A safety net for investors?

The proliferation of credit derivatives has given rise to the widespread use of collateralization—posting collateral against the risk of default. But as Saskia Scholtes reports, this practice may be creating its own risks

Over the past several years, the derivatives markets have grown at a furious pace. According to market surveys conducted by the International Swaps and Derivatives Association (Isda), total notional volumes of interest rate and currency derivatives stood at $142.3 trillion at year-end 2003, a 14% growth on 2002 and nearly triple the notional outstanding just five years before. Equity derivatives saw year-on-year growth of 21% to stand at $3.44 trillion and credit derivatives saw year-on-year growth of 29% to stand at $3.58 trillion.

However, while derivatives are heavily used as a risk management tool to hedge exposures to market fluctuations, critics of derivatives argue that such instruments create as many problems as they solve, or simply shift problems onto someone else’s plate. According to the critics, one of those problems is that a derivative’s ability to manage risks is dependent on the counterparty’s ability to make good on the obligations agreed to in the transaction.

In other words, an investor might protect against the risk of an asset falling in value by purchasing an option to sell if the price does fall. But if when the price falls and the investor goes to sell the asset, he discovers that the counterparty has gone bust, the hedge is worthless. And as the derivatives market has continued to grow, so too have concerns about the extent to which dealers are exposed to the credit risk of their counterparties in these transactions.

According to a report from the Office of the Comptroller of the Currency, in the fourth quarter of 2003 seven commercial banks accounted for 96% of the total notional amount of derivatives in the commercial banking system, with more than 99% held by the top 25 banks.

While market participants are quick to point out that these exposures are somewhat overstated—they represent notional derivatives volumes, taking no account of offsetting transactions and netting—critics of the derivatives market contend that such concentration in market-making has the potential to create over-concentration of credit risks. Their argument is that the failure of one large dealer or large user of derivatives could lead to substantial losses for their counterparties, potentially producing a chain of defaults.

However, dealers and users of derivatives alike are acutely aware of the need to manage their counterparty credit exposures. In the interests of preventing a repeat occurrence, techniques for mitigating counterparty credit exposure were top of the agenda at the recent Isda conference in Chicago, with the notion of posting collateral against derivatives transactions receiving considerable airtime. Andrew Palmer, global head of credit derivatives marketing at JPMorgan, says that collateralization is now a key component in mitigating counterparty credit risk across all derivatives businesses. “Collateralization means that if my counterparty defaults, I already have the cash in a segregated account and I don’t have to stand in line with all the other creditors and risk getting only x cents on the dollar.”

The mechanics

Collateralization effectively requires the parties to a derivative transaction to post a deposit against the payments they would have to make if the contract is triggered. For example, if a bank buys credit default swap protection from a small hedge fund, the bank will almost certainly want to make sure that the fund will be able to make good on that promise and so it might ask the fund to post collateral. As a rule of thumb, the smaller the hedge fund, the more money it will be asked to post. If the hedge fund goes out of business, the bank seizes the collateral.

In the last five years, the growth in the use of collateral arrangements has been dramatic. In 2000, Isda estimated that $200 million of collateral was secured against derivatives transactions. Isda’s latest collateral survey, presented at the industry body’s annual general meeting in April, estimates that just over $1 trillion of collateral was in use at the beginning of 2004, up a massive 41% from 2003.

Isda’s survey also showed that 50% of all derivatives transactions, measured by either volume or by exposure, are now covered by collateral, compared with 30% in 2003. Mitigating the risk that a counterparty will go bust or allowing that counterparty to conduct more derivatives business with a bank were identified as the two most important reasons for using collateral.

Banks’ insistence that their counterparties, including other big banks, post collateral is greatly reducing their exposure to those counterparties. An Isda survey of counterparty credit exposure among the major dealers, also presented in April, found that by demanding collateral from other banks, the 10 largest derivatives dealers reduced their original exposure to those banks by 91%. For a wider sample of dealers the average risk reduction was more than 80%.

Market participants argue that part of the growth in collateralization has simply been a function of the growth in the derivatives business itself, but there are also other factors at play. For one, large firms are placing increasing importance on using collateral for regulatory capital reduction—by asking for collateral, they are effectively lending less to their counterparties and can therefore maintain less regulatory capital.

“Collateralization means that doing derivatives business becomes cheaper and easier,” says a member of Isda’s collateral committee. “It is cheaper in the sense that the cost of capital is usually lower for the bank and the cost of the trade should therefore be lower for the counterparty. It is easier because credit risk appetite is normally greater for deals where collateral is a component.”

Furthermore, he adds, increased sophistication in credit risk measurement and improved price transparency in the derivatives market have contributed to the growth of collateral posted against derivatives transactions. “Banks have developed their ability to model the mitigating impact of the collateral and factor it into derivatives pricing. This has created a very strong incentive to put the collateral in place.”

Indeed, many market participants argue that the relationship between the growth of the derivatives market and the growth in collateralization is a symbiotic one. Collateralization allows dealers to trade more with their counterparties by reducing their net exposure and also to execute derivatives transactions with counterparties that have very low credit ratings or no ratings at all, such as hedge funds. As one trader put it, no dealer wants to extend unsecured credit to a hedge fund only to find that some 23-year-old fund manager has blown the entire book, leaving the bank holding the loss.

Jared Epstein, head of credit derivatives trading at Morgan Stanley, says, “Not every low-rated counterparty is a bad counterparty, so you would miss a lot of business and opportunity if you only traded with double-A rated entities. But in order for the Street to get comfortable doing trades with these counterparties, there has to be some kind of collateral agreement in place.”

Since the threshold of collateral required against a derivatives exposure is determined according to the perceived creditworthiness of the counterparty, hedge funds generally have relatively substantial collateral management programs. According to Isda, the proliferation of hedge fund trading in the derivatives space has been such that while banks and brokers are the most prolific derivatives counterparties overall, hedge funds have now become the largest category of counterparty for large collateral management programs.

Such programs are not without their costs, however. Tracking net exposures in derivatives transactions requires sophisticated systems and operational infrastructure and then there is the cost of the collateral assets themselves and finding them. These are costs that are happily borne by those banks with large derivatives businesses—most of the major dealers have dedicated collateral management teams within their treasury departments—but it can be an expensive hurdle for corporate counterparties and fund managers.

Kenneth Tremain, head of derivatives trading at Citigroup, says that it is still predominantly the case that there are a large number of corporate entities that refuse to collateralize their deals because of those costs and because of the potential liquidity impact on their balance sheets. However, he says, “In the event that a counterparty chooses not to use collateral, their transactions are then regarded as containing unsecured contingent credit risk which will then be factored into the price of those derivatives transactions. A dealer may choose to mitigate this risk through the use of credit derivatives, for example.”

Fannie and Freddie

For some time, the notable exceptions to increased collateralization have been the triple-A rated mortgage agencies, Fannie and Freddie, which the dealers have substantial exposures to. These two organizations use huge amounts of derivatives, mainly interest rate swaps, to soothe the asset liability mix on their balance sheets: they effectively borrow short-term money and lend long-term money. According to their current regulator, the Office of Federal Housing Enterprise Oversight, at the end of 2003 Fannie Mae held total notional derivative contracts of $1,041 billion, compared with $657 billion at the end of 2002.

The fact that Fannie and Freddie don’t tend to post collateral is partly due to their high credit ratings, but dealers have also assumed that these government-sponsored entities (GSEs) are backed by an implied guarantee from the government. Speaking at the Isda conference in April, Patrick Parkinson, associate director in the Federal Reserve Board’s research and statistics division, expressed concern about the exposure of the broker-dealers to Fannie and Freddie, saying that dealers “don’t seem to be mitigating any concern over the GSEs in their risk management systems”.

However, a number of traders argue that most banks no longer put much faith in the so-called implied government guarantee. A member of Isda’s collateral committee argues that the assessment of Fannie and Freddie’s credit risk is a purely rational one. “Fannie and Freddie’s ratings and internal risk management systems are such that they tend to have very high or infinite margin thresholds with their counterparties, and that is why they don’t post collateral,” he says.

Market sources say that it is also the case that the mortgage agencies are very diligent about keeping their access to counterparty credit open, making efforts to manage the degree of exposure which any one dealer will have with them by pursuing unwinds and terminations of positions and, more recently, posting bilateral collateral agreements in some cases.

Risks

Collateralization is not without its attendant risks. For those firms that choose to collateralize their derivatives positions, a large loss on a position or a credit rating downgrade can have a significant funding and liquidity impact as counterparties call for more collateral. Collateral demands arising from downgrades may be especially costly to meet because a downgrade would reduce the availability of funding and increase its cost at the same time.

Epstein at Morgan Stanley recalls the liquidity crunch experienced by a number of energy companies in 2002. “At the time,” he says, “these companies had huge derivatives trading books, but as they were downgraded they were forced to post additional collateral, in some cases restricting their ability to continue trading.”

However, the member of Isda’s collateral committee says that most firms manage that risk by calculating the potential liquidity impact of a downgrade in advance. “Firms that do this well will calculate the additional collateral which would be required at least once a month and ensure that the buffer is there and taken account of in the firm’s funding strategy.”

This is widely regarded as best practice for firms engaging in collateralization. Palmer at JPMorgan argues that the potential liquidity impact of a collateral call actually exerts a valuable discipline on the market since “firms not capable of posting the collateral shouldn’t be doing the business because they are over-leveraging. Collateralization therefore ensures that the right people are doing the right trades.”

Market participants argue that a major attendant risk associated with collateralization is in fact an operational one. Tremain at Citigroup points out that “the integrity of using collateral is only as good as the processes around it. The challenge is ensuring that, on a daily basis, all of a counterparty’s various transactions are taken into account and that you are using accurate marks for those transactions, especially with respect to the more exotic transactions.”

A collateral cushion Speaking at the International Swaps and Derivatives Association annual meeting in April, Patrick Parkinson, associate director in the Federal Reserve Board’s research and statistics division, welcomed the growth in the use of collateral against derivatives transactions but expressed concern that dealers’ collateral positions only cover current exposure and questioned whether the banks should not add a collateral cushion to cover marginal increases in positions. The size of the cushion would vary according to the volatility of the position. Kenneth Tremain, head of derivatives trading at Citigroup, explains that while hedge funds and other leveraged accounts are required to post additional collateral, the inter-dealer market has other ways of dealing with the problem. “Dealers generally examine their value-at-risk with a particular counterparty. If the VAR is too high, the dealer is likely to curtail trades that would add incremental VAR. The use of offsetting transactions is also a growing part of the market.”

Fannie and Freddie in the spotlight Although the mortgage agencies Fannie Mae and Freddie Mac do not typically post collateral against their derivatives exposures, market sources say that the agencies have agreements with many of their counterparties that would require them to post collateral in the event of a credit rating downgrade or loss of GSE (government-sponsored entity) status. Speaking at a conference in Chicago in May, president of the St. Louis Federal Reserve Bank William Poole said that if the mortgage agencies were required to collateralize their derivatives exposures, the potential liquidity impact on Fannie and Freddie would be significant. Every week, Fannie and Freddie must roll over roughly $30 billion of maturing short-term obligations. Should the market come to fear the creditworthiness of either firm, they would be forced to liquidate non-mortgage assets to obtain funds to redeem maturing obligations. Fannie Mae’s 10K report for 2003 reports a liquidity reserve of $65 billion, net of assets pledged as collateral. At the end of 2003, only $487 million of short-term assets were pledged as collateral, but in the event that Fannie Mae is forced to collateralize its entire derivatives portfolio, the agency would be left with a minimal liquid reserve should the market become unreceptive to new issues. As Poole puts it, the fact is that the agencies “depend critically on continuous market access, and with their minimal capital positions that access could be denied without warning”. While many in the market argue that the likelihood of ratings downgrades for Fannie and Freddie is slim, their maintenance of GSE status is considerably less certain. Concern about the growing size of Fannie and Freddie’s retained mortgage portfolios, the soundness of their risk management and the potential burden on the taxpayer should either fail, have led to a host of proposals for reform. Most recently, Richard Shelby, chairman of the US Senate Committee on Banking, Housing and Urban Affairs, proposed a bill which would replace the agencies’ current regulator with a new body. Such a body would have full power to appoint a receiver to liquidate assets in the event that either agency defaults and to adjust risk-based capital standards and minimum capital requirements. Shelby’s proposal was rejected by the Bush administration but the debate on how to tighten regulation of the GSEs continues.