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Strategic Finance

Why credit derivatives have a place in prudent businesses

Monday, 27 November 2006

On one hand, credit derivatives are risky for those who do not understand them. On the other, they have proved massively popular - the market's notional value has gone from zero to around $5,000bn in the space of a decade. Tony Jackson investigates Credit derivatives have had a decidedly mixed press in the past couple of years. Warren Buffet, the sage of American investment managers, described them in March 2003, as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal". But just two months later, Alan Greenspan, veteran chairman of the US Federal Reserve, said: "The benefits of derivatives, in my judgment, have far exceeded their costs."

Plainly, as Greenspan says, they do serve a purpose. The most obvious customers are banks and insurance companies, who between them created the concept. But as the market matures, credit derivatives can become a useful tool for corporations generally, if properly handled.

Let us begin by briefly defining what these derivatives are. The most basic form is that of the credit default swap (CDS), whereby a bank sells on the risk of a borrower defaulting, while retaining the loan itself. The other party to the transaction - commonly a general insurer or re- insurer - is paid an annual fee for taking on the risk.

The next step is the collateralised debt obligation (CDO). This is a portfolio of debt - normally put together by an investment bank - containing a combination of CDSs, bonds and various other debt instruments. The holder of the CDO generally does not own the securities themselves, but the yield is determined by their performance.

But the technicalities need not concern us here. The main point is that CDOs are these days tailored to individual requirements. In other words, buyers can find derivatives that match their own risk profile.

What is the point of it all? First, in broad economic terms it makes sense for credit risk - like any other risk - to be spread as widely as possible. That way, the system as a whole is more robust when disasters occur.

But why should companies be willing to assume that risk? One compelling reason, though a slightly unsound one, is that credit derivatives normally yield more than conventional government bonds. In the prevailing yield famine, many institutions are therefore powerfully drawn to derivatives. European insurers, for example, are commonly required by law to provide guaranteed returns on annuities, and struggle to meet their obligations when conventional yields are low.

This partly accounts for the curious fact that whereas the big players in the market are mostly American - J P Morgan, Goldman Sachs and Morgan Stanley - the market's global centre is in London. Americans, too, are searching for yield. But they have a huge supply of domestic high-yield corporate bonds to choose from, and Europe does not.

A more respectable argument for derivatives is that companies can benefit by assuming a variety of offsetting risks. Sticking with insurers for the moment as an example, it is an important principle in insurance to avoid correlation. It does not make sense, for instance, to have your entire risk portfolio exposed to hurricanes in Florida. And correlation can crop up in unexpected ways; after the 9/11 terrorist attack, some insurers discovered too late that they had unwittingly insured many of the companies occupying the Twin Towers.

Just as it makes sense to diversify the risks on the liability side, so with the assets. In the 1990s, UK life insurers invested heavily in UK equities. A broad equity portfolio, they doubtless reasoned, insured them against downturns in any specific sector. But as they subsequently discovered, they were heavily exposed to a single, correlated risk - that of a bear market.

It is here that credit derivatives come into their own. Because they can be individually tailored, an insurance company can pick - or construct - a product that offsets the risks it has assumed on the liability side.

What we are talking about here, in fact, is risk hedging. And this brings us to corporations in general. Hedging is, of course, an essential business tool. A manufacturing exporter, for example, must hedge its currencies; otherwise its business may turn out not to be manufacturing, but currency speculation.

In a similar way, there is nothing to stop operational risk being hedged through credit derivatives. If a company is worried about the price of steel rising, it can buy a derivative whose constituents will benefit from a rising steel price.

This can be taken a step further. The basic principle of the CDS, remember, is credit risk transfer. That is, the bank retains title to the loan it has issued, but sells on the risk of the borrower defaulting.

It is perfectly possible for a corporation to do the same with its receivables. This may sound like credit insurance, but is rather different in practice. Most important, insurance involves establishing a claim and haggling with the insurance company; with a credit derivative, payment is triggered by a so-called 'credit event', which is tightly defined under the terms of the contract.

In other words, it is open to companies not merely to buy credit derivatives, but to issue them. So what could go wrong?

In principle, a good deal. Recall that quote from Warren Buffett describing credit derivatives as financial weapons of mass destruction. Buffett knows a lot about credit derivatives - he is one of the world's biggest re-insurers - and his warnings cannot be dismissed out of hand.

His opening point is that derivatives can be massively hard to understand. If you think you are following the small print, he says, you are fooling yourself. He also makes the case, which is widely accepted, that derivatives may not so much reduce risk as concentrate it. In particular, the big investment banks are massive players in the market, and normally hedge their positions with other derivatives. Suppose they get that wrong, and the derivatives on both sides of the hedge turn out to be correlated in some unforeseen 9/11-type way.

The result, as Buffett says, would be meltdown. In other words, it is possible that the credit derivative system has the effect of exchanging the risk of frequent small disasters for that of rare but much bigger ones.

The chief counter-argument to that is pragmatic. As Greenspan at the Fed says, experience suggests that the big players in the market do in fact understand what they are doing. In the speech when he said the benefits have far exceeded the costs, he also argued that derivatives "unquestionably do pose risk-management challenges to market participants. But those challenges are manageable and thus far have generally been managed quite well".

This has been strikingly borne out by two massive US bankruptcies, Enron and WorldCom. Securities of both companies figured prominently in many credit-derivative packages. In addition, Enron was a large player in the derivatives market in its own right. And while the collapse of those companies obviously caused losses, the market continued to function smoothly.

This was despite the fact that by comparison with other derivative markets, the market was still relatively new and untried. And as the market matures, the risk of disaster arguably becomes less. It is always possible that this argument will be proved wrong, and some really big upset like that of long-term capital management in 1998 will put the whole system at risk, but the longer we go without a disaster, the less likely a disaster becomes.

One final word of warning. There seems little doubt that the search for yield, as discussed earlier, has been an important spur to the market's growth. And high yield inescapably means high risk. In the past, newcomers to the market have occasionally forgotten that, and had their fingers burnt accordingly.

There is a good case for corporations getting involved. But it has to do with the management of credit risk and the hedging of operations. It is not a market for gamblers. The professionals know the game, and will see you coming.

Tony Jackson is a regular contributor to the business pages of the Sunday Telegraph and other publications. He was with the Financial Times for 17 years, including positions as editor of the Lex Column, New York bureau chief and management editor. He was educated at Glasgow and Oxford Universities, with degrees in classics and archaeology, and has also worked as an academic and an advertising executive. He has also worked for various stockbroking firms as an investment analyst and market strategist.