Who’s Holding the Bag?

Everyone knows banks are shedding more risk these days. So where does it go?

But it’s not clear that shifting risk once concentrated at banks out to a larger market has reduced overall risk to the financial system. In fact, it may create new threats while also contributing to a corporate credit bubble. A July report by Fitch Ratings warns that a forced deleveraging of one or more large credit-oriented hedge funds would “be felt across multiple segments of the credit markets, rather than being contained to one or a few sectors.” For non-investment-grade firms, Fitch predicts, the resulting drop in liquidity could mean ratings volatility, lower issuance of junk bonds, and less access to various forms of structured financing.

Warning Signs

“There has been a real structural shift in the credit markets, and it has happened fairly rapidly,” observes Fitch’s Roger Merritt, who wrote the report. Merritt is referring to the rise of highly leveraged hedge funds that trade in credit and credit derivatives. A survey by Greenwich Associates says hedge funds now control as much as 30 percent of the trading volume in high-yield bonds and 26 percent of leveraged loans. In the structured-finance markets, notes Merritt’s report, “hedge funds now play a critical role in financing the least-liquid, highest-yielding subordinated tranches of transactions, giving them a degree of influence that far outstrips the notional size of their investments.” Further, Merritt says hedge funds are able to influence pricing throughout the credit market through their use of credit derivatives.

The collapse of Bayou Securities in August has revived talk of hedge fund regulation since this time last year, when former Securities and Exchange Commission chairman William Donaldson pushed through a rule requiring that hedge funds register with the agency. His successor, Christopher Cox, has reiterated that the rule will take effect in February, as scheduled.

Even 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.

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