dwy000

Hi oec2000, That's a good question, it's exactly what happend with Lehman (and AIG) and it's something that drives much of the risk management. The interesting part is that if counterparty B can't pay you back, technically you don't lose any cash but your loss is the cash that you still have to pay out on the hedge you have on the other side. As a result, if you really think A won't pay you, the best thing to do is take off the hedge and go naked on the underlying risk. By the way, I say "position" and "hedge" but these are interchangable because if they're offsetting it's just two positions in opposite directions so it doesn't really matter which one goes bad and which one stays good. Also, while it's simpler to think of directly offsetting trades, the bank actually runs a "book" of trades and they just try to keep a matched/hedged book as opposed to specific matching trades. Regarding collateral. As a backdrop, because the positions are all marked to market and collateral is adjusted each day, your risk is really only a 7-10 day move in the underlying position (rates, gold, FX, equity, whatever). That's because if you make a collateral call on day 1, the hedge fund will dispute the marks on the positions to try and buy time (marks are legitimately disputed all the time so this is not a big red flag). Then 2-3 days later the bank will say "enough" just pay the collateral we will settle the dispute as we go. Long story, but by the time you actually declare a default and close out the trade 7-10 working days have gone by and the position can continue to move against you. That's why the real risk management comes in taking off the hedge (or other side of the trade) so you don't keep paying out on the other side. But it's a fine line because now you're unhedged so if the fund comes thru you could have lost money on the position. With that in mind, the Master Agreement will stipulate whether you can "rehypothocate" collateral. This means that if I post US Treasuries to you as collateral, you can use those treasuries to post to another party as collateral of your own even though technically it's not your money. You wouldn't normally do that with a small hedge fund but it's necessary between the big banks because the amount of collateral is in the billions and it just wouldn't work to have separate collateral. So, to longwindedly answer your question, if B goes into liquidation, party A would declare a default, offset the amount it owed to B with the collateral posted to B and basically walk away even. Now in reality that rarely happens because as per above there will be a mismatch and if there's too much collateral A will claim it back and if there's not enough, A will pay out the extra owed to close out the trade. In addition, bankruptcy courts cause problems because they can "freeze" the situation and will not permit A to cancel the trades (this is A's worst nightmare but happens all the time). A will generally put on another hedge/position with another counterparty to replicate the lost hedge it had with B to keep the book flat. Hope this made sense. I never thought a value board would care about this level of detail. It goes to show the quality of investors here.

Still trying to get used to posting here. How do I incorporate your post in my reply for reference? Thanks. "Do the banks like WFC and BAC organize the derivative related business to reside in a subsidiary that is isolated from the rest of the subsidiaries and the retail side of the bank? Ie, if things did go bad, they could put the whole thing in runoff? Or do they treat the derivative side of their business as something like their regular operations and want to avoid hurting their reputation (reputation risk)? Fairfax has a non stated policy of standing behind their subs even though they are isolated in terms of risk. " No, they generally do derivatives out of the main banking entity. This is primarily for capital reasons since you can't count the derivative as a hedge if it's in a different legal vehicle than the underlying asset being hedged. In the late 90's a couple of lower rated banks and insurers set up derivative vehicles that were AAA rated seperate vehicles for the exact purposes you were suggesting (the most famous of which was CSFP, Credit Suisse Financial Products) but these went by the wayside largely due to the capital/hedging issue. Funny the comment on Fairfax. As a risk manager I used to insist upon a written guarantee from the parent for us to deal with a subsidiary. The marketers used to whine "do you really thing they'd let their subsidiary go under?" But the resounding answer is yes. That's exactly why they wouldn't give a written guarantee. When I hear things like BofA contemplating whether to file Countrywide for bankruptcy it makes me want to send the headline to the sales guys who called us crazy. Unfortunately not all the financials out there have the integrity of a Fairfax.

"Do you think the insiders/CEO's of these organizations have a feel for the risks? i.e. can we take a lazy approach and follow the management when they invest their own money especially when they appear to be trading so cheaply?" Hi Granville - thanks for starting the new thread. Re insiders/CEO's - boy, that's a good question. The short answer is no, I don't think they have a direct feel for the detailed risks, but they do have a feel for their risk managers, processes and procedures. A big money center bank would have millions and millions of trades on the books (number of trades, not notional amount). They tend to be done out of a variety of different areas - FX, equity derivatives, CDS, interest rates, etc. The individual desk would have very good knowledge of the trades but the risk management usually sits overtop of these different products and therefore doesn't have the same detailed knowledge but can see across the risks. If a bank puts on a trade with hedge fund whereby they are effectively short 1mn oz's of gold (notional of $1.6bn), the systems would capture that and the risk reports would show an increased exposure to lower gold prices. The bank then manages these underlying risks as a whole - i.e. they may have risk limits on gold whereby they can't lose more than $50m if gold moves by 10%. If this trade took them above that, they'd have to buy gold to hedge. There's added complication if that trade is in say Swiss Francs because now you have gold risk, FX risk, inerest rate risk, counterparty risk, etc. Virtually all of the risk is managed on "confidence interval" basis - i.e. they set limits based upon a 95% or 99% confidence interval in how much the underlying (gold in this case) could move in a given period. And as 2008 and most other crisises proved, all these risk parameters fall apart when you get a move that exceeds 99% confidence interval. The tough part as an investor looking at the banks is that the reporting of that gold trade is zero if the price hasn't moved. So the risk is there but it's not going to show up on the financials. And if they have a similar trade on with another counterparty where they are long the same amount of gold, now you've doubled your notional amount of gold trades to $3.2bn, doubled your credit risk (i.e. one on either side) but negated the gold risk so even if gold prices moved you wouldn't see it in the financials. Probably more detail and confusion than you were asking about but I hope it made sense.

"Thanks for sharing your experience Dwy000. Do risk managers get involved with swap construction language? A large part of negative sentiment could be allayed if every master agreement required the approval of a respected risk manager. Also, Citi reports that the majority of their CDS contracts are "bilateral". Is it fair to infer that these contracts are subject to netting arrangements following a default event? " Hi Rabbit (by the way, I'm new to the Board but I've enjoyed your posts in the past). Re swap construction language: again, it's complicated but generally speaking no. The risk manager will negotiate the terms of the Master Agreement (called an ISDA) and the collateral terms, then all derivatives will be documented under that master. Each counterparty will have credit limits and the fully netted exposure under the ISDA is monitored against those limits. In a very large, complicated or risky trade, the risk manager may get involved in the trade details but the vast majority of the trades are fairly standardized. The toughest part is often ensuring that the bank's risk systems actually capture the trade properly and report the exposure properly. When Citi says their contracts are "bilateral", it means that both parties (Citi and the counterparty) both have to post collateral if they are out of the money. Originally, stronger banks could have unilateral agreements under which only the counterparty (usually a hedge fund) posted collateral but the bank didn't have to. Again, that's largely gone these days except for very small hedge funds that don't have the infrastructure to accept and hold collateral. Hope that made sense.

I'm sensitive to the person who noted that this is probably the wrong board for this discussion but.... I'm far from a complete expert on this but I was a risk manager for one of the big banks for a long time so I'm fairly familiar with the workings. And from that I can say that as an investor you can NEVER know what the true risk is at any bank. You know how much the exposure is on a single day and the nature of it but the details are sooooo much more complicated. Plus there's the fraud risk (just ask UBS). Rarely do banks like WFC or BAC use credit derivatives for outright positioning purposes. They are generally purchased as a hedge or in an arbitrage situation. This is probably even more true now that the trading books are being minimized and shut down. For example, WFC might lend $100m to General Motors. This is usually done, however, not because the loan is such a great asset but because they have to do it to win more lucrative FX, asset management or other business from GM. Not wanting the GM exposure they will buy $100m (or less) of CDS on GM as a hedge. If the hedge is an accurate one, this not only gives them protection against default of GM but also means they don't have to hold as much capital against the loan so it's win-win. In an arbitrage situation, they might buy $100m of GM bonds that pay a spread of 200bps and sell CDS credit protection on $100m that generates an income of 220bps - thereby keeping 20bps/year. The notionals are big but the risk is actually fairly minimal. On the counterparty risk: there are generally 3 sellers of CDS (ie providing the protection) - banks, hedge funds, insurance companies. These days, virtually all of the trading of derivatives between these parties is done on a fully netted and collateralized basis. That means that every day they mark all the positions between them, net off all the +'s and -'s and then whoever is out-of-the-money posts collateral in that amount to the other. The AIG situation where you are uncollateralized unless the counterparty is downgraded is now a thing of the past. For hedge funds, they generally have to post excess collateral From a capital perspective, any exposure that's fully collateralized gets a far reduced (or zero) capital requirement. The capital requirements on derivatives are extremely complicated and not all that well developed (they try hard but it's such a broad category it's tough to accurately capture it). This is a VERY simplified discussion but I hope it points you in the right direction. The reality is about 100x more complicated and intricate. I reiterate though that nobody on the outside will ever be able to fully understand the amount, nature and risks of the exposure at the banks. This is true not just of derivatives but also the general loan/securities books. BB is a genius and probably has done more work on it than anyone but, in my view, with banks you're really betting on the big picture and management.

For risk and capital purposes, virtually all of those derivatives between the big financial institutions are collateralized so the risk is really the movement between collateral calls. That's what killed AIG, not the realized losses on the derivatives but when they got downgraded it triggered collateralization of the derivatives. It doesn't negate the fact there's billions of exposure but it's not as bad as the notional amounts the press loves to quote. Now if the collateral is US Treasuries.....but that's another discussion.