It's taken over three months to perform, but Fitch Ratings has managed to place a harness on the 10-ton elephant that is the credit derivatives market.

Over the last 10 years, credit derivatives have changed the makeup of the financial arena dramatically. The current default environment is "the first instance this new capital environment is contending with high levels of default," said Robert Grossman, Fitch's chief credit officer. Worldcom's default affected 70 CDOs rated by the agency. "This made it clear that large-scale defaults would be diffused in the capital markets in a different way from 10 years ago," he said, explaining what spawned the survey.

Roughly $2 trillion in size, Fitch's recently released credit derivative survey has so far been able to account for $1.3 trillion of this often misconstrued market. Out of approximately 200 global banks, 147 had responded to the rating agency thus far. In an effort to get 100% participation, Fitch is still gathering information, and results released last week were deemed "interim." The firm is going so far as to conduct sit-down interviews in order to capture information. In the end, institutions that do not disclose risk losing their rating from Fitch, said Grossman.

"The survey was initiated with the purpose of looking for unanticipated correlations of risk," he said. Without disclosure of credit derivative activity, it becomes difficult to perform clear analysis. "Investors will have a hard time placing losses in proper contexts without increased transparency," he said.

Publishing factual information about credit derivatives is akin to finding the gunman on the grassy knoll. Consider that while credit derivatives have been around for years, it seemingly only hit the mainstream radar this month, and that was due to uberinvestor Warren Buffet's comment calling the market's securities "financial weapons of mass destruction."

Fitch's survey found that total gross sold positions in credit derivatives was $1.2 trillion; of that $728 billion (61%) originated from U.S. institutions and the remainder stemmed from European banks and insurance companies. The largest sellers of credit protection were financial guarantors, who, in aggregate, have sold $222 billion of protection, including CDOs. And 61% of total contracts referenced corporates, the survey noted.

Who's behind the two

trillion-dollar curtain?

According to Fitch, counterparty risk was concentrated among the top 10 global banks and broker dealers; JPMorgan Chase, Merrill Lynch and Deutsche Bank rounded out the top three. As for reference entities - the underlying obligors whose credit risk is transferred - the top five consisted of General Motors, DaimlerChrysler, Ford, General Electric and France Telecom.

The real surprise uncovered by this enormous study wasn't necessarily the names but the geography.

Overall, the global banking industry was identified with $97 billion worth of protection. Yet while one-third of that was from U.S. banks, the rest stemmed from Europe. Fitch found 37% of European banks are net buyers of protection.

"European banks were very distinctive," said Roger Merritt, managing director, Fitch. While a handful of the largest European banks were buyers of credit protection, two-thirds of European banks turned out to be sellers, Merritt said.

According to Charles Prescott, a Fitch managing director based in London, 20% of European banks reported protection purchases in excess of E1 billion. And 90% of the protection sold globally was rated triple-B or higher. In fact, in a credit risk exposure breakdown, Prescott stated 13% were triple-A rated, 41% double-A and 26% single-A rated.

"There was some surprise in that German regional banks came out as [significant] net sellers of protection," said Bridget Gandy, managing director, Fitch. Due to the expiration of German government guarantees in the banking industry in 2005, "it's really loan replacement that they're doing," Gandy explained. Generally speaking, German banks appear to be dipping into the credit derivative marketplace looking solely for high ratings. "It's almost exclusively single-A rated and above," she said.

In addition to geography, Fitch's deconstruction of the market revealed interesting anomalies about specific industries.

The insurance sector was a major net seller of protection, with $283 billion of sold protection identified by Fitch. Financial guarantors were the largest protection sellers within the insurance umbrella, responsible for $222 billion of $283 billion identified.

But why would the insurance sector, which does not relish volatility, enter this obscure marketplace in such strong numbers?

"They foresee an opportunity to achieve higher yield during weak times," said Merritt. "The perception is that these instruments offer an opportunity to diversify."

However, in comparing figures, Merritt stated it appears the appetite from insurers has deminished and that a strategic pullback is underway. This could impact the growth of the credit derivative market, he said. "But our findings are certainly not complete." Merritt stressed that certain sectors, reinsurance in particular, are somewhat underrepresented as not all of those surveyed have responded.

While the survey did not include hedge funds, Fitch believes they are one of the most influential segments of the credit derivatives market and the fastest growing. "They're reportedly large buyers of protection, but I think increasingly [they are] playing on both sides of the market," said Prescott. It's approximated that hedge funds account for 5 to 10% of the total market, and Fitch is lobbying for non-regulated companies, such as hedge funds, to increase their disclosure

Fitch expects to conclude its survey in the next 60 to 90 days. The agency then plans to meet with global regulators and present its findings in an effort to increase transparency, Grossman said.

"We feel this marketplace is an effective way to transfer risk," said Grossman.

Copyright 2003 Thomson Media Inc. All Rights Reserved.


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