A scandal waiting to happen?

Credit derivatives give banks protection from defaults

By Emma Clark BBC News Online business reporter

After the Enron collapse, amid the worries over 'aggressive' accounting practices, and the shock of the half-a-billion dollar currency dealing losses at AIB, experts wonder what could be the next big shock to the global financial system. One likely culprit are credit derivatives.

Banking pundits have indulged in derivatives-bashing for years.

If you dig deep enough into any financial scandal, you can usually find a derivative or two to take the blame.

Futures & options

Future: paying money now in order to receive a stock or other instrument at a pre-determined time in the future

Option: paying a fee to have the choice of buying or selling an instrument at a pre-determined price and time in the future

Nick Leeson's expensive bet on Singapore futures made him one of the most notorious figures in international banking and brought down Barings Bank.

More recently, John Rusnak's creative use of options bamboozled risk managers at AIB's US subsidiary.

However, the ongoing furore over Enron's "aggressive" accounting, combined with a spate of corporate bankruptcies, has heightened sensitivity about more complex derivatives, known as credit derivatives.

Understanding derivatives

Last month, Sir Howard Davies, chairman of UK regulator the Financial Services Authority, warned about the perils of dealing with these types of instruments.

Mr Rusnak used fees from options to cover his losses

The simplest credit derivative is a default swap that allows banks to hedge the risk of default when lending money to another party. In essence, it is like purchasing insurance against potential losses.

The more complicated deals, such as collateralised debt obligations (CDOs), transfer risk from a portfolio of loans or bonds, often using an off-balance sheet, special purpose vehicle.

During a speech on insurance regulation, Sir Howard remarked: "One investment banker recently described synthetic CDOs to me as 'the most toxic element of the financial markets today'.

"When an investment banker talks of toxicity, a regulator is bound to take a heightened interest."

A risky business

The fear is that the sellers of credit protection or investors in CDOs - often insurance companies - are not adequately assessing the risks involved.

Credit derivatives

Derivatives used to protect against risk associated with loans and bonds

Also used to generate a profit for some investors

Examples include default swaps and collateralised debt obligations

"Insurance companies may not be pricing these risks appropriately, perhaps because they lack the sophisticated technology to price them which investment banks possess," said Sir Howard.

In the current economic slowdown, where more than a few companies have collapsed with unpaid debts, credit derivatives are being put under pressure.

"Plainly, defaults are getting higher and these deals are going to get tested," said Simon Hills, a director at the British Bankers' Association (BBA).

The worst-case scenario is that some derivative deal could blow up in the face of an unsuspecting investor, leading to even greater losses.

"Customers need to understand they risk they are taking on," added Mr Hills.

On the defensive

Players in the credit derivatives market, however, are quick to point out that such deals are a key way to mitigate risk of default.

Credit derivatives are not a new thing. The industry is getting very standardised with a lot of mature players

Rajeev Misra
Deutsche Bank

As a good example, Canada's Toronto-Dominion Bank reported last week that trading in credit derivatives helped it avoid major financial fall-out from Enron's collapse.

Established players also dismiss critics as scare-mongers who do not understand the credit markets.

Rajeev Misra, co-head of credit derivatives at Deutsche Bank in London, believes that advances in documentation have made the market more secure.

"There have been so many credit defaults in the last three months, and yet despite the increase, there have been no disputes [between sellers and buyers of protection]," he added.

"Credit derivatives are not a new thing. The industry is getting very standardised with a lot of mature players."

Disclosure

But even Mr Misra admits that there could be problems "in these volatile times if players don't have the right risk management and are not audited independently".

"Credit derivatives have grown up very quickly and that's worrying people. Infrastructure needs to catch up."

Coupled with inadequate risk controls is the issue of disclosure

"Reporting is a fundamental issue, how honest companies are and how good their reporting standards are," said Mr Misra.

"Enron was at fault because it used credit derivatives as a way to conceal losses and to massage the balance sheet in a way that hid things from investors."

But should unscrupulous use of credit derivatives damn the instruments themselves?

Stepping in

Sir Howard suggests the solution to the problem probably lies with the regulators.

He has made it clear that the FSA must work to promote understanding of the financial system.

"I hope that does not mean that I am required to describe the intricacies of synthetic CDOs in words of one syllable to primary school classes.

"But it does mean... retail consumers are given clear information which allows them to understand the decisions they are making."

But, if AIB is still making the same mistakes seven years after Barings went bust, there is always scope for someone to get their fingers burned.

And after all, at the end of the day, however much risk is transferred, it has to go somewhere.