Thursday, May 17, 2007

Credit Complacency = Fiduciary Risk

Much has been written about the potential impact of the sub-prime mortgage sector meltdown and the impact that tighter credit and falling home values might have on the economy. However, a weakening credit discipline due to the growing role and appetite of leveraged investors and an increase in the sophistication and complexity of credit instruments should also be of concern to investors.

The credit derivatives market has not captured investors’ attention because it has been dominated by private over the counter deals organized primarily by large investment banks. According to the International Swap Dealers Association the credit derivative market has doubled in each of the last 5 years and totaled $34 trillion in notional value at the end of 2006. Hedge funds also play a large role in this market. Lehman Brothers estimated they account for over 50% of the trading volume in this market.

Credit derivatives are simple in concept. They provided insurance against corporate bond defaults. Credit derivatives have become popular because they allow corporate lenders and bond investors to reduce and/or actively manage their credit risk by separating out the credit risk part of these investments and selling it to others. These sales contracts are called credit default swaps. The loans or bonds don’t change hands but derivatives dealers will make an agreement to insure them against a credit default for a fee. The dealers often pass along these risks by bundling these credit exposures into what are known as a synthetic collateralized debt obligation (CDO). Slices of the CDO are rated by rating agencies and then sold to hedge funds and institutional investors. CDO’s soaked up $150 billion of mortgage backed bonds last year, the majority of which included sub-prime mortgages according to Deutsche Bank.

As these risks are packaged, leveraged and structured in ever more complex ways, the nature of the resulting risks may not be transparent or fully disclosed and can be misunderstood, mis-modeled and inappropriately executed and priced. The typical borrower-lender relationship changes as the underwriters of the risk and the eventual risk bearers become disconnected. Risk sellers may be financially motivated to understate credit risk. Because of these issues, the market puts substantial reliance on credit rating agencies. However, the ratings agencies, whose role is to evaluate the risks of these structures, can suffer from both limited information and financial conflicts of interest[1].

Clearly the phenomenal growth of the structured credit markets has been due in part to easy credit and investors’ demand for yield. Many argue that the growth of the credit derivatives market should disperse credit risk amongst a broader and more diverse investor base thus making the credit markets more resilient to credit ”events”. However, the democratization of credit risk may also help disguise risk and transmit financial contagion much more efficiently. The real concern is that no-one really knows that these risks aren’t accumulating in an inappropriate way or aren’t being concentrated in areas which won’t be sustainable through an inevitable normalization or downward leg of the credit cycle.

Private equity, hedge funds, real estate and credit derivatives have all benefited from cheap capital and a strong economy. It is likely that the demand for these assets over the last few years has limited demand for traditional risky investments such as large cap stocks. Time will tell whether the ex ante risk reward expectations driving these investments is founded on sustainable fundamentals or just plain old leverage and perfunctory risk disciplines. For now, investment fiduciaries should be more cautious than usual about credit risk, leverage and lack of transparency in their portfolios.

[1] Frank Partnoy The Paradox of Credit Ratings / How & Why Credit Rating Agencies are not Like Other Gatekeepers.


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