IRD debate: There’s demand for derivatives, just no funding

Interest rate derivatives: The rates business rated for 2008

Interest rate derivatives: Rates - a year in the market

Interest rate derivatives poll: Global Winners

Delegate biographies: Learn more about the panelists

JF, Euromoney Welcome to the debate on interest rate derivatives. We have a lot to talk about, starting of course with the credit and liquidity crisis. Edward is going to kick things off by giving us his thoughts. EW, Calyon Capital markets have been in crisis for a year, instigated by the credit crunch. This has affected the whole financial sector. There’s been volatility in currencies. There have been strong fluctuations in commodities, in the appetite for private placements, and we’ve started to see knock-on effects into rates. European Central Bank president Jean-Claude Trichet’s comments triggered dramatic events in the most liquid market in the world: the swaps market in euros. The yield curve was already slighted inverted. The longer end was up. But it became even more inverted because of the announcement. Money rates went up because of the understanding that the ECB would raise rates. But that was contrary to the long-term views and was compounded by the fact that a lot of banks were not positioned that way, so then had to get out of positions, which made things worse.

JN, Nordea Yes, that inversion of the curve caught a lot of exotic desks on the wrong foot.

EW, Calyon We started with a crisis that was credit and funky CDOs. We’re now in a crisis where even the yield curve in the swap market dried up.

KP, LGIM Was the follow-through to impact led by banks cutting capital into trading lines? Some of the unwinding by exotics desks was because they had little risk appetite, or little ability to take risk.

EW, Calyon The market’s ability to absorb risk is much diminished compared with a year ago. Market players are no longer able to weather more risk, whether it’s exotics, commodities or forex.

JF, Euromoney Who’s providing liquidity?

KP, LGIM It’s tough to get business done from my end, which is predominantly in the UK, long-end interest rate and inflation swaps and some cross-currency swaps. The size in which you can transact easily has diminished substantially. It’s hard to get anything done in the inflation swap market in the UK. Banks are no longer willing to commit risk to their books. They don’t know where they can lay that risk off or for what price, because of the volatility and moves between taking on and managing. But there’s also a supply issue. Fewer people are willing to pay inflation or pay long-end rates.

JN, Nordea That’s exactly what we’ve seen. Very few markets can now claim to be liquid.

KP, LGIM It’s not just derivatives. If you want to buy a portfolio of corporate bonds or index-linked gilts, it’s harder to transact.

EW, Calyon If you want to buy a portfolio of CDOs, you’d probably find it quite easy at the moment! But clearly the structured credit market is severely impaired and there’ll probably be a weak market for years. A big question is if rates will follow the same path.

JF, Euromoney How exactly is the standstill in structured credit impinging on the rates business?

KP, LGIM Corporates are not fixing their rates and they’re not paying inflation supply because banks don’t have the appetite to give them lines, or they find it too expensive to raise debt because credit spreads have widened so much. There is still demand for institutions, life insurers and pension schemes to use derivative products, rates products and the simple linear products.

EW, Calyon To provide lines for corporate and institutional clients, banks need their own liquidity. While they are struggling with severely damaged balance sheets, it’s difficult for them to market aggressively to clients. Clients then feel they should focus more on getting that next credit line and less on how they hedge it. The demand is there. But until banks feel more confident in the way they’re funding themselves, derivatives business suffers.

KP, LGIM This will correct itself. There will be a period in which banks have to sort out their balance sheets. When they’ve recovered the markets will move on that, but it’s going to be a while.

JN, Nordea It’s not only getting rid of assets that are impaired or illiquid. Entire business models need to be changed. Large investment banks don’t have a business model where they can store senior risk, on and offloading risky equity, building large, seemingly riskless, positions that they need to fund. That de-leveraging process will take a long time. Even then people will be slow to jump back on the wagon. It may take a business cycle.

EW, Calyon Business model change is the core issue. It will be interesting to see how banks adapt. The financial sector has got carried away with one way of functioning. We’ve had an offset between the suffering financial sector and the corporate economy, which is not doing so badly. The reason the crisis has dragged on, and possibly saved us from systemic meltdown, is that parts of the large diversified institutions are still doing well. HSBC, for example, has had both tremendous losses and tremendous gains. Its Asian franchise is doing extremely well but its US subsidiary has taken very big losses. In their case, the gains outweigh the losses. We’ve been saying for a year that corporates will suffer, and maybe that’s starting to happen, but during that year banks have been restructuring. It’s a fine line between whether corporate defaults will increase to the extent that they bring the banks further down, or if the lack of defaults and the better core business will buoy up the banks.

JF, Euromoney If we are moving towards a deterioration in corporate credit, is this the end of the originate-and-distribute model that the banks have relied on for 10 years?

JN, Nordea People are starting to buy CLOs. The loans were the original asset to securitize and most of the structures are rock solid, whereas the CDOs are more complicated and diverse. The good value in CLOs is not only due to the fact that the underlying loans tend to be good, but also because you can do your calculations on the structures, if you have a view on the underlying cashflow. That’s not always true for CDOs, which could be anything.

EW, Calyon With the CLOs still being traded, the number of loans involved is reduced compared with the typical CDO structure with thousands of underlyings. But that brings us back to core natural business. Sub-prime as a business has existed for years, and it’s the same principle that brings us to insure against a cat getting ill. It’s massive portfolio, massive diversification, and then statistics. The business itself is well understood. But when you start distilling the business, extracting the poison and concentrating it, rather than just having unpleasant side effects it becomes lethal, and you end up passing this poison on. There needs to be an understanding of the underlying asset. When you’re three times removed from the asset itself, you’re no longer buying a right to claim an apartment in the US. You’re buying a statistic on performing or underperforming assets. That’s where ratings come in.

JF, Euromoney Are the rating agencies partly to blame?

KP, LGIM No. The industry was always clear about what ratings stood for and the calculations behind them. There was reasoning and logic about the ratings and there were reports explaining why CDOs were given specific ratings and what they stood for.

JB, Morley Fund Management Partly, but so are the investors who blindly used and still use ratings to determine eligibility for investment. How can you blindly trust a rating that has been paid for by the issuer? Especially when is it for a complex synthetic instrument based on other derivatives few people understand. I think everyone got carried away in the end thinking nothing could go wrong. Clearly it did.

JN, Nordea We are all to blame in that we as investors were not critical enough. The rating agencies got it wrong. The investment banks got it wrong. Very few got it right.

JF, EuromoneyWhen the structuring desks were putting together products, and you talked to the rating agencies before the credit crisis started, it must have been apparent at times that they didn’t know what they were doing or that their modelling was not quite right.

EW, Calyon Rating agencies have done what they said they would do. They run statistics on a portfolio and come out with a figure. You know they’re giving you historical statistics about the rate of default, etc. Basle II says that if your assets have an external rating you can’t apply your own rating in its accounting. You’ve got to apply the external rating. If the rating agencies are not reliable, then how can you have a whole regulatory and accountancy regime that hard-wires them into the way you run your books?

JN, Nordea Is Basle II to blame, because of this value-at-risk approach? It gives banks a big incentive to warehouse or store triple-A rated assets. From a regulatory point of view, this will destabilize markets, because you have a position where your limit is value-at-risk-based, which gives you negative gamma. You will be forced to close your positions at the worst time, and this is happening now.

JB, Morley Fund Management We can’t blame the rules and others. We believe you shouldn’t buy what you don’t understand. Relying solely on external credit ratings is naive.

JF, Euromoney Do you have any thoughts on being gamma negative and on risk positions in general?

KP, LGIM This time last year our clients were looking at structuring to bump up the yield, whereas now they’ll buy all-stocks corporates. So it is difficult for the structuring desks to convince people that the products are right. I don’t know to what extent the volatility of the markets was caused by the short gamma positions or the requirement that trades were stopped out when markets started to move.

EW, Calyon The exotics business has been fuelled by low rates but also by a race to innovate, to be more complex, more leveraged, and to play out on the greater non-linearities in the payoffs. People who would never have done an exotic have not only moved into exotics but are turning down your trade because competitors are offering something even more kinky. The more high-tech a payoff or structure seems, the better it is perceived to be. That has led to an accumulation of illiquid risk. The healthier banks have been able to analyse this, so people know what the risk is. You’ve set up controls that run your books and tell you your risk is illiquid. It’s become first order, and the banks are not willing to weather this because they’re suffering structured credit losses or weakened balance sheet. People have to stop and hedge. As Jesper mentioned, you’ll end up hedging at the wrong moment.

JF, Euromoney These whipper-snapper banks that are coming in, are they actually innovating, or are they just offering similar things at a better price?

EW, Calyon The most frustrating thing is when you know how they’re getting to their price, but you’ve developed a more sophisticated model that shows you their price is too aggressive. You’re losing deals and your sales force is complaining. It can be tempting to agree that we’re being too conservative. But you can’t run an exotics business if you don’t have that restraint. The leading banks in exotics have been doing it for 15 years. They’ve weathered several storms, probably because they leave a bit of money on the table. It’s money well spent because you understand more about what can go wrong and your business becomes more sustainable.

KP, LGIM The race to innovate in structured credit or exotics will get pushed so far and hit the boundaries. Some will fall off the cliff, the rest of us will come back to the middle of the field.

JB, Morley Fund Management Was it innovation or stretching the ideas too far? There is nothing wrong with structuring, but it got taken too far. These instruments will be back, but hopefully used a bit more carefully next time.

JF, Euromoney What about product trends? Obviously the market’s changed. How has that affected more sophisticated products?

KP, LGIM What a mainstream insurer or pension fund manager would term exotic is probably not at all exotic to a bank. Anything with optionality around it would be exotic for us: options on an inflation swap, or real-rate swaptions. But there’s no diminishment in appetite for doing those at the right price. There are natural liability-hedging products that take correlation risk and could be priced off an exotics desk. We’re keen to use those, and I’m sure that market will develop. But the hunt for yield has taken a different route because it can.

EW, Calyon There’s a trend towards balancing acceptability or suitability of structures against the client size. Another trend relates to banks being more concerned about what they do with their counterparties. Sometimes a counterparty wants to do something, but the bank, based on experience, knows that that structure could be negative for the client. And when something goes badly for a client, the bank ends up in trouble.

JN, Nordea Investment bank sales forces make no secret of the fact that they’re trying to offload their own assets. That is okay because we know there’s a need to offload these assets and it’s transparent. So there will be six to 18 months where the sales people getting rewarded within the investment banks will be those able to offload their own risk.

JB, Morley Fund Management The crisis has made some exotic products quite attractive. Returns are higher, but they are not suitable for all our clients and if we don’t understand it, we don’t do it. It is clear that banks are desperate in some cases for cash and we have been able to work with them. We have an appetite for longer-term risk whereas banks do not.

JF, Euromoney It will be interesting to see if culturally there’s a change in risk compensation within banks. Will the power shift from the front office towards risk managers and middle office? Some banks are already talking about remodelling compensation structures.

KP, LGIM That sounds sensible in principle, but in the good times when the producer is selling the product and making money on the trading book it’ll be harder. Market forces suggest that if somebody’s good at that, they get bid up for another bank and you have to reward them appropriately.

EW, Calyon If you work in risk management, middle office, controls or IT, it’s a hot market and you can command substantial compensation. Banks are taking it seriously. Institutions are under pressure from shareholders not to pay producers on the basis of a mark to market for a 10-year transaction. They’ve got to find something more in line with the risks the bank has taken. But if the market picks up people will start bidding up. A good producer is always a good producer. The crisis has opened people’s eyes. That thing that never happens happened. Teams were getting younger, asking for more money and becoming more arrogant about their value. Loyalty was decreasing. Anyone over 35 was made to feel a dinosaur. That has changed. The value of experience has increased, because people realize that living through a couple of crises or market cycles is valuable to an institution – more so than being the new star mathematician from Cambridge or Oxford.

JF, Euromoney What are the growth areas in rates?

EW, Calyon Geographical diversity has been a strong guarantor of stamina. US, Europe, Asia, emerging markets, are not in the same cycle. The US is at a low and possibly improving, Europe is getting worse and Asia is showing signs of getting sick. With emerging markets, it’s a harder call. Make sure you’re doing business in lots of areas. Mobilizing your sales force around one product is dangerous. Another angle is being in touch with clients. Most banks are so busy with their problems that they’re not listening to clients. The banks that listen will be the ones clients remember.

KP, LGIM It makes a big difference if your bank understands what you want. If they try to sell you some irrelevant product, you’re not interested.

JB, Morley Fund Management Yes, that is the key. We prefer to deal with those banks that listen to what we want, and spend less time telling us what we should buy from them.

JN, Nordea This deleveraging process is potentially beneficial for end investors. The crisis started in the US and spread, and suddenly assets are very correlated. But the solutions may be local. Who is going to provide liquidity to the Swedish government or the Danish mortgage markets? Local investors and local banks. It’s much easier to support the local market than to decide there’s value in US CMBS or whatever. Over the coming 12 months, there will be a tendency to go local.

EW, Calyon If you have to develop your sales franchise and keep revenues sustainable, you’ve got to have your fingers in several pies. But I agree that if you’re going to be a net risk-taker, then stick to things that you understand. Perhaps you’ll still make mistakes, but at least you will not lose money because of an unrelated event.

JN, Nordea Yes, I might lose money, but it’s acceptable in the sense that people around the organization are familiar with the risk.

KP, LGIM We talked about the rush to innovation. But there’s a move back to risk transfer and talking to your clients and understanding what they want. There are fewer banks, less liquidity and a premium on delivery. Trading spreads have widened for vanilla products, so there’s more risk, but there will presumably be more profitability in things like interest rate swaps, and trading spreads on those that have widened. It’s back to the traditional model in derivatives. In the swaps world for example, we need the service. You give us the service, we pay an appropriate price. A year ago it was impossible to see how banks could trade at the spreads that they were trading. It didn’t cover the cost of collateral, or the cost of credit, or the cost of admin over 50 years even. So there is money to be made from banks providing a traditional service.

EW, Calyon With increased volatility, non-financial clients are less concerned with the cost of hedging. They’ve made projections that building a plant is going to require this much money and they’ll have to service a debt for this much, and they can afford it if it’s a fixed rate of so much. If rates go lower, it’s a loss of opportunity, but it doesn’t matter. Their main business is getting that plant up and running. There’s more potential for business there, in people asking for more exotic products to cater for the case where they could cancel it or they could benefit from a decrease in rates.

KP, LGIM The future of the IRD market may seem gloomy, but there is attractive business to be done, and the market is booming. Clients want to de-risk, and get back to their core business. There’s huge potential to provide services and get paid for them.

JF, Euromoney As a buyer, you understand complex exotic products, but are there people who simply put their blinkers on and refuse anything structured?

KP, LGIM There’s always got to be a reason for it. If you work through why somebody would want to hedge their risk, then the reason it’s a good product for end users becomes transparent.

JB, Morley Fund Management Not all buyers understood the complex products they bought, nor perhaps did the sellers. That was part of the problem. Yes, people are refusing to look at anything called CDO or CLO, but they will miss opportunities.

JN, Nordea End users are approaching investment banks with their own ideas and asking them to structure something. Those products will not be highly complex, but they will have features that the end client will have difficulties implementing themselves, or the product may need some hedging, and that can be most efficiently done by the investment bank. Those products will be structured on top of a good macroeconomic story or a good liability-hedging story. But end users will ask if they could do it themselves. Structurers will be asked how they are hedging the product. Saying it’s a black box is not an answer. People know what your underlying risk is. How much money you make on it is a tough question, because up front the margins on those curve decisions are big, but it may turn out that they make a loss.

EW, Calyon The assumption with dynamic modelling is that you’ll be able to do what the model tells you to do. But if the market dries up, your dynamic hedging ceases to be the prerequisite that you need. The models are sometimes wrong, but most of the time they are not. It’s just that the markets are not behaving the way the models assume they will behave. You can’t buy. So the model’s telling you to do something theoretical, no longer practical, and you lose money. The only sustainable exotics business is where the product itself is not being sold. The product is a building block for a view that you’re pushing to someone or that someone is asking you to implement. This is the way you should sell it. It starts to fuel the innovation when you have products that can mimic a strong view about something, and this is true for hybrids, for example. The good salesman will also look at your business and what you’re exposed to. He has to understand your headache, come back to structuring desks, look at all their clients in that category, go away and build an offering that can be pushed as a product. It’s then an offering built around a need.

JF, Euromoney Obviously your desk can make more money through economies of scale if you can come up with a generic product and push it to more clients, but there is also a trend towards some sales people becoming liability-driven or asset-driven consultants.

EW, Calyon It depends what you call profitable. The bank’s expectations on its return on equity in rates business will probably decrease. Profitability will decrease in favour of stability of revenues. Rather than look for return on equity multiples above a traditional business such as lending or fee business, there will be an expectation that the derivatives business will be higher, but if it’s making 10 times more money on the same equity basis, something needs to be checked.

JF, EuromoneyTwo years ago, banks were setting up consultancy desks to talk to pension funds and others about their LDI needs, and they would put in place long-term bespoke solutions. How’s that functioning?

JB, Morley Fund Management It does not seem that this has been very successful. Much of this business has gone to start-ups.

KP, LGIM In the UK, the Netherlands and increasingly in the US, corporate sponsors want to de-risk pension schemes. If a scheme is closed, it’s in a de-risking cycle, and people are lining up to de-risk. There’s a reduction in the market capability of delivering that solution, but no diminishment in appetite. It’s harder for banks to talk to the clients about that because they’re already clear about what they want. They’re looking to find a way to implement it. Are they more inclined to hedge their risk today? Categorically, yes.

JF, Euromoney But it costs them more.

KP, LGIM The market price of removing inflation risk is higher today. The market price of removing interest-rate risk is lower than a couple of years ago in the UK. It’s better for inflation in euroland, but in the UK it’s hard to find liquidity in inflation.

JF, Euromoney That must make it difficult to put in place solutions to rein in duration?

KP, LGIM Yes, that has slowed. UK corporates can’t all move at once, because that would be £1 trillion of assets to be de-risked. But even for those moving down that line, their desire to de-risk has been curbed by lack of liquidity rather than transaction costs. You could not phone up and get a large trade done in a day.

Although we may have seemed negative, I’d like to emphasize the need for quantitative people doing modelling work. Those skills, those people and that industry will be fundamental to all our businesses, just applied in a different way.

EW, Calyon Model-driven business will continue to be active, but there will be stricter controls. There will be more constraints to balance sheets because the banks have to repair themselves. Development and innovation will be oriented towards new fields, in line with the concerns of clients, and clients will be under less pressure to outperform.

JF, EuromoneyHave end-user expectations changed, bearing in mind there is now a greater awareness of counterparty risk?

JB, Morley Fund Management Awareness of counterparty risk has increased. People are making sure they are on top of such risks, when before they may have been more relaxed.

KP, LGIM There’s more pressure to relate the appropriateness of the products with the credit line. There’s more concern from clients about how well diversified we are in terms of bank risk. So the pressure is certainly on us to ensure suitable diversification.

EW, Calyon This is where balance sheet comes in again. People were just interested in price; now it’s a combination of price, rating and existing exposure to that bank.

JF, Euromoney Everyone’s talking about clients taking credit rating into account. In the past everyone would take for granted that a big bank would be fine, whereas now they’re discerning on the credit rating.

KP, LGIM Credit rating has always been a consideration. There’s always a minimum criteria for banks to fulfil. We’ve always had diversification limits, but now you think more about spreading risk.

JB, Morley Fund Management Credit rating is only a part of it. There is a move away from simply relying on credit rating to other measures such as CDS spreads.

JF, Euromoney The higher-rated banks can’t be as competitive on pricing, though, because their funding levels are higher. If you’re working for a highly rated bank, does the credit crisis make it easier to sell products because there’s more consideration of counterparty credit risk?

EW, Calyon Price is still important. It’s more the type of bank, and not just the rating but the size of the balance sheet. You’re here today, but clients are sensitive to whether you will be there tomorrow. So the future will be brighter for commercial banks than for investment banks, at least in the short term.

KP, LGIM The better diversified the bank, the more willing clients are to include them on their panel.

JB, Morley Fund Management If products are cheaper, great. But it is little consolation if your counterparty is not there to pay out at the end.

JN, Nordea It depends whether you’re placing liquidity and having a credit risk, or it’s a trading relationship where you’re trading payment against delivery or something riskless. It differs a lot. On the deposit side you need to be well diversified and you need to have your credit department on top of things.

JF, Euromoney What about systemic risk?

JN, Nordea There’s a systemic risk. I would hesitate to point at specific banks and say: ‘I won’t deal with them because there’s a big risk’. There probably is, but there’s also risk with all the others as long as you don’t know what’s in the books.

KP, LGIM That’s the point of diversification. There’s a minimum creditworthiness criteria. You could’ve easily decided on a raft of banks that you don’t deal with for certain reasons, but SocGen are solid. There’s no problem with them! What you’re worried about is the problem you don’t know about.

JF, Euromoney But aren’t these banks implicitly government-backed anyway?

JN, Nordea They might be, and it turned out that Bear Stearns was too, at least for the bondholders. But you suffer a lot of volatility before you’re certain. And I wouldn’t bet that that’s the way central banks are going to play it in the future.

EW, Calyon The risk of systemic meltdown is probably going away. It will become more acceptable to see banks go bankrupt. The general public will be protected, which doesn’t bode favourably for pure investment banks. Governments and regulators would not allow Joe Bloggs to lose his savings with a particular bank that’s gone down because of sub-prime. However, a bank that has shareholders, bondholders and investment bank activity could go down.

JB, Morley Fund Management It seems that those that are too big will not be allowed to fail since they may drag others down too, such as was the case with Bear. But one day a small bank may go down and no one will be there to catch it. This will shock people who think you can’t lose.

JF, Euromoney How important is e-trading? Barcap got quite a steal on the market when it introduced Barx.

EW, Calyon E-trading in rates has not traditionally been one of the main channels. It exists in the bond and equity businesses, and it’s widely used in forex, so it’s appropriate for simple commoditized assets. However, it will increase in the rates business for two reasons. The first is because of an increased understanding and use of day-to-day derivatives. There are a lot of mature, well-organized funds, ALM managers, financial directors, who have a clear view of what they have to buy, what they have to sell. They need quick execution. They want to click and trade. The second angle is a global development trend. It’s becoming more expensive and risky to run a derivatives activity. Unless you have commercial business or something that requires a full-fledged derivatives activity, you’re better off working with other institutions who already have a platform, and being a price-taker rather than a price-maker. To do that in an industrial way, you can’t call up a sales person every time you want to know where the yield curve is, for example. You need electronic means. You need something cold, easily accessible and objective.

JN, Nordea Over the past few years a lot of institutions have chosen to be a price-taker because there have been liquid, transparent markets and every day a new fixed-income instrument has been able to be executed electronically.

KP, LGIM The liquidity provided on e-trading is not at the size or the spreads that we can get, so we pick up the phone. We have a very different operation from a treasury department since we have £300 billion under management. I’m not saying it would never be done, it just tends not to be.

EW, Calyon Size is a good point. You need the protection in e-business. You can’t have any old size, because if your system’s bugged and makes the wrong price, by the time you’ve reacted to your hit you’ve got £1 trillion in your books! You’re always going to have a limit – above a certain size it will be on the phone and somebody’s going to check.

JN, Nordea I’m only trading derivatives, and that’s all done by telephone, so we’ve outsourced all cash investment to asset managers.

JB, Morley Fund Management E-trading means greater transparency. A cynic would argue this is not in the bank’s favour. It has to work for both parties and in both cash and derivatives. It will become commonplace for vanilla instruments.

JF, Euromoney The ideal would be for one multi-dealer system to emerge that is trusted and everyone uses. But that doesn’t look likely.

EW, Calyon The pure multi-dealer platform is a good idea, but it does reduce what you can do. If there’s only one, they may have no interest in making it more attractive than the guy next door, because what’s the point in spending the money?

JB, Morley Fund Management This doesn’t now exist in equities that are electronically traded, so it is hard to see it working in rates without some external influence such as regulation.

JF, Euromoney What about future developments?

EW, Calyon It’s interesting to think about which banks are going to fare best in this crisis. That question is on every CEO’s and every shareholder’s mind.

JN, Nordea Nordea hasn’t taken the big sub-prime hits of the big universal banks, and is a relatively regional player. So we should be in a position to punch above our weight.

EW, Calyon That’s also the case with some Japanese and Chinese banks. Some have been hit, but those that haven’t see it as a good opportunity.

JF, EuromoneyThe Japanese banks are still well capitalized compared with others.

EW, Calyon Some of them have had a few good years and many years of restructuring. The Chinese banks are becoming more powerful and they’re looking abroad. On the rates side we see elements of growth and balances of forces. There are choices to be made and adjustments to business models. It’s challenging but also thrilling. On the business side, I’m still not convinced that there will be contagion to the corporate world. We’ll see some elements, but the corporate world has been resilient, with strong figures in many parts of the economy. So we might scrape through.

KP, LGIM The genesis of the crisis was a consumer-driven debt problem, so corporates which rely heavily on consumer spending are more likely to be in trouble.

JN, Nordea But the start of the crisis came from the sub-prime market where the underlying asset turned out to be not as good as everybody thought. The consumer-related assets in the securitized market will be the next to be hit.

EW, Calyon But most credit departments have already cut exposure to credit card loans. The contagion hasn’t happened, and that’s what keeps me optimistic.

JN, Nordea But there are huge consequences for the consumer. There are tighter lending standards, and that will hurt consumers more than corporates. We have the iTraxx and the CDX blowing up, but it’s transparent and everybody knows what the loans are. The consumer-related stuff is not a black box, but they’re large pools and they share characteristics with residential mortgages in the way they’re structured.

EW, Calyon In the UK that’s true. I am least optimistic about the UK, because of the leveraging of houses and the dependence on borrowing to fuel the standard of living. There’s not much saving. Loans are also floating rate, and if rates suddenly start going up then it can be tough. In other countries, in France for example, mortgages are all fixed rate and strongly regulated. It’s less liquid in France, which is one of the inefficiencies, but people don’t leverage their houses. They don’t borrow on the basis that their house has gained 20% in value. And that’s the case in most of continental Europe. Japan is similar.

JN, Nordea It’s the Anglo-Saxon world, Scandinavia and Spain against the rest of the world. The Scandinavian residential mortgage market is very Anglo-Saxon, apart from the fact that the Danish market looks a bit like the US agency pass-through market. It’s 80% loan to value, and the banks take the remaining 20% of risk. Traditionally, 99% of the market has been fixed-rate callable mortgages, so very like a US 6% agency pass-through. Over the past 10 years people have moved towards floating-rate borrowing. But there’s a prudent lending process and conservative LTVs. I would say Scandinavian mortgages are the buy of the year.

JF, Euromoney If the securitized credit card receivables part of the economy did see defaults, the question would be whether the defaults were at a level that had been included in the models that the banks used when doing the securitizations. There’s no evidence to suggest that there’s a Black swan effect in that market as you had with the Ninja loans in the US.

EW, Calyon But sub-prime is not doing that badly. It’s being leveraged up and its book value in banks is being leveraged down. If you were in the fortunate position of having lots of money and didn’t care what your return was for the next few years, in a lot of cases you might want to buy portfolios of sub-prime. It’s often knocked down in value because the other bank has put it down, and you then have to put it down, and then there’s a spiral of banks having to mark down their book value. But I have read that the actual rate of foreclosures and defaults is much lower than the rate of foreclosures and defaults that are book value in all the leading US banks. So unless sub-primes go up to that level, if you hold that portfolio you’re better off. The argument people have against derivatives is that the existence of derivatives markets can negatively influence the underlying value, simply because derivatives are marking it one way or the other. The underlying is possibly not as good or as bad as is being marked in books of people who have transferred risk into their books.