The Bond Market's Shaky Foundation

For example, Banca Italese, an Italian financial company that had specialized in asset-based lending, dove into the derivatives market in 2003. The bank started to offer fixed-rate financing, instead of its typical floating-rate deals, and used derivatives intended to offset fluctuations in interest rates. At the end of 2006, the bank reported, its exposure in the derivatives market was about $300 million. Not excessive, perhaps, for a bank with a market capitalization of $8.5 billion.

But Banca Italese never bothered to build a derivatives department devoted to analyzing the risk of its deals. Whoops. By the beginning of June, after euro interest rates had moved substantially higher, the bank's exposure had climbed to $800 million from the earlier $300 million estimate. The bank has spent $300 million to cap its interest rate risk -- it hopes. And the bank's market capitalization has dropped to $2.9 billion from $8.5 billion in a little more than five months.

Bond professionals know that Banca Italese isn't alone. They know that most players in the derivative market aren't capable of accurately assessing the risks of these instruments. In fact, they're increasingly worried that even the big credit rating agencies like Moody's, Standard & Poor's and Fitch aren't up to the job.

The Bond Buddy System

It's important to understand that bond professionals don't want to think badly of the job done by the credit-rating agencies. The bankers pay the rating agencies' fees. (Bet you didn't know that. Yep, the issuers of debt are the ones who pay the bills.) The bankers literally sit across the table from the rating agencies. The banks poach anybody on the other side of the table who they think has the talent to work for them. And the banks rely on the credibility of the rating agencies to sell their debt offerings. It's a pretty cozy club.