Credit derivatives market will evolve in face of crunch, GFI's Fewer says

By Evan Weinberger

New York, Dec. 12 - Write-downs in the credit derivatives market in the second half of 2007 are similar to write-downs that took place in the early 1980s and late 1990s, Donald Fewer, senior managing director at GFI Group Inc., which the market is evolving to deal with. Trading out of the hole the derivatives market has created is a better option than sitting on the debt, he added.

Banks are being forced to write down collateralized obligations at an unprecedented level - Fewer said he expects the total to end up somewhere around $500 billion - which will open the door to new instruments and indexes.

"Once the banks write down all of this debt, they're going to have to do something with it," Fewer told a press conference sponsored by the GFI Group Wednesday at the New York Athletic Club. "And that will play right into what the credit derivative market has achieved from its birth - and what it has achieved specifically in the last year to 18 months."

The key will be new pricing techniques developed in the last 18 months. The new pricing mechanisms will be able to "effectively deal" with the risk that an approximately $220 billion in leveraged loans, and the accompanying derivatives, that are currently in the pipeline, Fewer said.

Much of the downturn in the CDO market has come from the asset-backed class, specifically subprime mortgages and other high yielding asset-backed securities.

The single-name CDS market and the single-name ABX market will lead to the creation of a new index class for Alt-A mortgages, Fewer forecast. The new index will cover some of the poisonous asset-backed securities that have been causing so much trouble.

The development of the loan CDX market in June, the growth in the single name loan market and the development of the loan tranche market show the evolution to deal with the evolving and multiplying risks, Fewer said.

He added that there has been a huge uptick in single-name CDS contracts from the leveraged loan markets.

The weakness in the CDO market will lead to a significant repackaging of the existing loans and options, Fewer said. Many will be hard to trade, but super-senior and other quality paper will be repackaged and traded. "We will see the birth of a second and third generation market," he added.

CDO markets are more liquid in Europe, Fewer said. There is also significant room for growth in 2008 in the emerging markets CDO market, particularly in Brazil and Mexico, Fewer said.

The current problems in the credit derivatives market might lead some to question the value of CDOs, Fewer said. "We believe the basic pricing techniques of single-name CDS, index and specifically tranching will emerge as a major pricing mechanism that will provide the liquidity and the avenue to deal with not only this current crisis, but the birth of some very exciting and new product areas," he added.

One danger hanging over the credit derivative markets is ratings agencies rushing in to cut ratings on asset-backed CDOs without, Fewer warned, really understanding their components. At the same time, with the major banks writing down the prices of their debts, a lot of money is heading into distressed funds. Eventually, the banks are going to have to trade their debt at the low prices being offered, even if they don't want to, Fewer said.

"There's going to be some pain," he said. "But there's a better opportunity to start trading out of it than just sitting on it, because shareholders are not going to allow that to happen."

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