Banks Failing To Disclose Derivatives Risk

 |  Includes: BAC, C, CS, GS, JPM, MS, UBS
by: Rakesh Saxena
Some on Wall Street call it a “sensible” approach. “The more you disclose, the more you get Washington’s lawmakers excited, and there is more talk of regulation,” a Geneva-based hedge fund manager told his partners at a conference last week. “Without trades in over-the-counter currency forwards, interest rate swaps, commodity swaps, structured products and equity puts, the share-price outlook for all major banks will remain subdued, recovery regardless.” Senior risk managers from Credit Suisse (NYSE:CS) and Union Bank of Switzerland (NYSE:UBS) who were attending the conference were in complete agreement.
According to Bloomberg (October 16, 2009), “the top five U.S. commercial banks, including JP Morgan (NYSE:JPM), Goldman Sachs (NYSE:GS) and Bank of America (NYSE:BAC), were on track through the second quarter to earn more than $35 billion this year trading unregulated derivative contracts, according to a review of company filings with the Federal Reserve and people familiar with the banks’ income sources.” In other words, income from OTC derivatives is an integral and influential component of bank performance, particularly in an environment where the adequacy of loan delinquency provisions is still being debated.
But if Rep. Barney Frank has his way, a significant portion of that derivatives income will be eliminated by mid-2010. The Chairman of the House Financial Services Committee has been blaming OTC derivatives, including credit default swaps and collateralized debt obligations, for last year’s financial meltdown. Rep. Frank’s initiatives may force a move of much of the $600 trillion OTC market to exchanges or similar regulated systems. “Transparency is the key word,” a former SEC director declared on CNBC yesterday. “Let those who are buying these derivatives (i.e. corporations) know the real value of these deals.” But why can’t transparency be achieved now, today, by expanding disclosure on bank financial statements?
Quite clearly, the fair value measurement standards (per SFAS 157) adopted by banks provide a “framework” for making qualitative distinctions between various derivative contracts; however, the FSAS 157-related disclosure is not a substitute for a comprehensive risk analysis. For example, in theoretical terms, the most profitable OTC contracts for banks are those which reference emerging market assets (currencies, interest rates and commodities) and those which are long-dated (maturity). What is the total face value of such “exotic” contracts on the books of Citigroup (NYSE:C), Goldman Sachs (GS) or Morgan Stanley (NYSE:MS)? As another example, the fastest-growing business in the derivatives complex is equity-index insurance. How many long-dated index puts have been sold by Wall Street’s majors?
Regardless of the sophistication achieved in hedge techniques, the measurement of risk at liquidation on exotics is a highly subjective exercise. “It does not matter if you move these exotics to a regulated exchange, the systemic risk component will stay intact,” a Citibank treasury official explained. “Besides, a fair amount of the OTC deals are done through foreign branches or offshore entities, so Barney Frank’s efforts to engineer more regulation are counter-productive.”
This writer, who has been involved in the OTC derivatives matrix for more than two decades, is of the firm opinion that what equity traders and investors require is more detailed disclosure, not regulation. Before we get to the issue of how to control or regulate derivatives, we need to know, with a high degree of precision, the nature and size of such contracts on bank books. It is hard to believe that even seasoned analysts are making calls on banks without the benefit of a credible risk assessment of one key income source!
In this writer’s view (based only on personal knowledge and information from bank insiders), the counterparty and pricing risks on at least 50% of total derivative contracts are largely reliant on the shape of the global economy on one hand and on the health of emerging market corporations (including banks) on the other. On a cautionary note, the latter group needs to refinance $400 billion of debt, starting later this year.
Disclosure: Short BAC, C, JPM and UBS; combination of outright shorts and puts.