Risk evaluation, at the systemic level, for derivatives in banking is focused on credit risk as the primary measure. As I laid out last week, that is the wrong approach since defaults in derivatives are not the primary risk. In the example of John’s Hopkins Hospital (JHH) and its interest rate swaps with JP Morgan and Goldman Sachs, the primary danger to the banks is not that JHH will default on its payment obligations under the swap contract.
Since the swaps were originated earlier in the last decade under wholly different interest rate conditions, it has been very favorable to JPM and Goldman. JHH has been required to post additional collateral to reflect the changes in swap valuations, running that additional collateral through its income statement as cumulative “losses”. The opposite has been true for the bank counterparties who have been the timely beneficiaries of obtaining collateral throughout.
The initial estimates of bank earnings that have trickled out in the past few days are starting to “warn” of interest rate exposure. Yesterday, I collected some of the estimates for bank trading. Today, we get an article specifically dealing with interest rate swaps and interest rate risk.
Some of the numbers that get published about swaps feed an illusion of hedging, one that does not fully appreciate the system as it has evolved under the aegis of activist monetary policy. Further, there is little appreciation, it seems, to the tangled web of a small group of megabanks providing all the risk capacity into the system. The Bloomberg article notes,
“Bank of America, led by Chief Executive Officer Brian T. Moynihan, 53, had receive-fixed swaps with a notional value of $98.7 billion at the end of June compared with $19.4 billion of pay-fixed swaps. That means most of the Charlotte, North Carolina-based lender’s interest-rate swaps are vulnerable to rising rates.”
The numbers above are described in a manner that is not likely entirely accurate. First, they refer to the netted positive fair value of the swaps (and not notional) which is a valuation attempt for credit risk. Second, and more importantly, we don’t know how the bank has laid off the interest rate risk created by that mismatch. I am certain that Bank of America (mostly the Merrill Lynch sub) has incorporated this potential risk into its “portfolio” calculations and hedged in some way or fashion.
I argued yesterday just from estimated summer trading results that these banks do a poor job of that since dynamic hedging will always be susceptible to “tail events”; the math of traditional statistics cannot comprehend jump risk in any meaningful manner (multi-fractal geometry and Mandelbrot equations could potentially be useful, but there is no system for incorporation, at least none that I am aware of). But the real risks to the big banks that are IR swap dealers surround their continued ability to hedge and still maintain liquidity.
As the market values of their one-sided swaps move in the “wrong” direction, the problem is not just reduced valuations. There are collateral considerations since cash will have to be moved in the other direction now. That impacts “portfolio” liquidity characteristics that flow through to the other bank segments (including repos and securities lending/receiving).
Beyond that, the current estimations of risk exposure simply assume, as they did in 2007, for example, that the ability to hedge is a constant or near constant. One of the primary factors that nearly destroyed the system into 2008 was the lack of dealer appetite to take on new risk – hedging providers did not have or did not want to rent out risk capacity. As hedging demand rose into the lack of supply, banks were forced into balance sheet and risk capacity decisions they did not foresee both in their models or their structural planning.
While I think we are nowhere near that kind of dysfunction right now, there are hints of concern. A chart I posted last week showed a dramatic shift in the relation of dealer swap values. The net of positive fair value interes rate swaps to negative fair value swaps dropped precipitously in the first quarter of this year (the latest data – the period where the swap market moved even before the real rate selloff began).
The relationship between these two is a proxy for the level of hedging, and thus the capacity to hedge from other dealers. It suggests, in my analysis, that with all the major dealers (and, again, there are only four in the US) on the same side of the trade (having taken fixed for years expecting the Fed to extend and extend), systemic capacity to absorb new demand for hedging interest rate risk was strained. How would the system work if Merrill Lynch, because their models of interest rate volatility and vega could not anticipate the May-June tail/jump, reached out to Goldman to increase their hedges (as the “dynamic” models react to the unanticipated rate volatility) when Goldman is reaching out to Merrill Lynch at the exact same time for the exact same thing?
There is so much self-similarity here that it suggests fractal relevance. We have seen these types of situations in “vanilla” finance for as long as banking has been in existence. It’s called a run – where the capacity to extend a bank’s fraction of reserves is called in while other banks are experiencing the same thing at the same time. In that situation, in the modern, activist age, the central bank steps in to “lend” its capacity for reserves where the rest of the system cannot. There is no precedence in terms of who steps in to supply hedging capacity for interest rate risk. I would even go so far as to suggest it is not even a consideration, despite the 2008 experience (which the academic side of central banks is still struggling to process and fully understand).
My point in all of this is that there are risks, systemic risks at that, that go beyond these numbers and allusions. As I mentioned before, in terms of derivatives, the regulations are all focusing on credit risk as a primary method of quantification despite the fact that credit risk is the least concern in terms of dealer derivatives books. But that is how orthodox economics understands the system – it is the prism by which it defines operational constraints. Derivatives entail wholly different risks, but at the very least we should be aware of these concentrations (still) now that the rate environment has experienced at least one taper turn the “wrong” way. Leverage built solely on policy entails significant dangers.
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