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Dizzying New Ways To Dice Up Debt



Suddenly, credit derivatives--deals that spread credit risk--are surging

In June, an international bank client of J.P. Morgan & Co. called the august Wall Street firm with a not-uncommon problem. It had a basket of some 20 loans totaling more than $500 million to mostly investment-grade companies but wanted to lend more money to the same borrowers. And it wanted to reduce its capital requirements and protect itself against borrower defaults. In the past, Morgan's client would have had to sell all or part of the loans.

Not anymore. For a fee based largely on the credit quality of the borrowers, Morgan sold the other bank, which it declines to name, the right to require Morgan to pay off any of the loans if a borrower goes bankrupt. Morgan can either retain the default risks in its portfolio and collect the fee, or sell them piecemeal to a growing cadre of institutional investors that includes insurers, hedge funds, and other banks. Meanwhile, Morgan's client retains the actual loans and the customer relationships.

Welcome to the little-publicized but rapidly expanding new world of credit derivatives, the infant cousin of better-known and occasionally notorious financial derivatives. Besides credit-default swaps, a kind of guarantee that can be bought and sold, permutations include total-return swaps--which enable lenders to sell the cash stream of a loan but not the loan--and options on credit risk. Boosters say credit derivatives could alter for the better the credit-risk profiles of financial institutions and companies. By enabling lenders to strip loans, bonds, and other instruments into credit risks that can be privately traded in institutional markets, these contracts, they say, will promote portfolio diversification and reduce loan concentrations.

AVID PROSPECTORS. "The potential for growth is enormous," says Blythe Masters, global head of credit derivatives at J.P. Morgan, which claims a global market share of about 20%. "They deepen the liquidity with which loans are bought and sold and will help make the pricing of credit risk more rational." Adds Barry Finkelstein, a director for structured products at Merrill Lynch & Co., credit derivatives "are on everybody's radar screen. It's difficult to be a full-service derivative house without being in the credit-derivative markets."

Wall Streeters think credit-derivative activity could soon approach the multitrillion dollar financial-derivatives market in volume and importance. According to estimates, derivatives covering as much as $150 billion in credit instruments are now outstanding, up from just $20 billion or so last year.

That's still minuscule compared with the more mature financial-derivatives business, which includes futures, options, and interest-rate and currency swaps. One reason credit derivatives had been somewhat slow to develop is the fear of repeating the disasters that have plagued the financial-derivatives business in recent years, such as 1995's Bankers Trust/Procter & Gamble imbroglio. Indeed, while dealmakers and regulators alike are ebullient about the potential of credit derivatives for dispersing credit risk, they acknowledge that in the wrong hands, these instruments can--and most likely will--inflict heavy losses on some banks, companies, and investors. Christine M. Cumming, senior vice-president at the Federal Reserve Bank of New York, stresses that bank regulators view credit derivatives as a "positive development." But she concedes that the "potential for good also creates the potential for problems."

In the absence of a blowup, practitioners seem more focused on the good rather than the bad and the ugly. Many U.S. and foreign financial institutions are eagerly prospecting for business. According to the Comptroller of the Currency, Morgan has about three-quarters of all U.S. commercial bank volume, followed by Citibank, Chase Manhattan, and Bankers Trust. The comptroller's figures don't include certain types of transactions or the activity of foreign commercial banks and investment banks such as Merrill, another big player.

Along with the surge in transactions, the uses of these instruments seem to be expanding fast. Emerging markets, such as China, are a beneficiary, says J. Gregg Whittaker, Chase Manhattan's head of global credit derivatives. Many companies and lenders are interested in investing in Chinese businesses but don't want China's country risk. So Chase crafted default swaps that let investors unload that risk. And, he points out, industrial companies have begun to use credit derivatives to cut accounts-receivable concentrations. That way, they can "reduce credit risk while maintaining good customer relationships," he says.

One obstacle to expansion is the treatment of credit derivatives by bank regulators in calculating capital requirements. In most situations, regulators call for banks to put up the same 8% capital against these instruments as they do for the underlying loans. But some practitioners, such as Morgan's Masters, think credit derivatives could ultimately prompt regulators to relax the 10-year-old global-risk-based capital rules. "Credit derivatives suffer from the same one-size-fits-all rules as other bank credit instruments," she says.

Insurers, such as New York-based American International Group, are also becoming major players, though mainly as users rather than dealmakers. The business has "grown significantly," an AIG spokesman said, adding that AIG uses them to hedge credit exposures in insurance underwriting and investing.

These instruments permit institutional investors, for the first time, to buy into syndicated loans to noninvestment-grade companies, and thereby obtain returns higher than those on junk portfolios without junk's volatility. Mark R. Shenkman, president of Shenkman Capital Management, says the firm has invested in total-return swaps for nearly two years, achieving leveraged average annual returns in excess of 15%. Those transactions typically work this way: A bank originates a floating-rate loan to a company with interest at, say, 300 basis points over the London Interbank Offered Rate. But it actually lends the money to investors like Shenkman at perhaps 100 basis points over LIBOR. They, in turn, fund the company loan, accept default risk, and collect interest and fees. Currently, Shenkman says, the firm holds about 32 swaps for about 25 companies amounting to "several hundred million dollars." Unlike the case with fixed-rate junk, rising rates don't erode loan principal. "As long as you buy good credits, the returns are predictable," he says.

MINEFIELDS. To date, none of these deals has blown up, experts insist. Still, they recognize that the new market isn't without potential minefields. Says E. Gerald Corrigan, managing director of Goldman, Sachs & Co. and a New York Fed ex-president: "The unbundling of credit risk probably should be a good thing, assuming that people picking up the elements of credit risk understand what they're doing and the risks they're incurring."

Just as bankers have gotten burned by making bad loans, they could stumble by buying poorly structured credit derivatives. And deals may fail to allow for a spike in interest rates or an economic downturn. Corrigan and others are concerned about the reliability of models used to measure potential credit risk and set transaction prices. Tanya Styblo Beder, principal of Capital Market Risk Advisors, warns that risk models based on historical default data could prove invalid for credit derivatives linked to syndicated loans. Michael L. Brosnan, director of treasury and market risk at the Comptroller of the Currency, says that while credit derivatives are a "big plus," there are "going to be banks that won't use them wisely." Insurance regulators are taking no chances. In June, the National Association of Insurance Commissioners launched a study of insurer exposure.

For now, practitioners can only hope that when it comes to credit derivatives, Murphy's Law doesn't apply.By Phillip L. Zweig in New YorkReturn to top

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