Credit

A defense of credit derivatives by a few of the Federal Reserve governors will undoubtedly delight those pointing the finger at the Fed and other regulators for creating turmoil in the sub-prime mortgage sector. The two Fed governors said in speeches this week that the explosive growth of credit derivatives has in fact strengthened the US financial system, making it more efficient and resilient.

Their comments suggest the Fed believes the financial system is now in better shape to withstand shocks and absorb losses from the subprime mortgage market. One of the governors suggested the Fed would be wary about drawing conclusions about what stock and bond price movements say about the economy.

Don Kohn, Fed vice-chairman, said that credit derivatives, like all derivatives, “neither add to nor subtract from the stock of financial risk in the economy”. But, he added, “they do provide new and more efficient ways for sharing and hedging” existing risks and “facilitate the transfer of those risks to those who are most willing to evaluate and bear them”.
Randall Kroszner, a Fed governor, said that many concerns about the development of credit derivatives were ill-founded and that 70 per cent of outstanding credit derivatives were not complex products at all, but single-name credit default swaps.

Both governors flagged up the risk that defaults on credits embedded in complex derivative portfolios could be more closely correlated than banks believed, resulting in potential for higher-than-anticipated losses in bad times. However, Mr Kohn said, while the Fed monitored markets closely, it would be wary about drawing strong conclusions from recent market volatility that the economy was in trouble.