From: glevy@PRATT.EDU
Date: Sat May 07 2005 - 11:47:15 EDT
via Sara Burke from globolist. ================================================= Greenspan warns on credit derivatives By Richard Beales and Gillian Tett Financial Times May 5 2005 Rapid growth in the credit derivatives markets has created considerable uncertainty about how the global financial system might react to any new economic shocks, Alan Greenspan, chairman of the US Federal Reserve, warned on Thursday. The sheer complexity of derivatives instruments, in particular, coupled with the consolidation in the financial industry, made it increasingly hard for regulators and bankers to assess levels of risk, he said. "The rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress," Mr Greenspan told a Federal Reserve Bank of Chicago conference. Mr Greenspan stressed that derivatives had also brought considerable benefits, by spreading risks between multiple investors, which appears to have made the banking system more resilient to recent shocks. He also indicated that market forces were the best way to ensure investor prudence, indicating that he opposes excessive regulatory interference - or any clampdown on hedge funds. However, his comments come at a time of growing unease among international regulators about the potential challenges created by the fast-growing derivatives world. And, as Mr Greenspan acknowledged, regulators' problems are being exacerbated by poor information about the size of the market, the degree of leverage, and the balance of risk-sharing between investors. However, as Mr Greenspan pointed out, current regulatory regimes tend to measure CDOs according to their book value, not their risks. Moreover, investors may not always fully understand the instruments they are purchasing. "Understanding the credit risk profile of CDO tranches poses challenges to even the most sophisticated market participants," Mr Greenspan said. The issue is further complicated by the growing role of hedge funds, since these are opaque, highly leveraged - but also could potentially rush out of the market in a crisis. "Hedge funds could become subject to funding pressures that would impair their ability to supply liquidity to markets," Mr Greenspan warned. Separarately, he also repeated his earlier warnings abut the concentration risks created by the dominant role played by Fannie Mae and Freddie Mac, the two government-sponsored mortgage institutions, in the dollar interest rate derivatives market. "Concerns about potential disruptions to swaps market liquidity will remain valid until the vast leveraged portfolios of mortgage assets held by Fannie and Freddie are reduced," he said. These issues are particularly acute in the collateralised debt obligation (CDO) market, since when pieces of a CDO instrument are sold to investors, they carry widely differing levels of risk. A recent study by Morgan Stanley, for example, showed that while the face value of all CDOs sold in the past 16 months was $131bn, but when adjusted for risks, its fair value was nearer $350bn.
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