New York — ISDA has labored since its founding at making OTC derivatives markets safer and more efficient. We are naturally proud of our many accomplishments but the financial crisis showed we had much more to do. The industry’s recent progress — in reducing counterparty credit risk through clearing and portfolio compression, increasing regulatory transparency through trade repositories and strengthening operational infrastructure — reflects this commitment.
Further progress lies ahead and it’s important for our collective efforts to be focused on developing real solutions to real issues. Our recent study, Counterparty Credit Risk Management in the US Over-the-Counter (OTC) Derivatives Markets, contains some interesting data that should help to inform this effort. It indicates that the derivatives market might not have been as risky as some would believe.
We ask our readers the following questions. Did you know that:
- US banks only incurred $2.7 billion in counterparty credit losses on OTC derivatives products since January 2007?
- The total uncollateralized credit exposure among US banks relating to their derivatives activities is now only $109 billion?
- Dodd-Frank will likely increase variation margin by no more than $30 billion with the banks, and another $20 billion or so for the few remaining non-bank dealers?
- Credit losses on monoline exposures relating to sub-prime mortgages and executed outside the banking system dwarfed the counterparty losses at the banks? And that these products will remain outside Dodd-Frank?
ISDA has maintained for quite some time that the crisis was caused by bad residential real estate lending and investment. That’s where the losses were for the economy in general and that’s where they were for derivatives. We all know about AIG. We also should all know about the monoline insurers that rushed in to fill the void caused by AIG’s withdrawal from the sub-prime market. That entire industry virtually destroyed itself insuring super-senior tranches of sub-prime collateralized debt obligations. And, in doing so, it created tens of billions of losses in and outside of the global banking sector.
This could have been prevented. At a minimum, as the values of the insured products were declining, collateral should have been required. This was generally difficult if not impossible for insurance companies to do and it would have limited the amount of protection they could have sold. Instead, insurance companies were able to write sub-prime CDS protection and only had to post collateral once they had been downgraded to a certain level, if at all. It’s worth noting that today, virtually 100% of the remaining CDS market is regularly collateralized. It’s also worth noting that insurance derivatives are not subject to the provisions of the Dodd-Frank Act.
There was another element at work in the financial crisis that hasn’t received some of the notice that other contributing causes have received. Under the Basel II minimal capital requirements, banks could have purchased over $700 of super senior collateralized debt obligations for every dollar of common equity.
We wonder whether the facts from our study might point us in a more effective, efficient and economical direction than the current conventional wisdom would lead us. Do we really need hundreds of billions of dollars of initial margin to protect the system when there is only $30 to $50 billion at risk? Do we need to spend this money when the annual cost of prevention far exceeds the losses we have experienced coming through the stress test environment of 2007 to 2011? We think money is being spent unwisely and without the support of a cost benefit analysis. We will have more to say about making the derivatives markets safer in the weeks to come.
We encourage members to email us at derivatiViews@isda.org with their reactions to each View and to suggest new issues that might benefit from analysis and comment.