Here's a funny number to wrap your brain around. In 1998 the market for credit derivatives -- complex financial instruments that facilitate the buying and selling of credit risk -- did not exist. But by 2005, there were more than $16 trillion worth of credit derivative contracts outstanding. From zero to 16 trillion -- now that's a growth economy.
A very simple way to understand a credit derivative is as a kind of bankruptcy insurance policy. A bank loans money to an institution, let's say, just for fun, General Motors. The bank then turns around and pays another institution to assume the risk that General Motors might default on that loan. If G.M. doesn't default, the institution selling the "protection" pockets their fee and everyone is happy. But if G.M. does default, the seller of the credit insurance policy has to make good.
That's the simplest possible explanation. In the real world of credit derivatives complexity is exploding on an exponential scale. Debt obligations are sliced and diced into a bewildering array of packages and traded back and forth between an ever-expanding array of institutions -- including hedge fund, mutual funds, insurance companies and, once upon a time, even energy traders such as Enron. The theory, as the first paragraph of a new study by the International Monetary Fund, "The Influence of Credit Derivative and Structured Credit Markets on Financial Stability," states, is that "there is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient." (Thanks to New Economist for alerting us to the report.)
So, basically, the idea is that the more risk is spread out through the financial system, the less likely it would be that a single shock could precipitate a widespread credit crisis. Indeed, the authors of the IMF study say, there is evidence that the maturing of the credit derivative market is already smoothing the ups and downs of the credit cycle -- a historically observable pattern in which, over time, credit gets harder and then easier to obtain.
But there may be a couple of problems with the IMF's generally rosy assessment, underpinned, as usual, by the belief that letting markets handle problems with the least amount of government interference possible is the best way to maintain stability. As a monograph published by the Levy Institute in January notes, the new era of credit derivatives has never been tested by a serious downturn. Many of the largest players, such as hedge funds, are only lightly regulated and highly secretive. Last year, the mere downgrading of General Motors and Ford's corporate bonds "stunned the credit derivatives market," says economist Edward Chilcote, causing hedge funds to lose hundreds of millions of dollars. In a real economic downturn "a possible scenario is that many hedge funds will fail simultaneously 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 pressure on the credit derivatives market. The market might become illiquid, and the potential for a cascade of losses could rise."
Underlying that scenario is a more fundamental problem. Banks, as institutions that are in the business of lending money, are theoretically the parties with the most experience in evaluating risk and credit worthiness. By selling off their exposure to other parties, they are also transferring the responsibility of evaluating risk to institutions that aren't in the same business. Why should a pension fund be an expert in whether that loan to a power company in Brazil is a good bet?
The IMF study argues that a mature market in credit derivatives results in better "price discovery" than the old-fashioned way. With enough liquidity, and enough players, and enough trades, truly risky loans and debt obligations will be correctly rated by the unseen hand. Let's hope the authors are right. It would be peachy keen to imagine that capitalism is capable of naturally evolving into smarter and smarter forms.
But it doesn't always work that way. And sooner or later we're going to find out exactly who's right.