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| Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks |
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Bank of America warned that another one-notch downgrade would force it to post an extra $5.1 billion of collateral, followed by $1.5 billion more for the next incremental downgrade.
Providing $11.5 billion of extra security might seem manageable for a mega bank that held $93 billion of cash and securities collateral against over-the-counter derivatives trades at the end of September, while posting $87.8 billion to its counterparties.
But a jump to posting $99.3 billion of collateral would mark an increase of almost 50% on the total of $66.9 billion that Bank of America was forced to supply against its derivatives trades at the end of 2010.
It would also signal erosion or elimination of the buffer between the amount the bank posts against swap and option trades and the collateral it holds. The total collateral held by the bank against derivatives increased by less than $7 billion between December 2010 and September 2011.
Rating agency downgrades for Bank of America, and many of its peers, became inevitable even before Standard & Poor’s actions at the end of November. These will result in forced recalculation of collateral agreements between big derivatives players just as they are trying to slash their risk-weighted assets by recalibrating fixed-income exposure.
That in turn will complicate the task of regulators and investors in trying to assess the health of the main dealers. When the Federal Reserve announced the launch of a more exacting stress-testing drill for big US banks in late November, the focus in the markets was on a requirement that dealers model for exposure to a severe eurozone downturn and a potential rise in US unemployment to 13%.
There are plenty of other potential stress points that could cause problems with the mechanics of the markets without a sharp deterioration in underlying economic conditions. Some involve the effects of apparently benign trends such as the fall in global interest rates. This has resulted in an increase in the gross derivatives values on bank balance sheets. For both Bank of America and JPMorgan the gross value of the derivatives on their balance sheets increased by roughly $500 billion between the end of last year and the end of September to take totals at each bank to about $2 trillion, for example. Even after full netting benefits, JPMorgan still reported a rise in derivatives receivables from $80.4 billion to $108.8 billion. This move was largely an effect of the fall in rates on the value of interest rate swaps, the largest sector of the derivatives markets.
Both banks run roughly matched derivatives books, so the increase in gross derivatives values is not a sign of an increase in net risk exposure. The rise in the amount of money sloshing around these equivalents to banking supertankers nevertheless underscores the potential importance of changes in derivatives collateral management tactics.
Bank of America – along with Morgan Stanley – is the most likely of the big US derivatives dealers to be a victim of a tightening of collateral terms. The $11.5 billion of extra collateral that BofA warned it might have to post because of ratings downgrades is a number based on existing contractual derivatives arrangements. It will have to set new terms on future agreements and might face aggressive bargaining from some counterparties if its credit spreads remain at elevated levels.
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Credit investors have been inclined to shoot first and ask questions later when it comes to bond and default swap trades in Bank of America and Morgan Stanley in recent months. BofA’s 5% 2021 bond widened to a spread of 560 basis points over the Treasury curve at the end of November and its five-year default swap spread pushed close to 500bp. Morgan Stanley has seen five-year default swap trades at levels over 600bp and nominal quotes that were at times higher than those on Lehman Brothers in the days before its 2008 bankruptcy. Neither the corporate bond nor the single-name default swap markets are liquid at the moment, which leads to exaggerated price moves on low trading volumes. But signals from the illiquid credit markets could quickly start to have an effect on the price that dealers pay to remain active in more liquid derivatives markets, such as interest rate swap trading.
JPMorgan, which has seen less dramatic widening in its credit spreads, might feel it has a chance to win further market share and make life difficult for its rival derivatives dealers via aggressive collateral management.
JPMorgan has certainly been accused of bullying tactics in past collateral disputes, including its dealings with Lehman in the approach to its bankruptcy filing. JPMorgan has also been in the spotlight more recently for its role as a lender and custodian of funds for MF Global, although chiefly for its inability to provide regulators with answers about how MF was shifting funds through different accounts.
The bankruptcy of MF Global brought a renewed focus on the collateral arrangements backing repo-to-maturity trades. On November 28, just under a month after MF Global’s October 31 bankruptcy filing, Nomura made an unprompted announcement that it had slashed its use of repo-to-maturity trades backed by troubled European government bonds that were comparable to the deals that sank MF Global to $102 million, from $594 million on September 30. The thrust of the message for investors and counterparties was that Nomura had cut its overall exposure to Greece, Ireland, Italy, Portugal and Spain from $3.55 billion to $884 million. However, the bank was keen to stress that it had reduced trades using low-quality sovereign debt as collateral and it also made the point that its total repo-to-maturity exposure, including collateral of all types, had been cut by 51% from $770 million to $380 million.
The collateral posted by the big dealers and their clients to back trades in the $707.5 trillion over-the-counter derivatives market is generally either cash or high-quality government bonds such as treasuries. There is likely to be a sharp increase in demand for both these types of collateral, as dealers are downgraded and a move towards central derivatives clearing begins. Clearing alone might increase the collateral needed to back derivatives trades by as much as $2 trillion, according to an estimate by Morgan Stanley and Oliver Wyman earlier this year.
Regulators and counterparties would be well advised to pay close attention to any schemes designed to perform financial alchemy by transforming lower-quality assets into the prime collateral needed to keep the derivatives markets flowing.
