I occasionally entertain myself thinking about this set of puzzles:
(1) It is good for financial regulators and probably, let’s say, the world, if creditors are slow to pull money out of banks that run into trouble. In particular you don’t want everyone to want to move first and get their money out well before there’s a problem, because them getting their money out creates, or let’s say at least exacerbates, the problem.
(2) Banks also want that, since going bankrupt for no reason seems sort of harsh.
(3) But creditors want their money back – and being first out the door is a good way to ensure that that happens.
And since, when things go pear-shaped, there’s always some risk either that the rules won’t let the creditors move as fast as they want, or that the rules will change, it’s good to get your money out before there’s a problem. The best way to do that is just to keep your money to begin with, or only to give it to people who won’t get into trouble, but failing that, you want to get your money back when there’s a hint of trouble but things are still mostly fine. For some reason credit ratings used to indicate that state, since they worked so well last time, so a downgrade from nice investment grade to less-nice-but-still-investment-grade is a good time to check in with your money and see if it might miss you and want to spend a bit more time with you.
On the other hand, if you are a bank and you agree to terminate or collateralize lots of contracts upon a downgrade, you tend to have to come up with lots of cash at exactly the wrong time. So it is probably smart practice to mostly not agree to that sort of thing. But life being what it is you can’t win them all, so you agree to have some trigger-on-downgrade collateralization in some of your contracts, and you just push for those triggers to be as few and as far away from your current ratings as possible.
Anyway, let’s check in with some counterparties’ money:
Bank of America Corp., the lender that has bought back debt to strengthen its balance sheet, said credit downgrades in a hypothetical scenario may trigger demands for about $6.2 billion in collateral.
A two-level downgrade of long-term senior debt ratings would have prompted the bank to post about $5.1 billion of collateral tied to derivatives contracts and other trading agreements as of March 31, the Charlotte, North Carolina-based firm said yesterday in a regulatory filing. It would have had to post an additional $1.1 billion of collateral if trading partners opted to tear up contracts in a two-level cut.
That’s from Bloomberg, re: BofA’s 10-Q filed yesterday. Today Citi has a similar but smaller concern, estimating that a 2-notch downgrade to CIti would cost it $2.1bn in triggers, anda 2-notch downgrade of Citibank, NA (less likely) would cost it $2.6bn more. Downgrades are a-comin’ or whatever.
Here is a toy chart I made*:
This will be more, or possibly less, interesting when the remaining banks report. For now though there are some things you might expect, like GS and JPM driving a relatively hard bargain on triggering collateral, and Citi driving a relatively not-hard bargain. But take a look at the bottom of the chart for the two banks that have reported this quarter. Citi has taken off about $2.5bn of derivative liabilities in the last three months, almost a quarter of it with ratings-triggered collateralization, thus cleaning up its risk of triggered collateralization a bit. BofA, on the other hand, has taken off $10bn of derivative liabilities, yet has managed to double its ratings-triggered collateral exposure. That might suggest that, over all, counterparties are starting to drive much harder bargains with BofA than they used to.
* Info: BAC pages 66 and 128 here (1Q), and 9-10 and 170 here (4Q). C pages 41 and 105 here, 52 and 183 here. JPM pages 208 and 110 here. GS pages 25 and 134 here. MS pages 21 and 159 here. I make lots of arbitrary and unjustified assumptions, etc., including that holdco & bank are both downgraded two notches for entities where they’re broken out.