Heads in the sand

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It's funny. Risk has talked to plenty of risk managers over the past year, and most - if not all - have raised the possibility of a downturn in the credit markets. Several banks have increased their use of credit derivatives to hedge their loan books, while distressed debt bankers are being snapped up in preparation for an expected uptick in corporate failures. Regulators, too, have warned that credit spreads look too tight and are likely to widen, with some expressing concern about the number of high-yield borrowers taking advantage of tight spreads to borrow lots for little. Talk to structured credit product providers, however, and the likelihood of a turn in the credit cycle is very much downplayed.

Most credit structurers do, in fact, acknowledge that spreads are likely to widen over the short to medium term. And, indeed, a number of collateralised debt obligations (CDOs) have emerged over the past year that offer managers greater flexibility to generate returns in various market conditions, including spread widening. But ask a dealer if they are expecting a repeat of the high default rates of 2002, and how their products will fare in such an environment, and they tend to clam up.

The answer, of course, is pretty simple - some CDO investors, particularly those in the equity and junior tranches, will lose money if corporate defaults rise appreciably. And, in itself, there's nothing wrong with that. By buying CDOs, investors are taking exposure to the credit market, the direction of spreads and the corporate default rate. If investors don't have their own clear and informed view on any of these points, then they shouldn't be investing in credit.

Most banks have learned their lessons from the CDO mis-selling allegations that stemmed from overly aggressive - and, in some cases, misleading - sales pitches in the early part of this decade. CDO prospectuses and marketing materials now go into plenty of depth, and product performance under various market scenarios - positive and negative - is described. So why the shuffling feet and downward glances when asked about the effect of a rise in defaults?

It may very well be the case that structurers honestly believe defaults won't reach the levels of 2002, and that the worst-case scenario will be a gentle widening in spreads. But they should at least listen to the views of their own risk managers and talk openly about the effects of such a scenario. After all, transparency isn't just about having 100-page marketing documents.

Nick Sawyer, Editor.

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