Derivatives tie the world’s largest banks together in ways they’ve never been connected before. Credit ratings play a role, affecting derivatives in two ways — one from downgrades (a change in credit profile), the other from where these contracts are booked. This post covers the impact of a financial institution’s downgrade.
The over-the-counter (OTC) derivatives primary document, the “Master Agreement”, requires posting of collateral to protect counterparties. Further, bank capital requirements and derivatives trading on exchanges also demand more protection for higher risks. These facets tie systemic banks to one another. If one goes down, its impact cascades across the chain of counterparties.
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Derivatives Contracts: Like Idiot Mittens
Derivatives contracts tie the biggest banks together a bit like “idiot mittens” from my childhood. The contract is like the string threaded through the child’s jacket, clipped to a mitten on each end. The joke was that if you pulled on one mitten, the kid slugs himself with the other.
Derivative counterparties are like the mittens. If a counterparty’s credit quality declines, evidenced specifically by a credit rating downgrade, any bank on the other side of its contracts holding a “receivable” from that counterparty is legally entitled to demand collateral to ensure fulfillment of the contract’s promise of future performance. Collateral is primarily cash. Those same banks may need to carry additional regulatory capital due to their exposure to a now riskier counterparty. Wham! As we saw earlier, it’s primarily the biggest banks which trade derivatives.
Congress’s Financial Crisis Inquiry Commission released its report on January 27, 2011. In the FCIC Report press release, the FCIC Chairman, Phil Angelides, stated that the “greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done.” The politics of how all the warnings were ignored echoed ironically during the Commission’s hearings. Hearings on the role of derivatives took place over two days — June 30 and July 1, 2010. While the FCIC’s work continued, Congress itself passed Dodd-Frank within days of the derivatives hearings. The legislation was signed into law by President Obama on July 21, 2010.
A derivatives law expert, Professor Michael Greenberger of the University of Maryland School of Law testified before the FCIC precisely about the biggest banks’ interconnectedness due to derivatives on the first day of the derivatives hearings, June 30th of 2010. Without any further curiosity or inquiry into this structural shift that derivatives imposed upon the biggest banks in global financial markets, Congress passed Dodd-Frank. Those familiar with modern financial markets could see first of all how Dodd-Frank piled on tons of regulations (left to be subsequently determined) while leaving the taxpayer still behind the chain of systemic banks and secondly how politics trumped rational solutions.
The “ISDA”: The String on the Idiot Mittens
All large and sophisticated parties that engage in derivatives sign a legal document to have a legally enforceable framework for their trading relationship. The document, called the Master Agreement, specifies the thresholds the breach of which would require the posting of collateral.
Nearly all of these documents follow the format developed over the decades by the International Swaps and Derivatives Association (ISDA). For those who have seen the movie (or read the book) The Big Short, this is what the tiny band of very smart guys who ultimately made a bundle betting against the subprime bonds meant when they said they needed to get an “ISDA”. Only sophisticated institutional players were allowed into that arena.
The ISDA published, at least until 2015, an annual “margin survey” that showed the reported amounts of collateral and their estimated, larger “real” amount of collateral posted within the global financial system against derivatives contracts. The surveys state that most collateral posted is in the form of cash, usually with a depository institution. JPMorgan Chase, a major derivatives trading institution itself, makes a business of managing posted collateral. Clicking the next link will show you how collateral has built up over time — both collateral reported in the surveys and also the amounts ISDA estimated as the “real” collateral. The most recent survey in 2015 reported the data through year-end 2014.
derivatives-and-collateral-through-2014
Credit Ratings: Jerking the Mitten
There’s no arguing with data right from the banks’ own official annual reports to the SEC, their 10-Ks. The next link shows how Goldman Sachs describes the amount of collateral that would be demanded should it be downgraded a notch or two, in its 2011 10-K.
Goldman-Collateral-Triggers-10-k-2011
Since the bubble’s bursting, these institutions have become more explicit about the impacts of downgrades on collateral demands and contract terminations (a more severe form of protection with similar intent). Here are details from the largest banks’ 2016 10-Ks. Some show the amount of incremental collateral required by a second downgrade notch, some one notch or two notch.
JPMorgan Chase. One notch $1.166 billion. Two notches $3.546 billion. Not incremental.
Bank of America. One notch $498 million. Second notch an incremental $866 million.
Goldman Sachs. One notch $677 million. Two notches $2.22 billion.
Morgan Stanley. One notch $1.292 billion. Two notches an incremental $875 million.
Wells Fargo, which is much less involved in derivatives, simply states that if it were downgraded below investment grade (below BBB-/Baa3), it would be required to post $4.0 billion.
Looking at Goldman data again, from their 2008 and 2009 10-Ks, one can see how the largest banks’ credit profiles eroded. The following table present three years of derivatives exposure by credit rating letter-grade category with percentages by category calculated on the right. I highlighted each year’s largest categories. Since the AA/Aa2a and A/A2 categories were so similar in 2008, I highlighted both. Further, a quick calculation shows how collateral significantly reduces exposures — helpful to managing derivatives, but a practice with a major drawback.
Goldman-Sachs-Derivatives-Exposures-Net-of-Collateral-2007-to-2009
Could multi-trillion-dollar banks raise a few billion dollars when needed? Under stable circumstances as in recent years it would be easy. The issue is twofold. During the bubble’s bursting, markets were exceedingly unsettled. Raising money when a systemic institution is collapsing is expensive and difficult. Further, the modeling — estimates of values — was shown to be unreliable. Factors went haywire in the panic. Counterparties disagreed on valuations in subsequent legal cases. Since they are so interconnected, they may all be looking for funds at the same time.
Idiot mittens, holding hands. A systemic slug fest of collateral demands.