Credit derivatives: Toxic or magic?

By David Wigan

In May 2005, ratings agencies cut the debt of U.S. auto makers General Motors and Ford to "junk" after a sustained run of losses.

The fall of the once great automotive powers made global headlines, but among the hardest hit by the downgrades were investors in credit derivatives -- relatively obscure and complex products used to hedge bond and loan risk.

Because credit derivatives are leveraged, those that contained exposure to Ford and GM debt fell sharply, and some investors lost millions of dollars in a matter of hours. One institution was reported to be some $200 million (100 million pounds) in the red.

At the time, the episode heightened concerns that credit derivatives were an unpredictable threat to investors and financial markets, but since then fears have subsided.

"There will always be nay-sayers and it's right to ask questions about potential excessiveness of leverage," said Matt King, head of credit strategy at Citigroup. "But my general feeling is that doubts are increasingly replaced by acknowledgement of the robustness of the market."

A credit derivative is like a side bet on a company's ability to pay back its debt. The bet takes the form of an insurance policy where one party agrees to pay the other if a company defaults.

The insurance policies rise or fall in value based on the company's fortunes and can be traded or combined in portfolios known as collateralised debt obligations (CDOs), which give investors a choice of exposures to default risk.

Such has been the enthusiasm for the products that the market has doubled in size every year this decade, making it the fastest-growing on the planet.

From almost nothing in the mid-1990s, credit derivatives are now worth some $27 trillion. But while their popularity is confirmed, there is a nagging concern the investments are untested in an serious downturn, and could pose a threat to financial stability.

Many smaller banks and asset managers in the United States and Europe have bought into the promise of higher returns made possible by leverage, whose investments could be at risk if bond issuers started to default.

Even before the 2005 blow up, there were signs of instability. In 2001 and 2002 some investors lost millions of dollars on collateralised debt obligations (CDOs) after taking leveraged exposure to telecoms firms wilting under their debt.

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