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JUNE 12, 2006
Time for Banks to Ask, "What If?" With some financial institutions acting more like dare devils than mere risk takers, a systemic crisis may loom Has the increased risk-taking of banks boosted the odds of a systemic crisis -- one in which assets of all kinds plunge in value simultaneously and the markets threaten to shut down altogether? Commercial and investment banks are sitting on piles of exotic securities whose performance in extreme market moves has never been tested. Despite all the attempts at "stress testing" portfolios, no one really knows what would happen to the big banks if oil prices shot to $150 a barrel, or the dollar crashed, or a bird flu epidemic broke out. "NEVER BEEN TESTED." One of the biggest concerns is the credit-derivatives market, which has doubled in size, annually since 2001, to $17 trillion. Credit derivatives are bets on whether a certain company or group of companies will default on its bonds or loans. A handful of major banks dominate the market as designers, sellers, and buyers. JP Morgan Chase & Co. alone had bets on $2.3 trillion worth of securities at the end of 2005. On ordinary days, credit derivatives add to market liquidity by enabling speculators to take on the risk of a default by a bank borrower or a bond issuer, and the buyers of protection get to take those risks off their books. Normally these things change hands in an orderly way. But the market has never been tested by a major crisis. The danger is that investors who made money in calm times by speculating against defaults won't pay off as promised when defaults occur. Even if they do, they might lose their nerve, shrink their portfolios (if they can), and sit on the sidelines for a while, making it harder for loan and bond issuers to lay off new risks. And if that happens, a big chunk of the debt market could freeze up. AUTO SCARE. The good news: Big banks understand they have a problem and are working to fix one part of it, namely a huge accounting snarl that left thousands of credit-derivative deals in a legal gray area. A crisis of confidence is most likely when the market is missing crucial information, such as who owes what to whom. A scare last year following Standard & Poor's downgrades of General Motors Corp. and Ford Motor Co. debt grabbed the attention of senior management and speeded up an industry reform effort that was already under way. The key players in the ongoing project are Timothy F. Geithner, president of the Federal Reserve Bank of New York, and one of his predecessors in that job, E. Gerald Corrigan, a Goldman, Sachs & Co. managing director who has led two blue-ribbon panels aimed at promoting market stability. What makes credit derivatives so potent? Simply put, they allow instantaneous risk transfer. The most basic version is a credit default swap, whose fluctuating price hinges on the possibility of default by a particular company -- GM, say. Bettors agree on a hypothetical sum of bonds or loans on whose outcome they're betting -- say, $500 million. That's the so-called "notional" amount, totaling $17 trillion for all companies. The buyer of protection on GM makes regular payments to the seller of protection, i.e., the "insurer." In return, this insurer promises to pay the face value of GM loans or bonds in case GM defaults. NEED TO EXTRICATE. Since last September, the biggest derivatives dealers in the U.S. and Europe have been painstakingly untangling the accounting mess brought on by the fast growth of the credit-derivatives business. Until the Federal Reserve stepped in, it was common for one party to a credit-derivative contract to sell its position to another institution without even notifying its counterparty, let alone asking permission. So the person who owed you money could turn out to be a nonentity operating out of someone's den. As a result of the big banks' efforts, credit derivatives are safer than a year ago. But the danger hasn't completely gone away, because credit derivatives have become deeply embedded in the debt market. Risk-averse banks and bond buyers depend on speculators, including hedge funds, to take on the risk of default by iffy companies. If speculative sellers of protection flee the market in a crisis, some of those loans might not be made and those bonds not bought. "Credit derivatives should be stabilizing in crises, because they spread risk more broadly," says New York Fed President Geithner. "But there is inherently some uncertainty in how these markets will behave in stress. It's good to be humble about what we know. We have been a little lucky."  By Peter Coy Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | |
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