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| User Info | The credit derivatives market at the moment; entered at 2007-12-01 20:46:14 | |||
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Cplus Posts: 170 Registered: 2007-07-18 
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In the past week equity markets worldwide have begun a rally on the expectation that accommodation by the global central banks will be more successful on its second try and that the dollar may end its free fall and foreign buyers, no longer attracted by securities, may purchase instead the assets underlying them. These hopes will be in vain and the market fall will resume when the rally has been exhausted, probably sometime after the coming round of central bank accommodations. Something useful can be learned from the reaction of the various segments of the derivatives market to these events. The ABX and CMBX markets have disdained the rally and continue to feed on the bottom. The interest rates swap markets have begun what is until now a perfunctory retracement without much enthusiasm. The credit derivatives market, by contrast, has reacted strongly. Domestic CDX indices exhibit gains in single digits, while international credit indices and credit futures have performed like equities on crack cocaine. From the Thanksgiving peak, iTraxx Europe Crossover has gained about 13%, but still lags several Asian indices such as the iTraxx Asia ex-Japan which is up about 19%, as is the Credit Derivative Futures contract. Many CDS spreads have also tightened significantly. From such indications as are available, it appears that these big swings have taken place with little actually being traded. What will happen in these markets on the next major fall in the equity markets? The answer is obvious: to put it plainly, spreads will blast off into orbit at an altitude where the credit derivatives markets will be untradeable. In other words, the many sizable global credit derivatives markets will cease to function. This raises the question of how counterparties to these transactions will determine their profit and loss in the absence of a market. The daily marks of the Markit Corporation are based on the input of the contributing banks. Do these banks then create Level 3 accounting models for these derivatives in the absence of a functioning market? Do the counterparties accept this and pay up? Or, what is far more likely, do trillions of dollars notional fall through to years of litigation? Although the comment of a well known financier that derivatives are weapons of mass destruction is not accurate at least for this class of derivatives, in fairness it should be noted that such things were not current when the remarks were made. It might be better to describe credit derivatives as weapons of mass litigation. The effects may still be fatal to many but the pain will not be instantaneous or soon ended. Banks will experience double jeopardy. As the major participant in this market, they are at far greater counterparty risk than appears to be discounted in the OCC reports. In addition some of the collateral they hold in these transactions may be at risk of discounting in the ongoing credit crunch. By the way this raises an interesting question. How do they value collateral submitted by other firms and is it consistent with how they value their own assets? It is an irony that credit derivatives, designed to provide insurance and stability, are in fact accomplishing the opposite. When the financial system is restructured in coming years, the credit derivatives business will still have a function to perform but it will need to be transacted in public markets in a manner similar to other commodities. This will not magically provide liquidity in times such as we are experiencing, but it will make possible better risk management, and prevent the same sort of debacle we are witnessing in this market. Last modified: 2007-12-01 22:47:14 by cplus
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