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To: Bobby Yellin who wrote (22496)	11/2/1998 12:02:00 PM
From: Alex	Respond to of 116753

Hidden Risks in Credit Derivatives No real experience of a bad credit cycle yet Concern is mounting over the explosive growth of credit derivatives, with industry experts warning that the market has grown so fast that some banks may be exposed to significant positions in a product whose risks they still do not fully understand. Credit derivatives allow investors worried that a borrower may default or a bond may not be repaid to offload the risk to a third party. Volume has taken off this year as financial institutions have sought to protect themselves against corporate and sovereign defaults during, and in the wake of, crises in Asia and Russia. The British Bankers' Association says the global market for credit derivatives is set to grow to $740bn in 2000 from $180bn last year. Bankers have also hailed them as a revolution in credit risk management because they allow banks and corporates to transfer credit risk without jeopardising client relationships. They also allow investors to gain exposure to investments - such as Russian treasury bills (GKOs) - that may be off-limits for legal and regulatory reasons. However, experts say there are dangerous hidden risks and that the market has overshot the regulatory environment. "People are getting taken in by the hype and are not asking what could go wrong. Senior management have to ensure that what could go wrong is properly addressed and is properly monitored," said Phil Rivett, capital markets partner at PricewaterhouseCoopers. Two products dominate the market: credit default swaps (which offer insurance against defaults) and total return swaps (which allow an institution to acquire the cashflows of a bond or other investment without holding the instrument physically). Banks are by far the biggest buyers of such products, but insurance companies and corporations are featuring increasingly in such transactions. For example, a bank that has lent money to an Asian vehicle manufacturer but is worried that it may default can buy a credit default swap from a bank. In the event of default, the bank will pay a predetermined sum to the investor, who pays the bank a premium calculated on the perceived likelihood of default by the car manufacturer. In order to assess that probability, the bank will use an asset related to the car manufacturer - typically a bond issued by it - as a benchmark. This is known as a reference credit. However, analysts say there is insufficient liquidity in the credit default swap market to be able to extract enough information about default probability for pricing purposes. "People don't realise that there isn't a market value for these things. There's no model for pricing them because the information about default probability isn't there," said Jessica James, of the strategic risk management group at First National Bank of Chicago. There are also concerns about how reference credits are priced when a default or other credit event has occurred. This is often done by taking a poll of two or three dealers on a trading desk. "Credit derivatives are an essential part of everyone's risk management tool kit. But who knows the price of a defaulted asset? Many dealers will tell you they have no idea. So it becomes very difficult to collect prices," said Tim Frost, head of derivatives trading at J.P. Morgan. Another issue is the risk associated with counterparties, or the entities that are selling credit protection. Buyers of protection cannot always be sure they are also risk-free. There are particular concerns over the exposure of some counterparties to hedge funds, which borrow heavily to fund often risky positions. "The whole use of derivatives as hedging instruments has come into doubt because many of the counterparties have become dubious. There is a risk of a chain reaction right through the system. Where does the buck stop?" said one senior US investment banker. Finally, analysts are increasingly worried about documentation risk. They say that the terms used in credit derivatives contracts are wide open to conflicting interpretation, particularly when it comes to determining if a "credit event" has occurred. (A credit event has to occur in order to trigger default payment.) For example, credit default contracts on Russian risk were written in a variety of different ways by the parties involved. When Russia defaulted, many institutions found protection difficult to enforce because counterparties refused to accept a credit event had taken place. The International Swaps and Derivatives Association has issued standardised documentation for credit derivatives but analysts say terms can fail to take adequate account of foreign jurisdictions where certain concepts, such as bankruptcy, may not be recognised. Robert Pickel, ISDA general counsel, said it was working on fresh guidelines that should be ready early next year. The Financial Times, Nov. 2, 1998