On September 15, the Federal Reserve convened 14 large credit derivatives-dealer banks to an unusual meeting (Beales 2005b). The last such meeting occurred on September 16, 1998, in secret. At that time, a major financial institution was melting down and threatening to take some large banks with it. This time they met to discuss the same topic: the clearing of transactions in the credit derivatives market.

Edward Chilcote

English

Research Papers in Economics

The Levy Economics Institute of Bard College
Policy Note
2006 / 1
edward chilcote is a research scholar at the Levy Institute. He gratefully acknowledges comments from Martin Mayer. The author
bears sole responsibility for any errors in this Policy Note.
The Levy Economics Institute is publishing this research with the conviction that it is a constructive and positive contribution to the discussion
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Copyright © 2006 The Levy Economics Institute
CREDIT DERIVATIVES AND 
FINANCIAL FRAGILITY 
edward chilcote
On September 15, the Federal Reserve convened 14 large credit derivatives–dealer
banks to an unusual meeting (Beales 2005b). The last such meeting occurred on
September 16,1998,in secret.At that time,a major financial institution was melt-
ing down and threatening to take some large banks with it. This time they met to
discuss the same topic:the clearing of transactions in the credit derivatives market.
In 1998, the major Wall Street banks orchestrated a $3.65 billion bailout of a hedge fund
called Long-Term Capital Management. The fund had entered into thousands of derivative con-
tracts and was intertwined with every major bank on Wall Street (Lowenstein 2001, p. xix). If
Long-Term Capital Management had defaulted, its counterparties would have been left holding
one side of contracts for which there was no offset.Analysts expressed concern that banks would
rush to neutralize exposure from their one-sided positions and that this rush might overwhelm
the markets. Fearing that a run might ensue and foreseeing the potential difficulties of an unrav-
eling of the derivative swaps, banks decided to act.
Long-Term Capital Management did not disclose its risk or positions to investors or counter-
parties. The fund was highly leveraged. In one trading day it lost $533 million—one-third of its
equity (Lowenstein 2001, p. 191). Banks also suffered large losses (p. 170). In the days of this
unraveling, capital was scarce. Then–Treasury Secretary Robert Rubin (1998) characterized thetime and events as the “most serious financial crisis in many
respects of the last 50 years.”
In the last few months, a number of developments have
affected the credit derivatives market. In particular, the down-
grading of the corporate bonds of Ford and General Motors by
rating agencies stunned the credit derivatives market. The cost
of insuring some of General Motors’debt through credit deriv-
atives rose fourfold in five months (Gilbert 2005).Hedge funds
lost hundreds of millions of dollars, owing to their exposure to
derivative contracts and the downgrading of General Motors’
and Ford’s debt in May (Whitehouse 2005).
Credit derivatives are bilateral contracts that transfer cred-
it risk between parties. Some credit derivatives divide bonds
into parts to make bond trading less risky for some parties.
Banks pool different corporate bonds and cut these pools into
sections called tranches. Each tranche bears some risk. The
riskiest tranche, while offering the highest return, absorbs the
first portion of any loss a pool suffers.
Another type of credit derivative is the credit-default swap.
Credit-default swaps insure pools of corporate bonds against
credit losses. Credit-default swaps are contracts between coun-
terparties in which the protection seller agrees to compensate
the protection buyer if some “credit event,” such as a default,
occurs. It is a guarantee—a credit insurance policy. The seller
of the protection receives a fee up front for agreeing to provide
protection against some possible future credit event. The party
that assumes the credit risk must provide funding in the future
if and when a credit event occurs (Rule 2001).If there is a default,
the insurer or owner of the credit default obligation absorbs
the loss. If the probability of default increases, then the cost of
protection rises.So if the party that sold protection wants to get
out of the contractual obligation, it has to pay a higher price to
get some other party to do the insuring.
Credit derivatives such as credit-default swaps introduce
counterparty risk. Counterparty risk is the risk that the other
party to a contract will not be able to meet its contractual obliga-
tion. Contractual arrangements link counterparties and increase
systemic risk: if one fails, there is a higher likelihood that those
around it will also fail. Close interconnection means that the
financial performance of one institution is linked to the finan-
cial performance of its many counterparties.
Many credit derivatives pose systemic risk to the financial
system because they do not require credit-loss reserving. They
are pay-as-you-go. Paying for credit losses as they come due—
rather than reserving for them in advance—is unsound,because
funding might not be available when it is needed. In some
cases, the introduction of credit derivatives allows convention-
al credit-loss reserving to be circumvented.
Against this backdrop, evidence shows that banks are pro-
viding less for loan-loss reserves.The Federal Deposit Insurance
Corporation statistics on loan-loss provisioning suggest that
bank regulation today is more lax than at any time since the
early 1970s.In 2003,the provision-to-net-credit-loss rate stood
at 91.84 percent.In 2004,it dropped to 89.88 percent.This ratio
shows the amount of dollars provided for loan-loss reserves over
the actual dollars depleted from these reserves to cover net cred-
it losses. A ratio below 1 means that credit-loss reserves are
shrinking. In the last 30 years, there have been only five years
where this ratio has fallen below 1. In 2003 and 2004, the ratio
reached its lowest points since 1971. This decline is occurring
while loan growth is expanding.
The current legal structure entices counterparties in deriv-
ative contracts to act as first movers. The U.S. bankruptcy code
affords parties in financial derivative contracts exemption from
the “automatic stay.” This exemption allows counterparties to
terminate derivative contracts and seize collateral with debtors
that are in bankruptcy (Edwards and Morrison 2004, p. 3).
Exemption from the automatic stay exacerbates systemic risk.
Edwards and Morrison point out that a chain reaction—a run—
might have ensued,had one of Long-Term Capital Management’s
counterparties terminated or liquidated its derivative contracts
(p. 11). Long-Term Capital Management’s derivative positions
were unwound in an orderly fashion because of the Federal
Reserve’s oversight and intervention (p. 12). Edwards and
Morrison suggest that if the special provisions in the bankrupt-
cy code had not existed, the threat of an abrupt or disorderly
closeout of Long-Term Capital Management’s position would
not have been possible (p. 13). They say that the exemption
from the automatic stay provision of the bankruptcy code gives
derivatives institutions incentives to run on financially dis-
tressed counterparties (p. 16).
Many hedge funds and a few pension funds that specialize
in credit-default swaps and other credit derivative instruments
are secretive and unregulated.They do not disclose their risk to
counterparties. It came as a surprise to counterparties to learn
of Long-Term Capital Management’s financial position in 1998
2 Policy Note, 2006 / 1The Levy Economics Institute of Bard College 3
(Lowenstein 2001,p.xxi).Banks and other financial institutions
that have counterparty contracts with hedge funds are exposed
in ways that even they are not completely clear about.
Unlike 1998, when there were fewer players and a smaller
market, today’s market is large and expanding. According to
the International Swaps and Derivatives Association Mid-Year
2005 Market Survey, the notional amount for credit derivatives
in the first half of the year stood at $12.43 trillion. The annual-
ized growth rate for the first six months of 2005 was 128 per-
cent (International Swaps and Derivatives Association 2005).
According to the Financial Times, currently there are huge back-
logs of paperwork; some transactions have remained uncon-
firmed for “months or even years”(Beales 2005a).
Hedge funds are typical sellers of these derivatives and
receive large sums of money for the pledge to pay in the event
of default. The credit derivatives market has never been tested
during a serious downturn,when the incidence of credit defaults
rises.According to the Wall Street Journal, foreign investors are
purchasing some of the riskiest assets (Hagerty and Simons
2005). This complicates any potential bailout.
A possible scenario is that many hedge funds will fail simul-
taneously from exposure to credit derivatives, and banks will
rush to buy contracts to cover their exposure.A declaration of
bankruptcy by a major corporation would put further pres-
sure on the credit derivatives market.The market might become
illiquid, and the potential for a cascade of losses could rise.
Under such stress, a run on the assets of troubled institutions
that have counterparty contracts would become more likely.
Federal Reserve Chairman Alan Greenspan contends that
the economy is resilient because new developments, such as
the growth of credit derivatives, bring enhanced flexibility. He
argues that flexibility reduces the need for government action:
“Enhanced flexibility provides the advantage of allowing the
economy to adjust automatically, reducing the reliance on the
actions of monetary and other policymakers, which have often
come too late or been misguided”(Greenspan 2005a).He asserts
that if the economy maintains an adequate degree of flexibility,
the large imbalances will self-correct. Shortly before the col-
lapse of Long-Term Capital Management in 1998, Greenspan
was echoing a similar view about flexibility in the regulation of
the derivatives market. In February 1997, he argued that gov-
ernment regulation of the off-exchange derivatives between
institutional counterparties would be rash:“It would also seem
unwise to unnecessarily impede competition in the provision
of centralized trading or clearing facilities to derivative trans-
actions that are currently negotiated and cleared bilaterally.”
On September 16, 1998, in the midst of the collapse of Long-
Term Capital Management, and while his colleagues were active-
ly intervening to shore up problems in the financial market,
Greenspan testified before Congress,“Market pricing and coun-
terparty surveillance can be expected to do most of the job of
sustaining safety and soundness.”
Greenspan continues to stress the theme that private mar-
kets are effective at managing risk. Greenspan believes credit
derivatives have had a stabilizing influence on the economy.
Speaking before a conference on bank structure, he said: “The
development of credit derivatives has contributed to the sta-
bility of the banking system by allowing banks, and especially
the largest,systemically important banks,to measure and man-
age credit risk more effectively”(Greenspan 2005b).At a recent
meeting, he cited the credit crunch of the early 1990s and the
bursting of the stock market bubble as proof of the economy’s
continued “resilience”(Greenspan 2005a).
While Greenspan expresses confidence that the market will
resolve any problems on its own, one lesson relearned from
the disaster in New Orleans—about expecting the future to be
similar to the recent past—is that prudence dictates anticipat-
ing events, however unlikely, and working to counteract any
potential negative impact.Engineers had warned for years that
the levees could break in a large storm. The fact that the levees
had not been breached in the recent past should not have been
grounds for complacency.The events that unfolded should not
have come as a surprise to government officials.Small incidents,
such as a levee breaking, can trigger larger, more serious events,
such as flooding. Faith in “resilience” may not get us through
the next crisis. Decisive action to head off a future crisis in the
credit derivatives market is needed. Standardizing trading doc-
umentation,imposing time limits for clearing transactions,man-
dating strict margin requirements, rewriting the bankruptcy
code, requiring better public disclosure, and overseeing capital
adequacy and loss reserves for institutions engaged in the cred-
it derivatives market would be a good start.References
Beales, Richard. 2005a.“Is Fed Preaching to the Converted?”
Financial Times, September 15.
———. 2005b.“Three Yards and a Cloud of Dust.”Financial
Times,S e p t e m b e r  8 .
Edwards, Franklin R., and Edward R. Morrison. 2004.
“Derivatives and the Bankruptcy Code: Why the Special
Treatment?”Working Paper No. 258. New York: Columbia
Law School: The Center for Law and Economic Studies.
Federal Deposit Insurance Corporation. 2005. Historical
Statistics on Banking.
www2.fdic.gov/hsob/SelectRpt.asp?EntryTyp=10
Gilbert, Mark. 2005.“Still Think Ford, General Motors Can’t
Go Bust?”Bloomberg Online, May 6.
Greenspan, Alan. 2005a.“Reflections on Central Banking.”
Remarks at a symposium sponsored by the Federal
Reserve Bank of Kansas City, Jackson Hole, Wyoming,
August 26. www.federalreserve.gov/boarddocs/
speeches/2005/ 20050826/default.htm
———. 2005b.“Risk Transfer and Financial Stability.”
Speech to the Federal Reserve Bank of Chicago’s 41st
Annual Conference on Bank Structure, Chicago, Illinois
(via satellite), May 5. www.federalreserve.gov/boarddocs/
speeches/2005/20050505/default.htm
———. 1998. Testimony on the international economic and
financial system before the Committee on Banking and
Financial Services of the U.S. House of Representatives,
September 16. www.bis.org/review/r980918d.pdf
———. 1997. Remarks on government regulation and
derivative contracts at the Financial Markets Conference
of the Federal Reserve Bank of Atlanta, Coral Gables,
Florida, February 21.
Hagerty, James R., and Ruth Simons. 2005.“Mortgage Risk:
A Hot Export.”Wall Street Journal, September 22.
International Swaps and Derivatives Association. 2005. ISDA
Mid-Year 2005 Market Survey: Credit Derivatives at
$12.43 Trillion. New York, September 28.
Lowenstein, Roger. 2001. When Genius Failed: The Rise and
Fall of Long-Term Capital Management. New York:
Random House.
Rubin, Robert. 1998. Remarks at Yale Law School, New
Haven, Connecticut. October 17.
www.treas.gov/press/releases/rr2762.htm
Rule, David. 2001.“The Credit Derivatives Market: Its
Development and Possible Implications for Financial
Stability.”Financial Stability Review, June: 117–140.
Whitehouse, Mark. 2005.“How a Formula Ignited a Market
That Burned Big Investors.”Wall Street Journal,
September 12.
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2005.“How a Formula Ignited a Market That Burned Big Investors.”Wall Street Journal,

2005a.“Is Fed Preaching to the Converted?” Financial Times,

2005a.“Reflections on Central Banking.” Remarks at a symposium sponsored by the Federal Reserve Bank of Kansas City,

Derivatives and the Bankruptcy Code: Why the Special Treatment?”Working Paper No.

Historical Statistics on Banking.

Market Survey: Credit Derivatives at $12.43 Trillion.

Remarks at Yale Law School,

Risk: A Hot Export.”Wall Street Journal,

To order a Levy Institute publication, call 845-758-7700 or 202-887-8464 (in Washington,D.C.),fax 845-758-1149,e-mail info@levy.org, write The Levy Economics Institute of Bard College, Blithewood,

When Genius Failed: The Rise and Fall of Long-Term Capital Management.

Yards and a Cloud of Dust.”Financial Times,S e p t e m b e r 8 .

"Credit Derivatives and Financial Fragility"

http://www.levyinstitute.org/pubs/pn_1_06.pdf

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