Friday, November 10, 2006

We're just Pygmies on a field of elephants fighting for turf

Close to Solving Derivatives Impasse By Hamish Risk
The two-month dispute set back the creation of an index needed to measure the performance of credit-default swaps based on loans to companies in Europe, including Yell Group Plc and TDC A/S, Denmark's biggest telephone company. Investors are reluctant to participate in a market without a benchmark.

An agreement at a meeting next week would end a boycott by JPMorgan, Goldman Sachs Group Inc. and Citigroup Inc., which have refused to provide prices for the new index, created by a group led by Morgan Stanley. The index allows investors to speculate on the ability of 35 European companies to repay bank debt.

Credit-default swaps, created a decade ago to protect bondholders, have expanded to cover debt sold by more than 3,000 companies, governments and industries. Hedge funds and banks use the contracts as a less expensive way of betting on the creditworthiness of companies than purchasing bonds.

The creation of an index was crucial to the growth of credit-default swaps tied to bonds. Trading in those derivatives doubled last year to $346 billion and helped reduce borrowing costs for companies, according to the Bank for International Settlements in Basel, Switzerland.

Banks clashed because of different standards in Europe and the U.S. European credit-default swaps, geared toward banks seeking to hedge their risks, expire when the loan is repaid. In the U.S., where credit-default swaps are designed for hedge funds and investors, the contracts transfer to another loan made to the same company.

The new index was set up by the International Index Co., a Frankfurt-based joint venture owned by 10 firms. Morgan Stanley and Lehman Brothers Holdings Inc. in New York, Barclays Capital in London, Credit Suisse Group in Zurich, and Frankfurt-based Deutsche Bank AG and Dresdner Kleinwort Group agreed to provide prices for the index tied to European contracts.

JPMorgan, Goldman and Citigroup, based in New York, said U.S. guidelines should be used. JPMorgan's Christofides, Goldman spokeswoman Rebecca Nelson and Citigroup spokesman Jeff French said their banks aren't trading or providing prices for the index.

Under a compromise now being considered, the credit-default swaps will continue to trade when a loan is replaced. They will transfer to other loans made to the same company provided a majority of the 11 companies that own International Index agree, Christofides said. The vote is intended to ensure full disclosure of any new borrowing.

Banks have clashed over standards for credit-default swaps before. Until 2003, JPMorgan, Morgan Stanley and Deutsche Bank ran competing indexes to measure the performance of the market.

The merger [collusion?] of the indexes in 2004 into the iTraxx for Europe and Dow Jones CDX in the U.S. triggered a surge in trading. Growth has outpaced other derivatives, financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or the weather.

Credit derivatives helped spur record earnings for banks including Morgan Stanley, Goldman Sachs and New York-based Merrill Lynch & Co. this year. Derivatives accounted for more than 60 percent of revenue and profit at Barclays Capital, Chief Executive Officer Bob Diamond said in May.

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