Too Much Derivatives Risk In Too Few Hands

Saturday, November 19, 2005

Bloomberg on Friday ran this excellent story where ratings agency Fitch said that the 10 major players in the credit derivatives market hold more than two thirds of the risk in the $12.4 trillion market, which is about the same size as the US equity market. The story, fittingly written by reporter H. (for Hamish, not for High) Risk is an eye opener about the risks major banks are carrying on- and off-balance sheet. All together the size of the derivatives market is estimated around $270 trillion or alomost 20 times the size of the US stock market.
From Bloomberg:
The $12.4 trillion market for credit derivatives is dominated by too few banks, making it vulnerable to a crisis if one of them fails to pay on contracts that insure creditors from companies defaulting, Fitch Ratings said.
JPMorgan Chase & Co., Deutsche Bank AG, Goldman Sachs Group Inc. and Morgan Stanley are the most frequent traders in a market where the top 10 firms account for more than two-thirds of the debt-insurance contracts bought and sold, Fitch said in its Global Derivatives Survey for 2004 published today.
Investors use so-called credit-default swaps to insure debt payments or bet on credit quality. Demand surged this week for swaps protecting payments by General Motors Corp. on concern the world's largest automaker may use up most of its $19.2 billion in cash reserves in the event of a strike at Delphi Corp., its largest auto-parts supplier. Delphi defaulted on about $2 billion of bonds when it filed for bankruptcy on Oct. 8.
"Risk concentration remains high,'' said Ian Linnell at Fitch in London. "In the event that there was a major default, for instance General Motors, and then one of the major dealers also defaulted, the market would be in major trouble.''
Credit-default swaps are the fastest growing part of the $270 trillion derivatives market, based on the so-called notional value of the debts that underlie the contracts, according to the Bank for International Settlements. The default swaps market worldwide jumped 60 percent to $10.2 trillion in the first half of 2005, the BIS said in a report yesterday.
Fed Summoned Major Players in September
The growth is so rapid that the New York Federal Reserve in September summoned 14 of the biggest banks in the market, for failing to keep pace in processing the transactions, causing a backlog that threatened the stability of the banking system.
"The probability of a major dealer defaulting is extremely low, but as the market continues to grow, the issue is being ramped up all the time,'' Linnell said.
In a credit-default swap, the buyer pays an annual premium to guard against a borrower's failing to pay its debts. In the event of default, the buyer gets paid the full amount insured, and hands over defaulted loans or bonds to the swap seller. Swap prices typically decline when creditworthiness improves, and rise when it worsens.
A derivative is a financial obligation whose value is derived from such underlying assets as debt and equity, commodities and currencies.
GM was among the five companies most frequently included in credit-derivatives contracts in 2004, along with Ford Motor Co., France Telecom SA, DaimlerChrysler AG and Deutsche Telekom AG, Fitch said. Investors bought more contracts protecting payments from Korea, Italy and Russia than any other governments.
GM Credit-Default Swaps
Traders of GM credit-default swaps last week demanded upfront payments in addition to annual premiums to protect debt payments by the Detroit-based company. By doing so, the market relegated GM to the same status that Delphi and Delta Air Lines Inc. had just before those companies defaulted.
The annual cost of insuring $10 million of GM debt for five years using default swaps rose to a record of $2.35 million upfront plus $500,000 a year, compared with an annual premium of about $1 million early last week, according to Deutsche Bank prices. The debt-insurance contracts changed hands at about $260,000 at the start of this year, according to Bloomberg data.
The survey of 120 banks and financial institutions showed that banks are typically net buyers of debt insurance because they can use default swaps to reduce the risk of corporate loans.
Banks used credit derivatives to transfer a record $427 billion of credit risk from their balance sheets to other counterparties in 2004, up from $260 billion a year earlier, Fitch said.
We Are Talking Hundreds Of Trillions
The Financial Times had this report on the $270 trillion derivatives market, which is almost 34 times the size of the US public debt.
The use of privately-traded derivatives reached a record in the first half of this year with the notional amount of outstanding trades worth $270 trillion, the Bank for International Settlements said on Thursday.
Dealing in credit derivatives jumped particularly sharply but there was also strong growth in equity and commodity instruments.
The notional amount represents the value of the underlying assets on which the derivatives are based. Based on market value, which reflects the actual cost of replacing the contracts, the market grew by 16 per cent to $1.1 trillion.
While many derivatives such as futures are traded on exchanges where activity levels are closely monitored, the more nebulous over-the-counter or OTC world of instruments that are traded directly between counterparties has proved trickier to measure.
The semi-annual report from the BIS reported a striking 60 per cent jump in the amount of credit default swaps (CDS) outstanding to $1.2 trillion. The instruments are a form of insurance against a company's default.
The market for them barely existed five years ago but has exploded in the last couple of years as banks and investors such as hedge funds have used the instruments to lay off their risk to particular credit events.
In many cases, the CDS for a particular company is far more actively traded than that company's various bonds. Much of the growth has come from investors using the instruments to give them exposure to the market performance of a company's debt without the hassle of analysing and then tracking down the different bonds.
On Thursday the BIS also reported strong growth of 17 per cent each in the notional value of outstanding equity and commodity contracts to $5.1 trillion and $1.7 trillion respectively.
Overall, however, the pace of growth in OTC derivatives slowed to 7 per cent in the first half of this year from a rate of 14 per cent in the second half of 2004.
Interest rate derivatives remained by far the dominant category of the market, accounting for more than three quarters of the total by notional amount and almost two thirds when based on gross market value. Notional growth however slowed to 7 per cent from 16 per cent in 2004 as the use of exchange-traded interest rate derivatives picked up sharply. Exchange-traded contracts tend to be more short-term in their tenor than OTC instruments more sensitive to fluctuations in expectations for short-term interest rates.
I have nothing to add to these high-quality pieces of information about a market out of sight of non-institutional investors. I refer readers longing for more information to the posts "Snow: Sort Out The Hedge Fund Mess Yourself," Alan Greenspan's cautioning remarks here and Fed governor Donald Kohn's stern warnings in the classic speech "When The Unexpected Inevitably Happens." Michael Panzner, author of the bestseller "Stock Market Jungle" laid out his fears about a collapse in the derivatives market in the highly recommended editorial "The Coming Disaster In The Derivatives Market."

1 comment

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23 May, 2010 03:48

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