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?