Dueling Over Derivatives
Alan Greenspan and Warren Buffett do not agree on the trillion-dollar market for credit derivatives
Many of these hedge funds are said to be nursing material losses and could be hit with investor redemptions down the line. One large hedge fund manager, GLG Partners, said the ratings downgrade was partially to blame for a 14.5 percent drop in its $1 billion Credit Fund. But as a group, hedge funds managed to eke out a tiny profit for the first five months of the year.
And probably the worst result from the troubles in the credit derivatives market will be lower earnings from the big investment banks most active in facilitating the trades, such as Merrill Lynch and Deutsche Bank, which could be stung by the temporary reduction in deals.
Instead of portending economic devastation, the GM event might even have been salutary. Mazzocchi says that such market hiccups can help reveal and regulate the risks being taken on. "If there are gigantic positions out there that we didn't know about, the market will show us," he says. They are also extremely valuable in stress testing and steering what is still a very young market, adds Cornell University's Robert Jarrow, known for his decisive work on interest rate modeling.
Jarrow believes that the credit derivatives market, when run right, contributes greatly to the financial health and flexibility of the economy and that hedge funds, although the weakest link in the chain, are still unlikely to make the sort of dangerous miscalculations pioneered by the financial wizards at Long-Term Capital Management. "As long as the people who issue the contracts are responsible, then credit derivatives are welfare improving and make the system work better," says Jarrow. "But there will always be things that can't be anticipated, and there will always be human error and human greed."
Risky business
The global market for credit derivatives--insurance that protects against corporations defaulting on their debt--has grown quickly.
In trillions
1997 $ .180
'06 $8.2*
*Estimate
[Other labels]'04,'03,'02,'01,'00,'99,'98
Source: British Bankers' Association
Graphic by Rod Little-- USN&WR
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