At the center of the credit crisis are trillions of dollars in credit derivatives sold to creditors looking to hedge their credit risk from subprime loans. Trading in unregulated markets, buyers and sellers of credit derivatives weren't required to cover their potential losses from increased credit risk, which led to rampant speculation in these financial instruments. Buyers relied increasingly upon leverage until the collapse of the subprime market left sellers like AIG and Lehman Brothers overwhelmed by liabilities from defaulted loans.
Recently the Financial Accounting Standards Board (FASB) issued an amendment to its derivatives and hedging standard requiring that sellers shed some light on their credit risk exposure. However, the amendment won't go very far in providing an accurate picture of the credit derivatives market as a whole since many entities involved aren't public, such as hedge funds and insurance companies, among others, warns Mark LaMonte, senior vice president and head of the enhanced analytics group at Moody's Investors Service.
In these transactions the buyer and seller agree that if the third party named in the derivative does not pay the buyer a certain amount towards an asset, the seller will make a payment to the buyer. For a credit default swap, the most highly utilized credit derivative, the seller also agrees to move the defaulted asset onto its balance sheet.
Under the amendment, the seller must now disclose the reason(s) the buyer purchased the credit derivative, which shows whether companies are trading derivatives to hedge risk or for speculative purposes. To enable investors to more accurately assess the seller's credit risk exposure, disclosure of the approximate term of a credit derivative, the event or circumstance that would trigger payment and the current likelihood of payment are also required.
The seller must also reveal either the maximum potential amount of future payments under the derivative or that the derivative does not limit future payments, whichever is the case. A separate disclosure describes how the seller might recover some or all of a payment, for example by liquidating assets. Finally, the seller must disclose the credit derivative's fair (mark-to-market) value.
The amendment applies to annual and interim reporting periods ending after Nov. 15, 2008. "If companies are doing an effective job of managing risk internally they should have the information required for the disclosures readily available," says LaMonte.