Global Credit Derivatives Survey: Risk Dispersion Accelerates
Fitch surveyed 120 financial institutions (73 banks and broker-dealers, 39 insurance companies and reinsurers and eight financial guarantors) located around the world, focusing primarily on the credit default swap (CDS) and the synthetic collateralised debt obligation (CDO) markets. With the exception of one big broker-dealer, all the major institutions participated in 2005’s survey. The survey provides further disclosure and transparency to what is, at present, a very opaque market.
Some of the major trends and issues identified include:
The use of CDx among survey respondents continued to grow rapidly in absolute terms and increased by 82 per cent year on year. Globally, Fitch identified US$5.3trillion of gross protection sold and US$5.2trillion of gross protection bought as of year-end 2004. Additionally, US$159bn of cash CDO holdings were identified. Last year’s survey identified US$2.8trillion of gross protection sold and US$2.6trillion of gross protection bought plus US$155bn in cash CDOs as at year-end 2003.
Growth in the market has been spurred by a number of factors, including standardisation of documentation; the development of CDS indices and index-related products, resulting in improved liquidity and price transparency; and the greater use of CDx by institutions in search of diversification and yield enhancement in a benign credit environment characterised by falling credit spreads. Growth was also driven by a range of market participants, which now includes a wide variety of banks, insurance companies, hedge funds and, to a lesser extent, pension funds and asset managers.
Clearly, in the global CDx market, the amount of bought positions should equal the amount sold. However, the figures shown above give a net sold position of US$128bn at year-end 2004, representing a 36 per cent decline from US$200bn at year-end 2003. In absolute terms this reflects the omission of institutions that did not participate in the survey and transfer of risk to entities such as hedge funds, asset managers and high-net-worth individuals as well as small and medium-sized banks and insurance companies. This may also be representative of ongoing deficiencies in operational infrastructure and information systems, which is reflected in the continuing struggle on the part of some institutions to provide the requested information.
In addition to gross positions, Fitch also asked for market values for sold and bought positions, recognising that market values are a better measure of risk. However, as data was provided on an inconsistent basis, Fitch has not published any specific market-value figures. That said, with credit spreads continuing to tighten during 2004, influenced partly by a benign credit environment, it was not surprising to find on an aggregate basis that global sold positions had a positive market value. Correspondingly, given the movement in spreads, it was not surprising that global bought positions were out of the money. As most of the gains were reported by protection sellers, it seems likely that the offsetting losses reside primarily with protection buyers. Some of these losses may also be residing with institutions not covered in Fitch’s survey that have purchased protection, such as hedge funds, asset managers or emerging-market participants who may not have reported on mark-to-market basis. Theoretically, it is also possible that some of these losses may be residing in the banking book. However, given the general move towards mark-to-market accounting it is the agency’s opinion that this is not likely to be the case.
It should, however, be noted that the quality and consistency of the data submitted was mixed. For example, a number of firms struggled to provide attendant market values. Combined with an increasing dependence on model-driven valuations for pricing (stale and inconsistent, not reflecting the market), this may well result in losses being understated or wrong figures being submitted as part of the survey. This is not surprising given the rapid growth of the market and the difficulties institutions are facing in clearing the backlog in reconciling the increasing volume of CDx transactions. These issues highlight the need for entities to continue to invest heavily in the area of operational risk management processes.
In absolute terms the traditional single-name CDSs, the basic building block of CDx, continued to play a prime role within the market and registered 88 per cent growth to US$3.6trillion of gross sold in 2004, as the market continued to expand into new names and institutions. However, of more interest was the rapid growth of CDS indices and index-related products, which helped grow “other products portfolio” by 425 per cent during 2004 (2003: -1 per cent). Coupled with a 48 per cent (2003: 49 per cent) increase in portfolio products represented by single-tranche CDOs as well as other less common but growing products such as nth-to-default CDSs, credit swaptions and recovery swaps, this helped increase portfolio products overall. Although such products still remain small as a percentage of the total market, it is the agency’s opinion that broad-based indices and index products will continue to grow at a rapid pace in the future, as they provide a standard benchmark by which credit risk can be traded and hedged.
The trends identified above are highlighted in the charts above, which show the market breakdown of gross sold positions by products.
From a market-making perspective, the market was concentrated, with the top 10 global banks and broker-dealers holding 70 per cent of total gross sold positions (2003: 69 per cent). Concentration risk in the top 20 remained virtually unchanged. The top four counterparties were Deutsche Bank (AA-), Morgan Stanley (AA-), Goldman Sachs (AA-) and JPMorgan Chase (A+).
Collectively, though, these institutions are highly rated, they are dominant participants in many segments of the financial markets and the market is vulnerable to a disruption in liquidity should one or more of these institutions run into problems. Another aspect of concentration risk is that as market-makers these institutions run a diversified book of short and long positions with the implicit expectation that adverse spread movements in one position may be offset by spread movements in other positions at a portfolio level. However, to the extent that protection sold is not offset by an equivalent amount of protection bought on the identical reference entity, a hedge could result in a possibly significant shortfall due to the notional that would have to be paid out if a credit event is called.
An additional factor contributing to increased concentration risk is the use of similar models and risk management frameworks. In times of stress, since the models are all working on the same assumptions, a sell signal could result in a simultaneous rush to exit markets, causing systemwide problems. A good example of this was the flawed assumptions in correlations trading models that led to significant losses in the CDS market in the spring of 2005 when General Motors’ ratings were downgraded.
The emergence of hedge funds as important counterparties, reportedly controlling 25 per cent-30 per cent of trading volumes in the CDx market, is another source of concentration risk with the potential to dislocate this rapidly growing market, particularly from a liquidity perspective.
The survey revealed that synthetic CDOs as an asset class grew by 234 per cent to US$1.1trillion. The ability of the market to structure single-tranche CDOs, which allow a great deal of flexibility in customising transactions for customers, was the main driver behind the rapid growth in synthetic CDOs.
The increase in this activity also points to the growth of more complex and model-driven strategies that place an increasing amount of reliance on credit-risk models and assumptions about the extent of default correlations between different counterparties. The risk of relying on such models, which tend to be based on common assumptions across major financial institutions, is highlighted the Concentration Risk section above.
The survey also identified significant exposures to unrated tranches of synthetic CDOs at 14 per cent of total exposure (or US$164bn at end-2004). A significant portion of these unrated exposures may relate to true “first loss” positions that more often than not are retained by originators as they are more difficult to place with third-party investors. On an expected-loss basis, a large percentage of the losses are typically absorbed by these unrated tranches, which may limit the degree of actual risk transfer. As these unrated
tranches are likely to attract punitive capital charges under Basel II, financial institutions have started the process of selling down these exposures to third parties, like hedge funds and asset managers looking for high-risk, high-yield returns. This trend should reduce holdings of unrated tranches from their 2004 levels.
By contrast, as originators of credit, the global banking industry continued to be a significant buyer of protection, with a reported net position of US$427bn (2003: US$260bn) of protection purchased. Globally, banks and broker-dealers reported gross sold positions of US$4.6trillion versus US$2.3trillion in 2003. Gross bought positions also increased substantially to US$5.1trillion from US$2.6trillion in 2003. This growth was partly influenced by strategies put in place by banks to reduce exposure concentrations and simultaneously achieve diversification of credit portfolios as a means of enhancing yields. An additional factor influencing growth was liquidity in the secondary credit market, which has allowed the efficient transfer of credit risk to other sectors that lack the ability to originate credit. On a net basis European banks bought US$294bn of protection, North American banks and broker-dealers bought US$123bn of protection, and Australian and Asian banks bought US$10bn. Although the banking sector as a whole was a heavy buyer of protection on a consolidated basis, protection bought was relatively concentrated by institution and country. This helped mask differences at the country level, where generally the more sophisticated banks continued to be net buyers of protection, whereas smaller regional banks continued to use CDx as an additional means of originating credit.
Due to greater detail in this year’s survey, Fitch learned that approximately 32 per cent of exposure to gross protection sold was greater than five years’ maturity compared with 23 per cent in 2003. This growth could be viewed as a natural consequence of the evolution of the market to trade across the entire maturity spectrum, possibly in combination with investors reaching for more spread in a spread-constrained universe.
The global insurance/reinsurance sector (excluding financial guarantors) continued as a growing seller of protection in the aggregate, recording a gross sold position of US$397bn (including US$17bn of cash CDOs), compared with US$258bn in 2003 and US$174bn in 2002. As in the past, the results are distorted by AIG Financial Products’ dominant “footprint” in this market. After excluding AIG Financial Products, global gross sold exposures grew by 170 per cent, albeit from a low base. On a geographic basis with AIG Financial Products included, North America represented 79 per cent of the global gross sold position and Europe/Asia made up the remaining 21 per cent. Excluding AIG Financial Products, these ratios reversed.
As a sector, financial guarantors continued to be one of the largest sellers of protection (net basis) in the CDx market. In aggregate, financial guarantors sold US$275bn of protection and US$71bn of guaranteed cash CDOs (2003: US$256bn of protection and US$65bn of cash CDOs). The US$345bn of credit protection outstanding represented a growth rate of 8 per cent year on year. The growth rate has slowed significantly, reflecting the lower spread environment, which has curtailed new business opportunities, and a declining appetite for CDOs given the current portfolio mix. This may also reflect changing market dynamics, with banks choosing to delta hedge rather than selling super-senior tranches. Positively, however, the credit profile of the industry-wide CDSs and funded CDO exposure has improved since the last survey, moving to a weighted average rating of AA+ from AA.
As in the previous year, Fitch asked major intermediaries a number of specific questions about their exposures to hedge-fund counterparties. Though the general quality of the responses was poor, the survey discovered that hedge funds are growing rapidly and are estimated to have contributed approximately 25 per cent-30 per cent of the overall CDx trading volumes for active market intermediaries. However, getting any further meaningful estimate of notional exposures and mark-to-market positions held by hedge funds was difficult. In line with current market practice, all of the major market intermediaries reported that their hedge-fund exposures were at least partially collateralised, although the adequacy of this collateral can be adversely affected by sudden market shifts. Based on market feedback, the growth in the use of CDx by hedge funds can be traced to the use of CDSs as an alternative way to buy and sell credit risk and the use of trading strategies to trade credit-spread volatility, correlation and recovery rates. The increasing focus of hedge funds on the high-yield CDS market, which offers higher yields and volatility, has been an important factor in the high-yield CDx market’s growth (see Ratings Quality below).
A benign credit environment characterised by tightening credit spreads has clearly influenced a shift in the composition of the CDx market by ratings. On a relative basis the shift away from AAA and super-senior exposures towards lower-rated names continued, with AAA and super-senior exposures dropping to 14 per cent of gross notional sold from 17 per cent in 2003. This decline was driven by market conditions, including negative ratings migration, a fall in the appetite of monolines to take on increased exposure to super-senior tranches, increased use of delta hedging by dealers and greater use of synthetic technology to assume bespoke levels of risk. Below-investment-grade and unrated exposures represented 24 per cent of the surveyed market, compared with 18 per cent in 2003. Growth in the lower-rated tranches was influenced by demand from hedge funds and other institutions looking for high-yield assets as an alternative means of growing revenues. Another factor weighing heavily on the composition of the ratings mix was the influence of corporate positions (62 per cent of all derivatives traded by volume), which is a possible reason for BBB exposures increasing to 32 per cent from 29 per cent.
Other factors driving this shift in ratings mix, apart from a reduction in demand for senior and super-senior protection, include growth in demand for index-products and high-yield CDS indices, increasing interest in trading high-yield names plus a general maturing of the market resulting in more liquidity across the credit curve.
The second part of this survey’s findings, which concentrate on market developments, Global Credit Derivatives Survey: Market Developments.