Current macro-economic conditions make it more likely that we are heading into a less benign credit environment over the next 12 to 36 months than we have enjoyed over the past several years.
New and sometimes complex credit-risk transference instruments, notably credit derivatives, taken together with market liquidity challenges and the increased activities of untested hedge funds in the credit markets, will present serious challenges to banks and the banking industry when the credit cycle takes a negative turn.
It is essential for bankers to understand the complex risks being presented by these new realities. In the first of a two-part article, we begin with an exploration of some of the risks presented by credit derivatives and illiquid markets.
CREDIT DERIVATIVES
Credit derivatives have been a major source of financial innovation in recent years, and they come in many forms. Single-name credit default swaps, the most liquid credit derivatives, reference the performance of a specific corporate bond.
Exposure to a single credit can also take the form of a total return swap. Credit exposure to a portfolio of corporate names can be bundled into a credit-linked note, which has a credit derivative embedded in the note. Collateralized debt obligations can write credit protection on a basket of single names and raise funds to collateralize their obligations by selling CDO debt to investors.
Credit derivatives are growing rapidly and, in some ways, becoming more liquid. Recently, derivatives that reference credit indexes have begun to trade (e.g., the ABX index on securities backed by home equity loans).
These innovative new instruments have been a positive development in a number of ways. They have improved market efficiency by allowing the credit risks of loans and bonds to be at least partially borne by holders other than the owner, originator, or servicer of the loan or bond. Credit derivatives also allow users to take long or short positions in individual credits or credit indexes. Also, like traditional CDOs, these risks can be split, or “tranched,” among different holders with different risk appetites and return preferences.
Although the experience of banks and other financial firms with credit derivatives to date has been mostly positive, this experience has been against the backdrop of a favorable credit market. Changing macro-economic conditions have the potential to increase markedly the risks associated with credit derivatives.
Low interest rates, flat yield curves, and a global liquidity surplus have caused investors to reach for yield, either lowering credit standards or simply accepting triple-B risk for triple-A returns. Tight spreads have also encouraged more investors to explore credit derivatives, because they appear to offer additional yield relative to other trading strategies.
However, too many of these investors are not in a position to understand the character of the underlying credit risk they are taking when buying these instruments, and too many simply are not being rewarded appropriately for the risks they are taking. For example, investors in credit derivatives may be taking on the risks of an instrument without any expertise or experience in trading or investing in the underlying instruments.
As another example, if the underlying debt goes into default — as can occur when the economy turns downward — investors in credit derivatives own the credit risk but typically do not have any control over the workout of a bad credit.
Furthermore, many investors have responded to the tight credit spreads by further leveraging their risk positions in an attempt to improve nominal returns. As spreads tighten, more leverage is necessary to earn the same nominal return. And credit derivatives allow that type of leverage. For instance, a thinly capitalized investor can receive the credit spread on a $100 million portfolio of highly rated bonds with a down payment as little as $1 million.
MARKET ILLIQUIDITY
It is easy to get fooled into thinking a market is liquid simply because newly produced structured products sell so rapidly. The liquidity factor for new products is frequently a mirage, as it is fundamentally easier for dealers to create and sell structured credit products than it is to buy them back in pieces and redistribute the risks.
Even in a bull market, the use of complex credit instruments can turn liquid credits into relatively illiquid credit risk. For instance, CDO liabilities, backed by a basket of corporate bonds or mortgage-backed securities, are structured to meet the demands of specific investors. These securities are often less liquid than the underlying bonds. In addition, some credit default swaps require the delivery of an underlying bond if there is a default.
Moreover, derivatives as a class are commonly less liquid than the underlying cash securities in a market disruption. This is even more the case when the derivatives are highly “structured.” This illiquidity makes pricing and risk management more model-driven and more difficult.
No one can be sure what will happen if there are more sellers of credit protection than there are willing sellers of the reference bond. Inexperienced owners of credit risk might decide that the best move is to sell the position at any price, exacerbating price movements when there are relatively few buyers.
The behavior of new instruments and new players will undoubtedly lead to unexpected outcomes when the credit cycle becomes treacherous.
