SURVEY - DERIVATIVES: A form of protection for the rising risk of defaults: CREDIT DERIVATIVES by Rebecca Bream: Demand for hedging credit risk has boomed as the economy falters
Financial Times, Sep 25, 2001
By REBECCA BREAM
In the past 12 months credit risk has moved from being a secondary consideration for most companies and fund managers to an issue at the top of their agenda.
The fall from grace of many companies in the telecoms and technology sectors has emphasised the increasing risks investors are faced with, as well as the ways in which many companies are exposed through vendor financing contracts and trade credit.
Interest-rate, currency and commodity price risk have long been incorporated into business and investment strategy and often hedged through the derivatives markets. But when it comes to the risk that counterparties could go bankrupt, default on payments or pay late, most just hoped that they would be lucky.
Since the mid-1990s larger investment and commercial banks had been developing credit derivative products to allow themselves to hedge their own credit risk, generated through their corporate lending books and proprietary bond trading desks.
Banks were keen to reduce exposures to certain companies or industries without having to sell on loans and potentially damage valuable relationships with borrowers and by the start of 2000 a liquid over-the-counter market between banks in credit default swaps had developed.
The most common product in the credit derivatives universe, default swaps are essentially a type of insurance contract used to protect the value of corporate bonds, loans or other credit contracts.
The buyer of protection pays a premium to another party in return for a guarantee that if a negative credit event occurs it will recover the full value of the underlying debt instruments.
Investment banks have now become adept at hedging their own risks and have moved into the business of structuring new types of bespoke credit risk products for investors. The lucrative credit derivative and structured product businesses are among the few areas where investment banks are still actively expanding. As there is a shortage of people with the right skills, the market value of credit derivative bankers has risen sharply.
New products are emerging all the time. "The credit derivative market has inherited a lot of the creativity that was in the Eurobond market in the early 1980s," says Richard Williams, head of credit derivatives at Abbey National. "If there is demand, the market will find a product to satisfy it."
The expansion in the credit derivatives market comes from the surge of new users. "A lot of the market's growth is coming from smaller banks starting to hedge their risks, as well as insurers and reinsurers using credit derivatives to achieve more diverse portfolios," says Sanjeev Gupta, head of developed markets credit derivatives at CSFB.
UK retail bank Abbey National, for example, started dealing with the credit derivatives market at the start of last year when it set up a separate business group for financial products. The bank uses the market internationally to hedge its balance sheet and make some investments, but it keeps a risk-neutral position.
"We do not take on extra risks through the market," says Mr Williams at Abbey National. "It makes sense for us to think of credit derivatives as a risk management or transfer tool."
Fund managers are also buying credit exposure through derivatives, hoping to increase their returns or adjust their geographic or sectoral risks without having to buy or sell underlying securities. The fact that you can speculate on credits where the actual securities might be hard to get hold of is very attractive, as is derivatives' ability to isolate credit risk from currency and interest rate factors.
Predictions on the market's growth show rapid expansion. Research by PricewaterhouseCoopers estimates that the global credit derivatives market will grow to a total size of almost Dollars 1.6 trn by the end of 2002, from a size of about Dollars 900bn at the end of last year.
"Credit risk is ubiquitous," says Tim Frost, head of European credit derivatives at JP Morgan. "And the credit derivative market has not yet come anywhere near fulfilling the need for ways to hedge credit risk."
The European market is thought to be more sophisticated than its US counterpart, mainly because its risk management and investment needs are more complicated and require more developed derivatives products. The US has a mature and liquid credit default swap market but there is said to be less demand for portfolio trades or synthetic transactions. One area of development is the growing use of credit derivatives by companies, many of which have great trade and vendor financing exposures currently left unhedged. A period of economic weakness and rising bankruptcies is expected to focus companies on this issue. "The downturn could actually prompt a boom in credit derivatives," says Arne Groes at ABN Amro.
"Companies will get involved in credit derivatives but it is a slow process," says Mr Williams at Abbey National. "Companies that have seen their problems magnified as a result of having a large portfolio of credit risk will probably create liquidity for themselves by looking at them."
Lack of understanding of the market and its untransparent nature, as well as companies' reluctance to incur extra costs that might reduce margins in the short-term, have been offered as reasons for the low level of corporate use in credit derivatives.
Copyright: The Financial Times Limited
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