Sceptics insist that credit derivatives and synthetic securitisation are a flash in the pan. But most of the evidence suggests these techniques are so powerful and versatile that they will play a vital role in the new world of grown-up risk management.
In just three years, credit derivatives and CDOs have moved from the margins of international finance to the mainstream.
When the first bank CLOs were completed in 1996 and 1997, for NatWest, Bank of Tokyo-Mitsubishi, NationsBank and others, many bankers viewed them as a regulatory dodge which, given the amount of effort they entailed, provided only marginal benefits.
Credit derivatives too were widely considered unnecessary - "a derivatives market too far" in the words of one veteran.
Now, few institutions remain untouched by the synthetic credit phenomenon. Many routinely buy and sell credit protection on single names as a way to hedge risk or increase the returns on their credit portfolios. Many others banks have issued CLOs and other transactions using synthetic risk transfer techniques.
The sceptical view
But plenty of observers remain suspicious of banks' true motives in using CLOs and credit derivatives and many doubt whether these markets will continue to grow. There are two arguments for supposing that their current popularity is no more than a blip.
First, many predict that reforms to the Basle Accords will stem the flow of deals, by altering the regulatory environment for the world's banks.
It is true that regulatory arbitrage has been the main driver for much CLO activity so far. The gulf between the regulatory capital required for many assets and their true economic risk is just too great to ignore. And that is especially true for highly rated corporate debt - precisely the assets which are most easily securitised.
Plenty of banks, even those which actively measure and manage their economic capital, have still relished the chance to boost their published returns on regulatory capital by issuing a CLO or portfolio swap.
But some bankers claim that even though regulatory capital reduction remains an important motive, most banks want to do more than simply exploit loopholes in the current regulations.
"Most banks we work with have moved far beyond simply trying to get a reduction in their regulatory capital," says John Graham, who has been head of European structured finance at JP Morgan for the last two years. "A couple of years ago it may have been the case that a lot of banks were simply trying to reduce the size of their regulatory risk weighted assets.
"But now their fundamental motivation has changed. They may still be measuring and targeting regulatory capital because that is the data their systems are designed to cope with. But in many cases regulatory capital is only a means to an end. It is the best available proxy for the real target of economic capital. Their motivation is to manage their business going forward in the most efficient way."
There can be little doubt that many banks have become much more sophisticated in the way they view their credit portfolios. "Banks no longer simply want smaller balance sheets," says Jonathan Laredo, who is taking over from Graham at JP Morgan at the end of this year. "They want a smaller balance sheet with a better mix of assets."
Nobody can be sure what impact the new Basle guidelines will have on the way banks manage their credit portfolios. But if regulators allow banks to weight credit exposures according to some better measure of their true risk, it seems likely that at least some banks will avoid putting themselves through the pain and expense of doing a large portfolio transaction.
The second reason for supposing that synthetics will disappear as quickly as they have emerged is that in many parts of the world, bank funding costs are rising.
As competition in banking hots up and consumers gain greater access to information about alternative means of saving, retail banks are losing the deposits which have traditionally given them rock-bottom funding. In Europe, the euro could give this process an extra impetus by reducing barriers to cross-border saving.
And if, as now seems likely, Europe's state owned banks are eventually cut loose from the apron strings of the state, they will no longer be able to issue cheap, quasi-sovereign debt.
This could mean that retail financial services in Europe will move closer to the US model, in which many mortgage lenders and credit card issuers are specialist institutions. Their relatively low credit ratings make securitisation the most effective way to raise funds.
Certainly, most users of synthetic securitisation have been banks with low funding costs. For them, it makes sense to finance growth with deposits and cheap wholesale borrowing, and to use synthetic techniques to hedge risk. True sale ABS, combining risk transfer with funding, could become more attractive to these institutions in future.
However, true sale securitisation is much more problematic in Europe than it is in the US. Although some European countries now have a clear legal framework in place for securitisation, legal difficulties still militate in favour of synthetic structures in many countries. And pools of assets from more than one country are likely to remain difficult to securitise using conventional cash structures.
"Synthetics have been one of the hallmarks of the European market," says Eileen Murphy at Chase. "But there are so many variables involved - bank consolidation, the repricing of risk in Europe and changes to the depositor base, for example - that it is difficult to forecast whether the trend will continue to the same extent or not."
The synthetic defence
Those who believe that synthetic risk transfer will not only continue but will grow strongly in coming years counter this scepticism with two main arguments.
The world of banking, they say, is fast abandoning the mindset encapsulated by the 1988 capital adequacy regime. The problem with the Basle framework is not just that the capital weighting bands are a poor measure of risk. The regulatory model's fatal flaw is that it takes no account of risk across an entire credit portfolio.
A bank's oldest predators are the credit concentrations that imperceptibly creep up to danger levels, or unexpected correlations between different assets. A bank which builds more sturdy defences against these threats should be a more valuable bank.
"The biggest incentive for banks to use active credit portfolio management is that it should help their share price," says one credit structurer. "Banks which do it well should start to get equity market recognition."
Already, banks face parallel regulation from the rating agencies, as well as their statutory regulators. Banks with a less than sophisticated approach to managing credit risk face lower ratings and higher funding costs. In the same way, banks which increase their risk exposures could be penalised by the equity market.
Piers Brown, bank equity analyst at Commerzbank in London, says this is not happening yet. "Analysts are aware of some of the nuances about what banks are doing in terms of managing credit risk," he says. "But the market tends not to distinguish between different banks on that basis. Credit is seen as a cyclical issue and one which will hit banks as a sector every so often. There is a view that all will get hit equally."
One thing that could help the equity market to distinguish between banks according to their expertise in managing credit risk is greater disclosure.
Many regulators know that there is only so much they can do to stop banks from getting into trouble. One of the three pillars of the Basle reforms is for banks to disclose more information about their approach to risk management. That, it is hoped, will introduce greater market discipline into what was once a private matter between a bank and its regulator.
The other thing that might make the equity market take notice of credit portfolio management would be a banking crisis. Brown at Commerzbank acknowledges that a new credit crisis might persuade investors to look more closely at the issue. The growing concern about bank exposures to the telecoms sector has, he said, already raised the profile of credit risk among equity investors.
Many credit structurers believe there will be plenty of work for them in a world where banks focus on economic rather than regulatory capital.
"I would not necessarily predict a decline in the volume of deals if the BIS issues new guidelines which are more attuned to true economic risk," says Frank Iacono at Chase. "I would predict a change in the type of deals. It is hard for banks that are managed to a regulatory capital standard to find the incentive to pay for a large degree of economic risk transfer. They find it more advantageous to do a cheaper regulatory capital arbitrage.
"But if the regulatory capital requirement is more closely aligned to what the true economic capital should be then the regulatory arbitrage disappears and you will see an increase in the willingness of banks to pay to transfer real risk."
That could reverse the typical structure of CLOs and portfolio swaps. Many of the deals completed so far have hedged the least risky exposures in the portfolio and retained the first loss. In future we may see an increasing number of deals in which the riskiest portion only is transferred.
The other argument in favour of the continued growth of this market is that CLOs and portfolio swaps are not just tools for balance sheet management. Tranched structures also provide leverage for those who buy first and second loss positions.
Rather than simply trying to offload assets they have originated, banks are becoming active builders and managers of portfolios. If they want to take exposure to a sector or credit which adds to the diversity of their portfolio they can, if they choose, buy an asset or sell credit protection. Alternatively, they can buy leveraged exposure to that sector or credit through junior tranches of a portfolio swap or CDO.
"If your expertise is in understanding credit, you want to leverage that expertise," says Laredo at JP Morgan. "Just as an asset manager uses CBOs to get leverage - that is, increase their assets under management while getting wholesale investors to fund most of the purchase price of the assets - so a bank can use techniques such as securitisation and credit derivatives to get leveraged exposure to the credits it understands best."
As banks increasingly become portfolio managers rather than originators of assets, the traditional distinction between bank balance sheet CDOs and arbitrage CDOs is disappearing.
Already, European banks are using cash securitisation to leverage their exposure to bond portfolios, while asset managers are using CBOs in an ever widening range of ways, and gaining exposure to an expanding universe of assets.
In the future, both types of institution will compete on an increasingly equal footing as credit managers - trading on their ability to understand and source credit. They may gain leverage by raising funding in the wholesale markets or they may do so synthetically by using the balance sheet of a large bank.
But whichever funding route they take, they are likely to make ever more sophisticated use of credit derivatives to manage their credit portfolios. *