Credit derivatives may be altering market dynamics in a way that makes these derivatives and the bonds that underlie them riskier than we think. In particular, bonds may become more correlated than in the past because credit derivatives, rather than fundamentals and default probabilities, are driving their prices. Higher correlation may become most marked during a credit-based event. Investors who have to reduce their derivatives exposure or who have to hedge their exposure by taking positions in the underlying bonds will look at the bonds as part of a CBO package, and the bonds in that package will move in lockstep.
Rating agencies do not consider this new dynamic, so the ratings underestimate risk. If a set of A-rated bonds are put in a portfolio, the principle of diversification leads that portfolio to be less risky than the individual bonds. And the lower the correlation between the bonds, the lower the risk. Historically, bonds are not very correlated when it comes to default, so a rating agency that relies on historical data might come to the conclusion that the portfolio of bonds has low enough risk to merit an AAA rating. But if there is a credit derivative-based crisis, those bonds will become more correlated for no reason other than that they are bound into the same derivative instruments.
Things might only get worse when the rating agencies come around to marking these instruments correctly, because they will likely do so at the least opportune time. I don’t think they will wake up and start to revise ratings based on abstract arguments concerning market dynamics and the effect derivatives might play on the linkages between bonds. Instead, they will wake up when the market finally manifests the level of risk these instruments really contain; that is, when a crisis hits and the higher correlation becomes evident. So at the worst possible time, ratings may be revised and push many of these derivatives over the edge – either the A-rated or the investment-grade threshold. Many investors with ratings restrictions on their portfolios will be forced to liquidate these positions. The result will be a crisis laid upon another crisis.