REPORT: Credit Derivatives May Pose Risk

By CARRICK MOLLENKAMP Staff Reporter of THE WALL STREET JOURNALApril 6, 2005; Page A6

LONDON -- The International Monetary Fund, in an otherwise sanguine review of the world's financial system, warned that the growing market for credit derivatives and other complex securities could suffer a rapid and "disorderly" selloff if conditions turned negative.

The IMF's Global Financial Stability Report, which is aimed at identifying potential weaknesses in the global financial system, also expressed concern that it had found anecdotal evidence that big banks may have relaxed credit standards in the hotly competitive race to attract hedge funds as clients for trading, a business known as prime brokerage. Hedge funds increasingly have become a big source of revenue for investment banks both as trading clients and as borrowers.

In the review of the market for credit derivatives -- instruments designed to protect banks and borrowers from losses on loans -- the IMF study said investors could be hurt if the market turned sour. In general, the credit-derivatives market has been praised for dispersing loan and asset risk across a wide array of investors. The overall credit-derivatives market stands at more than $1 trillion and includes complex financial structures such as collateralized debt obligations, or pools of loans divided into different layers of risk and return.

But "if market conditions turn negative, many investors in these products could rush to exit at the same time, causing market liquidity shortages that could amplify price movements," the IMF said in prepared remarks. "Furthermore, elements of risk management systems designed to deal with these complex products have not been through a live test, particularly to see if in time of need, counterparties stand ready to absorb the additional market and credit risks from those who would like to shed them."

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