Why collateral fails to protect protection buyers

Felix Salmon claims:  “Today, there isn’t a company in the world — not even Berkshire Hathaway — which can write CDS protection without having to put up collateral.”  Felix goes on to imagine a perfect world in which regular margin calls guarantee that CDS are fully collateralized and there is no risk of failure to pay.

Unfortunately the value of CDS contracts tends to move very suddenly and it is precisely when counterparties issue large margin calls that firms like Lehman and AIG are forced to declare bankruptcy.  Collateral posting regimes may work with commodities and interest rate swaps where price movements are far less volatile than CDS, but there are many reasons to be concerned about the success of collateral posting in offsetting the risks of CDS contracts.

The OCC derivatives report has data on the fair value of derivatives from bank call reports (Table 6).  The data does not include derivatives held by investment banks at the holding company level.  It also increases by over $2 trillion in December 2008 due to the movement by Goldman Sachs of many derivatives into the Goldman Sachs bank.  On the other hand it illustrates how much the fair value of credit derivatives can change from one quarter to the next.

The chart below illustrates the sum of the gross positive and gross negative fair value of credit derivatives (red) and of other derivatives (blue) held by banks (that are subject to call reporting).

The fact that the fair value of credit derivative contracts jumped from $186 billion in March 2007 to $1 trillion in March 2008 to $2.2 trillion in December 2008 should be a matter of concern to everybody.  (Note:  GS accounts for $276 billion of the December 2008 figure.)  Can we really be confident that margining requirements will (i) be sufficient to protect protection buyers and (ii) not have the effect of pushing some protection sellers into bankruptcy?

Addendum: Another problem with trillion dollar changes in collateral needs is that to broker-dealers only accept cash collateral (and more rarely Treasuries).  In Q4 2008, it is hard to imagine that collateral could have been met without extraordinary aid from the central banks — which (i) relaxed rules for commercial banks prohibiting them from financing the brokerage assets of affiliates, (ii) lent vast quantities of cash against brokerage assets and (iii) dropped interest rates to zero making it easy to finance the costs of cash collateral.  I certainly hope that in the next credit crisis, the broker dealers aren’t relying on similar policies to facilitate their need to post collateral.


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