Credit derivatives Toxic or magic?

London, Dec 7: In May 2005, ratings agencies cut the debt of US auto makers General Motors Corp. and Ford Motor Co 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 dollars 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 dollars. 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.

Such was the extent of the losses that Dirk Lohmann, chief executive of Swiss reinsurer Converium, accused banks of passing on bad debt to insurance companies and ''pulling the wool over insurance company eyes.''

In 2003, the International Association of Insurance Supervisors said transfers of debt out of the banking system ''alter the balance of risks..., for example, by making the (insurance) industry more susceptible to downturns.'' And legendary US investor Warren Buffett, who is heavily invested in insurance companies, described credit derivatives as ''financial weapons of mass destruction.''

Babylon

But the use of credit derivatives to disperse risk has led to the belief that they are benign.

''You are taking a market that is less liquid and broadening the buyer space, as well as allowing investors to specify exactly the rating of the risk they want to take,'' said Ashish Shah, head of structured credit strategy at Lehman Brothers.

Thomas Huertas, head of wholesale banking at Britain's FSA, said that even though some risk remains, the industry is ''no longer an accident waiting to happen.'' ''Overall, credit derivatives have helped assure that risk is more closely aligned with return, and that capital is allocated more effectively to its most efficient uses,'' he said in April.

''In the economist's dictionary, this comes pretty close to a 'boon to mankind'.'' Derivatives themselves are not a new idea -- the first recorded options contract was found in Babylonian scripts written 3,800 years ago. And, in around 550 BC, Thales of Miletus ''having little money ... gave deposits for the use of all olive presses in Chios and Miletus,'' Aristotle wrote of an arrangement not unlike a present-day option.

Modern derivatives technology got a foothold in the late 1970s when interest rate swaps were first widely traded, while commodity derivatives took off after the sharp oil price rises around the 1990 Gulf War.

In the mid-1990s, banks looked for ways to cut regulatory burdens by shifting credit risk off balance sheets, and the credit derivatives market was born.

Among the most famous early deals was JP Morgan's Broad Index Secured Trust Offering (BISTRO), which used default swaps to release 25 billion dollars of credit risk into the market, the first synthetic collateralised debt obligation (CDO).

While confidence in credit derivatives has grown, potential problems remain. Even investment bankers admit that the models they use to price the highly complex instruments do not always work.

''The idea that correlation modelling is a reliable indicator is a myth'' said Jon Gregory, head of credit derivatives research at Barclays Capital. ''It is very difficult to make the models fit and different models lead to different sets of result.

The FSA earlier this year asked banks to use their own internal models to value a particular complex, illiquid portfolio, and was surprised by the results.''We had a wide variety of approaches and a wide range of valuations,'' Huertas told Reuters.

''We had an interesting dialogue as to how they came up with that range, and it confirmed the difficulties involved.''

Reuters