Things That May Not Blow Up The World: Derivatives?

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As Marc Faber prepares for war and Europe tries to figure out Italy, derivatives trade group ISDA wants you to know that one thing is safe: OTC derivatives.

This might surprise you, since they've been famously called "weapons of mass destruction" and since counterparty risk in the over-the-counter derivatives market has been a big motivating force behind regulatory changes. But ISDA concludes that that risk is no big deal:

The [report] shows very limited counterparty credit losses at the bank level. Since 2007, losses on OTC derivatives positions in the US banking system due to counterparty defaults have totaled less than $2.7 billion, a period that includes the failures of over 350 banks with assets of more than $600 billion, as well as the failures of firms such as Lehman Brothers, Fannie Mae and Freddie Mac.

The ISDA report includes this chart, from the Office of the Comptroller of the Currency, showing credit losses (how much U.S. banks actually lost on their derivatives counterparties not paying what they owed) and net credit exposures (credit risk as a percentage of outstanding notionals):

Losses peaked in 1Q09 and have never been more than $1bn in a quarter, even when Lehman filed. Which suggests that maybe derivatives counterparty risk really is no big deal? That's ISDA's claim - that, and that additional Dodd-Frank regulation of derivatives won't help much.

Of course this report has some caveats:

* It covers only commercial banks regulated by OCC - pure investment banks and foreign banks don't get covered. Total notional of OTC derivatives was about $601 trillion as of mid-2010, of which U.S. banks represented $223 trillion. There's some reason to think that OCC-regulated U.S. banks are more conservative about their exposure than non-banks would be, what with their being ... more regulated.

* The relative absence of counterparty risk is largely due to netting and collateralization - "Collateralization further reduces US banks' [net counterparty credit exposure] to $107 billion; a mere 4 basis points, or 0.04%, of gross notionals." But some categories of customer don't really post collateral, meaning that concentrated failures in those categories could increase risk. What categories? Well, in considering who might post in a new Dodd-Frank world, ISDA says "We do not believe we should include Sovereigns because we believe Sovereigns will only execute derivatives with dealers that do not require collateral." (Though that's changing!) And sovereign credit is looking ... well, it's looking terrible.

* ISDA's cheery data doesn't include the derivatives counterparties who actually blew up the world last time by writing uncollateralized custom protection, like monoline insurers or AIG:

AIG FP sold protection on over $60 billion of CDOs on sub-prime mortgages. After AIG was rescued by the Fed, AIG FP posted $22.4 billion of collateral between September 16 and December 31, 2008. Only $1.3 billion went to US banks or their affiliates while $4.5 billion went to US investment banks.

So had the government allowed AIG to fail, it would have more than tripled the total U.S. losses on counterparty risk since 2007.

ISDA Publishes Analysis of Counterparty Credit Risk Management in the US OTC Derivatives Markets [ISDA, report here (pdf)]

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