Selling More CDS on Europe Debt Raises Risk for U.S. BanksYalman Onaran
U.S. banks increased sales of insurance against credit losses to holders of Greek, Portuguese, Irish, Spanish and Italian debt in the first half of 2011, boosting the risk of payouts in the event of defaults.
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., Morgan Stanley and Goldman Sachs Group Inc., 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?”
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 -- JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. and Citigroup Inc. -- 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.
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.”
The bailout of Dexia SA 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 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?”
Banks also buy CDS on their counterparties to hedge against the risk of trading partners going bust, Duffie said. To ensure those claims are paid, the banks may be turning to institutions deemed systemically important, such as JPMorgan, according to Duffie. The bank, the largest in the U.S. by assets, accounts for a quarter of all credit derivatives outstanding in the U.S. banking system, according to OCC data.
Goldman Sachs said it had hedged itself against the collapse of AIG by buying CDS on the firm. Company documents later released by Congress showed that some of that protection was purchased from Lehman Brothers Holdings Inc. and Citigroup, firms that collapsed or were bailed out during the crisis.
U.S. banks are probably betting that the European Union will also rescue its lenders, said Daniel Alpert, managing partner at Westwood Capital LLC, a New York investment bank.
“There’s a firewall for the U.S. banks when it comes to this CDS risk,” Alpert said. “That’s the EU banks being bailed out by their governments.”
European leaders are doing everything they can not to trigger the default clauses in CDS contracts to avoid putting the banking system at risk. They persuaded bondholders to accept a 50 percent loss on their holdings of Greek debt in an agreement reached in Brussels last week with the Institute of International Finance, an industry association. The deal calls for a voluntary exchange of debt.
Another trade group, the International Swaps & Derivatives Association, or ISDA, decides whether a debt restructuring triggers CDS payments. The committee that will rule on the Greek deal is made up of 10 bank representatives and five investment managers and needs 12 votes to reach a decision. ISDA said on Oct. 27 that the agreement would most likely not be considered a default since it’s voluntary.
That determination is difficult to justify because almost every sovereign debt default includes some restructuring in which bondholders participate, according to Janet Tavakoli, founder of Tavakoli Structured Finance Inc. in Chicago.
Favoring Big Banks
“The ISDA ruling favors the big banks that sold the CDS because those banks sit on the ISDA board,” said Tavakoli, a former head of mortgage-backed-securities marketing at Merrill Lynch & Co. “Smaller banks or other institutions that might have bought the swaps to protect against a default like this don’t have as much influence.”
Some bondholders might challenge the ruling in court, Tavakoli said. Lauren Dobbs, an ISDA spokeswoman, declined to comment.
U.S. Treasury Secretary Timothy F. Geithner urged European leaders and finance ministers to increase the firepower of their 440 billion-euro rescue fund. The Obama administration’s stance might have been prompted by worries that defaults in the euro zone would hurt U.S. banks through their CDS exposure, according to Christopher Whalen, managing director of Institutional Risk Analytics, a Torrance, California-based bank-rating firm.
“Geithner keeps asking Europeans to fix their shop, but he doesn’t do anything to rein in the risk-creation at home through these derivatives,” Whalen said.
Leaders of the 17 euro-zone countries decided last week to more than double the size of their rescue fund to 1 trillion euros. They haven’t yet said how it will be financed.
Geithner and Federal Reserve Chairman Ben S. Bernanke have said they’re not worried about U.S. banks’ exposure to European sovereign debt. Regulators, including the Fed, are monitoring CDS risk, according to one official who declined to be named because he wasn’t authorized to discuss the matter. U.S. banks have collected sufficient collateral from counterparties on the CDS and should be able to manage defaults, the official said.
JPMorgan CEO Jamie Dimon, 55, said last month that the New York-based bank hedges its exposure to European sovereign debt through contracts with lenders in other countries, including Germany and France. The counterparties are diversified, and JPMorgan takes sufficient collateral to protect itself against losses, Dimon said during a third-quarter earnings call.
MF Global Holdings Ltd., a broker-dealer run by former Goldman Sachs co-Chairman Jon Corzine, reported $1 billion of net exposure to Spain and $3 billion to Italy in its second-quarter financials, explaining in a footnote that the net was partly due to a short position on French bonds. Those hedges weren’t enough to protect MF Global, which filed for bankruptcy yesterday after losses in the portfolio wiped out its capital.
Hedging and other ways of netting help banks report lower exposures than the full risk they might face. Morgan Stanley said last month that its net exposure in the third quarter to the debt of Spain’s government, banks and companies was $499 million. The Federal Financial Institutions Examination Council, an interagency body that collects data for U.S. bank regulators and disallows some of the netting, said the New York-based firm’s exposure in Spain was $25 billion in the second quarter.
The net figure for Italy was $1.8 billion, Morgan Stanley said, compared with $11 billion reported by the federal data-collection body.
Ruth Porat, 53, Morgan Stanley’s chief financial officer, said during a call with investors after the earnings report last month that the data compiled by regulators didn’t take into account short positions, offsetting trades or collateral collected from trading partners.
“It’s the firms that don’t post collateral because they’re seen as more creditworthy that pose the counterparty risk,” said Tchir. “Those could be insurance companies, mid-size European banks. If some of those fail to pay when the CDS is triggered, then the U.S. banks could be left holding the bag.”
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