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The Market Values Of Swaps Portfolios Are Easily Described. But They Show Bank Dealers Are Vulnerable

Every dealer bank could provide investors with maximum, minimum, and expected derivatives portfolio values.

But the risks associated with these values are too large.

To reduce these risks banks gained exemption from stays in bankruptcy.

The regulators are rightly concerned that this derivatives exemption will devastate other claim-holders, permanently increasing the banks’ costs of funds after a big fail.

Regulators are prepared to prevent this.

So, Are You Experienced?"

-- Jimi Hendrix

A very simple way to explain swaps positions to investors.

In earlier articles describing swaps, in particular interest rate swaps, by far the largest kind of swap by volume of transactions, I have argued that the confusing information that banks provide on quarterly reports could be summarized by two simple numbers:

  1. Credit provided to swap counterparties.
  2. Credit received from swap counterparties.

These two values simultaneously tell the bank's investors:

  1. the value of the bank's maximum obligation under current market prices (credit received),
  2. the value of the bank's maximum receipt under market prices (credit provided), and
  3. the current market value of the bank's swaps (credit provided less credit received).

None of these three values is remotely calculable from the existing reported information. Yet they seem important. And the banks calculate these values internally to determine how much money they are making.

Why don't the banks provide this swaps balance sheet?

The four dealer banks, Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and JPN Morgan Chase (NYSE:JPM), know the market value of their swaps portfolios. The problem they have is in providing the portfolio's value they real the portfolio's risks.

There are many issues that the banks would be expected to address once credit extended and used were a matter of public record.

  1. What is thr credit risk?
  2. What factors trigger failure?
  3. What is the effect of swaps on credit quality of the bank's other liabilities?
  4. What effect does swaps collateral have on the bank and its counterparties?

This is a discussion no one "experienced" wants to have. Not the banks; not the OTC Clearing Houses; not the bank and OTC exchange regulators, not the lawyers and accountants, and not bank supporters in Congress.

The calculations involved in getting useful information about swaps are so simple that we can make a few assumptions and come up with an idea of the magnitude of credit exposure for a typical dealer bank and that for LCH:Clearnet right here.

What is the OTC interest rate swaps exposure of a typical bank?

The average tenor of the interest rate swaps in the bank dealer portfolios and at LCH:Clearnet is about 5 years, so I will use that tenor to estimate the dealer's exposure.

Based on the chart below, borrowed from my last article on this subject, I come up with an average five year fixed-side swap rate of 1.5%, for the entire portfolio.

Then using the difference between the nearby (June '16) Eurodollar futures and the contract month 5 years out (March '21) to get the maximum payment and the maximum receipt (March '21, was trading at 98.13; June...


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