LONDON (Reuters) - The $45 trillion credit derivatives market, created as a way for banks to hedge their lending, is now also contributing to the risks that banks will fail.
The rise of the market over the past 15 years, however, also makes it crucial that a big bank not be allowed to go down.
“Because of derivatives, it gets more probable that a big bank is going to get into trouble, but then there would be intervention to make sure it doesn’t fail,” said Willem Sels, head of credit strategy for Dresdner Kleinwort.
About two dozen big banks are major broker-dealers in the CDS market, which means they take one side of nearly every contract. The failure of a dealer such as Bear Stearns would threaten the entire CDS market and other derivatives markets.
Credit default swaps (CDS) are bets on whether a company will default on its debts.
A bank that has made a loan to a company can buy protection to ensure it is paid even if the company defaults. The seller of protection receives an annual fee for promising to cover losses in the event of a default.
With the introduction of major indexes in 2004, the bulk of CDS trading shifted from hedging to making speculative bets on the direction of credit spreads and the economy.
Volumes of outstanding CDS on many of the roughly 3,400 corporate names, particularly those in the indexes, are now greater than companies’ underlying debts. That means in a default, overall losses are larger and spread to more players.
Yet while the corporate default rate remains low, the CDS market is already magnifying risks in the credit crisis as indexes hit record wide levels.
The CDS market is more liquid than the underlying corporate bond market and has led the slump in the credit markets.
The derivatives market can amplify fears or rumors as people rush to buy protection on a name such as Bear Stearns BSC.N and drive its spreads wider in a vicious spiral, increasing the risks a bank could suffer a liquidity crunch.
Such a scenario is more threatening to a bank, which survives on constant borrowing and lending, than to an industrial company, which can put off going to the debt market.
If a fund or investor goes under, banks must deal with another type of risk inherent in derivatives contracts.
A CDS contract is only as good as the financial strength of the counterparty on the other side of the bet.
“It has always been recognized that in any derivatives contract you take on counterparty risk, the mitigation of which is the main reason ISDA exists,” said Robert Pickel, chief executive officer of the International Swaps and Derivatives Association.
ISDA has put in a process to prevent a domino effect from taking down the entire market. But each bank must protect itself from counterparties, and banks can have cracks in their risk management systems.
Some triple-A rated counterparties such as bond insurers have not been required to put up collateral. And even when banks require counterparties to put up cash to cover falling asset values, they still can get caught short by an abrupt failure.
As for market risk, it is the dealer’s job is to balance CDS contracts on both sides so that its net risk is minimal.
But that job has become more difficult as CDS spreads have become more volatile, leading to dislocations in the market such as when few investors are willing to sell protection.
Such imbalances can make it more difficult for the dealer to carry out basic tasks of hedging and balancing the trading book.
Other risks come from the banks’ packaging of CDS into complex credit products, which started in a big way in 2005.
Banks took positions on hundreds of billions of dollars of CDS contracts solely to create other products to sell. But these products are now discredited.
“The air of suspicion is so deep-rooted given the opacity regarding the size and leverage, type and quality of the structured products that were developed since 2004, that it is causing funds to fail and financial institutions to be bailed out,” analysts at Societe Generale wrote in a note to clients.
Banks developed complex mathematical models to manage and hedge against the risks created by some parts of these packaged products that they could not sell.
But price dislocations in the tranche market became so extreme last month that bank models no longer made sense, indicating that all companies would default at once.
Banks have had to rejig these models and then rehedge based on their new models, exposing themselves to possible losses.
Regardless of the risks added by the derivatives market, CDS continue to play a key part in the defences that banks and investors are constructing.
“That’s the only way that there is to hedge,” said one trader in London after CDS indexes rose to record wide levels in the wake of the Bear Stearns rescue.
Editing by David Cowell