VideoEven Wall Street has expressed some concerns. Just this summer, Gerald Corrigan, a former Federal Reserve official who conducted a bank-sponsored postmortem on LTCM, reprised his role. The 273-page report of the Counterparty Risk Management Policy Group II painted a rosy picture of improvements in the financial world's handle on market and credit risk, but warned that operational risks resulting from the rapid rise in the use of credit derivatives and other financial innovations since LTCM's fall could, under the wrong circumstances, spiral out of control.
The CRMPG II report was not issued in a vacuum. In addition to — or perhaps in response to — Donaldson's push for registration, regulators and even market participants have been openly discussing derivatives and complex financial structures since last spring. Perhaps most strikingly, Fed chairman Alan Greenspan, who has often praised banks' use of derivatives to manage risk, seemed to hedge his previous comments in a May speech. He, too, focused on operational risks, noting that derivatives provide little risk mitigation if counterparties (read: hedge funds) fail to meet their contractual obligations when defaults occur.
May was also the month that Standard & Poor's and Fitch downgraded Ford and General Motors to junk status. Although they strained hedge funds and the credit-derivative market, the downgrades seem to have had little serious impact.
In June, however, the Bank for International Settlements (BIS) warned that structured finance — particularly structured credit derivatives — has grown so complex that market participants are forced to rely heavily on ratings. Yet, it noted, the very slicing and dicing of these products into different risk categories skews rating methodologies and makes ratings less reliable. Later that same month, the BIS also warned that the GM and Ford downgrades — widely cited as proof that the markets could withstand a major credit event — had been long expected and "might not be a true reflection of how these markets would function under stress" (see "What Is Operational Risk?" at the end of this article).
A Faster Credit Crunch?
Operational risk aside, Fitch's Merritt is careful to note that banks' risk-management practices have improved dramatically since the days of LTCM — in large part via the use of credit derivatives. And he credits hedge funds with adding liquidity to the market. Still, he says, "while banks have been using credit-default swaps to diversify their risk, there's a possibility that risk is being reconcentrated in hedge funds." Finance executives surveyed by CFO appear to understand this paradox. While 34 percent believe that innovations ranging from securitization to various types of derivatives efficiently transfer risk to the market, another 21 percent say they create hidden concentrations of risk.
Those concentrations raise a troubling specter for corporate borrowers. Hedge funds borrow heavily on margin from Wall Street, notes Merritt. "In times of stress," he says, "we've seen that financing can be withdrawn very quickly." Historically, corporations are used to cycles in which banks loosen and tighten credit, usually in response to changing default rates. Far from smoothing that pattern, hedge funds might actually accelerate it. "If there were a liquidity squeeze for some of the larger hedge funds," posits Merritt, "we could see credit availability withdrawn — and credit prices rise — faster than we've seen in the past."
Still, if such a crunch happened tomorrow, its impact would most likely be limited to companies heavily dependent on financing. Most companies, cash-rich and refinanced at rock-bottom interest rates, would go largely unscathed. But over the next three years, such an event could have an increasingly serious impact, as recently refinanced debt comes due and balance-sheet liquidity drops. "A lot of it has to do with the timing," notes Merritt. Moreover, with large global banks estimated to get as much as 25 percent of their revenue from business related to hedge funds, even companies that command unsecured loans from their bankers could find the price of credit spiking.
Among the dizzying array of derivatives, credit-default swaps are perhaps the most significant in terms of their potential impact on corporations. A booming market, the total notional amount of outstanding credit-default swaps is $6.4 trillion. The only specific mention of corporate risk in the Corrigan report warns that the credit-default market may undermine "one of the great strengths of the financial system...its capacity to organize and execute restructurings for troubled but viable companies."
That's because credit-default swaps create a potential moral hazard. Investors that purchase protection against a company's default, observes Merritt, "might not have the same incentive to pursue a successful workout that a traditional bank lender would." This, too, was acknowledged by CFO survey respondents, 27 percent of whom said that in general, derivatives and other financial innovations make restructuring more difficult.
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