Credit Mkts: credit derivatives Survive Stress Test
Dow Jones & Company, Inc. - January 20 2002
Dow Jones Newswires
NEW YORK -- Having roughly doubled in size in each of the past five years, credit derivatives have lately survived a series
of stress tests. Wall Street is hoping that this encourages even broader participation by new investors.
Last year was certainly the year for fallen credit angels, headlined by the default of Argentina and the bankruptcy of
Enron Corp. -- the latter was an actively traded name in the credit derivatives market over the past three years. But Wall
Street figures that successful negotiation of these credit craters has set the stage for further growth of credit derivatives,
such as default swaps, total-return swaps and synthetic collateralized debt obligations.
Some fear that broader participation by inexperienced players raises the risk of big blowups in the credit-derivatives
market. Indeed, a few analysts are predicting headlines from such an event this year.
Still, these instruments, once assigned to the fringes of risk management, encountered only a minimum of legal complications
in the Enron and Argentine cases.
"credit derivatives earned their stripes in the aftermath of Enron filing for bankruptcy," said John McEvoy,
cofounder of Creditex, a trading platform for credit derivatives. "The market did what it was supposed to do and that
has apprised many investors of the value credit derivatives hold for hedging credit risk."
And the continued expansion of the credit-derivatives market derives not just from the perspective of hedging credit risk,
but also from investors on the other side of the trade seeking a source of synthetic liquidity.
A credit default swap acts like an insurance position that allows buyers to transfer the risk of defaults or other kinds
of credit events, such as debt restructurings, to a selling counterparty, who is paid a premium that is derived from the
notional amount of the contract.
In effect, the seller or underwriter of the default swap establishes a synthetic long position in the credit of the company
without having to purchase the underlying cash bond.
Investors are increasingly using default swaps to "increase or reduce credit risk without the liquidity constraints
of the cash market," said William Cunningham, director of credit strategy at J.P. Morgan Chase in New York.
Indeed, liquidity in credit derivatives has grown so much that two-way activity is often better than that of the notoriously
illiquid cash bond market. "We are increasingly seeing the derivative dictate activity in the underlying cash bond," said
Mr. McEvoy. "credit derivatives act as a barometer for the underlying cash market as they concentrate solely upon credit
risk."
The growth of credit derivatives has also created better liquidity for less- popular issues as derivatives trading has
encouraged greater use of cash bonds for derivatives traders hedging their positions.
It "has created more demand for off-the-run paper," said John Cieslowski, vice president for credit derivatives
at Goldman, Sachs & Co. in New York.
Hedge funds have been particularly active users of these instruments. Jeff Devers, president of Palladin Group LP in Maplewood
N.J., a hedge fund that seeks to minimize risk and enhance returns from convertible bonds, uses credit derivatives to "isolate
credit risk." This way his fund solely takes on the equity exposure of a convertible bond. Mr. Devers expects further
growth of credit derivatives to add even more liquidity to the convertible bond market.
Another key development has been the use of synthetic collateralized debt obligation baskets, which are a series of default
swaps upon a range of credits bundled together. These credits are divided into tranches that reflect different risk ratings,
appealing to the divergent risk appetites of investors.
The two counterparties to a synthetic CDO are either offsetting the credit risk through such trades or are taking exposure
to a diverse number of credits that can augment the performance of their underlying portfolios.
Exposure to synthetic CDOs also raises a money manager's level of assets under management and either lowers or raises
the level of exposure to a particular credit.
Creditex, which brokers trading between counterparties in CDOs, has been a beneficiary of this growth. "The past
year saw many traditional CDO players enter the synthetic CDO market in credit derivatives and this contributed to a substantial
rise in market activity," noted Mr. McEvoy. ---
-- Richard A. Bravo, Tom Barkley and Julie Haviv
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