A hint that credit spreads are widening?

Derivatives Banks Concerned by Hedge Fund Leverage, Fitch Says
By Hamish Risk

July 17 (Bloomberg) -- Hedge funds are borrowing too much to finance investments in credit derivatives, contracts based on debt, which may magnify volatility in a market downturn, according to a Fitch Ratings survey of 65 banks, insurers and money managers.

Hedge funds' influence on credit derivatives and debt markets has continued to grow at a ``dramatic pace,'' Fitch said in today's report. The funds are responsible for 60 percent of all trading in credit-default swaps and about 33 percent of collateralized debt obligations, securities that package debt, the ratings company said, citing data from Greenwich Associates.

U.S. corporate bond risk premiums reached the highest in almost two years last week as hedge funds bought credit-default swaps to offset potential losses from the subprime mortgage rout. Bear Stearns in New York earlier this month was forced to provide $1.6 billion for one of two hedge funds that made wrong-way bets on subprime debt. The firm declined to bail out lenders to the other fund, which borrowed more money against its investors' capital to take bigger risks.

In a market slump, large transactions financed with borrowed money may ``result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,'' Fitch analysts led by Ian Linnell in London wrote in the report for the 2006 survey.

Banks and money managers bought and sold about $50 trillion of credit derivatives in 2006, more than twice the total in the previous year, Fitch said. The market has grown 15-fold since Fitch started conducting the survey in 2003, the ratings company said.
Counterparty Concentration

Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., Fitch said. The top 10 firms accounted for 89 percent of credit derivatives bought and sold in 2006, from 86 percent in the previous year, Fitch said.

``For better or worse, counterparty concentration appears to remain a feature of this market,'' Fitch analysts wrote.

Contracts based on the debt of General Motors Corp., the largest U.S. automaker, were the most frequently traded single- name credit-default swaps last year, Fitch said, followed by DaimlerChrysler AG, the world's second-largest maker of luxury cars.

After GM, contracts based on Brazilian government debt were the second-busiest in terms of the amount traded.

Banks and hedge funds say it's cheaper and easier to use credit-default swaps to speculate on the ability of companies to repay debt than trading the underlying securities.

In a credit-default swap, the buyer pays an annual premium to guard against a borrower's failing to pay its debts. In the event of default, the buyer gets paid the full amount insured, and hands over defaulted loans or bonds to the swap seller. Swap prices typically decline when creditworthiness improves, and rise when it worsens.

A derivative is a financial obligation whose value is derived from such underlying assets as debt and equity, commodities and currencies.