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Credit Default Swaps and Bank Leverage

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The Financial Times reports that that $45 trillion figure that most of us have been using for the size of the credit default swaps market is woefully dated. The International Swaps and Derivatives Association will announce today that outstanding contracts now total $62 trillion, up from $34.5 trillion a year ago.

Institutional Risk Analytics gives some useful commentary on credit derivatives and the related issue of bank gearing, focusing on JP Morgan’s counterparty issues (and a sobering bit of Bernanke gossip):

Martin Mayer makes an interesting comment on the BSC debacle and leverage generally in this week’s issue of Barrons:
In the OTC derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party. It’s an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit. The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps… Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don’t know who will wind up with obligations they thought they had insured against and they can’t meet.

For some months now, we’ve been pondering what happens to all of those net short credit default swap portfolios at dozens upon dozens of hedge funds that will be going out of business this year due to the Great Unwind. Hedge funds have no permanent capital, thus there are no assets available to support the defeasance of a book of net-short OTC derivatives positions should the fund be forced into involuntary liquidation.

In such a scenario, you can forget about netting; won’t be nothing left to net, in or out of bankruptcy. And since the old habit of simply writing more CDS contracts is not available once the fund starts liquidating, we wonder if leading CDS dealers like JPMorgan won’t be forced to take these trades back as hedge funds expire. What’s the “fair value” of a book of short OTC derivative positions taken by a dealer in payment of other debts?

Indeed, if you think of BSC not as a broker dealer, but instead as a clearing customer of JPM, then the logic of the acquisition makes perfect sense. JPM could not let BSC go into Chapter 11 because doing so might have started a chain reaction among the OTC derivative counterparties of both firms.

Between JPM, BSC and BSC’s customers there were three levels of leverage, making the ratio of Economic Capital to Tier One Risk Based Capital computed by The IRA Bank Monitor (4.7:1) for JPM at the top of the leverage pyramid seem entirely too generous! If you impute even a fraction of the downstream leverage residing with clearing customers to JPM, the giant bank’s capital shortfall becomes alarming.

A bank holding company, after all, is thinly capitalized and in many ways was the precursor of the hedge fund model. On a parent-only basis, JPM’s $314 billion asset balance sheet includes $200 billion representing investments in its subsidiary banks and non-bank units, supported by half as much equity and more than $200 billion in debt.

And remember that JPM’s on-balance sheet capital does not even partially support the counterparty risk of its vast OTC derivatives businesses, thus the BSC acquisition was a “must do” deal for Mr. Dimon. Think of it this way: JPM is essentially an uncapitalized, $76 trillion OTC derivatives exchange with a $1.3 trillion asset bank appendage. By the way, we are working to include factors for OBS securitizations in the next iteration of our Economic Capital simulation in The IRA Bank Monitor.

But you understand that Fed officials still believe, even today, that the US markets are not over-leveraged.

The story goes that shortly after Ben Bernanke was confirmed as Fed Chairman, he attended a dinner in New York attended by the heads of the major banks. All the big banksters were there. After dinner, Chairman Bernanke gave a speech and he at one point reportedly commented that the financial markets were “not very leveraged,” causing audible laughter from the audience.

According to one attendee, Lehman Brothers CEO Dick Fuld eventually spoke up and, while declaiming any intention to disagree with Chairman Bernanke publicly, told the newly minted Fed chief that his comments about the degree of leverage in the financial markets were mistaken. JPM CEO Jamie Dimon, who also attended the dinner, was reported to second Fuld’s comments.

Who would have thought that only several months later, Fuld and Dimon, both of whom are directors of the Federal Reserve Bank of New York BTW, would be calling upon Chairman Bernanke to rescue them from leveraged OTC swamp? Guess they’re not laughing now – or are they?

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24 comments

  1. RK

    Yves: This is an off post comment, but broadly relevant. Occasionally, an event in real life is eerily & accurately mirrored in a work of literature. This is the
    case with Balzac’s “Le Peau de Chagrin”, which you must have read in your youth. I haven’t read it in 20 years, but can still remember one central theme: Be
    careful what you wish for.

  2. eh

    Don’t be an alarmist. Everything’s OK — just look at INTC’s earnings from yesterday. Relax, ‘Safety in Numbers’ is the new slogan on Wall St.

  3. Observer

    I am just thrilled to see that Martin Mayer is still actively writing about all this. I have commented previously about his prescient views in 1999 about where we were going — and here we are in 2008. My only quibble is with his use of the word “will” here:

    “The truth is that the Fed had plenty of authority to take the steps that would have avoided today’s dangers and its own embarrassments. The problem was that the Fed lacked the will to supervise. Before we can restore the self-confidence of the market, we will need to create a Federal Reserve that believes in its own regulatory mission more than it believes in prudence at the banks.”

    There is hardly any more wilfull person than Alan Greenspan. The Fed did not lack the will to execute its regulatory mission. Under Greenspan, and under the dominant ideology of our era, he did not want to execute it, did not believe it is relevant or necessary, and is already whining when events catch up and, in a panic, the more perceptive or at least honest observers from the commanding heights of capitalism are suddenly repenting of their Radiant Future fervor and suggesting, nay demanding, reregulation, immediately if not sooner.

    But the Great Unwind will take some time, and if we’re not careful we’ll have have credit markets version of the botched cleanup of the last cathartic spinout in the dot-telecoms crash, that being the ever-uglier and ever-less-effective Sarbanes-Oxley.

    But meanwhile, we can rejoice that Martin Mayer has returned to the fray. At least someone has been there all along saying that the Chairman wears no clothes, just a daisy chain.

  4. foesskewered

    That was a nice anecdote, no doubt one which Bernanke wished he was never part of. But wouldn’t such asituation worsen counterparty worries, after all it’s a doublebind, can’t do nothing and can’t not do anything.

  5. vlade

    A small comment: you can get out of a deal in other ways, but it’s the less likely way as it tends to crystalize PnL (buyout). When you just offset, you still end up with some exposure due to maturity/notional mismatches (which might or might not be trivial on aggregate).

    The problem with cpty is that if CDS go, all other derivatives will go as well – most notably, IR swaps, of which I don’t doubt there’s much more in outstanding notional than CDSes. Basically, unwind like this would mean that the whole financial sector would go under, taking a huge part of medium/large commercials with them.

    Very scary.

  6. Anonymous

    “Indeed, if you think of BSC not as a broker dealer, but instead as a clearing customer of JPM, then the logic of the acquisition makes perfect sense. JPM could not let BSC go into Chapter 11 because doing so might have started a chain reaction among the OTC derivative counterparties of both firms.”

    This is the clearing account exposure – i.e. exposure as agent.

    “Think of it this way: JPM is essentially an uncapitalized, $76 trillion OTC derivatives exchange with a $1.3 trillion asset bank appendage”

    This is the direct exposure – i.e. exposure as principal.

    I’m not sure why BSC bankruptcy would have exposed JPM to outsized risk in the clearing account per se. JPM would have been exposed to the same systemic risk on its principal book as everybody else, although larger because its principal book is larger. But would the clearing account have posed a special risk for JPM?

  7. Anonymous

    If BSC was forced to some mark2mkt and not mark 2 imagination, wouldnt JPM (and all banks) have to mark their own portfolios to the same numbers?

  8. S

     Former ECB chief economist Otmar Issing said in an interview broadcast today that the central bank won’t tolerate the current inflation rate; Price increases are “not out of control, but this inflation rate is intolerable and the ECB will fight it,” Issing said in a Bloomberg Television interview in Frankfurt. “The ECB has a clear mandate: maintaining price stability.”

  9. Anonymous

    Is there a report or post w/ good overview / insight into the CDS problem? I understand that the notional amount isn’t really the issue, but would like a more in-depth understanding of the techical issues.

  10. Anonymous

    Thank God these synthetic devils are on top of the casino games!

    March 27, 2008 – The Securities Industry and Financial Markets Association’s (SIFMA’s) Asset Management Group (AMG) is part of a letter of agreement that was signed by the senior managers of 17 major derivatives dealers (Major Dealers). The agreement serves as an update to the Federal Reserve Bank of New York and other regulators and outlines goals, strategies and major benchmarks toward the continued improvement and streamlining of operational efficiency within the credit and equities derivatives markets.

    Also: President Bush will nominate Bartholomew Chilton and Jill Sommers on Thursday to serve as commissioners of the Commodity Futures Trading Commission, the White House said. Chilton would serve the remainder of a five-year term expiring in April 2008, while Sommers would serve her term until April 2009. Chilton is currently chief of staff and lobbyist at the National Farmers Union. Sommers was recently a lobbyist for the International Swaps and Derivatives Association.

    See also: In the process of executing matched principal transactions, miscommunications and other errors by our clients or us can arise whereby a transaction is not completed with one or more counterparties to the transaction, leaving us with either a long or short unmatched position. These unmatched positions are referred to as “out trades,” and they create a potential liability for the involved subsidiary of ours. If an out trade is promptly discovered and there is a prompt disposition of the unmatched position, the risk to us is usually limited. If the discovery of an out trade is delayed, the risk is heightened by the increased possibility of intervening market movements prior to disposition. Although out trades usually become known at the time of, or later on the day of, the trade, it is possible that they may not be discovered until later in the settlement process.

    We do not track our exposure to unmatched positions on an intra-day basis. These unmatched positions are intended to be held short term.

    To the extent these unmatched positions are not disposed of intra-day, we mark these positions to market. Adverse movements in the securities underlying these positions or a downturn or disruption in the markets for these positions could result in a substantial loss.

    Re: At December 31, 2006, we had 175 brokerage desks and 932 brokerage personnel (consisting of 821 brokers and 111 trainees and clerks) serving over 2,000 brokerage and data and analytics clients, including leading commercial and investment banks, through our principal offices in New York, Sugar Land (TX), Englewood (NJ), London, Paris, Hong Kong, Tokyo, Singapore and Sydney.

    Relax, these people have more chips!!

  11. Anonymous

    Banks’ new tool to deal with counterparty ris

    http://www.euro2day.gr/ftcom_en/126/articles/308874/ArticleFTen.aspx

    Rudimentary and idiosyncratic versions of these so-called contingent credit default swaps (CCDS) have existed for five years, but they have been rarely traded due to high costs, low liquidity and limited scope.

    But now there are high hopes that a revamped version of CCDS, which will bear the formal blessing of the International Swaps and Derivatives Association, will be more successful when it is released in two to three months’ time.

    Counterparty risk has become a particular concern in the markets for interest rate, currency, and commodity swaps – because these trades are not always backed by collateral, leaving banks vulnerable to sudden losses if counterparties collapse.

    he new CCDS was developed to target these institutions. Some banks have already started doing deals using a rough and ready version of the forthcoming standardised documentation.

    Trading volumes are thought to remain relatively small but, according to Bill Mertens, head of CCDS at Icap, the interdealer broker, demand has started to grow.

    “We’re constantly looking for the [point where growth] explodes. That may happen shortly,” he says.

    Unlike in a normal credit default swap, where the notional risk that is hedged is defined at the outset of the contract, each CCDS is linked to a second derivative, so the risk being hedged varies over time according to market movements in the underlying transaction. That means these contracts can be used to protect or lock in mark-to-market gains on the values of derivative contracts, as well as to protect dealers against counterparty risk.

    But dealers are sceptical that the instrument will take off, particularly where more liquid, if imperfect hedges are available, for example through more traditional CDS. GFI, a rival interdealer broker to Icap, abandoned CCDS last year because of a lack of interest, though it said it would re-enter the market if demand picked up.

    One counterparty risk officer at a leading European bank called CCDS “a product with nowhere to go”.

  12. Anonymous

    FYI:

    Interdealer broking steps into the spotlight

    http://www.financialnews-us.com/?page=ushome&contentid=2450361770

    Increased liquidity stimulated by the growth of lower cost trading and the increased use of equity derivatives products should all play to the brokers’ favour.

    Interdealer broker results, reports from the Bank for International Settlements, the US Futures Industry Association, Greenwich Associates and Tabb Group have all underscored both the recent growth and the market’s prospects.

    Link last year had total revenues of £81m, a near 70% increase over 2006 levels. Of reported revenues from equities, GFI recorded a near 40% increase to $239m (€151m) and Tullett Prebon had a 104% increase to £81m. Icap’s equity related revenues rose 69% in the year to March 2007.

    The latest BIS semi-annual survey showed that the OTC equity derivatives market expanded at a compound annual growth rate of 32% between 2001 and 2006.

    The Futures Industry Association’s annual survey of 58 reporting futures exchanges showed that on a combined basis, equity futures products accounted for 64% of the total volume last year, and more than 71% of the total volume increase.

    Tabb has also pointed to options volumes reaching a record 2.8 billion contracts in 2007, a 41% jump from 2006’s record, in response to a “perfect storm” created by institutional demand and regulatory overhaul.

    Patrice Cohen, managing partner of Louis Capital in London, said that in addition the impact of the markets in financial instruments directive and unbundling regulations were creating additional opportunities for the brokers: “It is becoming more common for hedge funds to have a relationships with firms like ours.”

    The growth of the equity business should not benefit the interdealer brokers alone – it should play to the exchanges’ hands, for the bulk of the customer-facing business done by the interdealer brokers is either done on-exchange, or passed through the exchange-run, over-the-counter clearing facilities.

    This is where Liffe’s Bclear and Eurex’s OTC Flexible facilities come into play. Using their services, participants can trade as they would normally in the OTC markets, seeking trading interest through the interdealer brokers without publishing their interest in order books.

    Once the trades are agreed, the brokers immediately give them up to the exchanges’ nominated clearing houses, which step in as counterparties to both sides of the trade.

    In this way the interdealer brokers do not need to give up the hedge funds’ names to banks, and the end users retain the benefits of OTC market flexibility while enjoying the security, automation, risk management and anonymity of exchange-traded environments. Furthermore, because the central counterparty clearer steps into the trade, the onerous and credit risk downsides of OTC trading are removed.

    >> Things are looking great…..LOL!

  13. Anonymous

    Nick Leeson, the futures trader who brought down Barings bank in 1995, weighed in on the rogue trading scandal that has rocked Société Générale, warning of a “black hole” in some markets unless risk-management systems caught up with the sophistication of trading desks.

    “Unless it catches up very quickly, you have a problem. [The] Jérôme Kerviel [case] has to inject a degree of reality into all of this,” Leeson told a derivatives conference in London, organised by Futures and Options Week, an industry publication.

    “Not enough investment goes into these back-office control functions,” Leeson said. “A lot of investment is directed towards the front end. As my story shows, this is very risky.”

  14. Anonymous

    JPMorgan to inherit legal woes of Bear Stearns

    http://www.iht.com/articles/2008/04/15/business/bear.php

    Bear Stearns said that regulators were scrutinizing “the bidding process for municipal derivatives that are offered to states, municipalities and other issuers of tax-exempt bonds.” It also said it was cooperating with the U.S. Department of Justice and the SEC.

    Bear Stearns’s municipal market activities since the early 1990s are also under investigation by the justice department’s antitrust division, the bank said. The investigations by the SEC and the justice department span the securities industry, the company said.

    In the same filing, Bear Stearns disclosed a civil investigation by the Federal Trade Commission into its EMC Mortgage unit seeking documents and information relating to business and servicing practices.

    Last month, the bank said, it received notice from the trade commission saying that its investigators believed EMC and Bear Stearns violated consumer protection laws in connection with servicing activities. The commission has offered to let Bear Stearns resolve the matter though talks before filing a complaint, the company said.

    The filing also noted that liquidators of two Bear Stearns mortgage hedge funds that failed last year filed a suit this month against the Bear Stearns and the auditor Deloitte & Touche. The suit, which seeks more than $1 billion in losses plus damages, accuses the company and the auditor of failing to fulfill fiduciary and professional duties.

  15. Anonymous

    Think of it this way: JPM is essentially an uncapitalized, $76 trillion OTC derivatives exchange with a $1.3 trillion asset bank appendage.

    Everyone digest this, fully. When you’re finished you will understand why the Fed will NEVER let any bank fail, EVER. When you understand that, that is their mission, you will understand their behavior. Banks due to counterparty risk CANNOT fail. Period.

  16. Kidder Reports

    $62 trillon is nearly twice the size of the $31.9 trillion value of all investment grade securities as calculated by the Capital Market Index (CPMKTS on the Amex).

    As of March 31, the index includes about 80% (9,743 securities). Not included in the index are asset-backed securities, municipal bonds, junk bonds, convertibles, preferreds and floating-rate securities.

    As an aside, public holdings of US T-bills surpassed $1 trillion for the first time in March.

  17. S

    Did anyone catch the $1B of gains on spread widening that JP had in its results for the quarter..more of the same

    Flash: JPM looking to issue capital – MS says it is a strategioc decision to maintian its relative capital position advanatage. yeah…ok

  18. Anonymous

    Like that “banksters” but wouldn’t bangsters be better. And let’s all remember it’s Home Debtorship not Home Ownership.

  19. Anonymous

    Does anybody know how much exposure foreign banks/hedge funds have to CDS’s? It has been argued that the Fed intervened to prevent BSC from going bankrupt because that would set off a chain reaction of bank failures tied to CDS’s. Looking forward, however, might the initial event that leads to this presumed chain reaction come from a failure at a foreign bank, such as in Europe where the ECB is more concerned with price stability and inflation than here than the Fed, and therefore might not be as willing to intervene?

  20. Yves Smith

    The big problem with trying to have an intelligent discussion re CDS is the lack of decent data. The $62 trillion number is scary, but it doesn’t tell you what you’d like to know, which is what the economic exposure is (oh, but then again, that’s calculated by the banks themselves, using their own models).

    I dimly recall a BIS chart which put the economic exposure at 2% of notional across the entire market (anyone with better factoids encouraged to speak up). Of course, that level isn’t static. It ought to go up with corporate credit deteriorating and volatility increasing. And the amount of CDS written relative to cash bonds tends to be higher on distressed credits.

    Anon of 3:34 PM,

    I don’t think there is any way of knowing, since this is an OTC market, but with London a bigger hedge fund center than the US, and some foreign banks being very active in CDS, like Paribas and UBS, a high proportion has to be overseas.

  21. Anonymous

    You said: “Fuld and Dimon, both of whom are directors of the Federal Reserve Bank of New York BTW, would be calling upon Chairman Bernanke to rescue them from leveraged OTC swamp? Guess they’re not laughing now – or are they?”

    I say: Yes they are laughing. Nothing like a good transfer of taxpayer’s money to their pockets to get a good laugh

  22. Richard Kline

    If one recalls the colloquial context for ‘daisy chain,’ this is a most fitting description! As vlade says en brief above, it’s the mismatch potential that makes life interesting here. In principle, these CDS positions offset, 31 T white snarks and 31 T black snarks; they just couple up two by two, no harm, no foul. But if one be a boojum and a link in the daisy chain drops out . . . all fall down.

    These instruments are indeed ‘weapons of mass financial destruction’ equivalent in their way to neutron bombs: if they go boof, they leave the buildings but kill the money. It would be perhaps the greatest show in the history of the world since the cometary vaporization of 13 kya, but we must might get the financial equivalent of a middling Ice Age out of it. . . . I’ll wait for the movie, thanks.

  23. Anonymous

    So if the volume of CDS exceeds the value of the marketplace, then wouldn’t an efficient market cause bankruptcy so that the CDS’s pay off? That is, if the value of bonds defaulting exceeds the value of not defaulting, then shouldn’t a market that maximizes value cause defaults?

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