Magazine article Risk Management

Credit Risk Issues 2008

Magazine article Risk Management

Credit Risk Issues 2008

Article excerpt

In an increasingly networked economy, distress can quickly send shockwaves up and down the supply chain. And few things are more distressing than whether you are going to get paid. As fear rises, people tend to dig in further and become more risk averse. What was once an "acceptable risk" may no longer be acceptable.

The 2007 liquidity crunch demonstrates that credit issues can be very contagious. Overbuilding in the housing sector rippled onto the the balance sheets of firms active in syndicating and securitizing risk. As those balance sheets collapsed, the debt market responded by rushing out the door. Corporate debt spreads over treasuries roughly doubled over the year across all quality of issues.

Were this a singular shock, the damage would have normally been quickly repaired through liquidity injections from central banks and recapitalizations from the sidelines (sovereign funds in this particular credit cycle).

But, unfortunately, the second wave in a tsunami can be worse than the first. As we enter 2008, corporate debt markets are expected to see far more volatility than most credit models ever envisioned. The second wave will arrive amidst this volatility. The demand for credit will rise about 50% in 2008 above 2007 levels with the maturing of several hundred billion dollars in commercial debt by major U.S. financial firms. With many banks throttling back their lending as 2007 ended, and evidence of increased deleveraging in the banking system, there is serious potential for a gap between supply and demand. When that happens, prices have a potential for spiking

What does this all mean to OTC (over-the-counter) markets in 2008? The short answer is wider spreads (particularly for short-term, low quality commercial paper). After that, there is likely to be a more systemic approach to managing counterparty risk.

We have seen this situation before. When credit risk shut down energy markets earlier in the decade, we saw the market structure reshape itself toward structures better equipped to manage liquidity and credit risk. This included, among other things, the adoption of exchange-type clearing mechanisms in the bilateral markets.

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In the United States, financial markets for certain commodities are regulated under the Commodity Exchange Act (CEA) if the traded instrument satisfies the statutory definition. By law, such contracts must be traded on a regulated exchange (e.g., NYMEX). All other instruments (both exchange traded and bilateral transactions) constitute the OTC market.

Contract standardization is the distinguishing feature of a regulated contract. A regulated contract is less prone to credit risk. For example, all futures contracts must be traded on an exchange approved by the Commodity Futures Trading Commission (CFTC) as a "designated contract market" (DCM). The only contract variable is price.

Standardization permits the exchange to guarantee performance. The clearinghouse "clears" the trade and manages the margin accounts guarding against risk of default. NYMEX ClearPort provides clearing services.

Other features of regulated markets include their objectives to limit the disruptive effects of speculation and provide effective price discovery.

In contrast, OTC markets may or may not enjoy the benefits of a clearinghouse or other features of regulated markets. For example, the Intercontinental Exchange (ICE), an unregulated exchange exempt from CFTC regulation, offers clearinghouse services for standardized, cleared instruments, thereby reducing bilateral credit exposure.

The lack of a standardized contract, for example, can increase back office costs simply due to process errors. Netting is more problematic as well. The absence of effective price discovery imposes additional burdens in locating deals. The number of counterparties can also be limited in OTC markets. …

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