Taking Risk To Extremes

Will derivatives cause a major blowup in the world's credit markets?

On May 10, global financial markets reeled as rumors spread that one or more hedge funds had such big losses on General Motors Corp. (GM ) stock and debt that they might collapse. Although it wasn't clear that was imminent, it's sure that any funds that had bet lately against GM stock while also piling up on its debt -- a favorite hedge-fund play -- would have been caught in a double whammy. On May 4, GM stock soared when billionaire Kirk Kerkorian offered to buy 5% more of the equity for $870 million. The next day, the value of GM's bonds plummeted after ratings agency Standard & Poor's (MHP ) downgraded $375 million of GM and Ford Motor Co. (F ) debt to junk.

The rapid fire series of events raised the specter that high-stakes -- and highly leveraged -- bets on the creditworthiness of companies could bring global debt markets to their knees. The explosive growth of credit derivatives -- financial contracts whose value is based on corporate bonds and loans -- is central to these worries. The market tripled in value to $8.5 trillion last year and is still growing exponentially. Investing legend Warren E. Buffett long ago labeled derivatives as "weapons of mass destruction."

Now the monetary authorities are getting rattled, too. The International Monetary Fund warned in its Apr. 6 annual report of a possible meltdown in credit derivatives if investors all tried to "run for the exit at the same time." Even Federal Reserve Chairman Alan Greenspan, long a fan of derivatives because they spread risk around the financial system, is starting to sound concerned. In a speech to Chicago bankers the day the auto giants' paper was downgraded, he said that some investors could face "unanticipated losses" because "the rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress."

Anxiety is high: Big losses in credit derivatives could set off a chain reaction. Banks, insurers, and bond and pension funds, as well as hedge funds, are inextricably linked as issuers, buyers, and traders. An apparently minor problem, such as a flurry of downgrades, could quickly engulf the financial system by sending markets into a tailspin, wiping out hedge funds, and dragging down banks that lent them money.

If that sounds like a replay of the Long-Term Capital Management hedge-fund meltdown, it is, only worse. In 1998, LTCM borrowed about 100 times its capital to hold derivatives worth some $1.25 trillion, or 1,000 times the fund's capital. Today, hedge funds are an industry with $1 trillion in assets, more than three times the size it was then and trade newfangled derivatives that are vastly more opaque and risky. "There's more borrowing by hedge funds in an untested, illiquid credit market than has historically been the case," says Peter J. Petas, founder of researcher CreditSights Inc. in New York.

The purpose of credit derivatives is to enable banks to transfer to a broader market the risk of defaults on corporate debt they've issued. No bonds or loans actually change hands. Instead, a credit derivatives dealer, usually another bank or a Wall Street firm, agrees to take on the risk of a default in exchange for a price, rather like an insurance policy. The dealer can also pass along the risk by bundling 100 or more credits, from top investment grade to junk, to create what's called a synthetic collateralized debt obligation (CDO). After slicing the CDO into tranches offering higher income for taking on greater risk, he sells them to large investors such as hedge funds, pensions, and endowments.

A DERIVATIVES TSUNAMI?

CDOs are the casino of choice for investors seeking high yields from bonds. The lure: Investors don't actually have to pony up any hard cash. They usually have to produce just enough collateral to show they can cover any losses. "It's a trade on a company's creditworthiness," says James M. Ballentine III, managing director at Lehman Brothers Inc. (LEH ) in New York.

So far, CDO players have surfed the huge wave in global credit markets successfully. That could change quickly. A sharp uptick in interest rates might push some companies to the wall. Surprises similar to Enron and WorldCom -- large, investment-grade companies that fall from grace overnight -- could roil markets. What's more, the number of bonds rated at just one notch above default has doubled in two years, pointing to an impending spike in defaults, according to S&P. "It doesn't need a 20% default rate across the corporate universe" to set off a selling spree, says Anton Pil, head of fixed income at JPMorgan Private Bank (JPM ). "One or two defaults can be very destructive."

Investors smell trouble ahead. Since January, outflows from junk-bond funds have totaled $6.9 billion, while low-grade companies are struggling to borrow money. The shift in sentiment is enough to depress bond prices -- with the added leverage of derivatives intensifying any move. Says Mark H. Adelson, structured finance research director at Nomura Securities International Inc. (NMR ): "These products magnify exposure to adverse changes. When things deteriorate and defaults go up, the consequences can be even worse."

Already, the credit-derivatives market is taking hits. The cost of insuring investment-grade debt against default is rising sharply. The Dow Jones CDX North American Investment Grade index -- which measures the price of so-called credit default swaps -- is up 18% since May 3. On May 10 alone, the cost of protecting a $100 million investment in top-quality paper spiked more than 12%, to $710,000, according to derivatives broker GFI Group. The same day, S&P downgraded several synthetic CDO portfolios built by Deutsche Bank (DB ) and warned others could follow. Earlier, Moody's Investors Services (MCO ) downgraded 11 deals, from other intermediaries tied to bonds of American International Group the insurer being probed by regulators.

Downgrades could have a disastrous effect on the latest flavors of CDOs. As demand soared, Wall Street created ever- more-complex varieties. The latest: CDOs cubed -- or derivatives that invest in derivatives of derivatives. Such an investment is three times removed from any bond or loan -- and far harder to understand and price. Thomas Finucane, financial stock fund manager with Boston's John Hancock Funds LLC, calls them "derivatives on steroids." Inevitably, he says, some bank will "lend to XYZ Hedge Fund on one of these funky derivatives, the thing will unwind, and then it's tap city." Banks, often the last line of defense, "will have to eat the loss," he says.

EXTENDING THE BETS

If that's the case, derivatives wouldn't have spread credit risk throughout the financial system as advocates claim. Some analysts fear credit risk is, in fact, concentrated among the five largest U.S. banks. They not only issue new derivatives contracts and trade them but also are the ultimate insurers backing them. Studies by bank regulators and rating agencies have found banks aren't using these instruments as risk-management tools, but rather as profit machines. CreditSights' Petas says investment banks are trading derivatives like mad, making investments in hedge funds that buy derivatives, and then lending money to funds so they can extend their bets in the credit market. Any unraveling of CDOs "has the potential to be extremely messy," he says. "There's just no way to measure what's at stake."

If things do go awry, the ripples may spread worldwide. Derivative demand has been as profound in Europe among investors seeking high income from synthetic CDOs that are top-rated by S&P and other agencies. Even so, two European banks have already sued Bank of America (BAC ) and Barclays Capital (BCS ) over how these instruments were sold and priced. New rules that require European investors to put derivative contracts on their books at market value could trigger an exodus if there are losses. When asked about the most likely source of the next corporate crisis, one high-ranking European regulator replied: "Derivatives."

Derivatives are not inherently toxic. One senior Wall Streeter compares them to fertilizer: "It can help your garden grow or can be made into bombs." To plenty of worried critics, the benign ingredient of bountiful liquidity can quickly become explosive when mixed -- as now -- with a lack of transparency, poor risk management, and excessive hype.

By Mara Der Hovanesian, with Chester Dawson in New York, and with Kerry Capell in London

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