The credit crisis continues to throw up big surprises. Just when it looks as if things are beginning to calm down, there's yet another bombshell - whether it be larger than expected writedowns at investment banks, the near-collapse of the monoline sector or the fraud at Société Générale - causing investors and dealers to retreat, liquidity to evaporate and interbank lending rates to spike.
The most recent bombshell was the near-collapse of Bear Stearns. Rumours that Bear was facing liquidity problems swept the market in early March, prompting the firm to declare on March 10 that there was "absolutely no truth to the rumours of liquidity problems".
Nonetheless, the rumours persisted, and with concerns about its mortgage exposures becoming more acute, counterparties simultaneously pulled credit lines, triggering emergency support from the US Federal Reserve on March 14 and its subsequent acquisition by JP Morgan.
As well as once again highlighting the dangers of liquidity risk, the Bear situation has pushed counterparty credit risk up the risk management agenda. Bear was a top dealer in the credit default swap (CDS) market and, as such, was considered relatively safe as a counterparty. While most participants tend to use collateral to manage counterparty risk exposure, the collapse of a major dealer would have caused havoc as counterparties rushed to liquidate the collateral they held against those positions and to replace the trades they had on with Bear.
Meanwhile, the crisis has brought to light the fact that, in some instances, little attention was given to correlations between the counterparty and the reference entity. Banks have reported billions of dollars in writedowns after buying protection on super-senior tranches of CDOs of ABSs from monoline insurers. Far from providing gold-plated insurance on these super-senior tranches, the sharp widening of monoline spreads has meant dealers have faced mushrooming exposure to their monoline counterparties, at precisely the time the hedge is most needed.
In response to this new-found appreciation of counterparty credit risk, and the concern that the market may grind to a halt in the event of default of a major CDS trader, a number of credit derivatives dealers are working to set up a clearing house for the over-the-counter credit derivatives market. The initiative is being developed in conjunction with the Clearing Corporation, and will initially be open to credit derivatives indexes.
The proposal has met with mixed responses. Some say they are sceptical, noting previous attempts over the past 20 years to create a central clearing house for the OTC market have come to nothing. Others point to the success of some exchanges in creating clearing services for a limited number of OTC instruments.
This initiative isn't going to solve all the market's problems. But, if nothing else, it might help restore confidence in the market.
- Nick Sawyer, Editor.