Even so, it seems to me that such risk management practices are important in governing credit risk in large banking organizations and, in many respects, reducing systemic risk, as well. Despite the common practice by banks that issue CDOs to retain much or all of the first-loss or “expected-loss” tranche, such banks have at least reduced their previous, full credit exposure.
Moreover, the sale and purchase of CDS also allow banks to manage concentrations and to further diversify their portfolios. In the event of highly unexpected defaults among investment-grade firms, a hedged bank’s losses will be reduced. The experience with credit derivatives in the Enron, World Com, and Parmalat events, indicate that these new risk products can work effectively.