Selling More Insurance on Europe Debt Raises Risk for Banks
Robert Caplin/Bloomberg
Five banks - Citigroup Inc., JPMorgan, Morgan Stanley, Goldman Sachs and Bank of America Corp. - write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency.
Nov. 1 (Bloomberg) -- Russ Koesterich, the San Francisco-based global chief investment strategist for the IShares unit of BlackRock Inc., talks about the impact of Europe's debt deal on global stocks and his investment strategy. Stocks retreated from an almost three-month high as Italian and Spanish bonds fell amid concern European leaders will struggle to raise funds to contain the region’s debt crisis. Koesterich speaks with Susan Li on Bloomberg Television's "First Up." (Source: Bloomberg)
Guarantees provided by U.S. lenders on government, bank and corporate debt in those countries rose by $80.7 billion to $518 billion, according to the Bank for International Settlements. Almost all of those are credit-default swaps, said two people familiar with the numbers, accounting for two-thirds of the total related to the five nations, BIS data show.
The payout risks are higher than what JPMorgan Chase & Co. (JPM), Morgan Stanley and Goldman Sachs Group Inc. (GS), the leading CDS underwriters in the U.S., report. The banks say their net positions are smaller because they purchase swaps to offset ones they’re selling to other companies. With banks on both sides of the Atlantic using derivatives to hedge, potential losses aren’t being reduced, said Frederick Cannon, director of research at New York-based investment bank Keefe, Bruyette & Woods Inc.
“Risk isn’t going to evaporate through these trades,” Cannon said. “The big problem with all these gross exposures is counterparty risk. When the CDS is triggered due to default, will those counterparties be standing? If everybody is buying from each other, who’s ultimately going to pay for the losses?”
Hedging Strategies
Similar hedging strategies almost failed in 2008 when American International Group Inc. couldn’t pay insurance on mortgage debt. While banks that sold protection on European sovereign debt have so far bet the right way, a plan announced yesterday by Greek Prime Minister George Papandreou to hold a referendum on the latest bailout package sent markets reeling and cast doubt on the ability of his country to avert default.The CDS holdings of U.S. banks are almost three times as much as their $181 billion in direct lending to the five countries at the end of June, according to the most recent data available from BIS. Adding CDS raises the total risk to $767 billion, a 20 percent increase over six months, the data show. BIS doesn’t report which firms sold how much, or to whom. A credit-default swap is a contract that requires one party to pay another for the face value of a bond if the issuer defaults.
The jump in CDS sold by U.S. banks on Greek, Portuguese, Irish and Spanish debt was almost the same as the decline in the exposure of German and U.K. lenders. German and U.K. risk related to Italy didn’t fall, even as the amount of CDS sold by U.S. lenders on debt related to that country rose.
Five Banks
Five banks -- JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C) -- write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.
In theory, if a bank owns $50 billion of Greek bonds and has sold $50 billion of credit protection on that debt to clients while buying $90 billion of CDS from others, its net exposure would be $10 billion. This is how some banks tried to protect themselves from subprime mortgages before the 2008 crisis. Goldman Sachs and other firms had purchased protection from New York-based insurer AIG, allowing them to subtract the CDS on their books from their reported subprime holdings.
‘AIG Moment’
When prices of mortgage securities started falling in 2008, AIG was required to post more collateral to its CDS counterparties. It ran out of cash doing so, and the U.S. government took over the company. If AIG had collapsed, what the banks saw as a hedge of their mortgage portfolios would have disappeared, leading to tens of billions of dollars in losses.“We could have an AIG moment in Europe,” said Peter Tchir, founder of TF Market Advisors, a New York-based research firm that focuses on European credit markets. “Let’s say Greece defaults, causing runs on other periphery debt that would trigger collateral requirements from the sellers of CDS, and one or more cannot meet the margin calls. There might be AIGs hiding out there.”
Dexia Bailout
The bailout of Dexia SA (DEXB) by Belgium and France last month resembled AIG’s rescue. The bank, based in Brussels and Paris, faced 16 billion euros ($22 billion) of new margin calls on Oct. 7 as a result of interest-rate swaps it had sold, Belgian central bank Governor Luc Coene said.The two countries agreed to aid Dexia on Oct. 9, assuring creditors -- including holders of CDS and other derivatives counterparties -- they would be paid in full, the same way AIG’s were after the U.S. takeover. Goldman Sachs and Morgan Stanley (MS) were among the lender’s biggest trading partners, the New York Times reported on Oct. 23, citing people it didn’t identify.
Benoit Gausseron, a spokesman at Dexia in Paris, didn’t confirm or deny the newspaper report.
“The risks for the U.S. banks are particularly relevant if their counterparties are European,” said Darrell Duffie, a Stanford University finance professor who has written seven books about derivatives. “What if they sold protection to some banks and bought protection from others, and they can’t get paid by the ones they bought protection from?”...finish reading from source
