Run for your lives! Fedsters laud credit derivatives

Section:

Rise of Credit Derivatives
Said Boon to U.S. Economy

By Krishna Guha
Financial Times, London
Friday, March 23, 2007

http://www.ft.com/cms/s/0a1f8e3a-d8d5-11db-a759-000b5df10621.html

The explosive growth of credit derivatives has strengthened the US financial system, making it more efficient and more resilient, two Federal Reserve governors declared on Thursday.

Their comments suggest the Fed believes the financial system is in better shape than in the past to withstand shocks and might absorb losses from the subprime mortgage market.

One of the governors suggested that the Fed would be wary about drawing conclusions about what movements in stock and bond prices say about the economy.

Don Kohn, Fed vice-chairman, said: "As these markets develop and become more complete, they facilitate risk transfer and diversification, thus increasing the resilience of the financial system.

"Credit derivatives, like all derivatives, are in zero net supply and, abstracting from the important issue of counterparty credit risk, they neither add to nor subtract from the stock of financial risk in the economy."

Mr Kohn added that credit derivatives "do, though, provide new and more efficient ways for sharing and hedging the risks that do exist and they facilitate the transfer of those risks to those who are most willing to evaluate and bear them."

Randall Kroszner, a Fed governor, said: "These developments have greatly enhanced the efficiency and stability of the credit markets and the broader financial system."

He added that many concerns about the development of credit derivatives were ill-founded and that 70 percent of outstanding credit derivatives were not complex products at all but single-name credit default swaps -- simple products that insure against the likelihood that a particular borrower will default.

Most der­ivative contracts entered into by banks with unregulated entities such as hedge funds were backed by collateral, Mr Kroszner said. But creditors should exert effective discipline on hedge funds to ensure they did not take ill-judged risks.

Both governors flagged up the risk that defaults on credits embedded in complex derivative portfolios could be more closely correlated than banks believed, resulting in potential for higher-than-anticipated losses in bad times.

Mr Kohn said that, while the Fed monitored markets closely, it would be wary about drawing strong conclusions from recent market volatility that the economy was in trouble. Economists did not understand why the risk premium on shares or corporate bonds was as high as it was, or why it varied as it did, he said.

"All these problems complicate our interpretation of what implications, if any, movements in equity markets have for the economy."

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