waves through the banking system and possibly brought down one of its bank creditors. Yet the biggest corporate collapse in history has been absorbed without undue stress on the financial system," says a senior credit rating analyst.
Performance enhancement
What is the reason for the banks' unusually good performance? Part of the answer is the transformation of the credit markets during the past five years and the development of financial tools, such as credit derivatives, which allow banks to transfer their credit risks to a host of other institutions in the global financial system. These derivatives allow the credit risk to be isolated from the underlying ownership of the asset.
However, it is hard to gauge how much weight to attach to this factor compared with other big changes in global banking. And, if credit risk has been transferred on the scale implied, could it simply be storing up new trouble in other parts of the financial system, such as the insurance industry? Risk does not disappear out of the system. "So where are the bodies buried," one banker quips with irony.
Certainly, financial regulators, such as the UK's Financial Services Authority (FSA), are anxiously trying to assess the extent to which potentially destabilising concentrations of credit risk may be building up in the financial system, outside the banks that have traditionally held it. Market participants say there is no need to worry. Credit disintermediation - as it is termed - is revolutionising the credit markets in a way that is wholly positive, according to the investment bankers that trade credit derivatives and arrange the structured products that bundle and unbundle, and slice and dice credit risk. As a result of their activities, they say, credit risk is both more accurately priced and more widely disbursed.
For investors, there is no difference between buying credit derivatives and buying the underlying bonds or loans, and it is less risky than holding equities, say market proponents. "Credit derivatives are a mechanism for transferring risk efficiently around the system," says Tim Frost, head of European credit trading at JP Morgan in London. Defaulted loans that would have knocked a hole in a bank's balance sheet 10 years ago "are now hits that we have spread around the system, and represent tiny blips on the balance sheets of hundreds of financial institutions", he adds.
Banks are changing
At the same time, credit derivatives are changing the nature of banking by creating transparent market pricing of credit and revealing the implicit subsidy in much traditional bank lending. "The loan market is where banks give money to companies at the wrong price, for relationship reasons and because loans have not historically had to be marked to market," says a European investment banker. That is changing. Pressures are intensifying on bank managements to maximise returns on equity, so they are frequently cutting back traditional lending, selling the loans they do make - or at least passing on the credit risk associated with them - and increasingly marking loans books to market. "I would argue that the existence of a liquid, transparent credit derivatives market has helped banks to quantify the nature of the risks they are taking in their loan portfolios and the level of the subsidy in many lending decisions," says Mr Frost.
"Commercial banks are transforming themselves from institutions that make loans which they monitor and hold on their books into financial intermediaries that originate and distribute credit risk," says Jonathan Dorfman, London-based head of global investment grade trading at Morgan Stanley. Using credit derivatives, banks can diversify and remodel their risk portfolios. An agricultural bank that chiefly lends to farmers' co-operatives and grain mills can transfer the risk on part of this loan portfolio to the market and assume, instead, the credit risk on loans made to German chemical companies, for example, or US cable companies. One market practitioner predicts banks will become "risk transformation engines".
Such changes in banks' activities are a key reason why they are less affected by the credit cycle, it is claimed. "The efficient market for credit risk transfer is a major, if not the major, factor in the superior performance of banks' loan portfolios in the past year," argues Stephen Stonberg, head of the risk transformation group and co-head of credit derivatives marketing - Europe at JP Morgan. He defines the credit risk transfer market broadly to include not only credit derivatives, but also securitisation, repackaging, asset-backed commercial paper, loan syndication and structures that pool multiple risks, such as collateralised loan obligations (CLOs) and collateralised debt obligations (CDOs).
Loan exposure
Among the banks that are thought to have gone the furthest both in cutting back loan exposure and hedging credit risk is Swiss bank UBS. Since its 1998 merger with Swiss Bank Corporation, which produced worryingly large concentrations of credit risk, UBS has been actively reducing its loan book. Recently, its international subsidiary UBS Warburg, disclosed it had hedged around 30% of its $52bn remaining end-2001 exposure, chiefly using credit default swaps - the most widely traded type of credit derivative.
UBS is one of the few banks publicly to disclose the level of its credit risk mitigation activities but most of the largest banks are probably undertaking similar, if less extensive, risk transfer programmes. Citibank, for example, is known to have hedged some of its Enron loan exposure by issuing credit linked notes, which are securities with embedded credit derivatives. Citibank sold about $1.4bn of these notes, created from Enron obligations, to investors between mid-2000 and early summer 2001.
Enron perfectly illustrates the way concentrations of credit risk have been atomised. "Ten years ago, Enron would have had 10 creditors. Today, the creditor list runs to 40 or 50 pages," says Mr Dorfman. These moves by banks to hedge their risks have occurred in the teeth of the most testing credit environments for decades. Corporate defaults soared in 2001, according to the rating agencies. Standard & Poor's calculates that 216 rated and formerly rated companies defaulted on a total of $116bn. That is more than double the previous record - in 2000, the figure was about $42bn. In 2001, the 10 largest defaults alone exceeded the total of the previous year, says rating agency Moody's.
It was not just junk bonds that went bad; 10 of the companies that defaulted in 2001 had been rated investment grade less than a year before, including Enron and Swissair. Moody's reckons it is the highest number in this category for three decades. The debt of another 60 companies dropped from investment grade to junk status.
Credit ratings improve
If a significant portion of these debts had been on bank balance sheets, the results would have been disastrous. Yet the banks' own credit ratings have been broadly improving, according to John Lonski, chief economist at Moody's in New York. In the US, the number of credit rating upgrades for banks and other financial institutions exceeds the number of downgrades - 56 against 43 (among non-financial companies, downgrades exceed upgrades by nearly four to one). This recent performance contrasts starkly with what occurred during the 1990-1991 credit crunch when the credit ratings of 269 US banks and financial institutions were downgraded, compared with 43 that were upgraded. "Banks today are significantly better placed than could possibly be expected, given that we are in the throes of the severest credit cycle since the 1930s," says Mr Lonski. Although the data applies only to the US, it illustrates the broad trend elsewhere, he says.
Supporting the claims of investment bankers, Mr Lonski thinks that credit derivatives and other credit risk mitigation techniques have played an important role in helping the financial system to absorb the rise in problem loans.
Credit transfer's role
Some market practitioners even argue that credit derivatives and other credit transfer techniques have made the current economic recession shallower than it would otherwise have been. "If banks are writing down loans and taking severe losses as a result of defaults, their ability to continue providing finance to industrial and commercial companies is limited," argues Sanjeev Gupta, head of developed market credit derivatives at CSFB in London. "If banks had not been able to transfer their risks to the market, and their lending had consequently contracted, the present economic cycle would have been much worse," he says. However, not everyone is convinced that the impact of credit derivatives has been as important as market proponents claim. Samuel Theodore, head of European banking at Moody's in London, sees many other reasons why the banks have fared better in this credit cycle than in the past. Bank earnings are much higher and more of their revenue comes in the form of fees and commissions from activities such as asset management and private banking, which are less closely related to the cycle. They also have a higher level of economic capital these days. Banks have also adopted more balanced lending strategies, partly in response to regulators' concerns, and they have greatly improved their credit risk management, adopting better internal rating systems. Mr Theodore believes the credit transfer markets may have played a role in the banks' improved health, but a modest one.
Business volume
The private nature of much of the credit derivatives market makes judging the real scale of credit disintermediation harder. The outstanding notional value of credit derivatives is reckoned to be around $1500bn worldwide (based on a British Bankers Association study). This includes products such as credit default swaps, total return swaps, credit-linked notes, basket swaps and other structured instruments, such as synthetic CDOs. Only a minority of deals involve publicly-rated securities.
JP Morgan analysts think the real volume of business is higher. They reckon that the outstanding notional amount of credit derivatives soared by 100%, to $2000bn last year because rising defaults and the September 11 terrorist attacks on the US prompted banks and other creditors to rush into the market and hedge their risks.
Other figures put the total market for CDOs at around $850bn but many of these structures are created from pools of physical assets. Only about half are synthetic structures, based on credit default swaps, according to researchers at Banc of America Securities. Around $100bn of these synthetic vehicles were issued last year, they calculate, although even that is probably an underestimate because it excludes some private transactions. Europe alone saw $50bn issuance of synthetic balance sheet CLOs last year. Banks use synthetic CLOs, a sub-category of CDOs, widely as vehicles to transfer credit risk to investors, while keeping the actual loan on their balance sheets. All this activity pales, however, beside the total size of European and US banks' loan portfolios, which is estimated to be around $20,000bn.
Regulators ask questions
Even so, the credit risk transfer market has reached a size at which it is attracting increasing attention from the regulators. Although they view it as positive, they, too, are keen to know "where the bodies are buried" - that is, whether investors in credit risks really understand what they are buying; and whether differences in banks and insurance company regulation encourage a transfer of risk that is not otherwise economically justified. Under current rules, banks are obliged to set aside much more regulatory capital against credit risks generally than are insurance companies, whereas the treatment of capital should, in principle, be the same when the risk is the same. If the driving force behind risk transfer is differences between banks' and insurance companies' regulatory regime, "we may be creating, not reducing market instability", FSA chairman Howard Davies said in January. Mr Davies illustrated the unease among regulators when he notoriously related a comment that an investment banker made to him: that synthetic CDOs are "the most toxic element of the financial markets today".
Investors in credit derivatives, who effectively receive a premium for accepting the risk, include banks that want to diversify their portfolios, specialised credit hedge funds and other types of funds, even pension funds, particularly in the wake of falling equity markets. But it is the insurance companies' involvement that is most often cited and that seems to be growing most rapidly. Life insurance companies invest in credit derivatives for the asset side of their balance sheets, while property and casualty companies and reinsurance companies accept the risk on the liability side and log premiums as fee income. Another increasingly important group of market players are the US monoline insurers (which specialise in a single line of business, insuring bonds). Examples of these are Ambac Assurance Corporation, MBIA Insurance Corporation and Financial Guaranty Insurance Company, a subsidiary of GE Capital Corporation.
Some insurance companies have set up "financial product" subsidiaries or "financial solution" subsidiaries, partly to gain greater flexibility to take credit risks. Many are based in Bermuda, where regulation is light. German and Japanese life companies are reported to be particularly significant investors in the more risky tranches of CDOs, in an effort to boost investment returns. CDOs are divided into layers of increasing risk, with the safest (super senior) tranche at the top and the most risky (junior) tranche at the bottom. Investors in the junior tranche lose their money first in bad times but receive a high proportion of overall profits in the good times.
Insurance company losses
Just how much insurance companies may have lost in the credit risk transfer markets during the past year is difficult to judge. In theory, diversification of risk should mean that the pain is also disbursed. However, that does not mean that holders of large portfolios of risky credits cannot lose a lot of money if there is a sharp deterioration in that market sector. American Express Financial Advisors (AEFA) discovered that last year.
AEFA, which sells financial planning and financial and insurance products, is a subsidiary of American Express Company (Amex). In 2001, it had to write down its investments by more than $1bn. That was mainly because of sharp falls in the value of its holdings of high-yield CDOs and losses suffered from buying the most risky tranches in such structures. Amex chairman Kenneth Chenault admitted in July that his company "did not fully comprehend the risk underlying these structural investments during a period of persistently high default rates". According to the rating agencies, the Bank of Montreal has also been obliged to take some write-down on its investments in such structures, although on a much smaller scale than Amex.
The AEFA experience has increased concerns that credit risk is being transferred from banks, which are supposed to understand this risk, to unsophisticated investors that do not. This is hotly denied, both by credit derivative traders and investors. Some of the institutional investors in credit are among the most sophisticated in the financial markets, with bigger research teams than the banks, says the head of credit derivatives at a top US securities firm. The suggestion that credit investors are all naively being seduced by sharp bankers into buying risk they do not understand is "patronising", says Eric Rothman, vice-president at ACE Finance Overseas Ltd (AFOL).
AFOL is affiliated with Ace Guaranty Re (AGR), a New York-based financial guarantee insurer. AGR, a triple-A rated firm, ultimately owned by Bermudan insurance company Ace Ltd, is highly active in the credit risk market, with an exposure of some $16bn in derivatives and structured products. Mr Rothman says the professional staff of AGR and its sister firm Ace Capital Re, which sometimes invests in the more risky tranches of CDOs, are "veterans of the capital markets", who have been influential in shaping the market documentation. Another buy-side player, Robert Kyprianou, a senior executive at Axa Investment Managers, subsidiary of the Paris-based Axa insurance and asset management group, claims: "Our specialised credit derivatives and structured products team is the best in Europe." His company is also Europe's biggest investor in the most risky, "first loss" tranches of CDOs, as well as managing such structures for other investors.
"We have lost money and made money in this sector," he says. "But we have done better that the market as a whole." Some people who entered the credit markets did not understand them and some are now withdrawing, he says. But he believes that does not make credit derivatives dangerous; quite the reverse. He thinks they have given a greater flexibility to money managers who wish to invest in Europe's still relatively small and illiquid corporate bond market.
Potential for problems
There is no evidence of any systemic difficulties, so far. Barry Hancock, head of the financial services practice at S&P, sees no problems in the transfer of credit risks to the insurance industry that "is of a magnitude to cause us concern, at present".
Yet concern remains about the potential of credit disintermediation to create problems, particularly if the credit derivatives market booms, as many participants predict. Can the banks be sure they have transferred the risk and that the deals are legally watertight when any major defaults occur? Mr Theodore says the banks often finance the hedge funds that are buying the banks' credit risk. "Banks could find that credit risk has gone out through the door and come back in through the window," he warns.