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"