So, Are You Experienced?"
- Jimi Hendrix
A very simple way to explain swaps positions to investors.
In earlier articles describing swaps, in particular, interest rate swaps, by far the largest kind of swap by volume of transactions, I have argued that the confusing information that banks provide on quarterly reports could be summarized by two simple numbers:
- Credit provided to swap counterparties.
- Credit received from swap counterparties.
These two values simultaneously tell the bank's investors:
- the value of the bank's maximum obligation under current market prices (credit received),
- the value of the bank's maximum receipt under market prices (credit provided), and
- the current market value of the bank's swaps (credit provided less credit received).
None of these three values is remotely calculable from the existing reported information. Yet they seem important. And the banks calculate these values internally to determine how much money they are making.
Why don't the banks provide this swaps balance sheet?
The four dealer banks, Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and JPMorgan Chase (NYSE:JPM) know the market value of their swaps portfolios. The problem they have is in providing the portfolio's value as they reveal the portfolio's risks.
There are many issues that the banks would be expected to address once credit extended and used were a matter of public record.
- What is the credit risk?
- What factors trigger failure?
- What is the effect of swaps on credit quality of the bank's other liabilities?
- What effect does swaps collateral have on the bank and its counterparties?
This is a discussion no one "experienced" wants to have. Not the banks, not the OTC Clearing Houses, not the bank and OTC exchange regulators, not the lawyers and accountants, and not bank supporters in Congress.
The calculations involved in getting useful information about swaps are so simple that we can make a few assumptions and come up with an idea of the magnitude of credit exposure for a typical dealer bank and that for LCH:Clearnet right here.
What is the OTC interest rate swaps exposure of a typical bank?
The average tenor of the interest rate swaps in the bank dealer portfolios and at LCH:Clearnet is about 5 years, so I will use that tenor to estimate the dealer's exposure.
Based on the chart below, borrowed from my last article on this subject, I come up with an average five year fixed-side swap rate of 1.5%, for the entire portfolio.
Then using the difference between the nearby (June '16) Eurodollar futures and the contract month 5 years out (March '21) to get the maximum payment and the maximum receipt (March '21, was trading at 98.13; June '16, at 99.32.). Half the difference is 60 basis points. Assuming the spread between the forecast of each semiannual Eurodollar rate increased from 60 basis points to zero in the first 2.5 years of the swap, and then from 0 to 60 basis points in the last 2.5 years, you get an annual average payment over 2.5 years of about 15 basis points from the first counterparty to the other. Then in the following 2.5 years, a roughly equal average payment goes to the other counterparty.
We will use Citigroup's reported interest rate swaps trading position, as reported on September 30, 2015, in Citi's 10-Q. It was slightly above $24 trillion. Using 60 basis points as a percent of total swaps as Citi's credit obligation, Citi has a claim on the rest of the swaps market of something over $144 billion and an obligation to the market of roughly the same amount. That's less than 10% of Citi's total assets of more than $1.8 trillion.
This amount might rise and fall with interest rates. If to take an extreme example, all Citi's swaps were fixed side pay at 1.5%, and the fixed side market rate were to increase by, say 100 basis points, Citi might owe the market nothing, and might be owed much more than $288 billion. Thus $144 billion is best thought of as a very rough estimate of what the average dealer bank owes the market, and the reverse.
Effects of accounting for swaps credits on LCH: Clearnet
What are the similar credit values for LCH:Clearnet? The exchange has a current (April 18, 2016) open interest of slightly more than $325 trillion. The chart below shows LCH:Clearnet's current notional amount outstanding (in grey) along with the amount of outstanding notional principal amount that LCH:Clearnet has removed from the market by "compression" (in pink: compression is the process of finding swaps that have matching payments on the same dates from and to a single counterparty. The exchange cancels them by matching receipts and payments.) Without the exchange and its compression, swaps outstanding would exceed $1 quadrillion notional. Below is a chart from LCH:Clearnet showing both open interest and compression on August 18, 2016.
Using our 60 basis point valuation adjustment, we estimate LCH:Clearnet's derivative credit at $2.1 trillion, somewhat larger than the total assets of Citigroup, making LCH:Clearnet Too Big To Fail (TBTF).
If we suppose that the derivative assets estimated for Citibank are about equal to those of the other three US dealer banks, and each of the four dealer banks clear half of their total OTC swaps through LCH:Clearnet, then roughly 12 percent of the assets of LCH:Clearnet are liabilities of the four largest US dealer banks.
LCH:Clearnet reports book capital of 926.5 million euros for 2015. I believe it is more than clear that the risk posed by a failing large dealer bank is not going to be covered through any resources provided by LCH:Clearnet. Viewed as a financial institution, loan assets are more than 2,000 times LCH:Clearnet equity.
If the positions of a failing dealer are managed by LCH:Clearnet and its clearing members as were those of Lehman Brothers, the positions of the failing dealer will be seized by members of the clearing house that believe they are able and willing to absorb a more than $10 trillion commitment to pay on outstanding swaps.
There will be at most about five days to revalue the failing dealer's positions and make an offer. (Recall each dealer values its own swaps, so the value assigned by LCH:Clearnet to the portfolio may not match the value to the dealer assuming the failed side of the trade.)
The swap payments cannot be simply cancelled, because LCH:Clearnet requires the payments on the swaps continue in order to pay other cleared members their matching cleared obligations.
Thus the other dealers will bid for the failed dealer's position and collateral. What will prevent the dealer that assumes the positions of the failing dealer from seizing collateral far in excess of the losses it faces from the failing dealer's obligations?
One thing. The seizing dealer is obligated by law to perform due diligence to determine market value of collateral during the roughly 5 business days it has to make its bid for the failed dealers swaps and collateral to the exchange. Given that only the other two US dealers, whose bids are lower, will be large enough and sound enough to accept the risk of this transaction; and they have already had the opportunity to bid, the winning bid itself is likely to be sufficient evidence of due diligence.
In short, nothing short of government intervention will prevent a profit-seeking member of the clearing house from undervaluing the failing banks' collateral.
Do Bank Regulators Plan to Intervene When a Dealer Bank Fails?
The clear answer is yes, in spite of the trappings of Dodd Frank such as the "living wills." The regulators have changed law, regulation, and the ISDA's Master Agreement to open the door for their involvement in the wind-down of derivatives positions.
First, Dodd Frank created the orderly liquidation authority (OLA). The OLA is not a bail-out, under the law. It is part of the process of winding down a failing firm. So it is part of an FDIC resolution procedure. But the key effect is to help the estate of the failing bank in meeting its exchange clearing house obligations for a reasonable time, during which the derivatives positions of the failing bank plus associated collateral may be transferred to other parties at something approximating fair value. In other words, it addresses my main concern - that the remaining clearing members not be permitted to cannibalize the collateral of the failing dealer.
The second measure the regulators have taken seems to me to be at once important and problematic. This is an amendment to the ISDA master agreement for swaps. The agreement was entered by several major banks and members of the "buy-side" of the market. It is designed to give the regulators some breathing room, two days, before derivatives and other "qualified financial contracts" counterparties seize collateral of a failed institution.
It appears that this might apply to bilateral swaps and the like. Two days is a disturbingly short time to get anything done. But it may not be possible to improve on the two days. After all, the purpose of a derivative is to provide a dedicated payment for a loan or other commitment in a timely manner. The counterparty can't wait.
Both of these new regulatory rules assume the dealer bank is being liquidated. From the taxpayer's point of view, the question is if, after providing the bank shelter from the derivatives law's onslaught, the bank turns out to be solvent, what happens?
There would doubtless be conditions imposed by the debtholders.
I am sure of one thing. The regulators do not intend to trust the dealer banks not to fail. And the reason is our inefficient derivatives markets and bloated OTC clearing houses.
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.