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Derivatives: Popular, risky, scrutinized
Regulators are looking at the vastly complicated, fast-growing world of credit derivatives.
September 24, 2005: 2:10 PM EDT
By Amanda Cantrell, CNN/Money staff writer

NEW YORK (CNN/Money) - Credit derivatives, complex investments based on the value of corporate bonds, have soared in popularity on Wall Street, sparking regulators to step up their scrutiny of this rapidly growing marketplace.

Derivatives are investments that derive their value from something else, such as stock options that trade based on the price of an underlying stock. Credit derivatives are bought by investors as protection against a possible default on an underlying bond.

One of the most common credit derivatives, a credit default swap, calls for the seller to pay if the underlying bonds go into default. The swaps are akin to insurance for investors, and supporters say they help spread and manage risk. (See correction).

The credit derivatives market overall was worth about $8.4 trillion last year, and has roughly doubled in each of the last three years, according to the International Swaps and Derivatives Association, an industry group.

Growth spurt

Helping to fuel the rapid growth: hedge funds that specialize in bonds and have become big players in the derivatives space.

The way that a hedge fund can profit is by selling credit default swaps to a bank, for example. If the underlying bonds go into default, the hedge fund covers the bank's losses. But if there's no default, the hedge fund profits.

"Our view is that the growth of the market ... has really helped disseminate risk through the system and minimize its concentration among certain lenders," said Louise Marshall, chief spokeswoman for ISDA, the industry group. "Our basic stance is that (credit derivatives) spread risk more thinly and evenly as opposed to it being concentrated within banks," she said.

Regulators want to ward off trouble in the rapidly growing market by making sure the sellers of these contracts are stable and have sufficient funds to meet their obligations.

"Risk transfer through derivatives is effective only if the parties to whom risk is transferred can perform their contractual obligations," Federal Reserve Chairman Alan Greenspan said in a speech last spring. "These parties include both derivatives dealers that act as intermediaries in these markets and hedge funds and other nonbank financial entities that increasingly are the ultimate bearers of risk."

Greenspan also acknowledged the benefits of derivatives, noting their risk-management features were "key factors underpinning the greater resilience of our largest financial institutions."

But regulators have also raised concerns. Last week, the Federal Reserve Board of New York met with several Wall Street firms to discuss its worries that the contracts are not being processed in a timely way, the Fed announced.

The regulators worry that a series of big corporate defaults, while unlikely, could nevertheless pose substantial risks to financial markets -- with ripple effects on interest rates and the broader economy. When General Motors and Ford debt first got cut to junk status last spring, many hedge funds and proprietary trading desks at banks reportedly lost hundreds of millions of dollars.

Tanya Azarchs, a managing director in the financial institutions ratings practice at Standard and Poor's, noted several concerns about the rapid growth in derivatives.

Potential problems

First, many hedge funds and other investors move so quickly that a big default or downgrade could trigger simultaneous sell signals, causing everyone to head for the exits at once. "In that stampede, liquidity dries up as everyone is selling and not buying," she said.

Another problem is with how trades are settled, Azarchs said, adding it was troubling to see that back-office operations of many players in credit derivatives markets were in disarray. "That makes you question whether anything else is wrong as well," she said.

Lastly, if trades don't get processed accurately after a default or series of defaults, there could be flood of lawsuits that can become "really messy and difficult for the court system" if the paperwork is in disarray, she said.

She noted that after S&P cut GM and Ford bonds to junk status in May, "Everyone headed for the exit at once and guess what? The world didn't come to an end. It was heartening that the system had resilience. No one kind of trade seemed to have been so big that it could bring down the system."

So do individual investors need to worry?

Only if they panic rather than waiting to see what shakes out, according to Azarchs.

"In those periods of market dislocation, smaller investors could be tempted to liquidate their positions at a substantial loss, which could lead to long-term investment losses," she said. "That's where they'd first feel it, before they felt any major repercussions on monetary policy."

(Correction: An earlier version of this story misstated one of the terms of a typical credit default swap contract. CNN/Money regrets the error. Return to top of story.)

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