If those in command of disclosure had their way, the average investor would be left with the impression that the total derivatives exposure of financial institutions (AIG, BAC, BCS, C, CS, DB, GS, UBS, JPM) is only a fraction of the notional value of outstanding contracts. “We are looking at risk levels to the tune of about 3%, post-netting,” a guest on CNBC said yesterday. In actual fact, given the opaqueness surrounding the open positions in credit default swaps, collateral debt obligations, structured notes, put options, currency swaps and far-forward transactions, there is no logical methodology which provides any acceptable risk indicator at all.
Perhaps in an effort to limit any adverse impact on share prices, and even on the financial system at large, the word “netting” has gained widespread popularity since the collapse of Lehman Brothers. But those who are assuming that netted exposure is a finite dimension of net risk are sorely mistaken. Even when netting is undertaken on the basis of sold and bought contracts with the same counterparty (with the same reference instrument, currencies or interest rates) realistic calculations of residual risk need to take into account variations in maturity dates (mismatches) and potential conflicts in the underlying contractual obligations; in other words, netted amounts shown in financial statements may never be netted in practice.
Of course, when netting is a consequence of fully-matched hedging (i.e. buying of risk from one entity and selling an exactly similar risk to another entity), counterparty credit considerations come into play, particularly in the case of longer-dated maturities. For example, risk may have been bought from an “AAA” credit and sold to an unrated name. Or, for example, one counterparty may be located in a country where government intervention (in favour of domestic exporters presently carrying negative derivatives positions) may result in the transformation of a supposedly fully-matched deal into an open risk transaction.
None of the bigger derivatives players (AIG, Citigroup, CS, DB and UBS) are known to have bought political risk insurance; therefore, the use of the term netting may be highly misleading in the context of developing-world-linked contracts. This political risk is further compounded by the fact that the most profitable emerging market deals were made for far-forward maturities, in the midst of illiquid and undeveloped markets and in the absence of verifiable benchmark rates. So any mark-to-market assessments are simply not applicable, specifically (for example) in the case of five-year-plus swaps with one leg denominated in currencies like the Indian rupee, the Russian ruble, the Turkish lira, the Brazilian real and the Chinese yuan.
Finally, and from the perspective of the overwhelming majority of retail and institutional investors, it is important to point out that netting in standard currency and interest rate swaps contracts is an entirely different affair from netting insurance-type transactions. A currency swap, for instance, may be evaluated via short-term interest rate differentials, leaving the widening or the narrowing of the differentials in the future as the key component of pricing risk. A credit default swap, on the other hand, is primarily guided by counterparty credit ratings available both at the point of execution and on a midstream basis; the proposition that there is a credible process through which a profitable credit default swap or a collateralized debt obligation can be netted against a matching contract is almost invalid, a myth without any technical foundations whatsoever. The unending sequence of “credit events” alone in 2008 must cast serious doubts on the integrity of the netting announcements being made periodically by the Depository Trust & Credit Corporation (DTCC) and by other monitoring bodies.
As traditional insurance actuaries will confirm, the pricing of insurance risk (life and non-life) is predicated on mathematical conclusions derived from historically proven, numerically substantive and heavily population data matrices. There is not even a remote equivalent of such tools in the hands of CDS and CDO providers; on the contrary, bond default risk is still commonly being quoted by utilizing option- and probability-driven computer models!
All this is not to suggest that the huge quantum of derivatives on the books of financial institutions will ultimately generate more-than-significant losses. The problem lies in the lack of transparency; in brief, we just don’t know. One can only hope that somebody in the Fed or the Treasury has access to all the necessary information and has made a considered finding on the systemic risk posed by the derivatives complex today. Or is one hoping in vain?
