VideoNaughty or nice? The question that Father Christmas poses to every child who clamours for a present also haunts the credit-derivatives market. Are these devices a clever way to disperse risk, making the financial system safer, as their enthusiasts claim? Or are they "financial weapons of mass destruction", in Warren Buffett's phrase, that are poorly understood and perilous boosters of credit?
So far the optimists have had the better of it. People have worried about financial derivatives for 20 years, but economies have proved remarkably resilient. These exotic instruments have not yet produced the cataclysm that Jeremiahs have long forecast. Indeed, the equity bear market of 2000-03 did not result in a banking crisis, as it might have done 30 years ago, when derivatives were still rare.
So far credit derivatives have proved a triumph of the financial sector's ingenuity. By dividing the bond market into digestible chunks, they have increased investors' appetite for corporate debt. That may well have lowered the cost of capital — good for the economy, since it should allow companies to invest more over the long run.
But credit derivatives have yet to face a really bracing test. They have grown in a time of low interest rates and narrow credit-spreads (an extra yield over government bonds to offset risk). Recent problems in America's "subprime" mortgage market (for borrowers with poor credit ratings) are a reminder that the sun does not shine for ever. What will happen when monetary policy is tighter, with interest rates increasing and spreads widening?
The Risk of Default
Credit derivatives are financial instruments that "derive" their value from the bond market. They can cover any bonds that are not issued by governments — that is, where investors face the risk that the borrower may not repay.
Their rapid growth stems from three market quirks. The first is that a traditional corporate bond bundles together a whole group of risks. A bond price might fall because investors are generally demanding higher yields for all fixed-income assets (interest-rate risk), because investors prefer bonds of one maturity date to another (duration risk), or because they think the company that issued the bond will have trouble repaying it.
Derivatives separate this last factor — credit risk — from the other two. This allows investors to insure themselves against the risk of default or, alternatively, to speculate that a default will occur. The instrument that does this is a credit-default swap or CDS (see jargon guide). Hence A agrees to pay a series of premiums to B; who agrees to compensate A if the bond defaults.
This allows investors to speculate on default without owning the bond itself. Those who buy protection could make substantial profits if the company gets into trouble, since the value of the swap will rise sharply. Plenty of speculation occurs and CDS positions are sometimes much larger than the bonds outstanding.
To date, the insurers have tended to do better than the speculators. This partly reflects today's benign economic conditions (few companies have gone bust), but also relates to the second quirk in the market. The highest-rated bonds (known as investment grade) tend to have delivered better returns than were necessary to compensate investors for the risk of default. In other words, someone who insured such bonds against default would have, on average, made money (conventional insurance companies, which insure against fire or theft, have not always done so well).
The third quirk of credit derivatives is that they allow corporate bonds to be sliced and diced on the basis of risk. Some investors (such as banks and insurance companies) may prefer to own the highest-rated (AAA) debt for regulatory or solvency reasons. Others, such as hedge funds, may want to take more risk and earn higher returns.
Derivatives known as collateralised debt obligations (CDOs) are a clever way to satisfy every taste. They are like a mutual fund that bundles together bonds, loans or swaps. But unlike a mutual fund, a CDO has different tranches that give investors different rights over this portfolio. For example, as interest payments on the underlying bonds come in, they will first be allocated to the senior tranches. Only when these have been paid will the more junior tranches get their share. And if defaults occur, the junior tranches take the first hit.
This tailoring can turn coarse corporate cloth into investment-grade haute couture. Take a bunch of companies, with bonds rated A (not the best credit-rating, but reasonably secure). Assemble them in a portfolio and give one group of securities rights over the first 70-80 percent of the cashflows from the bonds (and protection against the first 20-30 percent of defaults). Since it is highly unlikely that 20-30 percent of the A-rated bonds will go bust, the rating agencies will give such securities the highest AAA appellation. In a world where very few individual companies can command such a lofty rating, this transmutation makes such instruments highly appealing.
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