Traders Sowing Seeds of Destruction Prompt Crackdown (Update1)
By Shannon D. Harrington, Caroline Salas and Pierre Paulden
Sept. 24 (Bloomberg) -- The $62 trillion market for credit- default swaps, created to protect banks from loan losses, helped fuel a near-meltdown in the financial system and now may be regulated for the first time.
The derivatives precipitated plunges in the shares and debt of Wall Street firms, accelerating the collapse of Lehman Brothers Holdings Inc. and the U.S. takeover of American International Group Inc., the biggest U.S. insurer. Now, regulators want to bring oversight to a part of the credit market that may be more susceptible to manipulation than selling stocks short, according to U.S. Securities and Exchange Commission Chairman Christopher Cox.
Banks ``are suffering the consequences of their own actions,'' said Thomas Priore, chief executive officer of Institutional Credit Partners, LLC, a New York-based hedge fund with $13 billion in assets. ``They created a mechanism through default swaps to reflect a view on credit that has taken on a life of its own.''
The swaps became one-way bets on the demise of financial institutions as traders hedged the risk that their partners might implode, said Gary Kelly, a strategist at broker Tradition Asiel Securities Inc. in New York. The wagers sent distorted signals about credit risk, he said.
The resulting run on shares of financial companies prompted Cox yesterday to seek enforcement powers over the market. New York State will also start regulating some sales of the derivatives, according to Governor David Paterson.
Loan Protection
``The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing,'' Paterson said in a statement Sept. 22.
Banks started buying and selling credit derivatives in the mid-1990s to protect loan portfolios, Andy Brindle, the former head of JPMorgan Chase & Co.'s credit-derivatives group, said in 2003. The International Swaps and Derivatives Association started reporting credit-derivative volumes in 2001, when volume stood at $919 billion.
The contracts trade in over-the-counter deals, leaving each side exposed to the risk their partner will default. There's no exchange or clearinghouse for the swaps and no system for publicly reporting trades.
Credit-default swaps aren't issued or repaid by the companies referred to in contracts. The instruments pay the holder the face value of the amount protected in exchange for the underlying securities if a borrower fails to adhere to debt agreements.
Death Spiral
The market helped set off a death spiral for Lehman and AIG as a jump in the cost of protecting debt, or credit spreads, pushed down their shares. That eroded capital and prompted credit-rating companies to threaten downgrades. Bear Stearns Cos. met a similar fate in March before JPMorgan took the bank over in a rescue orchestrated by the Federal Reserve and Treasury.
Credit spreads were exaggerated as banks and investors hedging the risk of their trading partners defaulting rushed to buy swaps. That sent the price of protection soaring.
``The risk concerns became massively overblown,'' said Tradition's Kelly, who for the past three years made recommendations on stocks based on signals from credit-default swaps. ``Now, the time that the equity market starts heavily focusing on the CDS market, it's probably a period where its reliability is the most questionable.''
By Shannon D. Harrington, Caroline Salas and Pierre Paulden
Sept. 24 (Bloomberg) -- The $62 trillion market for credit- default swaps, created to protect banks from loan losses, helped fuel a near-meltdown in the financial system and now may be regulated for the first time.
The derivatives precipitated plunges in the shares and debt of Wall Street firms, accelerating the collapse of Lehman Brothers Holdings Inc. and the U.S. takeover of American International Group Inc., the biggest U.S. insurer. Now, regulators want to bring oversight to a part of the credit market that may be more susceptible to manipulation than selling stocks short, according to U.S. Securities and Exchange Commission Chairman Christopher Cox.
Banks ``are suffering the consequences of their own actions,'' said Thomas Priore, chief executive officer of Institutional Credit Partners, LLC, a New York-based hedge fund with $13 billion in assets. ``They created a mechanism through default swaps to reflect a view on credit that has taken on a life of its own.''
The swaps became one-way bets on the demise of financial institutions as traders hedged the risk that their partners might implode, said Gary Kelly, a strategist at broker Tradition Asiel Securities Inc. in New York. The wagers sent distorted signals about credit risk, he said.
The resulting run on shares of financial companies prompted Cox yesterday to seek enforcement powers over the market. New York State will also start regulating some sales of the derivatives, according to Governor David Paterson.
Loan Protection
``The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing,'' Paterson said in a statement Sept. 22.
Banks started buying and selling credit derivatives in the mid-1990s to protect loan portfolios, Andy Brindle, the former head of JPMorgan Chase & Co.'s credit-derivatives group, said in 2003. The International Swaps and Derivatives Association started reporting credit-derivative volumes in 2001, when volume stood at $919 billion.
The contracts trade in over-the-counter deals, leaving each side exposed to the risk their partner will default. There's no exchange or clearinghouse for the swaps and no system for publicly reporting trades.
Credit-default swaps aren't issued or repaid by the companies referred to in contracts. The instruments pay the holder the face value of the amount protected in exchange for the underlying securities if a borrower fails to adhere to debt agreements.
Death Spiral
The market helped set off a death spiral for Lehman and AIG as a jump in the cost of protecting debt, or credit spreads, pushed down their shares. That eroded capital and prompted credit-rating companies to threaten downgrades. Bear Stearns Cos. met a similar fate in March before JPMorgan took the bank over in a rescue orchestrated by the Federal Reserve and Treasury.
Credit spreads were exaggerated as banks and investors hedging the risk of their trading partners defaulting rushed to buy swaps. That sent the price of protection soaring.
``The risk concerns became massively overblown,'' said Tradition's Kelly, who for the past three years made recommendations on stocks based on signals from credit-default swaps. ``Now, the time that the equity market starts heavily focusing on the CDS market, it's probably a period where its reliability is the most questionable.''
