At the Risky End of Finance

The use of credit derivatives has boomed and bemused. These new financial instruments have yet to face their biggest test.

Naughty 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.

A guide to the jargon of credit derivatives

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.

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