Most were specialising in mortgages or over exposed to them. The listing of 'imploded' firms includes bankruptcy filing, temporary but open-ended halting of operations, or a "fire sale" of the firm. They include retail, wholesale, subsidiaries and entire companies.
With the massive downturn in the economy and slow recovery, banks needing to restructure their balance sheets are reluctant to lend, and are applying stricter credit conditions, probably until real growth and inflation both look persistent.
The high leverage of credit derivatives make them more fragile than ordinary funds
Goldman Sachs and Morgan Stanley each suffered at least 10 days of trading losses in the second quarter, underlining how turbulent markets have cast a pall on Wall Street since April, the FT reports. On three occasions, Goldman’s traders posted shortfalls of at least $100m, while Morgan Stanley’s traders reported losses of between $50m and $75m twice, but never lost more than $75m on any one day. These daily losses are subsumed within monthly profits, so that the actual gross losses and profits are unknown. We can see some losses as reported by US commercial banks in the past.
GS and MS are among banks responsible for unreported risk, among 5 banks that failed to report hundreds of $billions of dollars in credit derivatives bought from foreign counter-parties in 2009, leaving those exposures below the radar of regulators in the US and Europe. The under-reported exposures to credit default swaps came to light as the US Federal Reserve and the Bank for International Settlements were preparing first-quarter reports of the industry’s lending and risk activities. It was revealed as a footnote to the BIS report’s lengthy tables (June 2010). “This underscores how little transparency there was and how much information was missing,” said one BIS official familiar with the report. The missing data concerns financial institutions that were hastily granted bank holding company status in 2008 as safe harbour action in the middle of the Credit Crunch - essentially so that the investment banks now registered as deposit-taking could resort to the Federal Reserve's liquidity window for short term financing as wholesale market liquidity evaporated. 
The failure in reporting underlines how the conversion to Fed-regulated banks also introduced those firms suddenly to a raft of complex bank reporting standards, and raises new questions on the lack of scrutiny they faced under previous regulators (the SEC). The Fed, following a review of its quarterly report on cross-border risks, discovered that the group, which included Goldman Sachs, Morgan Stanley, American Express and CIT, only submitted claims on credit derivatives up to the amount where there was a corresponding position to hedge against. The additional risks, which totalled $400bn in the first quarter, were left out.
When in its recent quarterly return we see that GS earned 35% of its profits from derivatives, it is more than clear that hedging is only part of the reason for derivatives exposure and places question marks over how banks have netted their derivatives exposures to minimise capital reserve requirements, quite apart from the 'deouble-default' risk in a systemic crisis, which is shown up by the case described below of AIG.
BIS has pushed for transparency in the derivatives market, particularly that for instruments such as CDSs that are traded over the counter. Robert Rubin and Alan Greenspan successfully stopped credit derivatives from being subject to exchange clearing in 2000, soon after they had supported repeal of Glass-Steagal - two decisions that should have returned long before now to haunt them.
In a speech, Stephen Cecchetti, head of the monetary and economic department of the BIS, noted the events that threatened the world’s financial system in 2008 stemmed largely from the lack of knowledge about each bank’s risks. The Fed concluded the failure to report the derivatives positions stemmed from a lack of familiarity with requirements rather than any intentional move to withhold details.
Regulators plan now to update their 2009 cross-border risk reports to add the banks’ missing data.
Lehman Brothers books are taking years to net, recover and pay off, involving subsidiaries of Lehmans in many jurisdictions. But, at least the counterparties cannot sue on underwriting claims. By contrast, AIG's trading partners may force the now state-owned insurer to pay up for insured losses on corporate loans and mortgages for years, even decades, to come, complicating U.S. efforts to stabilize the firm.European banks including Societe Generale SA and BNP Paribas SA hold almost $200bn in guarantees sold by AIG allowing the lenders to reduce the regulatory capital reserves against write-downs and for loan-loss provisions.
The firms may keep the contracts to hedge against declining assets rather than canceling them as AIG said it expects banks to do (according to David Havens, MD of Hexagon Securities LLC). He said, “For counterparties to voluntarily terminate those contracts makes no sense. There’s no question that asset values have soured on a global basis. With the faith and credit of the U.S. government backing those guarantees, why would they give that up?”The falling value of holdings backed by the swaps may force AIG to post more collateral, stressing the insurer’s liquidity and credit ratings in ways that caused the firm’s collapse in Sept.'08, when AIG needed a U.S. bailout valued at $182.5bn after handing over collateral on a different book of swaps backing U.S. subprime mortgages.
As can be seen by the graphs derivatives contracts tend to be short term. The maturities for which AIG issued security guarantees appears absurd; how can the risks be quantified? God contracts for example shot up in the last couple of years in anticipation of fiscal uncertainties or anxieties. But this is trading on subjective or emotional or kneejerk opinion.
The average weighted term of the European swaps protection of residential loans is more than 25 years, and for corporate loans about 6 years (AIG regulatory filing). Contracts covering corporate loans in the Netherlands extend almost 45 years, and the swaps on mortgages in Denmark, France and Germany mature in more than 30 years.The portfolio shrank by half in 15 months to $192.6bn by March 31.
AIG’s models show banks will abandon more contracts. It expects the banks to cancel “the vast majority” of contracts in the next year as regulatory changes reduce the benefits of the derivatives for lenders.
Last month, AIG said in a regulatory filing that it may be at risk for losses for “significantly longer than anticipated” if the banks don’t terminate their swaps. “Given the size of the credit exposure, a decline in the fair value of this portfolio could have a material adverse effect on AIG’s consolidated results”(AIG June filing).The SEC asked for AIG to add the disclosure to the insurer’s “risk factors”.
RBS Group Plc, Banco Santander SA, Danske Bank A/S, Rabobank Group NV and Credit Agricole SA’s Calyon are also among banks that purchased the swaps. The banks could be forced to raise $10bn in capital if AIG fails (AIG June filing).
Santander said (to Bloomberg) through a spokesperson that the bank’s risk of an AIG failure is insignificant and fully collateralised. Calyon declined to comment (to Bloomberg). Representatives of the other lenders didn’t immediately return messages seeking comment.
Counterparties terminated or allowed to expire $27.8bn in the so-called regulatory relief swaps in the first quarter, and AIG got notice for another $16.6bn terminated in April. Some of the remaining swaps have suffered losses for which AIG posted $1.2bn in collateral as of the first quarter. Bloomberg reported, “You’ll have an increasingly toxic pool of credit-default swaps every quarter” as the least risky swaps are terminated, said Donn Vickrey, analyst at research firm Gradient Analytics Inc. “Swaps that are being held are done so for two reasons, either for regulatory relief or because they’re ‘in the money’” which means they are valuable hedges against asset declines.Some of the swaps are no longer being held for regulatory relief, and AIG has reclassified $3bn in swaps through March 31 likely to be kept after regulatory benefits expire, with $393m liability against those swaps.
Gerry Pasciucco, hired by AIG in November to clean up the Financial Products unit that sold the swaps, said in an interview in December that the European swaps would mature over time without loss and faced very little risk. Pasciucco said in April that future losses will be limited. The $192.6bn figure for the swaps includes $99.4bn tied to corporate loans and $90.2bn linked to prime residential mortgages.
The analysts' view is that the size of the portfolio and the ‘black box’ nature of its underlying loans and assets mean that mark-downs in the regulatory CDS portfolio may prompt collateral margin calls that pressure AIG’s liquidity.
The US government’s rescue includes a $60bn credit line, $52.5bn to buy mortgage-linked assets owned or insured by the company, and investment of $70bn. AIG plans to reduce its debt under the credit line by $25bn by handing over stakes in two non-U.S. life insurance units. AIG has tapped about $43bn from the line as of July 15 '10.
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