INEFFICIENT MARKET
by Edward Chancellor
This has been a year of record corporate defaults. Yet
thanks to the advent of credit derivatives, U.S. banks
have managed largely to avoid the debacle. Some people
argue that credit derivatives have produced a better
distribution of risk throughout the financial system,
thus increasing the growth potential of the global
economy. Alan Greenspan has even claimed that credit
derivatives are improving the measurement of risks.
On closer examination, however, we find that these
derivatives contributed greatly to the reckless expansion
of credit in the late 1990s. Far from improving risk
measurement, they have encouraged the adoption of
technical credit analysis methods, which are contributing
to unprecedented financial volatility.
According to the British Bankers' Association, the
notional market value of credit derivatives has grown
from $180 billion to over $2,000 billion over the last
five years. Banks (mostly of U.S. origin), securities,
houses and hedge funds have been large buyers of credit
default swaps. Insurance companies and re-insurers
(mostly European) have been net sellers. The banks have
done very well from this. According to Avinash Persaud,
head of research at State Street Bank, despite this
year's corporate defaults of a face value close to $200
billion, the loan losses of U.S. commercial banks are
running at around 10% of equity (compared with nearly 35%
in the early 1990s).
What is good for the banks is also good for the economy,
argues Charles Gave of Gavekal, a research boutique. In
the past, at the end of every economic cycle, the banks
would find themselves with bad loans, which caused their
balance sheets to shrink. The multiplier effect would
lead to the rapid contraction of credit. Under such
circumstances, even sound companies were denied access to
finance. Businesses were, therefore, forced to cut
spending and lay off workers. Gave suggests that all this
belongs to the past. With credit derivatives and the
securitization of debt, banks no longer exacerbate the
economic cycle. However, he admits that his rosy scenario
only holds as long as the 'shock absorbers' in the
financial system continue to operate.
There are several reasons why insurance companies are
unlikely to continue playing the shock-absorbing role.
First, they have been paid too little for the risk they
ended up carrying. As the head of a large European re-
insurer said recently, the industry has provided "naïve
capital" for the banks. Banks were never perfect at
assessing credit risk, but at least their loan officers
realized their jobs were at risk if the loans didn't pay
off.
Once credit insurance appeared, the banks lost interest
in estimating the quality of a loan over its whole life.
All they had to do was originate, sell it on and collect
on the insurance if it blew up. Without an incentive to
prudence, it was inevitable that loan quality would
deteriorate. Banks began playing a greater-fool game of
credit creation.
Another reason why insurers will be reluctant to provide
credit insurance is that they no longer have the
resources to do so. Insurers got into this business when
their balance sheets were bolstered by the soaring equity
market. At the time, many insurers increased the
percentage of equities in their portfolios from the
traditional 10% to around 50%. Thus, their increasingly
important role in the credit process was linked to the
level of the stock market.
As students of Japanese banking will know, this process
makes for both wonderful booms and terrible busts. During
the bear market, the insurers have seen their capital
adequacy ratios decline and have become forced sellers of
equities. Many are now getting out of the credit
insurance business. For instance, Scor, the troubled
French insurer, is set to wind down its $2.7 billion of
credit derivatives exposure over the next couple of
years. Many others will follow.
In the past, banks have been responsible for their share
of folly. As suppliers of credit, however, they had
certain advantages. They knew their customers well and
loans came with a long-term banking relationship.
Furthermore, a multiplicity of banks produced a variety
of opinions.
It is this variety of opinion, according to Persaud,
which is essential for the efficient operation of
markets. With credit derivatives, the assessment of
default risk has been taken away from the banks and
placed into the hands of the insurance companies. Having
no relationship with the debtors, the insurers have
adopted uniform methods of credit risk analysis. Risk is
now measured using technical methods, derived from the
bond and equity markets. This creates the potential for a
feedback loop.
During the bull market, a company's rising market
capitalization was sufficient justification for lenders
to supply it with credit. On these grounds, telecom
companies attracted over $1 trillion of loans between
1998 and the end of last year. The same process works in
reverse: falling equity prices lead to the presumption of
declining creditworthiness and an increase in funding
costs.
Thus a company that is out of favor in the stock market
may find that the insurance company is hedging its own
credit default risk by shorting the firm's bonds or even
its shares. Such activities could send a company into a
death spiral.
The potential for credit derivatives to reduce economic
cyclicality is wonderful. Perhaps their recent troubles
are mere teething problems. However, if they are to play
an important part in the future, credit derivatives need
to be properly priced. The suppliers of credit default
insurance will also need to apply a variety of measures
of credit risk and adopt a more long-term view than they
do at the moment.
They will need to be better capitalized. And above all,
they will need to improve their position relative to the
bankers who originate the loans. Unless the balance of
power changes, you can bet your last dollar who will end
up with the wooden nickel.
Regards,
Edward Chancellor,
for The Daily Reckoning |
