Dueling Over Derivatives
Alan Greenspan and Warren Buffett do not agree on the trillion-dollar market for credit derivatives
When a debt downgrade at GM took a bite out of several hedge funds last month, part of the blame fell on their participation in the credit derivatives market, a world of high finance that most investors know little or nothing about and that many simply don't understand. Ignorance, however, may not be bliss.
Credit derivatives are, in essence, insurance policies against the possibility that a corporation will default on its debt. They are traded by large investors like banks, insurance companies, pension funds, and hedge funds. For a premium, one investor assumes some of the default or credit risk in another investor's loan or bond portfolio. But just as many hedge funds do more than hedge, instead opting to take more-aggressive positions, credit derivatives are about more than just managing risk; they are also about speculating on it and trading it.
Just how well-capitalized and how smart those speculators are is a looming question. As is the kind of trouble they could cause for the markets should their gambles go bust.
As a tool for risk management and as an early-warning system of credit problems, the derivatives market has many fans. The demand for such insurance has created a lucrative business and made credit derivatives one of the fastest-growing financial markets in the world. Today, investors are holding credit derivatives with an underlying value of somewhere between $4 trillion and $8 trillion--no one really knows for sure--up from about $1.2 trillion in 2001. And none other than Federal Reserve Chairman Alan Greenspan has generally praised the trade, saying earlier this year that "credit derivatives [have] contributed to the stability of the banking system by allowing banks . . . to measure and manage their credit risks more effectively." This, along with the transfer of risk to an ever widening group of investors, Greenspan adds, has helped the economy avoid bank failures or credit crunches when big corporations, such as Enron, have defaulted.
Lethal weapons. But another master of high finance, Warren Buffett, has a different view. He famously railed against derivatives in a 2003 letter to shareholders, calling them "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
The problem is that while credit derivatives are great tools for moving risk, they do nothing to help extinguish it. And because investors can write multiple layers of protection on the same debt, they could actually magnify the market effect of a default.
As the desire for credit derivatives has grown, so has the chorus of concern. Even Greenspan has noted that the rapid growth and increasing complexity of credit derivatives have made it harder for banks and regulators to assess the risks being assumed in a market that is virtually unregulated.
Some data suggest that major banks--the most important participants in terms of steadying the credit derivatives market during any upheaval--may be using the market to increase their risk profiles instead of to reduce them. Add to that the broadening of derivative products to include some based on lesser-quality debt, and others tailor-made for specific clients that are ever more complicated and illiquid, and you have a market that even the most sophisticated players worry about.
advertisement
