Derivatives Are Too Mysterious. Let's Call Them Loans And Debt.

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Includes: BAC, C, GS, JPM
by: Kurt Dew

Summary

It would be a good thing to relieve dealer banks of the systemically important (SIFI) designation.

They are itching to pay all that excess required capital they carry to their stockholders.

But it would be easy. Just call the derivatives what they really are.

Here is the first step. Move credits and debts created by interest rate swaps onto the balance sheet.

"You'll probably scream and cry

That your little world won't let go

But who in your measly little world are trying to prove that

you're made out of gold and can't be sold?

So, Are You Experienced?"

-- Jimi Hendrix

Loans and debt are simpler than derivatives, and better understood, which is why I am proposing to rethink derivatives accounting and account for them as assets and liabilities.

Moving derivatives loans and debt onto the balance sheet makes the risks they create for the other stakeholders of banks far clearer. This would remove much of the derivatives confusion for stockholders. Reading a bank balance sheet would lose much of its mystery.

But, regrettably, it will reveal certain legislative hidden agendas that worked in favor of banks on the quiet.

These two revelations are each more than enough reason to make this change.

This accounting change will affect nearly every company that uses OTC derivatives -- hundreds of thousands of companies. And nobody will look better as a result, at first.

That is because there is an unreported credit risk in every OTC derivatives trade. But 99.9% of corporate reporters will not be materially affected. A couple dozen global dealer banks will fight bitterly against such a change, in spite of the obvious benefit to their stockholders. In particular, the four major dealer banks in the US -- Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS) and JP Morgan Chase (NYSE:JPM) -- will likely be opposed.

If we convert reported over-the-counter interest rate swaps (OTC IRS) into reported loans and debt, it will make the understanding of a bank balance sheet far, far easier. Which, of course, nobody among the big dealer banks and their toadies -- the exchanges, data providers, and some bank analysts -- wants, I think during my darker moments. (And dare I suggest complicity among some regulators and certain members of elected officialdom?)

But while OTC IRS can be simple for stockholders, it cannot be made simple for me to explain here.

Making a dealer bank's stockholder reports easier to understand is the single biggest favor the dealer banks could do for themselves in the eyes of investors. And we know, these dealers are all about transparency. And they hate all that regulatory capital and their bloated sizes -- so unfair.

On the other hand, there's a reason why we got into this mess. OTC IRS were introduced to the smaller banks and commercial borrowers as something "better than futures" because of clearer reporting in user portfolios. So that's how the idea that they were something other than loans and deposits was born.

This proposed accounting change is better because it is more revealing to bank stockholders. But there's a price for everything. The price to the reader for uncovering the truth about the risks of OTC IRS is a dive into the economics of the OTC IRS, with some accompanying pain.

This article tackles the too-complicated OTC IRS from a new direction. Derivatives are mysterious mainly because their accounting reports are disingenuous.

Making them loans and debt will bring attention to OTC IRS' ugly side and perhaps begin to put to death the notion that derivatives need their own bankruptcy law and bank regulations, and special systemically important financial utilities (SIFU) -- the OTC exchanges -- to protect the world from their risks.

Then the banks could return all that extra unnecessary regulatory capital to stockholders. We know they are itching to do that.

However, this new accounting direction is also intended to bring a nasty fact about derivatives into the light of day. Dealer bank investors will better understand the game they have signed up to play. The accounting change will clarify the poorly understood reality that the presence of derivatives makes the other liabilities and claims of banks riskier than investors are told.

And if this would add enough weight to the discussion to shame the bank dealers into cleaning this market up, that would be okay too.

Both counterparties to an OTC IRS extend credit. Both sides lend and borrow.

When my bank began trading IRS (and dirt was a boy) our trading area went through an extensive process with the bank's credit officers. We explained that we would draw down some of the credit line of the counterparty to a swap when we did a transaction.

The message was that the bank was extending credit to the counterparty and that the deriviatives desk was using some of the bank's line of credit for the counterparty. We set up the creaky process of informing the credit folk trade by trade, involving phone calls and huge computer printouts.

We provided credit officers with a value that we adjusted from time to time as interest rates changed and trades wound down.

That number was 0.5 X (swap maturity) X Diff. Diff was the difference between the first eurodollar futures rate (the June '15 contract) and the last eurodollar contract at the swap's maturity -- two years out if the swap was a two-year maturity. It was a rough estimate, but not biased.

But a more accurate formula looks something like this.

I wonder if my bank was alone in this process. (Other traders, please comment!) I know how swaps are reported to stockholders and collateralized today, and I can tell the reader this credit risk is not part of the process.

But we were far from alone in the swap dealing community in our awareness of this risk.

So how would this risk appear on the bank balance sheet if the derivative were reported as a loan today? Today, with the tons of computer time available to Financial Instrument Commodities and Currency (FICC) risk management, this credit risk could be recorded and reported much more precisely than our rough-and-ready method, above, and on a daily basis. It would be the market value of the loan included in the swap, in favor of the swap counterparty. This would go onto the balance sheet of the bank as a loan to the counterparty at fair value. The credit that the counterparty extended to the dealer (something I completely overlooked at the time) would appear as an obligation to the counterparty -- our debt -- also at fair value.

There would be another entry, quite similar to the current off-balance-sheet entry of an OTC IRS today. But this number, shorn of its credit side, could be directly integrated with a summary measure of the banks' interest rate risk exposure.

The poorly measured derivatives "asset" and "liability" values that currently appear on bank balance sheets are measures of the uncollected interest obligations, probably collateralized for the most part, associated with changes in interest rates subsequent to the trade.

These derivative assets and liabilities are presently not "netted," that is, banks have reported obligations both to and from the same counterparty at the same time. Once the debt obligations of the swaps are moved onto the balance sheet, the netting of these post transactions payments would make perfect sense and all objections removed. And the asset and liability obligations appearing in FICC now as derivative assets and liabilities would go to zero, as the credit would be part of the balance sheet loan or debt.

This would leave us with a single useful OTC IRS reported number from FICC: "How much will the bank lose (or gain) on its derivatives position for a 10 basis point change in the eurodollar rate at some appropriate maturity?" Five years seems about right at the moment.

Which brings us to the interesting part. These loans and debts -- where do they fall in the chain of seniority? And who is the most important counterparty in the brave new Dodd-Frank world, and what is its credit rating? But we have had enough derivatives fun for one article. I will take the mesmerizing issue of how a rating agency would rate derivatives assets in the next article.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.