Credit Derivatives: Trading, Investing and Risk Management, Second Edition

29

Cause and Effect: Credit Derivatives and the Crisis of 2007

Robert Reoch, Founding Partner, Reoch Credit Partners LLP

29.1 THE CREDIT MARKETS PRE-CRISIS

For most of history the availability of credit has been limited to two markets: the banking sector and the rest - a plethora of informal, unregulated direct lending mechanisms (person to person, credit cooperatives, micro lending, etc.). While a significant proportion of retail and small business lending may have gone through the informal markets, the majority of all borrowing and almost all large corporate borrowing has gone through the banking market.

As the global capital markets have evolved over the last 30 years, a new source of credit has grown exponentially and this is generally referred to as ‘bank disintermediation’. The whole corporate bond market effectively disintermediated the banks by directly pairing off non-bank providers of liquidity with corporate and sovereign borrowers. The banks themselves benefited from the growth of non-bank bond investors by tapping this sector for its own senior and subordinated liquidity needs. And, having established a huge investor base of non-bank credit investors, the next step in the bank disintermediation process was to allow assets traditionally funded on bank balance sheets (corporate loans, mortgages, etc.) to be moved into separate companies and be financed by these same non-bank liquidity providers.

It is this last development that has seen huge growth over the last ...