RISK...just another four letter word?
David Clementi, deputy-governor at the Bank of England, has issued a warning about the danger that credit derivatives and their use in securitization pose to the stability of the capital markets.
In the closing address to the International Bond Congress in London, Clementi surprised an audience of top borrowers, investors and bankers with his concerns at the rapid growth of credit derivatives and ABS - which many investment banks hope will bring back revenue lost from the shrinking profits in bond trading and underwriting.
Clementi said there was a danger of a lack of transparency in the market, particularly because of the increase in the use of synthetic CLOs, where the risk attached to loans and bonds is sold on to counterparties, without a sale of the assets. He said: "These markets mean that a bank need no longer remain exposed to its main customers but can rapidly take on large exposures to other credits without any new borrowing by the underlying entities. This could make it more difficult for creditors, shareholders and regulators to assess risk."
Clementi said it was a "major challenge" for authorities such as the Bank of England or the Federal Reserve to keep pace with the rapidly changing world of securitization and derivatives in collecting financial statistics.
Clementi is also concerned that many investors do not understand securitization. He said: "Some participants in this market may not fully understand, or may have differing understandings of , the transactions into which they have entered." Clementi said uncertainties remained about how courts in different countries would treat covenants and agreements in credit derivative deals.
The case of LTV Steel illustrates Clementi's concern. LTV Steel is engaged in a legal battle with Abbey National in Cleveland in the US over whether the assets securitized in a deal are the property of Abbey National or LTV Steel. The judge at the bankruptcy court in Cleveland, to the consternation of many participants in the securitization market, appears to favour LTV Steel's case, though Abbey National has told euromoney.com it is likely to appeal if it loses the case.
Investors, because of this risk, have to make sure they have conducted proper due diligence, said Clementi, adding: "I do think that there is too great a tendency to rely unthinkingly on the ratings agencies in this area."
Clementi also said that the merging of the lending, securities and insurance markets raised new risks. He said this risk was particularly evident now due to the international debate over whether restructuring of debt constitutes a credit event, thereby triggering a credit default swap. This row was sparked when Conseco restructured its debt late last year. The International Swaps and Derivatives Association is meeting now to discuss the issue.
The British Banking Association has predicted that the credit derivatives business will triple from $586 billion in 1999 to $1.581 billion in 2002.
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