Nothing infuriates the average American like the bailout of AIG. Not only was the company rescued by taxpayers from its own poor management and risk-taking. Its credit default swap obligations were also paid out — at 100 cents on the dollar — to Too Big To Fail banks like Goldman Sachs.
Politicians and candidates rant about no more bailouts. The multi-billion-dollar CDS losses at JPMorgan Chase immediately attracted more headline politics on the need for stronger regulation. In moves right out of The Exocist Congress again turns its head, ignoring the fact that JPMorgan Chase’s losses are only the tip of an iceberg. Regulators publish information telling the public of the huge CDS risks, yet they do little to address them. Moody’s is reviewing a number of these big banks for possible downgrade. Our ship of state is close to scraping by or colliding with this iceberg.
In a May 26, 2012, New York Times article reporter Azam Ahmed described the JPMorgan credit default swap trades and how large hedge funds profited from being on the other side of their losses. It’s a detailed blow-by-blow account of how the bank got into its predicament.
CDS pricing is often quoted by reporters as a barometer on the financial health of the entity in question. What is missing from reporting on credit default swaps is an examination of their risks.
Credit default swaps are not typical derivatives. Their contract values derive from changes in the underlying reference credit. But they are not swaps. An interest rate swap derivative is a financial contract in which two parties agree to swap the type of interest payment. For example, one party with a fixed-interest-rate bond might swap paying a fixed interest rate for another party’s floating interest rate payment like the one on the other party’s bank loan.
Credit default swaps are insurance contracts. If you buy fire insurance or life insurance and your house burns down or you die, the insurance company pays the claim for the event. The event in a CDS is the “death” of a company or government’s ability to pay its debts. If a human runs out of oxygen, he dies. If a company or even a country runs out of cash and the ability to raise more, it also ceases to exist as a going entity. That is the event covered by a credit default swap.
Insurance company actuaries — math-minded assessors of risk — use extensive historic data to measure the likelihood of a death or a house fire within the risk pool of the insured. Insurance companies are regulated to ensure that they have the cash available to pay out claims regardless of how far out into the future the event occurs. As they collect insurance premiums, they must put aside reserves to cover claims. Both the liabilities and the reserves set aside to cover claims are shown on the insurance company’s balance sheet.
When a bank “sells” a credit default swap, it is behaving like an insurance company. It is entering into a contract to make a payment to the policy holder (the counterparty on the other side of the contract) if a credit event occurs.
CDS risk is measured and managed very differently from normal insurance contract risk. First, CDS risk measurement is highly flawed. How often do countries suffer financial death? Not only is it very infrequent based upon observation. Countries can also raise taxes. The political ability to continue to raise taxes is very subjective, lacking the statistical background that underpins the insurance industry. Even public companies don’t default often.
Second, instead of setting aside reserves out of a portion of the premiums received for underwriting credit risk, the banks writing these contracts mostly buy insurance to cover the potential future claims. If TBTF Bank A writes a contract to insure TBTF Bank B against the risk of default on some European sovereign bond, TBTF Bank A turns around and buys the same kind of insurance from TBTF Bank C. It may be like reinsurance, for those who follow the insurance industry, but regulators examine the ability of reinsurance companies to pay claims, too. Somebody has to keep reserves to cover claims.
Most derivatives exposure is explained in the footnotes of the biggest banks’ annual reports. Their disclosures are also less comparable, using differing presentation formats and even measurement methodologies. Only small amounts are put on the banks’ balance sheets.
The disclosures on CDSs provided by the biggest banks in their annual reports also lead to a false sense of security. For example, at the end of 2011 Bank of America disclosed that it had both written and bought notional amounts totaling $2 trillion in credit default swap protection. Goldman’s disclosure in their Federal Reserve filing FR Y-9C was similar — $2 trillion in notional amounts both bought and sold. Both big banks create the appearance of a balanced book, the bought insurance offsetting the sold.
One needs only to look at a quarterly derivatives report published by the Office of the Comptroller of the Currency to see the huge systemic risk involved in credit default swaps. The OCC report pulls together data provided to both the Federal Deposit Insurance Corporation and the Federal Reserve. The banks give the regulators this information. The regulators merely make it public.
The OCC makes several astounding points in its recent reports. The regulatory agency notes that the top five banks hold 99% of all credit derivatives (Graph 4 in the fourth quarter report). What if one of these started to fail as Europe crumbles? Will TBTF Bank C be able to fulfill its claim obligations to TBTF Bank A? Or TBTF Bank A to TBTF Bank B? It’s a financial game of dominoes, and only the taxpayer stands behind these obligations if the game collapses.
Graph 5B shows how netting reduces every $100 of gross exposure to a mere $7.50, through netting. Netting is when banks net out what they owe to each other. I owe you $100, and you owe me $92.50. I owe you a net $7.50. This certainly helps reduce exposure. But anyone following the Lehman bankruptcy can describe big disagreements over valuation, timing and legal jurisdiction that complicate reality when push comes to shove.
Graph 6B shows trading’s contribution to gross revenues at five huge FDIC-guaranteed banks. They all took hits in the fourth quarter of 2011. Up to that quarter, JPMorgan Chase sourced 14% of its gross revenues at the bank from trading. Goldman is a trading machine, having derived over 50% of its gross revenues from trading in the first three quarters.
The most worrisome graph though is Graph 5A. It shows total credit exposure to risk-based capital at the top five FDIC-insured banks by derivatives holdings. By the fourth quarter of 2011 JPMorgan Chase’s total credit exposure was 256% of its risk-based capital. Goldman’s was 794%, by far the highest percentage of the pack. Is the Fed worried about Goldman? How about the OCC?
Missing from this Group of Five FDIC-guaranteed banks in several of the OCC graphs is Morgan Stanley. Its story is the most puzzling, partly covered in my earlier post. With the third largest amount of derivatives held by bank holding companies within the U.S.’s jurisdiction (see Table 2) Morgan Stanley isn’t included in these comparisons even though it holds more credit derivatives than bank holding companies Bank of America or Citigroup.
Credit default swaps didn’t show up in Bank for International Settlements’ global derivatives volume reports until 2004. They were a new product. Was speculation in these highly risky products what Congress had in mind during the Depression when it created FDIC insurance of bank deposits? Even anti-regulation Alan Greenspan thought not when he testified to Congress in 1999. He told Congress it should be outside the FDIC guarantee’s reach. What headline will it take to cause regulators and Congress to stop turning their heads away from this systemic bubble?