Demystifying Dealer Bank Derivatives: Better Accounting Rules

| About: Bank of (BAC)

Summary

A previous article proposed moving the debts and loans associated with swaps onto bank balance sheets.

The benefit would be a far clearer understanding of the risks bank stock- and debt-holders face.

This post considers how the change would affect bank customers.

It begins the process of considering the effect on swap dealers and swap clearers.

Tell me lies.

Tell me sweet little lies.

- Fleetwood Mac

In the previous article discussing over-the-counter interest rate swaps (OTC IRS), I touted the benefits of breaking OTC IRS into their two components, an off-balance-sheet interest rate play and an on-balance-sheet credit and debt. This accounting change would radically ease stockholder's difficulty in valuing the shares of the dozen or so derivatives dealers around the globe, and in particular the market values of the four major US dealers, Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and JPMorgan Chase (NYSE:JPM).

Why is this not done already?

Swap End-User Credit Risk

OTC IRS markets were first designed to meet the needs of commercial users and lending banks intending to use swaps to reduce the interest rate risks innate to the commercial lending business. Swaps succeeded in eliminating a reporting problem commercial users hedging with futures could not address. Futures positions require hedgers to pay the entire capital gain or loss resulting from changes in interest rates on the day of the change.

Futures work for grain, livestock, metals, marketable bond, and later, also worked for energy traders; all of whom may discount their market-valued inventories to meet futures margin calls. Futures positions do not include extended credit, as do swaps, because of the fact that they are marked-to-market at least daily.

But a financial institution with loans and deposits which can't be market-valued on a daily basis has no way to show stockholders why large and frequent futures payments and receipts reduce risk. The volatile income stream futures hedges produced for financial institutions were a source of alarm to stockholders and ultimately ended their use as hedges of interest rate risk.

This development was the cause of the rapid rise of OTC IRS dealers to prominence in the world of Fixed Income Currencies and Commodities trading (FICC).

Swaps dealers realized that although bank futures hedgers could not account for futures in a way consistent with the economic value of their positions, swaps dealers using futures could mark both trades to market and thus avoid the misrepresentation of risk that loans hedged with futures faced. In effect, the swaps dealer intermediated the accounting problem that futures created for commercial hedgers.

For hedgers, swaps permitted a delay in the payment of gains and losses associated with changes in interest rates. In turn, this permitted lenders and borrowers to report these gains and losses, along with gains and losses on the loans and deposits the swaps were hedging. The result was that corporate and commercial lending income reports were reflective of the low interest rate risk that swaps were there to produce.

But information was lost in this process. When two counter-parties enter a swap transaction, both parties know that the constant interest income that the swap is creating for the customer happens because the dealer has committed to advance funds to the customer during the high side of the interest rate cycle and take funds during the low end. The values of the resulting debt are included in the swap price, but they are buried, not reflected on the balance sheet of either party.

In the early days of OTC IRS trading, the issue was swept under the rug. After all, it was reasoned, there was already a lot of dirt under that rug. The magnitude of the buried swap credit risk was small compared to that of standby letters of credit (LCs), another off-balance-sheet obligation common in the banking system at the time.

Standby LCs however, were in the process of being reined in by bank regulators. The fiction that there was no credit extended when a bank writes a letter promising to pay debts of its customer who cannot, came to an end. Capital charges of standby LCs now match those of loans to the same customer, dramatically curtailing that source of bank disingenuity.

But the credit extended in a swap lived on unreported. And swaps rapidly gained in popularity, growth that continues unabated among corporate customers and retail bank hedgers today. It will likely explode when interest rate levels return to normal in a few years.

Derivatives Growth

But as the market grew, the volume of expected unreported credit became a source of alarm to the banks themselves, as banks forecast the future size of the market and the possible credit risk that would result.

This is not much of a problem on the customer side of the business. Customer reporting of the small amounts of credit associated with the swap hedges they were using would be easily identified by customer stockholders as immaterial to future performance, in the normal case where the use of swaps is an appropriate risk reduction activity.

Inter-dealer credit risk

But the better informed swap dealers have long understood that they were working in gas tanks, lighting matches to find their way. Understanding the potential long-run peril of their business, they saw the need to band together, forming the now quite powerful International Swap Dealers Association (ISDA). The dealers wisely surrounded themselves with the best accounting and legal advice money could buy from the early beginnings of the industry.

And the accountants identified a serious concern. While hedging customers were not under any real pressure from the credit associated with their swaps, the inter-bank dealer market players soon would be in trouble.

As with most trading markets, transactions between professional traders outnumber transactions with customers by almost nine to one. And the inter-bank dealer custom of ignoring inter-dealer credit risk was not going to fly with OTC IRS.

The Eurodollar Credit Flap

This was not the first time the dealer market custom of ignoring credit risk associated with open positions with other dealers had become an issue. Inter-dealer credit risk first raised its ugly head in the London Eurodollar markets. The "ballooning" of bank balance sheets resulting from the enormous volumes of Eurodollar deposits banks trade with one another created issues among stockholders and bank regulators in the early days of Eurodollar markets - the 70s and 80s. The volumes were mind-boggling by the standards of the day.

Some poorly informed economists warned that these deposits were part of the money supply and would therefore create inflation. That notion was rapidly debunked.

But then Fed Chairman Arthur Burns briefly considered the possibility that the Eurodollar credits and debts between banks be netted and taken off balance sheet - to be called "arbitrage assets." That idea was mercifully dropped before the demise of Continental Bank showed the great error of such a decision. The unnecessarily large volume of credit banks extend to one another in the Eurodollar market remains an issue, but it has taken a back seat to derivatives.

At this relatively early point in the development of the derivatives industry, the industry accountants and lawyers came up with a dramatic fix. The basic problem they perceived was that derivatives, if tied up in bankruptcy, would result in substantial new problems. Consider the position of a derivatives trader that has payment obligations to a bankrupt party. That derivative requires both payments and receipt, perhaps backed by collateral. In bankruptcy, the estate would resist closing the position. The reason is clear. The solvent party would be forced to make the payments associated with the swap. The bankrupt party would not be required to make their payments. And collateral held by the solvent party would require judicial approval to be released.

Since there was, and still is, nothing in the reported financials of any financial institution to tell its counterparties how much the ultimate amount tied up in the bankruptcy court would be, this might set off a panic reaction.

Exemption from bankruptcy law

The solution the lawyers and accountants proposed was quite radical. They lobbied Congress for derivatives to gain an exemption from the rule of stay in bankruptcy. In other words, to place the claims of a solvent derivatives trader above any legal protection of insolvent counterparties.

To make this suggestion is not particularly surprising. That Congress actually granted derivatives this right is beyond surprising.

Consider, for example, the effect on the FDIC. It is an FDIC function to examine the solvency of a financial institution under pressure from panicked depositors and other short-term liability-holders. It is not uncommon for the FDIC to resolve a bank insolvency by paying off all the threatened bank's obligations in full using only the bank's assets, and the time it takes to find a quality price, leaving no damage from the bank run to any investors other than stockholders.

Indeed, during the wind-down of the Savings and Loan Crisis in the US, the FDIC was, for some years, the largest holder of OTC IRS positions on the globe.

But now, with exemption from the stay in bankruptcy, the counter-parties of a failed dealer seize the insolvent counter-party's collateral immediately, determine fair value of both swap and swap collateral, trade out of their position and sell the collateral before the FDIC is involved.

In short, the debt of derivatives counterparties, assuming the counterparty has been diligent in assessing collateral, is senior to that of the bank's depositors.

The Advent of over-the-counter clearing counterparties (OTC CCPs)

With the use of central clearing counterparties for interest rate swaps, both the information available to regulators of markets and the risks faced by counterparties are reduced. But the nature of their function is obfuscated by the failure to account for swap debts as loans and credits as debts.

If accounted for properly, the distinction between the negligible risks of futures exchanges and the substantial risks of OTC CCPs would become immediately clear. In fact, LCH:Clearnet, the primary clearing house for interest rate swaps, would lose its designation as a clearing house and be re-identified, correctly, as a financial institution.

It would definitely be SIFI and would undoubtedly grow quite rapidly.

At the moment, although government-mandated to move their interest rate swaps with other dealers onto OTC CCPs, the dealers appear to be dragging their feet, with the process seemingly stalled at about 50% of the total.

But faced with the choice of owing several billions of dollars to each of the three other major bank dealers and owing the same amount to the OTC CCPs, I have no doubt that the shift to clearing would be swift.

The implications for bank regulation of the change are, I am quite certain, already understood by both dealer banks and their regulators - but not by the public. In the next post, I will consider this issue.

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.