No fix for the derivatives monster

June 17, 2009

It’s still not clear if the Obama administration has a plan for dealing with the derivatives monster, which is one of the biggest problems regulators must confront in dealing with the potential collpase of a “too big to fail” financial institution.

The administration’s financial regulatory reform package would give the FDIC, and in some cases the SEC, broad authority to transfer a firm’s derivatives book to a “bridge instititution” to avoid “termination of the contracts by the firm’s counterparties.” But that may be easier said then done.

In fact, the FDIC currently has the power to transfer derivatives contracts for banks it oversees–but it must do that in one day before it takes over a bank. But still no one has ever said how such a tranfer would take place with a bank the size of Citigroup, which has a derivatives book with a notional value of $32 trillion.

Would Citi’s derivatives book be transferred to JPMorgan Chase, which already has the largest derivatives portfolio, with a notional value of $87 trillion? Could JPMorgan, even temporarily, possibly manage all of those derivatives contracts?

 Of course, there’s always Goldman Sachs, which has a derivatives book with a notional value of $30 trillion. But what happens if Goldman balks because it’s uncertain of the risk it would be taking on? Can the FDIC simply force Goldman to comply, or will the federal government be forced to provide some sort of financial guarantee to Goldman?

The 85-page white paper is silent on all of this.

In the case of Lehman, the vast majority of its 1 trillion in outstanding derivatives contracts terminated the moment the investment house filed for bankruptcy. That set-off a mad scramble by Lehman’s counterparties to claim whatever collateral they could to make them whole on any in-the-money derivatives trades. The financial world is still dealing with the reprecussions from that event, with many of Lehman’s trading partners facing tens of billions in losses on those busted derivatives contracts.

During the weekend that Lehman was spiraling towards bankruptcy, federal regulators had hoped some bank would step-up and buy or assume Lehman’s derivatives book, which only had a notional value of $700 billion. But there were no takers. No bank could get a handle on the potential risk on such short notice.

In the end, this argues for putting some outer limits on the size of a derivatives book at any one institution. Increasing capital requirements for banks with sizeable derivatives books is good, but it won’t slay the derivative monsters.


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