Broker Stocks Outlast Skeptics

Another big cash cow for Wall Street firms comes from the wide array of exotic financial products they've been selling to hedge funds to drive trading. The market for credit derivatives, a specialized security that essentially serves as an insurance policy against a corporate default on a bond, is booming. Yet Wall Street firms provide investors with little information about the risks they've assumed in backing these deals for customers.

David Hendler, a financial services analyst with CreditSights, says too much of what's been fueling earnings are so-called "black box" items and other off balance sheet financings that are hidden from view.

"Are the earnings good because they are sustainable or because they are frothy? We really can't tell,'' says Hendler. "It's a black box.''

Recently, Goldman Sachs shed a bit of light on some of the risk it is taking in the credit derivatives market. A section of its 2005 annual report dealt with Goldman's obligation to supply underlying securities, bonds, to counterparties in these deals. In the report, Goldman appended a new risk statement saying it could "forfeit the payments due to us'' under its credit derivative deals if it's unable to make good on its delivery obligation.

The disclosure is a response to the Federal Reserve's effort to bring more clarity to the murky world of credit derivatives and the delays incurred by brokerage back offices in settling trades and delivering securities. The Fed is concerned about the possibility of a meltdown in the $12 trillion credit derivatives market, in the face of a major market selloff.

Much of the growth in the credit derivatives market has come in the past three years, when stocks have been heading higher and corporate defaults are near all-time lows. The problem is no one knows how things with shake out in this relatively new market when stocks head south and corporations start defaulting on their bonds.