Derivative exposure at the major US Banks

[Grenville]

As timely as the day's headlines, note that BoA just settled this exact issue with Lehman this week!

 

I have attached the bankruptcy proceeding documents between Lehman and BoA. They are pretty interesting reads. Thanks for the tip dwy000. One is a summary by the individual managing the derivatives settlement for the debtors and the other is the settlement details with BoA and Merrill. The haircuts on their claims are quite large and with three years passed hopefully all the other counter parties agree to the framework settlements.

 

 

One question, the documents refers to primary and guarantee derivative claims. What's the distinction between the two?

 

The attachments were found here:

http://chapter11.epiqsystems.com/LBH/docket/Default.aspx?rc=1

Declaration_of_Daniel_Ehrmann_in_Support_of_-_Declaration.pdf

Motion_to_Approve__Debtors_Motion_fo_-_Motion_to_Approve.pdf

[dwy000]

 

"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."

 

 

Hi dwy000,

 

Great posts, and thank you for your insight.  I am trying to understand the comment above, and have a question about the comment you made earlier. 

 

1. Trying to understand the cashflows from above which results in net 20bps.

 

On the bank's long bond position, they receive 200bps, and on the bank's short CDS position, don't they receive 220bps? Isn't this a net receipt of 420bps to the bank, rather 20bps?

 

2. Is the above arbitrage trade a riskless trade? 

 

I see risk if the GM bonds default - the long bond position will lose its value of $100mn and the short CDS credit protection position could potentially lose another $100mn as they have to pay out to the CDS credit protection buyer. So that would mean that the bank would have net exposure of $200mn?

 

Not sure if my understanding is correct of the arbitrage trade as you outline above ...  Thank you for your help advance in understanding the arbitrage trade.

 

Kiwing - good catch!!  My mistake entirely.  In my haste I put "sell CDS protection" instead of "buy CDS protection".  You are right, that would double the exposure instead of negate the exposure.  I meant they would buy protection to offset the loan risk

[dwy000]

As timely as the day's headlines, note that BoA just settled this exact issue with Lehman this week!

 

I have attached the bankruptcy proceeding documents between Lehman and BoA. They are pretty interesting reads. Thanks for the tip dwy000. One is a summary by the individual managing the derivatives settlement for the debtors and the other is the settlement details with BoA and Merrill. The haircuts on their claims are quite large and with three years passed hopefully all the other counter parties agree to the framework settlements.

 

 

One question, the documents refers to primary and guarantee derivative claims. What's the distinction between the two?

 

The attachments were found here:

http://chapter11.epiqsystems.com/LBH/docket/Default.aspx?rc=1

 

Thanks Grenville!  I'd only seen the summary and not the documents themselves.  Makes me glad I didn't go to law school.

 

Re primary vs. guarantee - the guarantee claims would be ones where the trade was done out of a legal entity that wasn't the primary trading vehicle (i.e. where the primary claims are) but for which the primary entity had provided a full guarantee.  It would just collapse the legal structure to aggregate to a single claim.

[dwy000]

 

"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."

 

 

Hi dwy000,

 

Great posts, and thank you for your insight.  I am trying to understand the comment above, and have a question about the comment you made earlier. 

 

1. Trying to understand the cashflows from above which results in net 20bps.

 

On the bank's long bond position, they receive 200bps, and on the bank's short CDS position, don't they receive 220bps? Isn't this a net receipt of 420bps to the bank, rather 20bps?

 

2. Is the above arbitrage trade a riskless trade? 

 

I see risk if the GM bonds default - the long bond position will lose its value of $100mn and the short CDS credit protection position could potentially lose another $100mn as they have to pay out to the CDS credit protection buyer. So that would mean that the bank would have net exposure of $200mn?

 

Not sure if my understanding is correct of the arbitrage trade as you outline above ...  Thank you for your help advance in understanding the arbitrage trade.

 

Kiwing - good catch!!  My mistake entirely.  In my haste I put "sell CDS protection" instead of "buy CDS protection".  You are right, that would double the exposure instead of negate the exposure.  I meant they would buy protection to offset the loan risk

 

Looking again, with the prices I used in the example I should have changed the bond to a sell instead of the CDS position to a buy.  They would sell the bond (pay 200bps) and sell credit protection (income of 220 bps).  Collect net 20bps.  In a default, they would gain on the bond short position but pay out on the CDS they sold - in theory, in exactly the same amount.

[ubuy2wron]

All of this exchange underlines the truth of the statement of derivatives and credit default swaps are financial instruments of mass distruction. Since most of the banks and other participants have opaque balance sheets such that even the internal risk managers can not fathom exactly the size and scope of their direct exposure the  entire structure becomes a house of cards every time an AIG  like entity becomes an important participant. As long as we have a system that is based on a heads I win tails society or the tax payer loses we will have more crises. I would like the roller coaster to stop thank you very much. No rational investor is going to lend 500000 to barber with spotty credit to buy a home he can not afford yet financial engineering made it all possible. You can not even consider the guys at AIG selling the CDS stupid if it had not been for the Lehman BK they may have come out the other side with a great trade and a huge bonus. And no one has had to give back any of the bonuses from the gravy years. Dick Fuld is still wealthy, Stanley Oneal  from Merrill Lynch has at least 200 million

[kiwing100]

 

it seems that the CDS may not be offering a a hedge to Greek bond investors.  They have yet to determine whether there is a credit event on Greek bonds with the voluntary restructuring.  Holders may be facing a 50% haircut on the bond and no payout on the CDS. 

 

http://online.wsj.com/article/SB10001424052970203554104577002131748108506.html?KEYWORDS=DAVID+REILLY

 

In that case, the arbitrage trade by banks of being long a bond and long CDS where you capture the income differential may result in substantial losses if the underlying are Greek bonds.  Use of leverage in this position would magnify this significantly.  So what seems like a riskless trade may not be ...

 

Also I am wondering which financials have naked short CDS on Greek bonds, they are likely to face more margin calls (like AIG did in 2008).  Also which financials are short CDS on Italian, and Spanish  govt debt, and bank debt ...  Margin calls caused the downfall on MF Global and Dexia putting pressure on their liquidity ...