U.S. banks increased sales of protection against credit losses to holders of Greek, Portuguese, Irish, Spanish and Italian debt in the last quarter of 2011 as the European debt crisis escalated.
Guarantees provided by U.S. lenders on government, bank and corporate debt in those countries rose 10 percent from the previous quarter to $567 billion, according to the most recent data from the Bank for International Settlements. Those guarantees refer to credit-default swaps written on bonds.
JPMorgan Chase & Co. and Goldman Sachs Group Inc., two of the top CDS underwriters in the U.S., say they have bought more protection than they sold, indicating they may benefit from defaults in the region. That outcome is called into question by JPMorgan’s $2 billion loss on similar derivatives, which shows that risks don’t vanish when offsetting bets are taken, said Craig Pirrong, a finance professor at the University of Houston.
“All these hedges trade one risk for another,” said Pirrong, whose research focuses on derivatives markets. “The banks say they’re flat on European risk, but that’s based on aggregated positions. We don’t know how those will hold off if the European crisis blows up.”
JPMorgan Chairman and Chief Executive Officer Jamie Dimon said last week that the bank was trying to reposition a portfolio of corporate credit derivatives and used a flawed trading strategy. The lender, the largest in the U.S. by assets, is believed to have sold protection on an index of corporate debt and bought protection on the same index to hedge its initial bet, according to market participants who asked not to be identified because their trading strategies aren’t public.
The two bets moved in opposite directions this year, causing losses and proving that even hedges that look perfect can break down, Pirrong said.
JPMorgan said in a regulatory filing that it purchased $144 billion of CDS related to the five European countries as of the end of the first quarter, while it sold $142 billion. Goldman Sachs bought $175 billion of protection and sold $164 billion, the firm said in its filing. Spokesmen for the two New York-based companies declined to comment. Bank of America Corp., Morgan Stanley and Citigroup Inc. report only net CDS exposures.
The five banks together account for 96 percent of the credit-derivatives market in the U.S., according to the Office of the Comptroller of the Currency. JPMorgan has written a quarter of the total. U.S. banks’ sales of CDS on five European countries’ debt surged 30 percent during 2011 from $496 billion at the end of the previous year, BIS data show.
Not all protection sold by banks is matched exactly by protection bought. CDS purchased and sold on Spanish sovereign debt can have different expiration dates. Banks also can net a swap on a Spanish bank with one on another lender. Even if those two firms are in a similar condition at the time of the trades, one could deteriorate faster, increasing the cost of CDS.
Some of the swaps sold by U.S. banks were bought by European lenders trying to reduce exposure to the five so-called peripheral countries. Since it’s considered insurance, a German bank can subtract the value of the contracts it purchased on Spanish debt from the total value of its holdings, with the understanding that if Spain doesn’t make good on its payment, the CDS underwriter will pay instead.
British, German and French banks’ loans to the five countries were reduced by 5 percent in the fourth quarter to $1.33 trillion, according to the BIS data. That was a $73 million decrease compared with the $53 million increase in U.S. banks’ CDS exposure to the periphery.
The cost of insuring Spanish sovereign debt increased to a record 552 basis points yesterday, meaning it would cost 552,000 euros ($700,000) to insure 10 million euros of debt from default for five years, according to data compiled by Bloomberg. Contracts on Italy’s bonds climbed to a four-month high of 515 basis points. Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.
“As the JPMorgan example showed, these are all relative-value trades, and the legs might go in different directions,” said Paul Rowady, a New York-based senior analyst at Tabb Group LLC, a financial-markets research and advisory firm. “It’s not surprising that these relations are being tested today because of the dislocation in credit markets.”
JPMorgan and other banks rely on proprietary models to gauge the risks of such correlations in their derivatives positions. Dimon said last week that some of those models had proven wrong.
More than half of the CDS related to Spain, Italy and Portugal were to protect defaults by companies in those countries, not the government, according to data compiled by the Depository Trust and Clearing Corp., which runs a central registry for over-the-counter derivatives. About a quarter of the total in each country was protection on bank debt.
As lenders in the five countries face mounting losses and funding strains, it’s impossible to model accurately how the risk on different institutions will change, Rowady said. Government and central bank interventions in markets can also upset correlations in those models, he said.
Last week, Spain’s government took control of Bankia SA, the country’s third-largest lender, and asked banks to increase provisions for souring real estate loans. Losses of Spanish banks could top 380 billion euros, according to the Centre for European Policy Studies. Moody’s Investors Service downgraded the credit ratings of 16 Spanish banks yesterday and 26 Italian lenders earlier this week.
More Spanish loans soured in March, fueling concern that the government’s focus on making banks clean up real estate was too narrow as the economy entered a second recession. Bad loans as a proportion of total lending jumped to 8.37 percent in March, the highest since August 1994, from 8.30 percent in February, the Bank of Spain reported today.
Counterparty failure is another risk for financial companies selling insurance on the debt of the five counties. When a swap is triggered by default, a bank could find that a client who sold the protection can’t pay. The firm still has to make good on its promise to pay whoever bought protection.
Lenders try to mitigate this risk by asking for collateral from their counterparties as the value of the CDS or other derivative changes. Dexia SA failed in October when the bank faced 47 billion euros of such margin calls on interest-rate swaps it sold. If Dexia hadn’t been bailed out by Belgium and France, it wouldn’t have been able to put up the collateral, causing losses for its unidentified counterparties.
Collateral in Hand
U.S. banks didn’t suffer losses when swaps on Greek sovereign debt were paid out in March because prices of CDS had surged and collateral was collected in advance, according to Francis Longstaff, a finance professor at the University of California Los Angeles. While collateral protects middlemen from counterparty risk, there could be unexpected losses if the price of CDS doesn’t rise to reflect an imminent default, he said.
“Sudden defaults would shock the market because then you wouldn’t have the collateral to cover the full payment,” Longstaff said.
Banks also may discover that collateral they hold might not be worth as much, said University of Houston’s Pirrong. That happened in 2008 when banks saw the value of mortgage-related securities held as collateral plummet.
“Collateral is a great way to protect yourself,” Pirrong said. “But when the financial system is in a crisis, you might end up holding an empty bag.”