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FW: Bear Stearns deal boosts J.P. Morgan’s derivatives exposure

BEAR CHURNS

Bank is already largest player in swaps market. And the market just got more concentrated.

By Marine Cole
March 24, 2008

The government-supported sale of Bear Stearns announced last week may have halted a run on investment banks, but its pending acquisition by J.P. Morgan Chase would increase the buyer’s already hefty exposure to possibile failures by other banks and financial institutions, an exposure known as counterparty risk. Much of that exposure is the result of derivative contracts to which J.P. Morgan is a counterparty.

For starters, J.P. Morgan’s own exposure to derivatives could balloon if the deal is completed. At the end of 2007, J.P. Morgan’s exposure totaled $77.2 trillion in notional value, exceeding that of any other commercial bank, while Bear Stearns had $13.4 trillion in notional value.

Granted, the combined total exposure if the acquisition goes through could amount to less than that, since derivatives involving the two banks themselves would be cancelled. And with over-the-counter derivatives totalling a notional $516 trillion at the end of June 2007, according to the Bank for International Settlements, Bear Stearns’ exposure might look like a drop in the bucket. Still, its failure might have resulted in defaults on contracts held by its counterparties, including J.P. Morgan, though the potential magnitude of the resulting losses is impossible to determine.

This, of course, reflects the double-edged sword that derivatives represent. While the contracts might reduce risk by enabling counterparties to hedge their exposure to an underlying position, the instruments also cause the fates of otherwise separate parties to become intertwined. Other parties might thus have failed even if only Bear Stearns were deemed no longer creditworthy. Now they will be exposed to J.P. Morgan’s creditworthiness instead.

That may be reassuring to regulators concerned about systemic risk. In a research report it published last week, Bear said its more than 5,000 derivative counterparties and more than 1,000 futures counterparties were among the reasons the Federal Reserve and Treasury Secretary Henry Paulson felt compelled to find a buyer for the bank rather than see it go belly-up. Counterparties to these contracts are mostly banks, but also include hedge funds and insurance companies.

“Banks are probably the biggest counterparties to other banks, especially in dollar terms,” said Nishul Saperia, director of credit products at Markit, which provides data, valuations and trade processing for the credit derivative industry. “This is why the Fed came in and made sure Bear didn’t go down. All the other banks would have been impacted.”

Perhaps none more so, however, than J.P. Morgan. While its $77.2 trillion derivative exposure at the end of 2007 was down from the $91.7 trillion it held as of Sept. 30, 95.2% of which is traded over the counter, it’s a safe bet that J.P. Morgan would have suffered if Bear Stearns couldn’t fulfill its contractual obligations. After J.P. Morgan, the U.S. commercial banks with the largest derivatives exposure are Citibank, with $34 trillion, and Bank of America, with $32 trillion, according to the Office of the Comptroller of the Currency.

Of course, counterparty risk didn’t surge overnight. It’s inherent in the derivatives market. But it’s been rising because of the credit crunch, which led market participants to use more derivatives, especially credit default swaps, to protect against potential defaults. The more derivative trades there are, the more counterparty risk exists.

Fears about counterparty risk were crystallized recently when bond insurers ran into problems. MBIA and Ambac, which were large sellers of credit protection through credit default swaps, risked the loss of the triple-A credit ratings they must have to offer such protection until they raised more capital. Industry critics think they need to raise still more capital.

For now, the sale of Bear may have reduced counterparty risk. But with J.P. Morgan inheriting the investment bank’s counterparty exposure and providing a guarantee to all of its trading obligations, what risk remains will become more concentrated.

“It certainly increased the degree of concentration,” said Roger Merritt, a managing director at Fitch Ratings. “J.P. Morgan is one of the dominant players. Bear Stearns was also a dominant player. You’re now combining two dominant players into one. The amount of outstanding transactions is concentrated in fewer hands.”

According to Fitch, concentration among credit derivatives counterparties has been increasing, with the top 10 institutions providing 89% of the total notional amount bought and sold in 2006, for instance, up from 86% at the end of 2005.

The numbers themselves don’t tell the entire story. For example, the Bear Stearns acquisition would expose J.P. Morgan to bond insurer Ambac, which has been struggling to maintain enough capital to secure its triple-A rating, “Ultimately, Ambac expects that J.P. Morgan Chase will assume the liabilities of Bear Stearns under these contracts,” Ambac said in a statement last week following the announcement of the proposed deal.

Indeed, it’s possible that the transaction will prompt increased oversight of the derivative market. While banks already post collateral as security to back their derivative transactions, based on the quality of the counterparty and on the type of transaction, the amount they post is at their discretion. The International Swaps and Derivatives Association, which represents and sets standards for the derivatives industry, merely requires that participants document the amount of collateral in a standardized ISDA agreement.

A May 2007 ISDA study noted that while dealers collateralize most of their inter-dealer credit exposure, the coverage percentage decreased slightly since 2004, when ISDA last conducted a study. Some observers expect bank regulators to demand that ISDA compel collateral and perhaps increase it.

If nothing else, calls from regulators for the industry to improve its transparency and clarify its ambiguous settlement practices are likely to be repeated with more urgency. J.P. Morgan’s deal for Bear has “increased the amount of attention focused on it,” Fitch’s Mr. Merritt observed. Mr. Paulson recently raised the issue, but that was before the deal took place. Now, says Mr. Merritt, “You have fewer players out there.” FW

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