And credit derivatives. Particularly in combination with leverage. Geithner pretty clearly is more worried than the folks invited to the Goldman Sachs' conference on global risks last fall. He worries that a market that has grown up under very benign conditions (low and stable long-term US interest rates, falling credit spreads, high levels of cash on corporate balance sheets) may not fare so well should conditions turn.
The money quote:
And when innovation, such as we are now seeing in credit derivatives, takes place in a period of generally favorable economic and financial conditions, we are necessarily left with more uncertainty about how exposures will evolve and markets will function in less favorable circumstances. The past several years of exceptionally rapid growth in credit derivatives and the larger role played by nonbank financial institutions, including hedge funds, has occurred in a context of very low realized credit losses, low expectations of future default risk, a high degree of confidence in the financial strength of the major banks and investment banks, relatively strong and significantly more stable economic growth, less concern about the level and volatility in future inflation, and low expected volatility in many asset prices. Even if a substantial part of these changes prove durable, we know less about how these markets will function in conditions of stress, and the most sophisticated tools available for measuring potential losses have less to offer than they will with the benefit of experience with adversity.
Geithner doesn't go as far as Michael Lewitt of Harch Capital, who argues that "offering credit derivatives to hedge funds" is like "offering alcoholics a nightcap." But he does highlight a series of concerns, including:
1. The amount of credit derivatives outstanding relative to the cash market. Credit derivatives decouple credit bets from the constraints of the cash bond market. If you like the credit of a company (or country) that doesn't actually need to issue, no problem - sell a credit derivative (insurance against default). The problem: the notional amount of credit derivatives outstanding now often exceeds the amount of actual debt - which can make things interesting in the event of default.
"Large notional values are written on a much smaller base of underlying debt issuance. The same names show up in multiple types of positionsâ€”singles-name, index and structured products such as CDOs. These create the potential for squeezes in cash markets and greater volatility across instruments in the event of a default"
2. Leverage. Leverage contributes to lower credit spreads (more money chasing the same set of assets). And, in turn, lower credit spreads create incentives to take on more leverage to make bigger bets, as bigger bets are needed to generate big returns when spreads are low.
The apparent increase in the scale of demand for exposure to credit risk relative to the growth in supply of credit has contributed to a substantial reduction in credit spreads and to some erosion in credit terms. Banks and dealers have reported pressure to reduce initial margin levels. The scale of leverage in some transactions is reported to have risen. The spread of portfolio-based margining creates the potential for greater overall leverage in the financial system.
3. What might be called Rajan risk (after the IMF's Ragu Rajan, see this paper). Banks (and others) who create and sell CDOs (collateralized debt obligations, which can be built out of credit derivatives -- synthetic CDOs include credit derivatives, not just bonds) and CMOs (collateralized mortgage obligations) often end up holding the bits that they cannot sell to others.
Major banks and dealers at the core of these markets generate both short- and longer-term credit and market risk exposures from a number of sources and activities, including trading positions, loan commitments that support securities issuance, and warehousing positions in advance of packaging and distributing them. Retained interests associated with securitization transactions are substantial relative to capital of the largest firms.
The irony: securitization initially helped make illiquid loans more liquid and move them off banks' balance sheets; now the process of securitization may require that the banks keep some highly illiquid tranches.
Geithner does not ignore the arguments that Greenspan used to make in favor of financial innovation, noting that "risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries" and that financial innovations have contributed to the "flexibility and resilience of the financial system in the US." But Geithner also injects a tone of concern missing from many of Greenspan's speeches: "There are aspects of the latest change in financial innovation that could increase systemic risk ... amplifying rather than dampening the movement in asset prices, the reduction in market liquidity and the associated damage to financial institutions."
Stephen Kirchner will of course just use this admission as fodder in his ongoing efforts to mock me (and a few others) as worry warts immune to the full charms of modern intangible-based (trading correlation is rather intangible) Anglo-American financial capitalism.
Full disclosure: I worked for Geithner at both the Treasury and the IMF.