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Credit Safest Since ’08 as Clearinghouses Control Swaps

Credit Markets Safest Since 2008 as Derivatives Migrate
Parts of the Lehman Brothers company sign is shown at Christie's auction house in London. Photographer: Ben Stansall/AFP/Getty Images

Credit markets, which inflicted more than $2 trillion of losses and writedowns on the world’s biggest financial institutions from 2007 through 2009, are now seen as the safest since before the financial crisis.

The amount of money at risk in over-the-counter derivatives has fallen to the lowest level in three years, according to the Bank for International Settlements in Basel, Switzerland. To close all trades, U.S. banks would need less than half the amount required at the worst of the downturn, the Comptroller of the Currency in Washington says.

A combination of voluntary bank reforms and international regulation is reining in a market that threatened to topple the financial system three years ago. Government-prompted use of clearinghouses, which act as a sort of guarantor to lessen the effects of a default by counterparties in a trade, has led to almost $14 billion worth of collateral being pledged to back up transactions in the credit-default swap market.

“Counterparty risk in the over-the-counter derivatives market is going down decidedly,” said Darrell Duffie, a professor of finance at Stanford University and a member of the Federal Reserve Bank of New York’s financial advisory roundtable. Duffie, author of “How Big Banks Fail and What to Do About It,” warned before the crisis about a lack of risk management and poor pricing models in credit derivatives.

‘More Cautious’

The financial system is safer because of higher capital and cash requirements for banks, increased collateral, or margin, for swaps and the use of clearinghouses, Duffie said.

Banks trying to rebuild their balance sheets are also contributing to the improved atmosphere for credit. “Some of the lower risks are simply from the crisis itself causing people to be more cautious,” he said.

During the worst of the meltdown three years ago, banks stopped making short-term loans when they couldn’t determine how exposed their trading partners were to subprime mortgages and the credit-default swaps written against the loans.

Financial companies reported more than $2 trillion in losses, according to data compiled by Bloomberg. The September 2008 bankruptcy of Lehman Brothers Holdings Inc., the largest in history, exacerbated the crisis and came just before the government’s takeover of American International Group Inc. in a bailout necessitated by the insurer’s use of credit swaps that would total $182.5 billion. A month later, Congress passed a $700 billion financial markets rescue plan.

Junk Bond Revival

Investors are now returning to higher-risk markets as more information about trading partners and financial guarantees emerges.

Sales of high-yield, high-risk debt in the U.S. surged 44 percent to $197.7 billion through Aug. 2 compared with the same period last year, Bloomberg data show. The Markit CDX North America Investment Grade Index, which investors use as a measure of U.S. corporate credit risk, has fallen to 97.5 as of yesterday from a high of 279.7 in November 2008, according to index administrator Markit Group Ltd.

Investors demand an extra 2.18 percentage points in yield to own the bonds of U.S. banks instead of Treasuries, down from 7.26 percentage points in December 2008, according to Bank of America Merrill Lynch index data.

Two-year interest-rate swap spreads, a gauge of fear in the financial system, also signal less concern about the financial system even though Europe is struggling with a sovereign debt crisis and the U.S. came within days of defaulting as lawmakers failed to reach an agreement on raising the nation’s $14.3 trillion borrowing capacity.

Shrinking Spread

The spread measured 24.7 basis points yesterday, down from more than 60 in May 2010 when concern first rose that Greece would need a bailout and more than 167 in October 2008 following Lehman’s bankruptcy. The gap averaged about 40 from 1988 to August 2007, when defaults on subprime mortgages ignited the worst financial crisis since the Great Depression.

International regulators working through the Basel Committee on Banking Supervision are attempting to lessen risk in financial markets by raising capital standards on the world’s largest banks. Those firms will need to have available capital of as much as 9.5 percent of common equity by 2019. The requirement was 2 percent in the 1990s.

While the use of clearinghouses has been voluntary, the Dodd-Frank Act mandates that most swaps must be processed through them once they’ve been traded on exchanges or similar systems. The European Parliament voted in May to allow regulators to decide which interest-rate, credit-default and other swaps should be processed by these institutions.

$20 Trillion

Banks have adopted measures to cut risk before the rules take effect. Since 2009, more than $20 trillion in notional amount of credit-default swaps, mainly executed between banks, have been accepted by independent clearinghouses. Notional value is used to determine periodic swaps payments, and doesn’t represent actual money changing hands.

Prior to that year, contracts were traded privately between investors and banks, which had to rely on each other to not default and make good on losing trades.

While the creation of credit swaps in the 1990s freed up capital to allow banks to make more loans, they also made it easier to bet on or against a borrower’s creditworthiness.

Trading in the contracts grew so fast that banks struggled to keep up with the paperwork. Former Fed Chairman Alan Greenspan complained at an industry forum in May 2006 that dealers often recorded trades on “scraps” of paper, calling the practice “appalling.”

Daily Monitoring

Clearinghouses reduce risk by becoming the buyer to every seller in derivative transactions. They require initial margin to accept a trade and monitor market prices several times daily to ensure losing positions don’t accrue. If investors can’t meet their daily margin call, their trades are sold off.

They can also move trades from one bank to another, easing a situation such as when Lehman failed and its trading partners’ collateral was trapped by bankruptcy proceedings. Clearinghouses allow regulators access to traders’ holdings and prices.

The banks that dominate the market began clearing credit-default swaps at IntercontinentalExchange Inc.’s U.S. and European clearinghouses in 2009. JPMorgan Chase & Co., Goldman Sachs Group Inc., Bank of America Corp., Citigroup Inc. and the U.S. arm of HSBC Holdings Plc accounted for 96 percent of all private derivatives at the end of the first quarter, according to Office of the Comptroller of the Currency, or OCC, data.

Bank Obligations

The amount banks would have to pay if all outstanding OTC derivatives were settled, one measure of market risk, totaled $21.1 trillion at the end of 2010, according to the Bank for International Settlements, or BIS, the lowest since it was at $20.4 trillion in June 2008. At the height of the financial crisis in 2008, the total was $33.9 trillion.

U.S. commercial banks would have had to pay $353 billion to close all derivative trades at the end of the first quarter, the OCC said in June. That’s the smallest amount since the fourth quarter of 2007 and less than half the peak of $800 billion in the fourth quarter of 2008, OCC data show.

Derivatives are contracts whose value is derived from underlying assets such as stocks, bonds, currencies and commodities, or events such as changes in interest rates or the weather.

Other measures of market risk have also improved. The percentage of the $364 trillion notional value of interest-rate swaps that are handled by clearinghouses more than doubled to 51.8 percent at the end of 2010 from 21.3 percent at the end of 2007, according to the International Swaps and Derivatives Association, an industry and lobbying group.

More Margin

The number of trades backed by margin doubled from early 2009 to the first quarter this year, according to the OCC. The largest U.S. commercial banks held collateral against 72 percent of their netted exposures as of March 31, compared with a range of 30 percent to 40 percent in the first quarter 2009, OCC data show.

While measures of risk have been declining since the crisis, a deteriorating global economy and banks seeking more profit may reverse that trend. Manufacturing reports from Asia to Europe and the U.S. this week signal a slowdown is underway. The Dow Jones Industrial Average slid for eight consecutive days until yesterday, preventing its longest slump since 1978. The index is down 2.9 percent today as of 1:52 p.m. in New York. Yields on two-year Treasury notes fell to 0.31 percent, the lowest on record.

“There’s concern the economy is weakening,” said Kurt Wilhelm, director of financial markets at the OCC. “Any time the economy weakens, there will be concerns about credit” related to companies unable to pay their debt, he said.

Long-Term Capital

Banks have lowered risk taking after past crises and then reversed themselves.

The September 1998 near-collapse of Long-Term Capital Management, a hedge fund that had more than $1 trillion in derivative contracts, required a $3.625 billion bailout by 14 banks including Goldman Sachs, JPMorgan and Merrill Lynch & Co. that was orchestrated by the Federal Reserve Bank of New York.

Two years later, the banks successfully lobbied Congress to exempt private derivatives from regulation when they helped pass the 2000 Commodity Futures Modernization Act. The derivatives market exploded six-fold to $598 trillion in notional value in 2008 from less than $100 trillion in 2000, according to the BIS.

“History shows us that the regulatory and legislative changes will stick, but the bankers are the smartest guys in the room,” said Kevin McPartland, a senior analyst in New York with Tabb Group, a financial markets research and advisory firm. “They will eventually find ways to do the business they want to do and make the money they want to make.”

Structured Notes

Before the financial crisis, Basel capital rules allowed large banks and investment banks to employ credit swaps to reduce the amount of capital required by regulators by using the contracts to shift risk from their balance sheets. That, in part, made the contracts popular with banks, McPartland said. “We saw how that worked out.”

Banks are selling more structured notes, which package debt with derivatives to offer higher returns than savings accounts while carrying more overall risk of losing money.

Sales of the investments, which can have returns as high as 20 percent versus about 4 percent for a corporate bond, rose to a record $25.3 billion in the first six months of 2011 from $22.2 billion a year earlier, according to data compiled by Bloomberg from prospectuses filed with the Securities and Exchange Commission.

LCH.Clearnet Cash

Because of the greater use of clearinghouses, investors now know how much margin and guaranty funds have been set aside to help cover potential losses. Before such trades were cleared, money wasn’t always advanced to back positions.

LCH.Clearnet Ltd., the world’s largest interest-rate swap clearinghouse, has almost $16 billion in margin via cash and acceptable securities and $1 billion in a default fund, according to the company. Rate swaps account for the largest part of the OTC derivatives market, at $364 trillion in notional value as of the end of 2010, BIS data show. Credit swaps totaled $30 trillion, down from $42 trillion at the end of 2008.

Margin at Intercontinental Exchange’s U.S. and European credit-default swap clearinghouses, the world’s largest, totaled $8.3 billion at the end of the first quarter, according to the company. Guaranty funds, which are a separate level of collateral from margin held by the clearinghouse for use in default situations, were $5.6 billion.

‘Daisy Chain’

No guaranty funds existed for credit swaps prior to the clearinghouses being created.

Use of clearinghouses in the previously unregulated swaps market eliminates the need for dealers to pass along their risk, said Chris Allen, an exchange and brokerage analyst with Evercore Partners Inc. in New York.

Before clearing, the only way to get the swap off the balance sheet was to enter an offsetting trade with another market participant, who would then often offset that with another trade. This made it hard to identify the underlying winners and losers.

“The daisy chain gets compressed” by clearinghouses because they are the ultimate trading partner, he says. “You’re reducing risk in that regard.”

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