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Credit derivatives used as scapegoat for crunch -ING
October 16, 2008 / 5:28 PM / 9 years ago

Credit derivatives used as scapegoat for crunch -ING

LONDON, Oct 16 (Reuters) - Credit strategists at ING said on Thursday that credit derivatives were being unfairly blamed by politicians and commentators for the near meltdown of financial markets following the collapse of Lehman Brothers LEHMQ.PK.

“The CDS (credit default swaps) market is being used as a scapegoat for political and economic goals,” ING credit strategist Jeroen van den Broek wrote in a note to investors.

U.S. Securities and Exchange Chairman Christopher Cox joined other regulators and policymakers last week in saying that the lack of regulation of the $55 trillion CDS market was a growing concern.

”Sure the CDS market is challenged,“ van den Broek said citing recent defaults and credit events, lack of interest in structured credit products and heightened fears of counterparty risk. ”But it is an essential part of the hedging possibilities for all market players.

“And although the structures that carry the toxic waste have often been enhanced by CDS, it is thoroughly unjust to blame the product,” he said.

Writedowns on structured credit products such as collateralised debt obligations (CDOs) based on subprime mortgages were a major trigger of the credit crisis.

By comparison, writedowns due to structured products based on portfolios on derivatives, such as synthetic CDOs, have been lower and are due mostly to declines in market value. [ID:nLO289945]

On Wednesday Belgian financial group KBC (KBC.BR) disclosed a writedown of 1.6 billion euros on investments in synthetic CDOs, caused partly by ratings downgrades. [ID:nLF191934].


In late July, derivatives dealers and industry associations agreed in a letter to the New York Federal Reserve Bank that they would make CDS market operations more efficient and would create a central clearing house by the end of the year.

The chairman of the U.S. Commodity Futures Commission said this month, however, that centralised clearing was not enough and that “broader reform of the OTC (over-the-counter) derivatives markets is also needed and will require decisive congressional action”.

ING strategists said the actual weaknesses of the market did not drive calls for greater supervision.

“It’s not the fact that (the market is) OTC, non-transparent and used by speculative accounts that worry the authorities, but it’s the fact that they misjudged the global effects of the Lehman default due to CDS,” ING analysts said.

In March, market commentators had said that the bailout of Bear Stearns was necessary because of the counterparty risk it posed as a dealer in the CDS market. Regulators said, however, that the bailout was driven by concerns about the repo market.

The collapse of Lehman meant that for the first time, a dealer and central counterparty vanished from the CDS market.

“Authorities misjudged the effects of Lehman and underestimated the power and volume of CDS,” the ING note said. “It’s not the product that’s to blame; it’s the false estimation by the authorities.”

Since the Lehman event, the CDS market has held up well by comparison with both the cash bond and equity markets, said Maureen Schuller, another credit strategist at ING.

Spreads are now tighter in the CDS market and liquidity is greater, particularly in the benchmark indexes, than in the cash bond market, she said.

Investors have been selling bonds, particularly those close to maturity, in order to raise cash, which has driven up short-term spreads, she said.

Europe’s leading CDS index, the Markit iTraxx Europe index ITEEU5Y=GF of 125 investment-grade credits, continues to trade tighter than its all-time wide levels in March.

Bonds, by comparison, are already trading wider than the levels they reached in the last downturn in 2002 to 2003, Schuller said.

“Cash bonds are front-running a recession, while the CDS market has some catching up to do.”

(For a factbox on basic facts about the CDS market, click on [ID:nLE193130]).

Reporting by Jane Baird; Editing by Sharon Lindores

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