JPMorgan Joins Goldman Keeping Italy Derivatives Risk in Dark
(For more on Europe’s debt crisis, see EXT4 <GO>.)
By Christine Harper and Michael J. Moore
Nov. 16 (Bloomberg) -- JPMorgan Chase & Co.
and Goldman Sachs Group Inc., among the world’s biggest traders of
credit derivatives, disclosed to shareholders that they have sold
protection on more than $5 trillion of debt globally.
Just don’t ask them how much of that was issued by Greece, Italy, Ireland, Portugal and Spain, known as the GIIPS.
As concerns mount that those countries may not be
creditworthy, investors are being kept in the dark about how much risk
U.S. banks face from a default. Firms including Goldman Sachs and
JPMorgan don’t provide a full picture of potential losses and gains in
such a scenario, giving only net numbers or excluding some derivatives
altogether.
“If you don’t have to, generally people don’t see
the advantage to doing it,” said Richard Lindsey, a former director of
market regulation at the U.S. Securities and Exchange Commission who
worked at Bear Stearns Cos. from 1999 through 2006. “On the other hand,
if there were a run on Goldman Sachs tomorrow because the rumor was that
they had exposure to Greece, you’d see them produce those numbers.”
A case in point: Jefferies Group Inc., the New
York-based securities firm, disclosed every long and short position it
held on European debt earlier this month after its shares plunged more
than 20 percent. Jefferies also said it wasn’t relying on credit-default
swaps, contracts that promise to pay the buyer if the underlying debt
defaults, as a hedge on European holdings.
‘Funded’ Exposure
By contrast, Goldman Sachs discloses only what it
calls “funded” exposure to GIIPS debt -- $4.16 billion before hedges
and $2.46 billion after, as of Sept. 30. Those amounts exclude
commitments or contingent payments, such as credit-default swaps, said
Lucas van Praag, a spokesman for the bank.
Goldman Sachs includes CDS in its market-risk
calculations, of which value-at-risk is one measure, and it hedges the
swaps and holds collateral against the hedges, primarily cash and U.S.
Treasuries, van Praag said. The firm doesn’t break out its estimate of
the market risk related to the five countries.
JPMorgan said in its third-quarter SEC filing
that more than 98 percent of the credit-default swaps the New York-based
bank has written on GIIPS debt is balanced by CDS contracts purchased
on the same bonds. The bank said its net exposure was no more than $1.5
billion, with a portion coming from debt and equity securities. The
company didn’t disclose gross numbers or how much of the $1.5 billion
came from swaps, leaving investors wondering whether the notional value
of CDS sold could be as high as $150 billion or as low as zero.
Counterparty Clarity
“Their position is you don’t need to know the
risks, which is why they’re giving you net numbers,” said Nomi Prins, a
managing director at New York-based Goldman Sachs until she left in 2002
to become a writer. “Net is only as good as the counterparties on each
side of the net -- that’s why it’s misleading in a fluid, dynamic
market.”
Investors should want to know how much defaulted
debt the banks could be forced to repay because of credit derivatives
and how much they’d be in line to receive from other counterparties,
Prins said. In addition, they should seek to find out who those
counterparties are, she said.
JPMorgan sought to allay concerns that its
counterparties are unreliable by saying in the filing that it buys
protection only from firms outside the five countries that are “either
investment-grade or well-supported by collateral arrangements.” The bank
doesn’t identify the counterparties.
Citigroup, Morgan Stanley
Bank of America, Citigroup Inc. and Morgan
Stanley also don’t list gross amounts of CDS on GIIPS debt in their
filings. All three banks provide figures within their disclosures that
they say include a net of their credit-default swaps bought and sold on
the five countries.
Citigroup’s net funded exposure as of Sept. 30
was $7.2 billion, and its unfunded commitments were $9.2 billion, the
New York-based bank said in a filing and a presentation. Bank of
America, based in Charlotte, North Carolina, said total net exposure was
$14.6 billion for the five countries, while New York-based Morgan
Stanley listed $2.1 billion.
Jon Diat, a Citigroup spokesman, declined to
comment, as did Bank of America’s Jerry Dubrowski, JPMorgan’s Howard
Opinsky and Morgan Stanley’s Mark Lake.
Banks exchange collateral, usually cash or liquid
securities such as U.S. government debt, with trading partners as the
value of their credit-default swaps fluctuates and their perception of
one another’s ability to repay changes.
Bungee Cords
If the value of Italian bonds drops, as it did
last week, a U.S. firm that sold a credit-default swap on that debt to a
French bank would have to provide more collateral. The same U.S.
company might be collecting collateral from a British bank because it
bought a swap from that firm.
As long as all three banks can make good on their
promises, the trade doesn’t have much risk. It could all unravel if the
British firm runs into trouble because it’s waiting for a payment from
an Italian company that defaults. The collapse of Lehman Brothers
Holdings Inc. in 2008 demonstrated some of the ripple effects that one
failure can have in the market.
“We learned from Lehman that all of these firms
are tied together with bungee cords -- you can’t just lift one out
without it affecting everyone else in the group,” said Brad Hintz, an
analyst at Sanford C. Bernstein & Co. in New York who previously
worked at Lehman Brothers and Morgan Stanley. More disclosure “may push
the stock prices down when it becomes clear how big the bungee cords
are. But it certainly would be a welcome addition for an analyst.”
FASB Rule
The Financial Accounting Standards Board in 2008
started requiring companies to disclose the worldwide gross notional
credit protection they’ve written and bought. As of Sept. 30, JPMorgan
said it had sold $3.13 trillion of credit-derivative protection and
purchased $3.07 trillion, up from $2.75 trillion sold and $2.72 trillion
bought at the end of 2010, filings show. Goldman Sachs disclosed it had
written $2.07 trillion and bought $2.20 trillion, about the same amount
it reported at year-end.
At the end of the second quarter, those two firms
accounted for 43 percent of the $24 trillion of credit derivatives sold
and bought by the 25 largest banks in the U.S., according to the Office
of the Comptroller of the Currency. The top five account for 97 percent
of the total, the data show.
Guarantees provided by U.S. lenders on
government, bank and corporate debt in Greece, Italy, Ireland, Portugal
and Spain rose by $80.7 billion to $518 billion in the first half of
2011, according to the Bank for International Settlements.
‘Ultra-Transparency’
Neither FASB nor the SEC requires banks to
disclose how many of those derivatives are written by country or region.
That’s something Richard Fisher, president of the Federal Reserve Bank
of Dallas, would like to see changed.
“We should have ultra-transparency on those
institutions,” Fisher said of the biggest financial firms in a Nov. 14
interview at Bloomberg headquarters in New York. “They should report
both their gross and their net CDS exposure, and they should do it
country-by-country. After all, they need to inform their shareholders.”
Banks are reluctant to provide the figures in
part because doing so would reveal too much information about their
positions and operations, said Jon Fisher, a portfolio manager at Fifth
Third Asset Management in Minneapolis, which manages more than $16
billion. The sheer size of the numbers may also be a deterrent,
investors said.
‘Biggest Fear’
“I think the biggest fear is the numbers are so
large that even though they offset, it would maybe shock people,” said
Ralph Cole, a senior vice president in research at Ferguson Wellman Inc.
in Portland, Oregon, which manages $2.8 billion including JPMorgan
stock. “Maybe they don’t think that disclosure will be treated fairly or
understood well.”
Still, “they need to give us a good reason why we
shouldn’t see that,” he said. “More disclosure is better, and you can
see that in their valuations right now.”
Bank of America, Citigroup, Goldman Sachs and
Morgan Stanley have each fallen more than 40 percent this year, while
JPMorgan has dropped 23 percent. Each of the lenders trades at least 24
percent below book value, indicating investors are questioning the
assets on the firms’ balance sheets.
Lloyd C. Blankfein, 57, Goldman Sachs’s chairman
and chief executive officer, said in an interview with the Financial
Crisis Inquiry Commission staff last year that the amount of the firm’s
derivatives trades shouldn’t be a cause for alarm.
‘Longs and Shorts’
“We either have netting agreements, or they foot,
or they cancel each other out, or they’re longs and shorts on the same
instrument,” he said, answering a question about how the firm manages so
many contracts in a crisis. “The only way you can run a business like
that is to have these systems work so they can aggregate stuff, so you
can run the business on a macro basis, and also so you can get the
details quickly if you need them. And that’s all systems and
technology.”
Lindsey, the former SEC official who’s now
president of New York-based Callcott Group LLC, which consults on
markets and market operations, said few firms have systems that can
portray their real-time exposure to trading partners.
“That’s very difficult for any firm to have a
good handle on all of that -- you know large positions and you know what
certain positions are, but to be able to say I’ve adequately aggregated
all of my long exposure and all of my short exposure to a specific
counterparty may be very difficult,” Lindsey said. “I don’t know of a
firm where it’s not pulled together by a phone call, where somebody
says, ‘OK, we need to know our exposure to X,’ and a lot of people stop
their day jobs and try to find an answer.”
‘Needlessly Cause Reaction’
Lindsey said banks may be wary of disclosures
that could confuse investors. Figures such as gross notional exposure --
the total amount of debt insured by credit derivatives -- give
investors an exaggerated sense of the risk and could “needlessly cause
reaction,” he said.
Other methods, such as stress-testing, scenario
analysis or so-called value-at-risk estimates, rely on models that may
underestimate risk because historical data on sovereign defaults show
them to be unlikely.
“If you’re looking at your exposure to a
defaulting sovereign, there’s a relatively low frequency rate,” Lindsey
said. “So it really depends on what they’ve done internally to back up
their ideas of what their assessment of the probability of default is.”
--With assistance from Donal Griffin, Dawn Kopecki, Yalman Onaran and
Hugh Son in New York. Editors: Robert Friedman, Peter Eichenbaum
To contact the reporters on this story: Christine Harper in New York
at charper@bloomberg.net; Michael J. Moore in New York at
mmoore55@bloomberg.net
