Wednesday, October 15, 2008

What went wrong? (Part II) Don't blame it on derivatives


WASHINGTON D.C., Tuesday, October 14, 2008 – In testimony before the US Senate Committee for Agriculture, Nutrition and Forestry, Robert Pickel, Chief Executive Officer of the International Swaps and Derivatives Association, Inc. (ISDA), called for better understanding of the benefits of credit default swaps (CDS) and their positive role in the global financial industry.

"Both the role and effects of CDS in the current market turmoil have been greatly exaggerated," said Mr. Pickel in his testimony. "To say that CDS were the cause, or even a large contributor, to that turmoil is inaccurate and reflects confusion of the various financial products that have been developed in recent years. There is little dispute that ill advised mortgage lending, coupled with improperly understood securities backed by those loans, are the root cause of the present financial problems."

Some of these mortgage loans had been sold by lending banks and repackaged as securities called "collateralized debt obligations," or "CDOs". Although CDO and CDS are similar abbreviations, they are very different products. A CDS is a privately negotiated contract between two parties. A CDO, on the other hand, is an investment security that can be bought and sold freely on the market. Like other securities in the US, CDOs are subject to the disclosure and other requirements of the securities laws; nevertheless it appears that these CDOs, widely sold to investors throughout the US and the world, were fundamentally mis-priced. Worse, in some cases the structures of the CDOs themselves were extremely complicated and apparently not well understood.

Mr. Pickel emphasized the need for prudent risk management and appropriate use of credit risk mitigation tools. He stated that CDS have continued to perform well in the wake of defaults of major market participants, both counterparties and issuers of debt. CDS participants have settled trades in an orderly way precisely according to the rules and procedures established by ISDA and market participants.

During the testimony, Mr. Pickel discussed the five major credit events that took place within the last several weeks - Tembec Inc., Fannie Mae and Freddie Mac, Lehman Brothers and Washington Mutual. All these companies were referenced under a large number of CDS. Despite defaults by these firms, the derivatives markets, and in particular the CDS market, has continued to function and remain liquid.

Critical to this success is understanding the difference between notional values of privately negotiated derivatives and actual amounts at risk. Payment streams in connection with these events are much smaller than is commonly understood; gross market values are approximately 2% of the commonly referenced measure of notional amounts. In recent days, the Depository Trust and Clearing Corporation (DTCC) estimated that in connection with the Lehman CDS settlement, for example, the net funds transfer from net sellers to net buyers of protection is expected to be approximately $6bn, a much smaller number than has been widely reported in the media.

Recent market events clearly demonstrate that the regulatory structure for financial services has failed. An in-depth examination of this structure is self-evidently warranted. In this examination it is ISDA's hope that the facts surrounding OTC derivatives, and the role they continue to play in helping allocate risk, in providing liquidity and helping price discovery, will highlight the benefit of derivatives and of industry responsibility and widely applied good practices recommended by ISDA.

Mr. Pickel concluded his testimony by stating that derivatives have continued to perform well during a greater period of stress than the world financial system has witnessed in decades. CDS activity has been a tremendous success and ISDA is confident that policymakers and market participants alike will find their prudent efforts in helping build the infrastructure for derivatives have been rewarded.

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