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The European Union’s ability to write down 50 percent of banks’ Greek bond holdings without triggering $3.7 billion in debt insurance contracts threatens to undermine confidence in credit-default swaps as a hedge and force up borrowing costs.
“It will raise some very serious question marks over the value of CDS contracts,” said Harpreet Parhar, a strategist at Credit Agricole SA in London.
“Customers” that accepted ISDA documentation when buying credit default protection on Greece are
now discovering that ISDA defends the position that a 50% discount on Greek debt is “voluntary” and
therefore not a credit event for credit default swap payment purposes according to its documents.
This makes the ISDA “standard” credit default swap (CDS) ineffective as a hedge for the widened
spreads (reduced price) of Greek debt, and it makes it ineffective as a protection against default using
reasonable standards of impairment to define default. ISDA can defend ambiguous definitions so that
payment on the credit default swap is virtually impossible.
Language Arbitrage: You’re Not a Sucker, You’re a Customer
Banks that play this game call it “language arbitrage.” Anyone that bought sovereign credit protection
on Greece after accepting ISDA “standard” documentation without modifying the language now finds
that they are on the wrong side of an “arbitrage.” An arbitrage is a riskless money pump. In this case,
it means that money has been pumped out of credit default protection buyers with no risk to their
counterparties, the financial institutions that ostensibly sold them credit default protection on Greece.
Derivatives King Always Wins
Note how the "Derivatives King" JP Morgan wins on its contracts, even on both sides of essentially the same bet.
By the way, I have a couple of questions:
What the hell are banks doing in all these derivatives markets in the first place?
Isn't it time banks act like banks instead of arbitrage hedge funds?
Sorry banks , "No Soup for you!"
Morgan Stanley said last month that its net exposure in the third quarter to the debt of Spain’s government, banks and companies was $499 million. The Federal Financial Institutions Examination Council, an interagency body that collects data for U.S. bank regulators and disallows some of the netting, said the New York-based firm’s exposure in Spain was $25 billion in the second quarter.
Five banks -- JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C) -- write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.
While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.
In theory, if a bank owns $50 billion of Greek bonds and has sold $50 billion of credit protection on that debt to clients while buying $90 billion of CDS from others, its net exposure would be $10 billion. This is how some banks tried to protect themselves from subprime mortgages before the 2008 crisis. Goldman Sachs and other firms had purchased protection from New York-based insurer AIG, allowing them to subtract the CDS on their books from their reported subprime holdings.
Banks also buy CDS on their counterparties to hedge against the risk of trading partners going bust, Duffie said. To ensure those claims are paid, the banks may be turning to institutions deemed systemically important, such as JPMorgan, according to Duffie. The bank, the largest in the U.S. by assets, accounts for a quarter of all credit derivatives outstanding in the U.S. banking system, according to OCC data.
Goldman Sachs said it had hedged itself against the collapse of AIG by buying CDS on the firm. Company documents later released by Congress showed that some of that protection was purchased from Lehman Brothers Holdings Inc. and Citigroup, firms that collapsed or were bailed out during the crisis.
U.S. banks are probably betting that the European Union will also rescue its lenders, said Daniel Alpert, managing partner at Westwood Capital LLC, a New York investment bank.
“There’s a firewall for the U.S. banks when it comes to this CDS risk,” Alpert said. “That’s the EU banks being bailed out by their governments.”
European leaders are doing everything they can not to trigger the default clauses in CDS contracts to avoid putting the banking system at risk. They persuaded bondholders to accept a 50 percent loss on their holdings of Greek debt in an agreement reached in Brussels last week with the Institute of International Finance, an industry association. The deal calls for a voluntary exchange of debt.
Another trade group, the International Swaps & Derivatives Association, or ISDA, decides whether a debt restructuring triggers CDS payments. The committee that will rule on the Greek deal is made up of 10 bank representatives and five investment managers and needs 12 votes to reach a decision. ISDA said on Oct. 27 that the agreement would most likely not be considered a default since it’s voluntary.
That determination is difficult to justify because almost every sovereign debt default includes some restructuring in which bondholders participate, according to Janet Tavakoli, founder of Tavakoli Structured Finance Inc. in Chicago.
“The ISDA ruling favors the big banks that sold the CDS because those banks sit on the ISDA board,” said Tavakoli, a former head of mortgage-backed-securities marketing at Merrill Lynch & Co. “Smaller banks or other institutions that might have bought the swaps to protect against a default like this don’t have as much influence.”
That's the rub RS. What is the banks' alternative to the 50% haircut other than be at the mercy of a government bailout, assuming the CDS calls would cause failures at the issuers of the CDS?
The problem is that banks think they hedge when they do a cds but then have another transaction with the party that took the other side of the cds. As teh article states 5 guys write the vast majority of all CDS. Volkcer pointed out the absurdity recently by noting that the notioanl amount of CDS is several multiples greater than the original exposure. Perhaps if we limited , controlled , banned CDS the banks would be more careful in what risks they assume.
As far as the 50% haircut. I think Greece should exit the Euro. Clearly thie country club they joined has some expensive membership dues.
I agree, but that is not something the banks can force. And while it may be the best overall solution, it would lead to a lot of short-term pain in Greece, including huge inflation and more unemployment.
The only reason the banks engage in this is that the regulators go along with it. The traders/bankers aren't that stupid. Thye know they can't be effecitvely hedged when the system just pases the hot potato back and forth.
Today we learn that currency swaps are really just lending.
Would you like more of your hard-earned money to flow to fatcats? Wish granted! Attorney Walker Todd, who spent two decades in the legal departments of the Federal Reserve Banks of New York and Cleveland, names the back-door bailout of the eurozone banking system by our very own Federal Reserve as the top economic story of the upcoming year – or, at least one of the most outrageous. In a nutshell, the Fed is helping European banks by opening up the short-term ‘emergency’ lending pipeline, which means that U.S. taxpayers are indirectly bailing out private European capitalists. This is being done through a bit of financial hocus pocus called “swaps” – essentially the trading of dollars for euros. Such a maneuver allows the Fed to prop up European banks while claiming that it is not 'technically' directly lending. In other words, swaps are an attempt to hide the truth from the public.
As Gerald O’Driscoll put it in the Wall Street Journal: “This Byzantine financial arrangement could hardly be better designed to confuse observers, and it has largely succeeded on this side of the Atlantic, where press coverage has been light.” O'Driscoll observes that the Fed has no authority to bail out European banks and warns of what economists call “moral hazard” – the nasty habit of banks to engage in even riskier behavior when they get bailed out.
Why is this happening? Well, because the squid is strangling morality, democracy, and the rule of law. We pay, they play. “This is an attempt by our own governing elites to maintain a false vision of how the world works, or how ‘we’ think it should work,” Todd told AlterNet. “This comes at the expense of many people who never will go to Europe, who know no European bankers, and who have no European bank accounts.”
You may not know a European banker, but you can be sure that one is just now raising a glass of bubbly in your honor. After all, you paid for it.
Our story thus far: CDS obtained their favored status as unregulated insurance policies courtesy of the Commodity Futures Modernization Act of 2000. It was sponsored by then-Sen. Phil Gramm (R-Tex.) — and benefited Enron, where his wife, Wendy, was a director on the board. The energy company had discovered the fast profit of trading energy derivatives, which was much easier to achieve without those pesky regulations. Late in the year, the CFMA was rushed through Congress. Passed unanimously in the Senate and overwhelmingly in the House, it was mostly unread by Congress or its staffers. On the advice of then-Treasury secretary Lawrence H. Summers, the bill was signed into law by Bill Clinton.
No one associated with this awful legislation has yet to be rebuked for it. Anyone who actually read this debacle and recommended it should be banned for life from having anything to do with public policy or economics.
Why does it matter if swaps are not insurance? In a word, reserves. That is the key difference between insurance and swaps. State insurance regulators actually require reserves from insurers — a lot of reserves — to ensure payments can be made in the event any payable event occurs. The swaps industry does not require reserves. Not even one penny against billions in potential losses.
I think you can see why this matters so much. Swaps are a lot less profitable as an insurance product than they are as a trading vehicle. That is the primary issue that we all should be concerned about. It is exactly how AIG blew itself up. There is nothing that prevents the marketplace from doing it again. We could very well see a repeat unless this gets resolved. Indeed, the odds heavily favor such an event occurring, unless we collectively do something to stop it.
Credit-default swaps are insurance products. It is well past time we regulated them as such
isda declared the restructuring event on greek cds. No reason to ban cds.
Ban mortgage forgiveness.... Flmoazzz.
w67 for a change i agree with you.
"Credit-Default Swap Time Bomb Failed to Go Off Over Greece: View"
300_mercer > w67 for a change i agree with you.
w67thstreet > Ban mortgage forgiveness.... Flmoazzz.
I think everyone agrees on that.
That's the problem with predicting anything that's going to happen. They keep changing the F'ing rules on us.
As I have maintained for the 3/4 years Ive been on this site. Must seperate commercial and investment banking. Give them 2/3/5 years to break up. Until then there will never be the same consumer confidence in the system ever again. Its hardly if ever discussed.
Since the volumes have been way down for 4 years in a row, a trader quitting (or being fired) in this space is more common than not, actually. All the big banks have far fewer CDS traders than in 2008. Yawn.
Amateur property investors are caught up in the growing controversy over the sale of complex interest rate swaps to small firms, it has emerged.
One budding investor – Jessica Naraghi, 23, from Bolton – ended up with an amortising base rate collar swap even though she did not take out the loan it was meant to protect.
Her decision, aged 19, to say ‘yes’ to Royal Bank of Scotland’s Global Banking and Markets salesman over the telephone has cost Ms Naraghi £73,000 and left her £36,000 in the red.
Loan documents show that NatWest, owned by RBS, required Miss Naraghi to purchase the capital markets product as a condition of securing her £472,000 loan in June 2008. It said a precondition of any agreement was that the bank was “satisfied with the customer’s interest rate hedging arrangements”.
“I wanted to purchase a commercial property,” said Ms Naraghi, who was advised by her property owning father about the merits of buying commercial real estate to generate a profitable return. “They agreed to give me a large loan but it did not go through. But they activated the swap two days before.”
The swap taken out on June 4 capped her interest rate payments at 5.5pc but only allowed them to fall to 4.5pc and meant that she paid more interest as Bank base rates fell in 0.5pc. The £16,755 fee was paid upfront.
When Miss Naraghi complained, she said she was told to keep paying because failing to do so would harm her credit rating. Later, in June 2009, when she instructed a solicitors firm, NatWest insisted that RBS was “in no doubt that the correct paperwork has been obtained, the correct procedures followed and a clear instruction given by Miss Naraghi to proceed with the transaction”.
Ian Settle, NatWest’s commercial banking director in Bolton, added: “Miss Naraghi chose to enter into a hedging instrument prior to drawing on the loan and it was also our customer’s choice not to drawn down on the loan.”
Letters from RBS Global Banking and Markets, however, suggest the paperwork was not complete. The bank wrote in October 2008 requesting “the formal trade confirmation” that it sent in June be signed and returned.
The bank said if it did not receive the paperwork “we will assume that you have approved the terms of the transaction as set out in the formal confirmation, unless you notify us of any objections that you might have with the next five London business days.”
Ms Naraghi said: “I never saw the man from RBS and he never explained to me that if rate goes down I have to pay a lot of money. He was ringing me constantly to take the swap. He had me under pressure to take it. But I never signed anything. It was all verbally, on the phone.”
As the interest payments increased she called a stop last year and paid a break fee to terminate the agreement. “I refused to pay any more and they terminated the agreement and took another £36,000 from my account for termination of agreement. My account is now £36,000 overdrawn and they are intending to take legal action against me,” she said.
RBS said it was invesitgating the complaint. “RBS has strict policies in place to ensure that interest rate swaps are sold properly,” a spokesman said. “We regularly carry out audits of our businesses to ensure our policies and procedures are robust, meet the relevant regulatory guidelines, and are followed by staff.”
J.P. Morgan Chase & Co., the nation’s largest bank, surprised the market today, saying it has taken large losses stemming from derivatives bets gone wrong in the bank’s Chief Investment Office.
On the conference call, J.P. Morgan CEO Jamie Dimon said the bank had taken $2 billion in trading losses in the past six weeks and could face an additional $1 billion in second-quarter losses due to market volatility.
“There is a risk that a loosely defined hedging exception can open the door to a lot of mischief,” she said. “The Fed should look at tightening the definition of hedging as a result of this situation.”
To hear it from the financial services industry and its loyal cadre of academic cheerleaders, the reason we need trillions of dollars in credit default swaps is that they lower the cost of borrowing for corporations and households. By making it possible to “hedge” risks, the derivatives make investors more willing to buy bonds and banks more willing to buy and make loans, thereby increasing supply and lowering the cost of borrowed money. Or at least that’s the theory.
But a 2007 paper by Adam Ashcraft and Joao Santos, two researchers at the Federal Reserve Bank of New York — JPMorgan’s chief regulator — concludes that it ain’t necessarily so.
“We find no evidence that the onset of [credit default swap] trading affects the cost of debt financing for the average borrower,” Ashcraft and Santos write.
It turns out that the swaps actually may lower borrowing costs by 15 to 20 basis points for a handful of large blue-chip companies considered the safest and most transparent — that’s a difference of less than a fifth of a percentage point in the interest rate. But the researchers found that for all corporate borrowers, credit default swaps raised borrowing costs for the average firm by 20 basis points. For the riskiest firms — those that are typically the newest and least understood — the rate was 40 basis points higher.
And why would that be? According to Ashcraft and Santos, it’s because the market knows that the lead bank, or the lead underwriter, can use credit default swaps to hedge their own risks, which makes other banks and investors less confident that the loan was carefully underwritten in the first place.