One for the underdog
Credit derivatives are weapons of financial mass destruction. Credit derivatives are toxic waste. Credit derivatives have led us into a death spiral.
Not really. Greed leads to destruction of value. Greed makes people sell and buy risky products in the hope of earning high fees and returns. And greed leads markets into a downward spiral.
It’s easy to blame a product, but the blame lies with every participant in the financial chain. Home owners borrowed more than they should have relative to their income and the value of their homes. Investors were comfortable buying risk they didn’t completely understand. Rating agencies continued to use the same assumptions when rating structured products even though it was evident that credit markets were in a bubble. Regulators allowed banks to leverage more than they should have. Bankers continued to structure and sell complex and sometimes risky products because their compensation structures incentivized them to do so. And everyone danced merrily while the music was playing.
Credit derivatives were only one of the means by which we got to where we are. But they’re not the culprit. Credit derivatives encompass a range of products – from a single credit default swap, which is akin to insurance against a default, to the riskiest slice of a portfolio of credits. These “toxic” risky slices have received much attention given their recent poor performance. But in the past they generated high returns, which is why they were popular with not just hedge funds but also pension funds and insurance companies.
More importantly, there is more to credit derivatives. Credit default swaps allow banks to hedge their default risk to illiquid loans on their balance sheet, just as buying options allows companies to hedge their exposure to exchange rates or commodity prices. Given they are over-the-counter contracts, credit default swaps can be tailored to create investments for insurance companies that better match their liability profiles, much like corporates use interest rate swaps to better match their assets and liabilities. And contrary to popular belief, credit default swaps are not illiquid – in fact, they are more liquid than bonds with thousands of transactions daily.
Some banks did use credit default swaps to arbitrage their regulatory capital requirements, and some investors used them to speculate. But a market doesn’t grow as large as the credit derivatives market based on just arbitrage-driven and speculative trades. One can use interest rate swaps and options speculatively – does that mean we cut these products out of the market altogether?
Much of the criticism that credit derivatives have come under – increased counterparty risk, risk of failed settlement, undue leverage and speculation – is fair. But what’s not is blaming a tool for our problems. That makes us look like bad carpenters. Let’s focus instead on how to build something good.
Anu Munshi
Partner, B&B Structured Finance Ltd.
GREAT TO HAVE A MARKET EXPERT SHARE EXPERIENCE AND TEACH – MAKES [MATERIAL] MORE RELEVANT. [HER] ENTHUSIASM IS INFECTIOUS! THANKS VERY MUCH FOR A GREAT COURSE, IN PARTICULAR THE CASE STUDIES – VERY USEFUL TO PUT INTO PRACTICE WHAT WAS TAUGHT.