Financial Times (Letter to the Editor)
Published: January 31 2008 02:00
From Ms Janet Tavakoli.

Sir, Robert Pickel, chief executive of the International Swaps and Derivatives Association, made a predictable smoke-screen response to the criticism of the credit derivatives market made by William Gross, Pimco’s chief executive (“Net exposure is the best guide to derivatives’ market impact”, January 29).

Mr. Gross’s numbers may have been gross, but the debatable “net” numbers offered by Mr Pickel seem to be offered only to obscure the central point.

Credit derivatives have had an astonishing impact on the recent destabilisation of the capital markets. Here is just one example: first, lend money to mortgage lenders who will use that money to lend to people who cannot pay them back. Securitise these obligations by allowing hedge funds to put up minimal cash for the appearance of taking the first loss in a deal, and allow the hedge funds to hive off most of the excess income.

Then persuade financial guarantors to use a type of credit derivative to “insure” the “safest” part of these unstable structures. After that, use credit derivatives to transfer the middle risk that you could not sell, the mezzanine tranche, to yet another securitisation, Now do the same thing all over again.

You have just destabilised the financial guarantors, because the “safe” credit derivatives-based structures are now in danger of losing substantial principal. But you are doing fine, because you used a credit derivative to buy credit default protection on the financial guarantors from some poor sucker, who was not paying attention.

Mr Pickel would have you believe that Mr Gross made “potentially damaging errors”, but I would argue that cynical use of credit derivatives is responsible for leaving the market in a pickle.