For more than nine months, the market has been attempting to sort through the tangled web of counterparty risk that has entrapped Wall Street.

After all, this problem has halted new issuance, slowed trade volume and brought down banking powerhouse Bear Stearns.

Counterparty risk has traditionally been focused on the stability of the fund that is involved in a trade, instead of the participating bank. However, rampant liquidity fears and the breadth of bilateral over-the-counter (OTC) trades on banks' books have made defaults a real possibility for the financial institutions market, sources said.

What is even more alarming, according to market participants, is that derivatives contracts are concentrated in a small number of institutions.

The largest five commercial banks - JPMorgan, Citigroup, Bank of America, HSBC and Wachovia - hold 97% of the total notional amount of derivatives, while the largest 25 banks hold nearly 100%, according to the Office of the Comptroller of the Currency's (OCC) quarterly report on bank trading and derivatives activities issued this month.

The OCC also reported that the net current credit exposure, the primary metric the OCC uses to measure credit risk in derivatives activities, increased $57 billion, or 22%, to $309 billion during 4Q07. The measure is 67% higher than at the end of 2006.

Heightening the widespread fear that the impact of a major counterparty default will be systemic is the colossal size of the market. At the end of 1H07, just the total notional amount of CDS contracts alone was a whopping $45 trillion, according to a market survey from the International Swaps and Derivatives Association (ISDA). The notional amount of total derivative contracts outstanding was approximately $164 trillion as of 4Q07, the OCC said.

If a counterparty defaults, OTC derivatives would be immediately and significantly repriced, with credit spreads likely widening dramatically, Barclays Capital said in a report issued earlier this year.

For example, a failure of a major counterparty that had $2 trillion outstanding in OTC credit derivatives might trigger losses of $36 billion to $47 billion in the financial system solely because of the immediate repricing of credit risk, Barclays said. The bank noted that these losses would be realized by investors who had exposure to the defaulting counterparty. But in addition to these losses, there could also be large, potentially concentrated, mark-to-market losses even for those investors without exposure to the defaulting counterparty, because of the repricing of risk.

Eyes On The Broker

The investment banking firms with strong prime brokerage businesses, like Bear Stearns and Lehman Brothers, are not the most heavily concentrated derivatives dealers but they increasingly come under fire for counterparty risk.

These investment banks have seen how margin calls can wipe out an entire firm because of investors' liquidity concerns. "All of the broker/dealers essentially have a gun to their head every day because, if there is ever any doubt about their financial insolvency, there is going to be a run just like at Bear Stearns," said Christopher Whalen, managing director of Institutional Risk Analytics (IRA), noting that customers will seek out the larger universal banks that have a direct relationship with the Federal Reserve. "The broker/dealers don't have a level playing field," he said.

However, larger commercial banks are not immune to counterparty troubles either, especially since banks have increasingly served as counterparties to each other. JPMorgan, for instance, is the largest derivatives player with approximately $85 trillion in the total notional amount of derivative contracts at the end of 2007, according to the OCC. This sum includes both exchange and OTC trades.

"Before the crunch, people were less concerned about their interbank counterparty exposures than their buy-side exposures," said Mark Beeston, president of T-Zero. "Now they want to be certain of all of these exposures in a timely way and to a level we hadn't seen before." Beeston noted that, in the past, if a bank wanted to step into a trade and a fund wanted to step out, it would not have been a problem given the market preference for exposure to an established investment bank rather than a fund. "I think that assumption has been dramatically challenged by the events of the last month to six weeks."

Whalen proposed that this exposure was the reason why JPMorgan was forced to buy Bear Stearns.

"The risk from the clearing house and the exchanges has been shifted to larger commercial banks like JPMorgan," Whalen said. "JPMorgan is now an exchange. You have all of these bilateral trades that flow through JPMorgan's books; they were the clearing-house for Bear. Bear was not a broker/dealer but rather a customer, and if [Bear] had gone down, all of these bilateral trades would have ended up in front of a bankruptcy judge."

However, other market participants were not certain that the banks were as tightly connected as Whalen had described. Others agreed, however, that JPMorgan's leading position in the derivatives market would have injured the company if Bear had been left to fail. JPMorgan did not return calls for comment by press time.

While most commercial banks are fortunate to have half of their liabilities come from core deposits, IRA's Whalen said, there are still banks like JPMorgan and Citigroup, among several others, that have less than 50% in core deposits and are dependent on securitization via these OTC instruments to manage their liabilities. "That is now gone. Banks have absolutely no flexibility in terms of asset/liability management," he said. Exacerbating this issue, commercial banks reported credit trading losses of $11.8 billion in 4Q07, versus losses of $2.7 billion in Q307, according to the OCC report.

Yet, despite vocal concerns over the possibility of further margin calls and deteriorating balance sheets, not all market participants are convinced there is enough attention being paid to the potential impact of counterparty risk.

Since JPMorgan and the Fed rushed to bail out Bear Stearns instead of letting the bank fail, the market has not been able to work through a situation of this magnitude, sources said. "If participants in credit derivatives transactions had suffered material losses because of Bear's demise as a counterparty on swaps that these institutions were party to, I think there would be a major rethinking going on of how to manage counterparty risk. And I just don't think there is right now," said Mark Adelson, a partner at Adelson & Jacob Consulting.

While government intervention may stave off liquidity troubles at banks, it may turn out to be a double-edged sword with respect to termination events in master agreements. In a master agreement between a bank and a pension plan, for example, the application by the plan for a minimum funding waiver, if the pension were concerned it would not meet its minimum fund requirement, should give the bank the right to terminate the trade, said Sherri Venokur, member of the firm Lowenstein Sandler. "The mere fact that they are applying for a waiver is a red light that there could be a problem," she said.

However, now that the Fed has given the investment banks access to its discount window, then the window's use could be an additional termination event, she said, if it is used as an emergency measure. "It is like kicking the guy when he is down. Once there is a sign of trouble, the counterparties get greater rights and that can cause more trouble."

The Other Side of the Trade

The degree of risk for bank trade counterparties varies by fund. While most bank trades with hedge funds are collateralized, with smaller funds and sometimes even with bigger ones, banks frequently go out to the funds with a one-way pledge agreement meaning that no matter how the market moves, the bank will never pledge collateral to the fund.

"This puts them at greater risk since they are not holding any bank collateral," Venokur said, noting that funds with one-way pledge agreements might have assumed this was just standard. "Banks put a lot of these agreements in a format that makes it look like a standard form that is not subject to negotiation. But [funds] should realize that every document can be negotiated no matter what font it is in."

Negotiation and attention to detail is a key in assuring adequate protection in a trade. "People who have not put a lot of attention and care into these documents are going to get burned," Venokur said.

However, ISDA maintains that its efforts to ensure that the basis on which all derivatives trades are done has produced a legally binding and smooth process in the event of a counterparty failure, which would mitigate the risk. These options include netting out (settling a trade on a net basis), as well as closing out a trade in the event of default or posting collateral for a trade.

"The firm has legal opinions in the enforceability of collateral arrangements in a wide range of jurisdictions, as we do for netting opinions in a wide range of jurisdictions," an ISDA spokeswoman said. "That gives [a party] the certainty that if they have done the trade with a counterparty in one of these jurisdictions, the counterparty will be subject by law to close out [the trade]," she added.

There are a number of banks that have become more conservative over the years, meaning that they are willing to pledge dollar for dollar and they want the counterparty to pledge dollar for dollar as well, Venokur noted. "There are a number of well-heeled financial institutions that want to take a conservative view and will frequently do that," she said. One example of these institutions is Goldman Sachs.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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