[OPE-L] credit derivatives

From: glevy@PRATT.EDU
Date: Sat May 07 2005 - 11:47:15 EDT

via Sara Burke from globolist.

Greenspan warns on credit derivatives
By Richard Beales and Gillian Tett
Financial Times
May 5 2005

Rapid growth in the credit derivatives markets has created considerable
uncertainty about how the global financial system might react to any  new
economic shocks, Alan Greenspan, chairman of the US Federal Reserve,
warned on Thursday.

The sheer complexity of derivatives instruments, in particular,
coupled with the consolidation in the financial industry, made it
increasingly  hard for regulators and bankers to assess levels of
risk, he said.

"The rapid proliferation of derivatives products inevitably means  that
some will not have been adequately tested by market stress," Mr Greenspan
told a Federal Reserve Bank of Chicago conference.

Mr Greenspan stressed that derivatives had also brought considerable
benefits, by spreading risks between multiple investors, which
appears to have made the banking system more resilient to recent shocks.

He also indicated that market forces were the best way to ensure
investor prudence, indicating that he opposes excessive regulatory
interference - or any clampdown on hedge funds.

However, his comments come at a time of growing unease among
international regulators about the potential challenges created by the
fast-growing derivatives world.

And, as Mr Greenspan acknowledged, regulators' problems are being
exacerbated by poor information about the size of the market, the
degree of leverage, and the balance of risk-sharing between investors.

However, as Mr Greenspan pointed out, current regulatory regimes tend  to
measure CDOs according to their book value, not their risks. Moreover,
investors may not always fully understand the instruments they are

"Understanding the credit risk profile of CDO tranches poses
challenges to even the most sophisticated market participants," Mr
Greenspan said.

The issue is further complicated by the growing role of hedge funds,  since
these are opaque, highly leveraged - but also could potentially rush  out of
the market in a crisis.

"Hedge funds could become subject to funding pressures that would  impair
their ability to supply liquidity to markets," Mr Greenspan warned.

Separarately, he also repeated his earlier warnings abut the
concentration risks created by the dominant role played by Fannie Mae
and Freddie  Mac, the two government-sponsored mortgage institutions, in
the dollar interest rate derivatives market.

"Concerns about potential disruptions to swaps market liquidity will
remain valid until the vast leveraged portfolios of mortgage assets held
by  Fannie and Freddie are reduced," he said.

These issues are particularly acute in the collateralised debt
obligation (CDO) market, since when pieces of a CDO instrument are
sold to investors, they carry widely differing levels of risk.

A recent study by Morgan Stanley, for example, showed that while the
face value of all CDOs sold in the past 16 months was $131bn, but when
adjusted for risks, its fair value was nearer $350bn.

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