Fitch: Hedge Funds "Challenge" Credit Derivatives

NEW YORK (HedgeWorld.com)--Preliminary results of Fitch Ratings' survey of global financial institutions use of credit derivatives found that hedge funds are one of the fastest growing and most influential segments of the market for these products.

As protection buyers, hedge funds make up 5% to 10% of the total market. According to Fitch this influential segment could present "additional challenges to the market related to hedge funds' propensity for minimal disclosure, their demonstrated ability to influence pricing/liquidity and the potential for increased counterparty risk."

The survey, however, did not include any hedge funds. Fitch surveyed 200 global banks, insurance companies, reinsurers, financial guarantors and broker-dealers and focused primarily on those selling protection through credit derivatives and collateralized debt obligations.

Fitch found that a surprising level of counterparty risk is concentrated among the top 10 global banks and broker-dealers. "While these institutions generally are solid investment-grade risks, material nonperformance due to financial deterioration or contractual disputes is a potential risk," said Roger Merritt, managing director of Fitch Ratings, in the statement. The top three bearers of counterparty in this market are: J.P. Morgan, Merrill Lynch and Deutsche Bank. Mr. Merritt also said that although the conventional view is that banks are primarily net buyers of protection, nearly three-quarters of the European banks surveyed are net sellers.

"The banks are using credit derivatives as an integral part of their revenue-generating business," he explained, "enabling certain European banks to diversify by gaining exposure to regions and sectors where they are underweighted."

Fitch expects to continue to gather data from companies that have yet to respond, for another 60 to 90 days and stressed that the findings released last week are only preliminary. "A lack of standardized terminology and reporting, while not unexpected given the market's relative immaturity and the diversity of respondents, does, on balance, make interpretations and comparisons more challenging," said Managing Director Ian Linnell.

By the grace of regulatory serendipity, within a few days of the release of Fitch's preliminary findings, the Office of the Comptroller of the Currency (U.S. Treasury) released a report on credit derivatives in which it concluded that national banks are taking on greater credit risks in their portfolios. The OCC said that 19 banks sold protection, i.e. assumed credit risk, covering US$291 billion in credits as of years end, up US$20 billion from the third quarter.

CFaille@HedgeWorld.com

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