Scary ... rock the boat, rock the boat :0)
China thirst for US bonds seen driving derivatives growth
In this intertwined financial world of ours, coincidences are becoming fewer and fewer. Such may be the case with China's economic boom and the surging popularity of credit derivatives.
William Pesek
Monday, October 10, 2005
In this intertwined financial world of ours, coincidences are becoming fewer and fewer. Such may be the case with China's economic boom and the surging popularity of credit derivatives.
The market for credit derivatives, mainly contracts designed to transfer risk associated with bonds and loans, grew 48 percent to more than US$12 trillion (HK$93.6 trillion) in the first half, an almost fivefold increase in the past two years, according to the International Swaps and Derivatives Association.
It's growing so fast that the financial infrastructure is having trouble keeping up; some contracts to insure bond payments are going unsigned for months.
The trend reflects a move by banks to go beyond selling off their loans in the form of asset-backed or other securities to hedging their credit exposure on a huge scale.
And why not, given that an explosion in the number of hedge funds globally is creating demand for greater risk?
The upshot, says Charles Dumas, London-based managing director of Lombard Street Research, may be that "a big chunk of the world's debt is suddenly being laid off as credit derivatives."
In a world of surging oil prices and myriad other uncertainties, he is intrigued by the "Kate Moss-style slimness" in the difference between US treasuries and riskier debt. While credit spreads widened a bit after the May downgrades of General Motors and Ford Motor debt, they "look unduly narrow" once again, Dumas says.
At the same time, a study done for the Federal Reserve found foreign demand for US government debt is keeping yields on 10-year treasuries about 1.5 percentage points lower than they otherwise would be, a thinner gap than estimated by Wall Street strategists.
What's China got to do with all this?
Brad Setser, a US Treasury economist now with Roubini Global Economics in New York, was one of the first to suggest a relationship between the surge in credit derivatives, the explosion in the number of hedge funds and the buildup in China's currency reserves. His theory is this: demand for treasuries from China's central bank - and others in Asia - is a key reason US yields are so low.
Low Treasury rates, in turn, have inspired a search for yield that's propelling the growth in the market for collateralized-debt obligations and, eventually, the market for "synthetic" collateralized debt obligations.
Such debt obligations bundle together bonds, loans or credit default swaps into pools of assets. A synthetic version pumps up the risk and return potential by using other derivatives as its underlying assets. All this may amount to untold leverage and risk in a global financial system struggling to keep up.
The growth in the market isn't necessarily a bad thing. It may just reflect how derivatives have come into their own as risk management tools.
Ditto for the growth of the hedge- fund industry - it may be a sign of maturity for the global investment business.
The question is whether China's accumulation of currency reserves is raising the stakes. The People's Bank of China holds roughly US$753 billion of reserves, and keeps adding more.
That growth comes against the backdrop of a readiness by China - and other Asian central banks - to keep its currency from rising and the US dollar from falling. It put a floor under the dollar and a ceiling above US debt yields.
The risk is that it has created complacency in global markets - a sense among investors that rates won't move against them.
This is something Setser and Nouriel Roubini of Roubini Global Economics have been warning about for months.
They wonder if the risks are larger than investors appreciate, especially with the Bush administration thinking it has an infinite credit line to increase borrowing. US rates at current levels may not amply compensate investors for the risk of a plunging dollar.
It hardly helps that the world is in a rising interest-rate environment.
"Normalization of policy rates in expanding industrial economies will put upward pressure on all kind of rates and risk premia that have been held down by low policy rates," International Monetary Fund chief economist Raghuram Rajan said in April. "This could cool some red-hot markets, including the one for housing and high-yield debt."
Steps are afoot to improve the derivatives market's infrastructure.
On September 15, the Federal Reserve Bank of New York summoned 14 of the world's biggest banks to a meeting to reduce a backlog of unconfirmed trades. Regulators worry that it threatens the banking system's stability.
Yet the bottom line, Setser and Roubini say, may be a financial system that is out of whack - one that has developed an unhealthy reliance on the willingness of central banks in Asia to buy US debt indefinitely. This arrangement is arguably unprecedented.
"No one has any experience with the adjustment process that will ensue when the world's biggest economy is also the world's biggest debtor, while it alone is absorbing most of the world's spare savings," Setser said. BLOOMBERG |
