Behind the euphoria surrounding credit derivatives, is there another LTCM in the offing?
Financial derivatives are "weapons of mass destruction," wrote Warren Buffett, the Oracle of Omaha in Berkshire Hathaway's annual letter to the shareholders (2002). That definition seems to have a ring of truth to it, for the way the financial community is embracing new and advanced versions of derivatives is raising concerns the world over. Credit derivatives are one such instrument. The financial press is now replete with stories of financial institutions losing huge amounts of money thanks to these complex beasts. Consider this: French reinsurer SCOR, suffered net losses to the tune of 769 mn in 2002 and 2003 owing to credit derivatives, which ultimately led the company to exit the credit derivatives market. Corvus, a Russian-doll Collateralized Debt Obligation (a Collateralized Debt Obligation that invests in other Collateralized Debt Obligations) launched by the British bank Barclays in December 2000, with a face value of $950 mn in tranches rated from AAA to B, has performed badly over a period leading to a host of law suits filed by investors claiming damages. Corvus took a beating since September 11, 2001, which led in downgrade of its rating by rating agency Fitch in December 2002. Fitch in 2003 started publishing details of the Corvus portfolio on its website, which raised concerns among investors. For example, it was revealed that the fund had exposure to other CDOs, all constructed by Barclays, some of which were never sold externally.
Even as more of such cases are coming to the fore, the credit derivatives market is exploding, reaching gigantic proportions. From a humble beginning in 1992, the market's volume in the year 2003 reached $3.6 tn. According to McKinsey, it is all set to touch the $10 tn mark by 2007. Nonetheless, skeptics fear that eventually something will happen to bring down the global financial system. Credit derivatives allow banks to free the risk capital. Now with more capital available at their disposal, they actively get into lending business, and then again use credit derivatives to transfer credit risk to free up more capital. Ultimately, banks may end up getting exposed to more risk than they are actually supposed to take. |
