There is a rather dispiriting resemblance between the latest credit crunch and the bursting of the dotcom bubble, writes Tony Jackson in his Monday column.
But here’s the fresh angle. The market has been struck by the disturbing notion that credit derivatives might not be worth what they were supposed to be.
This should hardly be news to anyone who read Warren Buffett\’s broadside against derivatives four years ago. There is no market, he pointed out, for complex derivatives. So instead of being marked to market, they are marked to model — or in some cases, marked to myth.
Currency or interest-rate derivatives are at least priced off a market rate, says Jackson. But credit derivatives, though, are something else again. Loans are not traded and no two are alike. Even corporate bonds — in Europe anyway — are too thinly traded for the exchange price to be reliable.
Lex notes that CDOs are twice removed from their underlying mortgages – which is how in the whacky world of financial engineering you can end up with an AAA-rated tranche, actually constructed from lower-rated asset backed securities. The theory is that with enough securities to absorb initial and subsequent losses, the buffer is deemed big enough to allow some tranches to achieve high-grade ratings, despite the underlying collateral.
In the early days, say Jackson, credit derivatives were about protection – often supplied by an insurance company. But with the advent of CDOs, banks hoover up that protection, credit default swaps, to package and spit out in sliced -up form to investors.
This raises a serious question of whether credit derivatives are a suitable asset class for portfolio investors at all. For a start, they give hedge funds scope to book mythical profit, of which they can then take their 20 per cent cut.
Once the markets have been purged of their excessive appetite for risk, credit derivatives may still be in demand for their original function of hedging risk – thought less so as a means of blindly assuming risk in the hunt for yield.
Recall that just before this latest episode kicked off, the cost of insuring risk through credit derivatives had dropped back to an all-time low. That might happen again. But not for long, I fancy.