Netting Derivatives: Slippery Slope Marred by Opaqueness

If those in command of disclosure had their way, the average investor would be left with the impression that the total derivatives exposure of financial institutions (AIG, BAC, BCS, C, CS, DB, GS, UBS, JPM) is only a fraction of the notional value of outstanding contracts. “We are looking at risk levels to the tune of about 3%, post-netting,” a guest on CNBC said yesterday. In actual fact, given the opaqueness surrounding the open positions in credit default swaps, collateral debt obligations, structured notes, put options, currency swaps and far-forward transactions, there is no logical methodology which provides any acceptable risk indicator at all.

Perhaps in an effort to limit any adverse impact on share prices, and even on the financial system at large, the word “netting” has gained widespread popularity since the collapse of Lehman Brothers (LEHMQ.PK). But those who are assuming that netted exposure is a finite dimension of net risk are sorely mistaken. Even when netting is undertaken on the basis of sold and bought contracts with the same counterparty (with the same reference instrument, currencies or interest rates) realistic calculations of residual risk need to take into account variations in maturity dates (mismatches) and potential conflicts in the underlying contractual obligations; in other words, netted amounts shown in financial statements may never be netted in practice.

When netting is a consequence of fully-matched hedging (i.e. buying of risk from one entity and selling an exactly similar risk to another entity), counterparty credit considerations come into play, particularly in the case of longer-dated maturities. For example, risk may have been bought from an “AAA” credit and sold to an unrated name. Or, for example, one counterparty may be located in a country where government intervention (in favour of domestic exporters presently carrying negative derivatives positions) may result in the transformation of a supposedly fully-matched deal into an open-risk transaction.

None of the bigger derivatives players (AIG, Citigroup, CS, DB and UBS) are known to have bought political risk insurance; therefore, the use of the term netting may be highly misleading in the context of developing-world-linked contracts. This political risk is further compounded by the fact that the most lucrative emerging market deals were made for far-forward maturities, in the midst of illiquid and undeveloped conditions and in the absence of verifiable benchmark rates. So any mark-to-market assessments are simply not applicable, specifically (for example) in the case of five-year-plus swaps with one leg denominated in currencies like the Indian rupee, the Russian ruble, the Turkish lira, the Brazilian real and the Chinese yuan.

Finally, and from the perspective of the overwhelming majority of retail and institutional investors, it is important to point out that netting in standard currency and interest rate swaps contracts is an entirely different affair from netting insurance-type transactions. A currency swap, for instance, may be evaluated via short-term interest rate differentials, leaving the widening or the narrowing of the differentials in the future as the key component of pricing risk. A credit default swap, on the other hand, is primarily guided by counterparty credit ratings available both at the point of execution and on a midstream basis; the proposition that there is a credible process through which a profitable credit default swap or a collateralized debt obligation can be netted against a matching contract is almost invalid, a myth without any technical foundations whatsoever. The unending sequence of “credit events” alone in 2008 must cast serious doubts on the integrity of the netting announcements being made periodically by the Depository Trust & Credit Corporation (DTCC) and by other monitoring bodies.

As traditional insurance actuaries will confirm, the pricing of insurance risk (life and non-life) is predicated on mathematical conclusions derived from historically proven, numerically substantive and heavily populated data matrices. There is not even a remote equivalent of such tools in the hands of CDS and CDO providers; on the contrary, bond default risk is still commonly being quoted by utilizing option- and probability-driven computer models!

All this is not to suggest that the huge quantum of derivatives on the books of financial institutions will ultimately generate more-than-significant losses. The problem lies in the lack of transparency; in brief, we just don’t know. One can only hope that somebody in the Fed or the Treasury has access to all the necessary information and has made a considered finding on the systemic risk posed by the derivatives complex today. Or is one foolishly hoping in vain?

Disclosure: Author holds short positions in C, GS, JPM, XLF

Comments

[Ishortyou:]

those derivatives or contracts have to be transparent and trade openly on a like NYSE platforms, their secrecy ruins the credit market.

Jan 06 09:43 AM

[monday1929:]

Even if the liars (banks) were acidentally telling the truth here, and assuming all counterpaties will make good (an absurd assumption), that may leave about 3 trillion in losses for JPM, Citi ie. the U.S. taxpayer.

Jan 07 02:13 PM

[Rakesh Saxena:]

Dear monday1929: I am in the process of assessing the "even if" scenario you talk about. But, whichever way you look at it, the potential losses are staggering indeed. Many thanks - Rakesh


On Jan 07 02:13 PM monday1929 wrote:

> Even if the liars (banks) were acidentally telling the truth here,
> and assuming all counterpaties will make good (an absurd assumption),
> that may leave about 3 trillion in losses for JPM, Citi ie. the U.S.
> taxpayer.

Jan 07 02:15 PM

[Christopher...:]

Good comment. The last several graphs are especially important. I still do not think people appreciate how entirely screwed up CDS contracts are as an insurance/barrier option type offering. In plain vanilla, single name CDS, we are pricing the obligation to fund par less recovery on a corporate bond default, but we price this risk vs. short-term spreads and volatility!!!

Then there is the correlation problem. Unlike ship sinkings and earthquakes, traditional low-beta insurance risks uncorrelated to the economy/markets (and, indeed, were a hedge to the economy/markets!!!!), CDS is high beta and thus cannot really be hedged. Even a very broad portfolio of such risks will still go to hell in a severe downturn such as we see today. CDS does not manage risk, it creates risk in vast amounts in order to generate commission income for the CDS dealer community.

That is why I believe that clearing is not really the issue when it comes to "fixing" CDS. I think we need to abandon the ISDA model, which was copied from the IR/FX template, and look at more traditional insurance type models and capital/collateral levels before CDS or its successor make sense and thus gain investor support

Jan 07 03:15 PM

[Rakesh Saxena:]

Dar rc whalen: Good point re getting rid of traditional ISDA contract formats in favour of insurance-driven documentation. Many thanks- Rakesh


On Jan 07 03:15 PM rc whalen wrote:

> Good comment. The last several graphs are especially important. I
> still do not think people appreciate how entirely screwed up CDS
> contracts are as an insurance/barrier option type offering. In plain
> vanilla, single name CDS, we are pricing the obligation to fund par
> less recovery on a corporate bond default, but we price this risk
> vs. short-term spreads and volatility!!!
>
> Then there is the correlation problem. Unlike ship sinkings and earthquakes,
> traditional low-beta insurance risks uncorrelated to the economy/markets
> (and, indeed, were a hedge to the economy/markets!!!!), CDS is high
> beta and thus cannot really be hedged. Even a very broad portfolio
> of such risks will still go to hell in a severe downturn such as
> we see today. CDS does not manage risk, it creates risk in vast amounts
> in order to generate commission income for the CDS dealer community.
>
>
> That is why I believe that clearing is not really the issue when
> it comes to "fixing" CDS. I think we need to abandon the ISDA model,
> which was copied from the IR/FX template, and look at more traditional
> insurance type models and capital/collateral levels before CDS or
> its successor make sense and thus gain investor support

Jan 07 10:11 PM

[oapoki:]

It is sad to see you guys commenting on these, admittedly complex issues, with no idea what you are talking about.

Has any of view taken a look at an ISDA contract? Has any view used an ISDA contract in practices? Has any of view wlaked through the process of netting in a bankruptcy?

I would simply state that "action talks and BS walks". It is not accidental the the derivatives industry has grown to these levels - they add value because they enables participants to hedge risks - even if people misuse thes einstruments (like everything else). In the absence of the ISDA agreement, with its associated actual netting (not imagined as the author contends) benefits (as we have seen in the case of Lehman), we would have chaos.

ISDA contacts have proven to be extremely robust in the face of extreme conditions, and I hate to see what would have happened intheir absence.

So be acreful what you are wishing for!


On Jan 07 10:11 PM Rakesh Saxena wrote:

> Dar rc whalen: Good point re getting rid of traditional ISDA contract
> formats in favour of insurance-driven documentation. Many thanks-
> Rakesh

Mar 07 09:00 AM

[Rakesh Saxena:]

Dear oapoki: FYI I have been working with ISDA contracts for a very long time, and have reviewed hundreds of such contracts when closing derivative transaction, though I am not a lawyer by profession. If you have read any of these contracts with precision you will realize the point I am making: that where the shift in the fundamental nature of the contract towards "insurance driven" coverage did not fully capture the risks involved and the counterparty risk. I am not suggesting that such contracts should be abandoned. - Rakesh


On Mar 07 09:00 AM oapoki wrote:

> It is sad to see you guys commenting on these, admittedly complex
> issues, with no idea what you are talking about.
>
> Has any of view taken a look at an ISDA contract? Has any view used
> an ISDA contract in practices? Has any of view wlaked through the
> process of netting in a bankruptcy?
>
> I would simply state that "action talks and BS walks". It is not
> accidental the the derivatives industry has grown to these levels
> - they add value because they enables participants to hedge risks
> - even if people misuse thes einstruments (like everything else).
> In the absence of the ISDA agreement, with its associated actual
> netting (not imagined as the author contends) benefits (as we have
> seen in the case of Lehman), we would have chaos.
>
> ISDA contacts have proven to be extremely robust in the face of extreme
> conditions, and I hate to see what would have happened intheir absence.
>
>
> So be acreful what you are wishing for!

Mar 07 11:15 AM