“Plain Vanilla” Trouble

I’ve been going on for years about the Credit Default Swap (CDS) business, and the way it can and does push the real economy and markets around.

Today, though, a secondary effect of that market’s lack of transparency may be a real problem for all the major players in the world financial system.

“But, but, but” you say.  The financials are up in the stock market today.  The Dow Jones is roaring.  New claims for unemployment are lower than they’ve been since 2008.  The S&P is higher than it’s been in over three years.  Multi-family housing and the Philly Fed survey both surprised to the upside.  Even the Greek mess looks like it might be pushed past the looming March 20 due date.

So why am I writing about trouble, and why do I call it “plain vanilla?”

Because the most important news today in the financial world didn’t get noticed.

I’m talking about the Moody’s Investors Service notice that they were putting more than a hundred top-tier banks around the world on credit watch with negative implications.  While the reason is probably due to the unknowable exposure to CDS, especially CDS written on European sovereign debt, the result is to threaten the base credit rating of virtually every large bank in the world.

That’s when understanding how counterparties protect themselves in the swap market becomes important to every investor.  Recall, if you will, that AIG was the largest AAA insurance company in the world before its collapse.  Because it was AAA, those who held the other side of Credit Default Swap contracts with AIGFP didn’t require collateral deposits on the subprime and CDO bond CDS that AIGFP wrote.  That’s also why the crew at AIGFP got paid more than a million dollars per person, even when you include administrative assistants and back office clerks in calculating the average pay.

AIGFP essentially used no capital when it wrote its CDS contracts, and the AIGFP team convinced senior management they were collecting “free money” with those contracts, thus producing infinite return on capital.  Nice.

When the problems began to surface was when the underlying AAA bonds for those CDS contracts declined so much that even AAA-rated AIG had to post collateral with counterparties, at least for some of the contracts.  When AIG itself got downgraded from AAA to AA (and then even farther), every contract required collateral.  It was a margin call on a massive scale, so large that even the biggest AAA insurance company became insolvent.

After AIG ran out of cash, the US Government put up more than $80 billion without even asking anyone.  Subsequent payments, bringing the total over $200 billion, were all to meet those margin calls.  I’m still seriously pissed that the margin calls were not negotiated down to market levels, but got paid out at full face value.  There were others in similar trouble at the time, and they got their problems settled with CDS counterparties for pennies on the dollar.

But back to the real point — what a massive downgrade to all the major banks might do.

As large as the CDS market is, it pales in comparison to the “plain vanilla” interest rate swap market.  The latest Office of Comptroller of the Currency report on US bank derivatives activity shows that 6.2% of the gross “notional” value of contracts is credit-related, while over 10% is currency-related and more than 80% is the interest rate swap business — the “plain vanilla.” [See the pie charts on page 9 of the report.]

Almost every swap contract of every type has a provision for posting of collateral if either party drops below a certain (high) credit rating with one or more rating agencies.  In effect, every bank of any size in the world may soon get margin calls from their interest rate and currency swap counterparties.  The total notional value of those swap contracts (at US banks alone) is nearly $250 Trillion dollars!  And we have five banks representing 96% of the total face amount of those derivatives, and over 85% of the exposure even after you net out the long and short positions and only look at the exposures as if every counterparty to those contracts performs without defaulting on their payments.

While my friends in swap groups and legal departments at every large bank won’t be getting much sleep the next few days as they figure out how much they might have to post as collateral (and how much collateral they may need to demand from all their trading partners), the effect of an industry-wide downgrade like Moody’s is threatening would be to take at least hundreds of billions of dollars out of other uses at those banks.  And those dollars are the most valuable kind — capital.

Stay tuned.  Whatever comes next, capital and its racier cousin liquidity may well become very precious commodities in the world banking system.  This is the kind of pre-tremor that sets up global crises.  Remember Lehman?


4 Responses to “Plain Vanilla” Trouble

  1. Just when we all thought it was fine to get back in the “water”….what a spoil sport you are. I think I actually understood a lot of that…sort of. Thanks

  2. Conscience of a Conservative says:

    CDS’s seems a lot like the insurance side letters that Spitzer went after some years ago. Banks take on some risk, then enter into a CDS contract to show the regulator they’ve hedged that risk so they can reduce regulatory capital, except because of counter-party exposure everyone’s exposed to one another. It’s non-sense. In the days of the insurance side letters, an insurance company would engage in a reinsurance deal with AIG then negate that with a side-letter but keep the side-letter private. The whole thing is regulatory arbitrage and if the shit hits the fan the gov’t has to bail out the system since the hedges are not legit. At least that’s my take…

  3. Raymond May says:

    I would love you to post a comment on CFTC.gov on this subject – we need fair, transparent SEFs asap

    (see odexgroup.com)


  4. fredhavell says:

    I have been away from this business for a long time, but I believe many of the contracts do not call for collateral under any circumstances from the majors when those contracts are written by the majors and sold to peripheral players. Still, the main point remains, this is only a mitigating factor.

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