The Need for Credit Derivatives Reform

JP Morgan’s loss shows exactly why we need an effective Volcker rule or a return of Glass Steagall, along with transparency in all derivatives, especially credit derivatives.  While the markets are somewhat volatile now, we certainly are not in a 2008 freefall.  Yet JP Morgan managed to lose at least $2 billion and counting.  Under extreme conditions, could this derivative position have lost 10x that? 20x given there is practically zero liquidity during a crisis?

While a $40 billion loss still would not leave JP Morgan insolvent, it would most likely put it below regulatory capital minimums, especially considering a fair amount of JP Morgan’s other assets would have lost value too.  This in turn could lead to a liquidity squeeze, (an ability to obtain funds needed in the near-term, typically from short-term markets), which could leave JP Morgan unable to meet its obligations.  In that case, JP Morgan would essentially be bankrupt and a bailout, to protect depositor assets would most likely be necessary.

There is also a concern whether a similar bailout would even be possible.  Consider that the total amount of the bank and corporate bailouts was $16 trillion across all Fed and Treasury programs (source: CBO, July 2011).  While the bailouts were mostly low or no-cost loans, they cost the government at least 2% – 3% per annum, borrowing long term and lending short term.  Can the country afford something like this again?

Worse, this is not even the largest threat.  Everyone in the financial world is worried about the level of borrowing both in the US and globally.  The leverage is extremely high when one considers the sum total of government, corporate and personal borrowing.  Yet the amounts discussed do not even consider the $80 trillion to $300 trillion credit derivative market (depending on your source).

Derivatives add leverage to an economy.  An investor in credit derivatives agrees to an obligation to pay based upon a reference asset, but only puts up a small portion of the notional amount as collateral.  So a $1 billion credit derivative may only have $100 million or more likely closer to $10 million as collateral.  What this implies is $900 million or $990 million of assumed risk without collateral.  That is essentially added leverage to the system.  Multiply this type of leverage by the credit derivative market size and we have a catastrophe waiting to happen.

Further, unlike cash obligations, derivatives are promises to pay and therefore include counterparty risk.  Unlike Goldman Sachs selling a bond to AIG, if the bond defaults, the only loss is to AIG’s account.  If a credit derivative, at 50x the notional size of a bond trade, goes bad for one counterparty, it may be so bad that the other counterparty would now suffer losses as well.  Indeed this is what happened with AIG and led to $182 billion of taxpayer funded bailouts and guaranties.

So if the market suffers another downturn, how many more crippled institutions will we have that will require a bailout, due to direct exposure on their assets, credit derivative positions or counterparty risk?  What would happen to the economy in the face of such gargantuan losses, even if a bailout could save the market again?  Both are scary questions.

Since credit derivatives are not standardized and not traded on transparent markets, there is no way regulators can adequately check the exposure and market value of financial institutions.  And therefore, our markets are in a precarious position, especially with an overleveraged U.S. Government standing behind the deposits of too big to fail banks.

By: Anonymous OccupytheSEC Member

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