The Bank for International Settlements warned in its 75th annual report that despite the flurry of events triggered by the General Motors and Ford Motor Co. corporate credit rating downgrades this spring, it remains to be seen how the credit default swap and CDO markets could handle a string of credit blow-ups or an abrupt turn in the credit cycle. Because the ratings downgrades of the auto giants were somewhat anticipated among investors, the rather "orderly fashion" in which the credit markets adjusted themselves post-ratings action "might not be a true reflection of how these markets would function under stress," according to the BIS.
The BIS released the 233-page report, which detailed a number of other economic concerns - such as the U.S. current account deficit and declining dollar, the thin margin between perceived safe and risky investments, and China's currency peg - a day prior to the G-8 Summit last week. The mention of CDOs and CDS in the report highlights the increased attention to the sector among regulatory agencies and in the headlines. Some market players are anticipating increased scrutiny as the investor base could further broaden to include more inexperienced buyers.
"Even though these new credit markets are still relatively small in size, recent innovations have arguably transformed the trading and management of credit risk on a permanent basis," the BIS wrote. Much of the growth in the market in 2004 was due to innovations in custom CDO tranches, the growth in high yield and structured finance for use as CDO collateral, and CDO squared structures, the BIS wrote. The organization is anticipating further development in the markets to take the shape of CDS futures and options markets, and pointed to the upcoming introduction of market fixings on CDS index swaps in March as a catalyst for growth.
While the BIS was positive on certain developments within the CDS and CDO markets - the size of which the international body estimated at $673 billion and $165 billion in 2004, respectively - it characterized the structures as yet untested under stressful conditions. The primary risks the BIS pointed out in the structures hinged on the immaturity of the models used to predict future cashflows and the market's ability to function under stress. The BIS called the dominance of the rating agencies' role in the development of credit risk characterization of the market a result of market participants still in an early stage of building up internal analytical capabilities.
"...There is relatively little experience with the performance of ratings on CDOs, and rules of thumb employed by investors in using ratings on corporate bonds may be misleading when applied to highly leveraged structured instruments," the BIS wrote. "Even at a more basic level, progress still needs to be made in understanding the nature of portfolio loss distributions, the risk profile of CDO tranches and their sensitivity to credit risk correlations." The BIS wrote the "correlation smile" or the shape of the CDS index tranche price curve is an example of the flaws in standard portfolio risk models. The models currently used assume that the index is linked by a single correlation parameter, but the variation in spreads depending on tranche imply the existence of separate correlation estimates, the BIS wrote.
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