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.
Then there are the hedge funds, which are among the most active traders of these derivatives. "What happens if a hedge fund has $5 billion in a given name, and it blows?" asks Wilbur Ross, who made a killing buying up old steel assets and who runs two hedge funds and six private equity firms. "The problem with this market is that nobody knows."
Ross sees one possible scenario: Some investors who thought that they had bought protection from a hedge fund might be "left naked" if the hedge fund can't pay off the claim. This could cause the investor who bought the insurance to default, creating a dangerous ripple effect through the whole economy.
Unlike banks and insurance companies, hedge funds are only loosely regulated. Since many of them are newly minted, there is no assumption that they have the same expertise at gauging risk as a bank might. And the search for yield may be making them take on more risk than is prudent.
The role of hedge funds has been steadily increasing over the past few years, providing an ever larger portion of the liquidity necessary to oil the market. Fitch Ratings surveyed market participants last year and found that insurance companies have been leaving the market, while hedge funds have grown to account for about 30 percent of current trading volume.
But the rush to the exits following GM's and Ford's descent into junk-bond status was a clear sign to some that leveraged hedge funds' appetite for credit derivatives could also be dangerous. The downgrade came on the heels of Kirk Kerkorian's announcing that he would add to his position in GM stock. Because many assumed that the debt was safer than the stock, the combined events upset the model being used by some investors, particularly hedge funds, to set up and price their risk in correlation trades--deals whose profit depends on the idea that something happening in one place will have a predictable effect elsewhere.
Hedge funds, which often take positions that are highly leveraged, began facing margin calls and had to unwind some trades, exacerbating price swings and forcing more traders to exit. Liquidity dried up. And there was, according to the Bank for International Settlements, "a circle of deterioration."
No bailouts. The fallout in the credit derivatives market from the GM debt debacle, of course, was far less severe than many had predicted. Despite all the doomsday scenarios, no hedge funds imploded. Nor did the markets see a rampant sell-off, although the bond market did suffer some temporary jitters. Americans did not wake up to find a repeat of 1998, when the spectacular flameout of a fund named Long-Term Capital Management roiled markets around the globe, requiring an emergency $3.6 billion bailout orchestrated by the Federal Reserve Bank of New York.
Matteo Mazzocchi, head of global derivatives at the Europe-based in-vestment bank Dresdner Kleinwort Wasserstein, says that most of those currently involved in the credit derivatives market are "buy and hold" investors who plan to keep their positions until they mature. They were not damaged, he says. The only ones hurt were the hedge funds that piled into an illiquid trade on leverage and then stormed the same exit.
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
This story appears in the July 25, 2005 print edition of U.S. News & World Report.