Toomre Capital Markets LLC

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Derivatives: the risk factor is frightening according to FSA

The Guardian reported on February 1st 2007 that the Financial Services Authority out of the United Kingdom has said now would be a bad moment for the financial markets to have one of its periodic traumas. According to the article Derivatives: the risk factor is frightening written by Nils Pratley, "The shock to the system would be 'much greater now than two or three years ago'. Regulators are paid to be cautious, so at one level this pronouncement is unsurprising, but 'two or three years' is not long ago. Can things really have changed so much?

Well, yes, in spades. The biggest change is the growth of credit derivatives, the process by which securities such as corporate debt, mortgages and shares are sliced, diced, packaged and repackaged. Investment banks house too much creative computing power these days, and the face value of credit derivative contracts is reckoned to be about $30 trillion - yes, trillion. It's an enormous number and about eight times as much as in 2003. So something very big has changed very significantly." [Underlining and emphasis added]

Toomre Capital Markets LLC has previously written about the credit derivatives market and how it now is sometimes a leading indicator for corporate events, such as private equity buyouts. TCM has also previously recommended that Wall Street and investment professionals read the post Suggested Reading: Timothy F. Geithner Speech on Credit Derivatives. Based on other articles and the various search phrases readers use to arrive at this web site, regulators appear to be increasingly worried about their insight into increasingly complex capital markets. Investment banks and specialist hedge funds dominate much of the trading activity in credit derivatives, which predominantly trade in privately negotiated transactions between the buyer and the seller that are codified with International Swap and Derivatives Association derivatives documentation. As a result, there is limited disclosure of transaction terms, trade magnitude to the general public.

The Guardian article concludes with the following:

Jean-Claude Trichet, president of the European Central Bank, said last week that "there is now such creativity of new and very sophisticated financial instruments ... that we don't know fully where the risks are located. We are trying to understand what is going on but it is a big, big challenge."

Trichet sounded like a man witnessing an accident but unable to do anything, which hasn't always been the attitude of central bankers towards derivatives. Many used to argue that these instruments do important work in spreading risk and reducing the cost of borrowing.

Now, though, there seems to be a change of tone. Timothy Geithner, the US Federal Reserve's man in New York, said last year that the derivatives revolution may make financial crises less common, but more severe when they do occur. You may not be reassured.

With both credit and mortgage spreads close to their tightest levels relative to U.S. Treasuries, Toomre Capital Markets LLC wonders what trauma will cause the fixed-income spread markets to widen considerably. Such widening also would likely produce trauma for credit derivatives sector. Perhaps only then will market participants learn whether these fears of regulators are appropriate.