Credit derivatives may spark the next financial crisis, comments FT

Writing in the Financial Times, John Plender comments that in the period between the break-up of the Bretton Woods semi-fixed exchange rate system in the early 1970s and the near-collapse of LTCM in 1998, financial crises were frequent. Yet for the best part of a decade an eerie stability has prevailed.

Many private sector bankers, he writes, believe that the newer markets in credit default swaps, which investors use as insurance against corporate default, and CDOs are inherently stabilising. That is because they spread risk more widely around the system. At the same time technology, which facilitates trading in complex new financial instruments, serves to make markets more efficient.

He adds that the credit euphoria in the markets, which has caused the yields of riskier bonds to move closer to the risk-free bond yield, is partly driven by the prime brokerage divisions of investment banks competing ferociously for hedge fund business. They have loosened lending standards and margin requirements relating to the amount of collateral they require to support a given amount of hedge fund debt.

However, no central banker believes that we are witnessing the end of volatility or the demise of the credit cycle, he argues, though some youthful bankers in the private sector are prepared to argue that case.

He quotes Christopher Whalen of Institutional Risk Analytics, a consultancy, as saying that given the lower risk premiums in credit markets, it may no longer be prudent to assume credit default swap contracts will be liquid when the adjustment comes.

He goes on to argue that risk models can ignore the potential occurrence of very low-probability scenarios with potentially extreme outcomes, in which one big loss can wipe out several years of positive returns.

Plender concludes that systemic crisis could arise in a conventional corner of the markets. But given the novelty, opacity and complexity of derivatives trading, and challenges that central banks face in trying to understand the risks involved, there is a high chance that the lightening will go there.

Source: Financial Times