Wednesday, April 1, 2009

Derivatives Becoming “Unmanageable…”

Interesting information from Fitch. Trading costs rising and spreads widening with fewer players in the system.

Again, there is just no way that derivatives are going to resume the growth rate they were on, despite our central banker’s and Government’s intent to the contrary.
CDOs Becoming ‘Unmanageable’ as Trading Costs Surge, Fitch Says

By Neil Unmack

April 1 (Bloomberg) -- Managers of collateralized debt obligations are struggling to operate the funds because the cost of trading the underlying contracts has soared, according to a report by Fitch Ratings.

Some CDOs that package credit-default swaps are now “virtually unmanageable” because prices for the contracts have risen so high, Fitch said in the report today. Managers select contracts included in so-called synthetic CDOs, and seek to protect bondholders by trading out of companies that may fail.

Banks started closing down or scaling back units that bought and sold CDOs last year, Fitch said. That’s increased the spread between bid and offer prices for credit-default swaps that banks left in the market can demand.

“Those desks that remain in the correlation trading business have seen their allocated capital and risk appetite dramatically reduced, resulting in larger bid/ask spreads,” analysts Manuel Arrive and Lars Jebberg wrote in the report. The lack of market “liquidity” has become “a major hindrance” for managers of CDOs, they wrote.

The cost of credit-default swaps on the benchmark Markit iTraxx Europe index of investment-grade bonds has risen to almost 180 basis points from about 20 in 2007, according to data compiled by Bloomberg. That means it costs 180,000 euros ($239,000) a year to protect 10 million euros of debt from default for five years compared with 20,000 euros before the credit crisis.

The contracts used to speculate on corporate creditworthiness and a rise indicates a deterioration in credit quality. CDOs pool bonds, loans or credit-default swaps, channeling their income to investors in layers of differing risk.

It seems to me that protecting one’s self against risk has become very risky! Derivatives attempt to assess and assign risk the easy way – math models made up and run in a computer. That concept as a whole creates a moral hazard as people no longer work at assessing risk because they think they are removed and protected when in fact they have only shifted the risk onto the entire system.

Perhaps if businesses did their due diligence, they would choose more wisely who they do business with. Unfortunately, the risk is being moved onto our Government and that makes US a risk. The fallout and consequences of allowing derivatives to get out of control will be haunting us for decades. We had an opportunity to do the right thing – allow those who took risks to fail – but that window is closing rapidly as we attempt to backstop everyone and everything.