Dream baby, make me stop my dreaming,
you can make my dreams come true.
-- Roy Orbison
One of the bed-time stories of the over-the-counter (OTC) derivatives industry is the story about netting derivatives exposures. It's a popular story since it's the linchpin upon which the measurement of both value and risk in a bank's derivatives portfolio is based. When I dealt derivatives, I slept well. Why? Because a man from the legal department gave me a copy of "The Netting Fairy Story." I read it every night before bed.
The story goes like this. Upon the apparent insolvency of a party to a derivatives agreement, netting is the right of the solvent party to "close out" its trades at market value. To "close out" a derivatives agreement is to pay to or receive, from the estate of the failing counterparty, the market value of your joint derivatives agreements. There are many thousands of different agreements you have with the failing dealer. The "market" trades yields, not prices. And derivatives are not bonds. There is no "standard" relationship between yield and price. Each separate dealer rolls her own. So you alone, using your formula, and of course, the fact that your counterparty has failed, decide what these derivatives are worth. If the insolvent party has posted collateral sufficient to cover your version of the net obligation, you seize it along with the collateral you have posted. And voila! The positions are gone.
The netting fairy has two things in common with the tooth fairy. Believers benefit greatly from their faith in the tales. But nobody has ever seen the tooth fairy or the netting fairy. The two possible Too Big to Fail (TBTF) examples, for which netting was designed, Lehman Brothers and AIG (NYSE:AIG), did not have their important positions netted. The netting fairy was a no show. This tells us something. Netting is not the simple process that the accounting rules for derivatives assume. In the case of Lehman Brothers, there are still derivatives agreements that Barclays (NYSE:BCS) has not settled.
In this article we consider the intended effect of netting, before and after an actual insolvency, according to the bed-time story. Then we compare that to what really happened -- and thus make the necessary leap from children's dreams of netting to the adult reality.
Netting is crucial to the reported income and risk of the four OTC derivatives dealers, Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and JPMorgan Chase (NYSE:JPM). If it is a fiction, perhaps stockholders need to rethink their investment based on the facts. But I am not holding my breath in anticipation of a regulatory revelation.
What is netting?
Maybe a week after you become a clerk on an OTC interest rate swap trading desk, you might begin to understand the meaning of those derivatives charts on the PowerPoint slides in your MBA lectures. And what was incredibly boring in those lectures at Uni Tech is suddenly very fascinating. Even disturbing.
As beads of sweat form on your brow, you turn to a more experienced colleague. You say "Wait a minute. Did we just make a swap deal with JPMorgan (say) where they owe us money, we owe them money, but there is no profit for either of us in the trade? That is insane!"
"Ah," says your colleague. "You are one of those literal thinkers we must reeducate here on the derivatives dealing desk. You need to understand netting! Or as I call it, 'The Donner Party Option.'"
He goes on to point out that the money we owe JPM will be always collected and the money JPM owes us will always be collected if it matters (if it matters ???), even if one of the banks becomes insolvent. There is no credit risk.
And, with a gleam in his eye, he adds, "Netting means this apparently lose-lose derivatives trade is really a win-win! Suppose JPM becomes insolvent." your colleague continues, in a condescending tone.
"We have a little maneuver we call 'swap marking-to-market in default.' Here's how it works. We tell the clearing bank that holds the collateral for the deal to return all the collateral we provided to back our exposure to JPM, and an amount of JPM's collateral that seems fair to us. Since the JPM dealers are no longer at their desks, but at home, emailing resumes, it works for them too!"
"Wow," you say. "I feel better already. So where do we find out how much JPM collateral we deserve?" "Easy," your colleague explains. "Our chief dealer makes a wish before bed that night. The derivatives fairy, from accounting, will put the amount that he wishes for under his pillow."
"But," you ask, "What if we become insolvent?" Your colleague says, "No problem. That's why I call it the 'Donner Party' option. It costs us nothing. Our bank's estate won't be happy because JPM will go through the estate's collateral like Sherman through Georgia. But that's why we take our bonuses in cash. We'll be out of here."
"OK," you say. "I get it now. But knowing all that, how does our chief dealer, and JPM's chief dealer -- both really bright guys with tons of experience -- decide on the value of this inter-dealer derivatives trade? An interest rate swap is only two debt obligations with a value, net of credit risk, of zero. I learned that much at Uni Tech. I figure the value of the trade, including credit risk, is about 5% of the size of the trade and negative. Even though I understand the Donner Party option makes the negative value of credit risk a good thing, I still can't understand doing a deal where one dealer loses what the other dealer earns."
"Ah," says your more experienced colleague. "That's how they got to be chief dealers. Each of them assigns the same derivative trade their separate versions of its value. They devised these really, really, complicated formulas for valuation purposes. The genius part is that both of them assign the same trade positive value from their separate points of view, since the formulas vary from one dealer to another. We call that 'magic money' since, in reality -- a place we all avoid -- the true value to one counterparty must be the negative of the true value to the other counterparty. The great thing is, because of the 'Donner Party' option, this scheme really works, after a fashion. The only bank that ever needs to report a derivatives loss is an insolvent bank. And of course they don't care."
"But there's a reason why the number of major derivatives dealers is now only four. Over time these really, really, complicated formulas can go haywire. The bank then goes rogue, as senior management discovers the problem, and slowly unwinds its derivatives book at a loss. This process takes years."
How do regulators cope?
Regulators cope very well. You can see the regulators' version of the netting story in the Comptroller of the Currency's ((OCC) Quarterly Report. The most recent report is to be found here.
In this report the OCC provides the quarterly percentage of gross credit risk of the banks that is not reported, due to netting. The amount of reduction in netting creates in reported credit risk for the banks as a whole varies between 91 percent and 86 percent.
As the dialog above suggests, the remaining credit risk after netting is an egregious underestimation of the risk of derivatives to each bank's other liability-holders, who bear the entire credit risk created by a derivatives trade. Yet it overestimates the credit risk experienced by the derivatives desk, which is less than zero due to the "Donner Party" option.
The effect of the dealers' ability to bury this risk is that the risk-adjusted profitability of derivatives is vastly overestimated - if it is not a complete figment of the imagination. Either way, there are substantially more derivatives traded than if derivatives traders bore the risk they create.
To better understand what the dealers are doing in these markets the OCC provides some useful detail. Bear in mind that over 90% of the derivatives traded by the entire US banking system are traded by the four major dealers, Bank of America, Citigroup, Goldman Sachs, and JP Morgan. Morgan Stanley, once number five, has almost totally exited derivatives trading. Hmmm.
The graph below breaks up total trading into its components, interest rates and currencies (the two markets traditionally dominated by the banks), and equities and commodities. It also includes credit derivatives, a topic I will not discuss here. Notice the rather dramatic decline in interest rate swaps (IRS), the largest category, beginning in 2014. I believe the decline is entirely due to a major shift by the dealers from bilateral IRS to "cleared" IRS. Cleared IRS are bilateral swaps with the original counterparties replaced by novation with a Clearing Counterparty (CCP), most commonly LCH:Clearnet, a subsidiary of the London Stock Exchange.
Clearing an interest rate swap does provide a way to bring down exposure to credit risk. The exchange tries to do what bilateral counterparties claim they can do. It attempts to net its trades.
That is, it looks at its trades with Citigroup, for example. Where it finds expected payments from Citigroup on the same day as expected receipts, it cancels the two. This CCP netting, called compaction, has successfully reduced over 60% of the CCP's exposure to its counterparties. A very significant reduction in risk, since Notional Principal Amount (NPA) outstanding at LCH:Clearnet (the CCP for interest rate swaps) would exceed one quadrillion dollars without compaction! Instead it is a mere $350 trillion. I hasten to add that even this NPA overstates the risk of derivatives, because of netting. Don't forget netting.
One can learn who uses the CCP, in the chart below. Interestingly, the dealers' use of the CCP varies widely. Goldman Sachs, particularly, does not use it so often as the other three, in spite of a Dodd Frank mandate to use the CCP where practical.
I suspect the reason is revealed by the OCC's Table 8, which displays the average maturities of the individual dealers' IRS. Note that Goldman Sachs specializes in long-dated IRS, greater than 5 year maturities. These long-dated swaps will be both more volatile than short-dated swaps and less liquid. That means that the likelihood that the swaps would be successfully compacted by the exchange is lower, reducing any gains to Goldman Sachs from clearing.
Considering both the growing maturities of IRS, and the fact that compaction has probably affected the relationship between trading volume and NPA, derivatives trading is undoubtedly growing. Trading volume has grown more than NPA. The risk per unit of volume of IRS has grown as well, with maturity. Goldman Sachs, in particular, seems to be swinging for the fences in the derivatives market!
Is netting a realistic way to settle with a bankrupt counterparty?
We have only two pieces of evidence of the effectiveness of netting, which -- according to the bankruptcy code -- exists to reduce systemic risk. Thus netting matters primarily to the big derivatives houses where, Congress claims, it's the solution to the systemic risk problem. Our evidence is therefore limited to Lehman Brothers and AIG. Interestingly, there was no netting in either case. In the case of Lehman Brothers, the firm's OTC and futures positions were both passed, in their entirety, to another party, Barclays. In the case of AIG, the government took over the firm and paid AIG's derivatives obligations.
On the evidence, the "prevention of systemic risk" justification for netting doesn't wash. The real point of netting is that it creates the fiction that 86%+ of derivatives credit risk isn't really there. But it really is there. This risk waits to be rediscovered by liability-holders of future insolvent TBTF banks, when the next Donner Party forms.
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.