Counterparty Risk in Derivative Transactions: More than Dimon Thinks
At September 30, 2009, JPMorgan Chase was a party to $79.0 trillion in notional value of derivative contracts, against which it had total capital of $1.67 trillion. Table 3 to 9/30/09 Report of Office of Comptroller of the Currency. In his testimony to the Financial Crisis Inquiry Commission, Jamie Dimon devoted a sentence or to two to the risks of derivatives, but said nothing about the past, only proposing to do something in the future. This suggests that he isn’t concerned about JPMorgan’s derivatives. Here are some reasons for concern, and stories about people who didn’t worry enough.
Derivatives include futures, options, forwards, swaps and credit default swaps. Here’s a table showing the total derivatives of the five largest banks and related data:
|Bank||Total Derivatives $Tn||Total Credit Exposure $Bn||Total Risk-based Capital $Bn|
|Bank of America||40.1||198.0||147.0|
Table 4. JPMorgan Chase was a party to $6.36 trillion in notional value of credit default swaps, both as a seller and a buyer of protection. Table 2. According to Depositary Trust & Clearing Corporation, four weeks ago there were a total of $15.15 trillion in notional value of credit default swaps outstanding. DTCC only counts one side, so to make these numbers comparable, you have to double DTCC’s figure. You also have to assume that there has not been a great change in the total outstanding since 9/30. With those assumptions, JPMorgan was a party to 21% of all CDSs. The top five banks together were a party to 40% of all CDSs.
One of the major risks in derivatives is called counter-party risk, the risk that the other party to the contract will not perform. The OCC report does not put a figure on this risk. It uses very rough measures, such as gross positive fair value, which is sometimes shown on financial statements as “derivative receivables”. That is the total of all derivative contracts with a positive value, that is, if the contract terminated, the counterparty would owe money to the bank. Then there is gross negative fair value, “derivative payables”, the total of amount the bank would owe if the contracts terminated. These are the only numbers JPMorgan Chase reported in its recent SEC filing. Derivative receivables were $80.2 billion, down from $162.6 billion a year ago. Derivative payables total $60.1 billion, down from $121.6 billion a year ago.
The OCC doesn’t address bankruptcy of counterparties, as in the case of Lehman Brothers. JPMorgan has 75,000 derivative contracts with Lehman. Paragraph 3, page 2 of bankruptcy pleading viewable here, enter “Lehman Brothers Holding in the box for Debtor and 4325 in box for Docket #.
Let’s see what happened to a couple of derivative holders. Aliant Bank of Birmingham, AL, entered into two interest rate swaps with Lehman, and posted a Fannie Mae security with a face value of $5,250,000 as collateral for its (Aliant’s) obligations. The security was held by JPMorgan as agent for Lehman. Lehman’s bankruptcy was an event of default under both swaps. Aliant demanded payment of the amount due it upon default, and demanded return of its collateral. Lehman refused to pay. JPMorgan refused to deliver the collateral, on the ground that it had set-off rights against Lehman. Aliant sued. Dkt. 1726. The matter eventually settled. Aliant got an unsecured claim of $2.8 million, the value of which is unclear, and transferred the claim to JPMorgan. Aliant must have gotten its collateral back, but it took a year.
Here’s another. In 2002, Lehman created the Dante transactions under which AFLAC bought notes. Under a very complex set of documents, Lehman had first call on money from the venture, and AFLAC had second call. The documents provided that if Lehman filed bankruptcy, it lost its first priority for payment, and AFLAC got first call on the money. When Lehman filed, AFLAC filed suit in England for declaratory judgment that it is entitled to the money. AFLAC won, but the English Judge didn’t deal with the effect of the American bankruptcy.
Then Lehman filed a suit in bankruptcy court for declaratory judgment that the shifting of priority for payment could not be enforced against it under bankruptcy law. Lehman asserts that under the Bankruptcy Code clauses in contracts that become effective only when a bankruptcy is filed are unenforceable. Apparently AFLAC filed a motion to dismiss in the bankruptcy case, which was denied,causing a lot of heartburn for investors in similar deals.
Fannie Mae and Freddie Mac lost millions on derivative transactions with Lehman.There are other lawsuits and losses from counterparty risk as a result of the Lehman bankruptcy.
Maybe Mr. Dimon shouldn’t be so quick to assure us that derivatives are safe at his bank.