Is The Fed Facing Margin Calls From European Banks?

Marla Singer's picture

by Marla Singer and Geoffrey Batt

Buried in the depths of page 26 of the Office of the Special Inspector General for the Troubled Asset Relief Program's (SIGTARP's) November 17, 2009 report "Factors Affecting Efforts to Limit Payments to AIG Counterparties" hidden in footnotes 33 and 34 is something of a mystery.  It might be the beginning of an interconnected financial chain involving Dubai, the Federal Reserve, AIG, Basel I, Eastern Europe and even Switzerland and which, even if it doesn't worry you, probably should.  Or it might be nothing at all.

Consider first "footnote 33," that reads as follows:

The first Basel Accord, known as Basel I, was issued in 1988; it focused on the capital adequacy of financial institutions. The capital adequacy risk—the risk that a financial institution will be hurt by an unexpected loss—categorizes the assets of financial institution into five risk categories (0 percent, 10 percent, 20 percent, 50 percent, and 100 percent). Banks that operate internationally are required to have a risk weight of 8 percent or less....

The original paragraph that references the footnote reads thus:

As of September 30, 2009, AIG had $172 billion in exposure to swaps in its foreign regulatory capital portfolio.  The portfolio contains swaps purchased by financial institutions, principally in Europe, to provide regulatory capital relief under Basel I. [note 33]  AIGFP’s COO informed SIGTARP in July 2009 that they expect that most of these swaps will be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II.  Currently, financial institutions are required to hold a certain level of capital against their assets, and one way for a financial institution to reduce the amount of capital is to purchase swap protection on its assets.  However, new requirements decrease the level of capital required for such assets and, in most cases, there will be limited capital benefit to holding on to the existing swaps. Nonetheless, AIG warned in a June 29, 2009, SEC filing that if credit markets deteriorate, the company may recognize unrealized losses in AIGFP’s regulatory capital credit default swap portfolio. [note 34]  AIG could continue to be at risk if the swaps in its regulatory capital portfolio are not terminated by the end of first quarter 2010 as expected. (Emphasis added).

Taken together we read the thrust of this section to mean that a number of European banks, seeking to limit their regulatory capital requirements under Basel I (read: seeking to increase their leverage) bought swap protection on their assets from AIG.  These obligations still sit with AIG and, in the event credit markets sink materially, AIG is likely to take losses on these instruments.  Not just that but:

According to an AIG SEC filing, an ongoing concern for AIGFP is whether it will have to post more collateral if credit markets continue to deteriorate.  The amount of future collateral postings is partly a function of AIG’s credit ratings, which may be affected by any further decline in AIG’s financial condition. (Emphasis added).

Simply put, AIG might also have to post more collateral.  Moreover, though AIG initially expected most of these swaps to "be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II," we see from footnote 34 that:

Subsequent to the June filing, European regulators adjusted the implementation timing of Basel II, potentially affecting the holders of AIGFP’s regulatory capital swaps to hold beyond previously anticipated termination dates.

In other words, AIG is still on the hook- and hadn't planned to be.

This raises a number of questions:

  1. If the European banks that bought swap protection from AIG are still relying on this protection to meet their capital requirements, and AIG might be unable to make good on the agreements, are these banks actually out of Basel I compliance as we type this?
  2. Are the banks still able to use swap protection to reduce their collateral requirements because of the implicit or explicit backing of AIG by the Federal Reserve?
  3. If this situation existed in September-November 2008, as it certainly appears to have, how exactly can the Federal Reserve claim in good faith that it lacked the leverage to negotiate with these banks from a position of strength?  (One assumes that many of the same names collecting payment from AIG were also AIG swap protection buyers of the sort mentioned in the SIGTARP report).  Failure to back up an insolvent AIG would have resulted in near-immediate Basel I non-compliance as the protection offered by these swaps, and on which these banks depended for their reduced capital requirements, evaporated- a near death sentence.
  4. Or had these banks somehow, and in the middle of the credit crisis, managed to boost their capital to levels that made the swaps unimportant?
  5. If so, why keep them on the books now, instead of unwinding them?
  6. Since it doesn't seem likely that a teetering AIG could make good on these agreements without substantial assistance is the Fed is currently the ultimate backstop for AIG?
  7. Does this mean that the Fed is effectively underwriting these swap agreements?
  8. Will the Fed post collateral if deteriorating credit conditions at AIG (today's -$11 billion news suddenly seems especially daunting if the potential insurance shortfall has an effect on credit ratings) or general credit market issues require it?  Or are we missing something significant?  By September 30, 2008 AIG had already posted $974 million in collateral for its "Foreign Regulatory Capital" portfolio.
  9. What if European banks are hit with more losses from, oh, we don't know, say... Dubai?  Deleveraging, risk reduction and credit tightening would have an effect on LIBOR, the Eurobond market and, of course, Eastern Europe.  Might not that sort of contagion easily spread to, say, Switzerland, which enjoyed the other side of the carry trade for years by lending Swiss Franc like mad to any Eastern European mortgage borrower who could sign documents?
  10. Could it be that the Fed, once again, might have to bail out the world?

Or maybe we are just missing something obvious.

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JohnKing's picture

Round up the usual suspect.

Gwynplaine's picture
Gwynplaine (not verified) JohnKing Dec 1, 2009 7:11 PM

Another good line applies from the same movie (same character actually):

"I'm shocked, shocked to find gambling going on in here!"

- Julius J. and Philip G. Epstein, "Casablanca"

Quackking's picture

Res ipsa loquitur. The thing speaks for itself.


Jail 'em.


SWRichmond's picture

Excellent info of the kind I look for; Vielen Dank, Fraulein Singer.

  • Are the banks still able to use swap protection to reduce their collateral requirements because of the implicit or explicit backing of AIG by the Federal Reserve?  It certainly seems that way.
  • If this situation existed in September-November 2008, as it certainly appears to have, how exactly can the Federal Reserve claim in good faith that it lacked the leverage to negotiate with these banks from a position of strength? They lied their fucking asses off, like a teenager who stayed out too late drinking and having sex.
  • Does this mean that the Fed is effectively underwriting these swap agreements?  It would certainly seem that way.
  • Will the Fed post collateral if deteriorating credit conditions at AIG or general credit market issues require it?  Nah, the Fed will hire AIGFP to manage a new program and pay them $Billions to do it.
  • Could it be that the Fed, once again, might have to bail out the world?  That'll be right after they test the triparty liquidity drain thingy.
Anonymous's picture

Good points, however i'd like to hear more about the teens getting drunk and having sex.

just.a.guy's picture

Interesting!  A few questions:

A.  Is the $172 Billion in exposure cited the maximum possible loss or a best guess estimate at the time of the report?

B.  The 8% Basel I requirement appears to be something other than what we'd normally think of as "Tier 1 capital" -- How does that 8% risk requirement correlate in rough terms to leverage ratio?

C.  Of the biggest banks in regulatory compliance thanks to the swaps with AIG, how compliant are they?  That is, how far above the Basel I requirement (the 8% or Tier 1 equivalent) are they?

D.  How far below compliance would they be if AIG defaulted on its exposure when called upon to make good on their commitments?

...but the upshot of this does appear to be, as Marla says, that the US taxpayer is implicitly guaranteeing a pile of European banks.

SWRichmond's picture

It'll be a gas to see how the Fed posts collateral for AIGFP.  What'll they name it?  Maiden Lane 26?

Marla Singer's picture

Assuming buying swaps on your assets dumps them from the 100% level down to the 50% mark for the purposes of capitalization requirements, that implies that if you lost all the benefits of the swaps you'd see capital requirements pop by 50% of the total notional amounts of the swaps or that bank would be undercapitalized by about $86 billion without them.

There are a lot of assumptions in there.  I really don't know off hand what the exact impact of swaps is, or what kind of capital requirements were already on those assets.  Obviously, if the swaps are dropping assets from the 100% to the 0% capitalization requirement mark (I doubt this) then you would see banks scrambling to raise something like $172 billion in capital to make up the difference.

just.a.guy's picture

Thanks for the response.  From what you wrote, it sounds like the notional exposure to AIG would max out at $172 Billion, which would be the maximum hole that would be covered in the capital ratios (were the swaps turning 100% exposures into 0%).  So if I read you correctly, it sounds like it's likely a potential balance sheet hole of somewhere between $86B - $172B.  I suppose the question is how thin the ice is under those bank balance sheets at present...

Another thing:  I'm not experienced with these types of contracts, but it sounds like the European banks have the option to extend them?  I wonder if AIG has the option to terminate them as well?

It would surprise me if the banks would enter a contract like this for a much longer time period than the previously believed implementation date of the lighter Basel II requirements.

And if AIG has an out at some point soon, the flip side of this is that there could be a lot of unhedged European banks looking for a counterparty (or to raise capital) in the not too distant future?

Thanks for what is a very interesting story.

Hephasteus's picture

Ya but just think of how abusive you could get with this if this is their reality construction. You take a group of 5 credit worthy people and let them co-sign their way to owning something really big.

Anonymous's picture

Then you call the boys from Robert's Lounge Crew (aka GS) to bust it out!

cougar_w's picture

Tish-tosh. Just print more dollars.

Any child who can count to 10 on their fingers can manage a monetary crisis these days.


AN0NYM0US's picture

Interesting as I believe that whatever the next big thing is (opportunity to go short or long) it's already out there hidden in plain view  as the lyrics go "And I know, I should have known" - sort of like back in March when Barney and Sheila arranged the $500bn line for the FDIC just a few days in advance of Timmay's big plan

Anonymous's picture

Basil, Schmaesil, who cares about rules while there's still so many virgins to be raped?

Anonymous's picture

Sir, civilized societies rape their virgins in an orderly manner.

See Junila under:

So while you may jest, human history well shows that laws are used to justify anything in stressful times. Especially when you have criminals handling the finances and laws.

tip e. canoe's picture


boy those brits can play good romans can't they?

Careless Whisper's picture

The bad news is always found in the footnotes. Seems like you're on to something here. At least we know the next problem won't exceed $172 Billion.

Anonymous's picture

Oh good lord.

And what, pray tell, was supposed to make the swaps go away by end of first quarter 2010?

I'm beginning to sense uneasily the word DEFAULT is becoming very prominent in my own subconscious when considering the US Financial situation.


Marla Singer's picture

"AIGFP’s COO informed SIGTARP in July 2009 that they expect that most of these swaps will be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II."

There's your answer.

Ned Zeppelin's picture

Speaking as a business attorney, I am duty bound to point out that the term "expect" precedes every smugly well-crafted lie. If it is the case, you simply say it will be, not that you "expect" that it will be.  "Expect" means a lot of things: I hope, I dream, I can posit, I yearn, I wish, but it does not mean "I am certain. . . "

Rollerball's picture

Regardless whether taxpayer money is imminently at risk (or latently), we should be FOIA'ing these contracts since they represent substantive systematic risk to national security.  Sheila Blair Witch project best roll out the Ouija board.

tip e. canoe's picture

the spirits say F - U - B - A - R

WaterWings's picture

It'll be the Turbo Timmay version of Basel II. So, nothing will really change. Tell the FDIC they're gonna have to respect da law. Haha! Good one!

Nothing changes until fractional reserve banking is outlawed. 

The private control of credit is the modern form of slavery.

Upton Sinclair (1878-1968)

Anonymous's picture

Don't worry. We're too big to fail.

Hephasteus's picture

Ya the titanic never sank. It's just a fairy tale to cover up the inadequcies and impotence of frozen water.

JacksWastedLife's picture

Danke for Titanic analogy! =)

johngaltfla's picture

Marla, it is fascinating that you found this just as Ambrose posted this in the afternoon in the UK Telegraph:


Morgan Stanley fears UK sovereign debt crisis in 2010

(link: )

Coincidence? I think not. Excellent work Marla that is some hardcore reporting we'll never hear about on CNBC.


After all Krudlow's first story is that important financial crisis happening in the Tiger Woods' household.

Lionhead's picture

This needs to be forwarded to the Senators questioning Bernanke at the reconfirmation hearing. Excellent work!

Jestocost's picture

but I thought everyone here knew the AIG TARP bailout was to protect certain European (and American) banks???

cougar_w's picture

Everyone does know.

But it wasn't enough help, apparently. So this can go on and on, looks like. Is BB ready to wire another $200B to European banks? Will we have to raise the US debt ceiling twice this year?

At some point it degenerates into a parody of itself. Such is the state of global macroeconomic policy.


tip e. canoe's picture

speaking of the debt ceiling, the water's reaching oh so close to the top:

wonder if timmy is feeling like john cusack at the end of 2012 right now?

MonkeyMan's picture

By my reckoning, that would give just under 3 weeks until it ticks over the limit. Just in time for Christmas! Perfect timing I think - you can always use a further 10 Trillion dollars or so during the holidays...

Anonymous's picture

Could someone explain what all this means in plain english. I have a Masters in Molecular Biology and I still can't understand this stuff....

deadhead's picture

it's like when one of those biological critters that you study (say, a virus) mutates on its own and becomes an e-bola type of thing.  at first it hits a few people in,say, the middle of Africa but then the little critter starts spreading to other places....then, the shit hits the fan because a few people knew about it but decided to either cover it up or outright lie about it.



msjimmied's picture

That's what I love about ZH, the thoughtful humor..deadhead, you are the absolute gentleman.

JacksWastedLife's picture

*the shit hits the fan because a few people knew about it but decided to either cover it up or outright lie about it.* - that is a correct explanation but previous two sentences are nonsense. =)

mikla's picture

As a biologist, you can understand complicated systems with hard-to-quantify inputs.  You're absolutely qualified to understand this stuff (you merely require some terminology background, which comes with time).

The "Basel Accord" (Basel I) was an international agreement to decide how to settle transactions across international boundaries by international banks.  Among other things, it "caps" leverage at 12:1, or requires 8% capitalization.  It was deemed greater than 12:1 leverage (less than 8% capitalization) would jeopardize an institution's viability, and a bank with less than 8% capitalization would thus not be trusted to clear transactions as agreed.

Because of the promise of greater returns in the past few decades, banks wanted to lever-up beyond 12:1 ... no problem!  All you needed to do was purchase insurance against your default, and VOILA!  You didn't even need to keep 8% capitalization ... because the insurance you just bought would pay out in case you, as a bank, failed.  The accounting morons called this "insurance" as the same thing as the minimum 8% capitalization.  Accountants were morons because insurance is only as good as the ability of the underwriter to pay the claim.  Silly accountants didn't seem to understand that insurance companies often didn't maintain *ANY* reserves against credit default swaps like these (um ... infinite leverage?)  It was a house-of-cards just begging for a light breeze for an excuse to come down.

AIG was a big seller of this insurance.

Fast-forward to today.  European banks are levered up at 30:1, 40:1, 80:1, and over 100:1.  While the US banks are screwed at that level too, European banks are screwed FAR worse (even less reserve requirements, smaller GDPs, etc.)  Iceland anyone?

Now, banks are starting to teeter-on-the-edge, and the counter-parties are getting nervous they won't be paid.  Everyone knows leverage is FAR beyond the 12:1 international agreement (for all the international banks).  Counter-parties are starting to lean on AIG to kick in the cash to cover the minimum 8% capitalization (e.g., "margin call").

They are so screwed.  The money does not exist, will never exist, and there is no scenario by which it will ever exist.  For various reasons, you can't even print this amount of money (though central banks everywhere will try).

Since AIG is already insolvent, and it's the back-stop to so many European banks that are insolvant, the domino of failures assumes the "daddy-of-them-all" (the US Fed) will just cut checks for everybody.  Uh, they may try, but it can't happen.

It's all going to blow.  What people don't understand is that it's *already failed*.  The only difference is that through fraud, obfuscation, and rampant central bank interference, price discovery is hindered and the accountants haven't done their *&@#! job yet.

I'm a biologist too.  We biologists need to stick together.


andrew123's picture

Thanks for the explanation.  I am a little confused as to why you are certain the Fed can't provide more money.  Also, is there any way to tell which European banks are most at risk?

Anonymous's picture

They'd have to provide $640 Trillion. Sure, they could do that, but gas would be at about $1 Million per gallon. And you wouldn't be getting a raise for a while. Assuming that you had a job.

Burnbright's picture

Yay! I am not the only biologist here! Well the Fed actually can provide more liquidity, personally I enjoy how they call it liquidity rather than inflation or expanding the money supply at least. I think what our previous biology friend was talking about though is that the Fed, if it were to create even further liquidity would guarantee a hyperinflationary event, if that hasn't already been done.

It is really just a matter of how stupid you think Ben Bernake is, or if you believe BB is doing this all on purpose i.e. problem reaction solution toward pushing global governance and one world currency.

Personally I have no idea what BB's reasons could possibly be, however I do believe he will provide more liquidity. He hasn't let any institution fail yet and I am willing to bet he never will.


Josey Wales's picture

I also have a MS in Molecular Biology and I began to switch my investments to metals when I started researching the markets.  What I saw were money growth, derivatives outstanding, Treasury debt, and all other concievable metrics of liquidity going parabolic.  Parabolic rates of growth end with a crash and return to equilibrium.  Complex systems all behave the same way, I doubt these guys running the show ever took a class in biology.

Anonymous's picture

mikla - thanks a ton for the explanation (I'm a lowly Aerospace Engineer who has never understood the Basel I & II thingys). But I'd love to have an elaboration of your comment: "For various reasons, you can't even print this amount of money (though central banks everywhere will try)."

I don't understand why. When the Fed makes new money, there are all types of methods to do it, from having their primary dealer friends buy Treasuries that the Fed buys back in a week, to selling them to unnamed parties that routinely oversubscribe auctions, etc etc. But the last step always involved someone's finger pushing a button on a computer and money coming into existence in some Fed check register.

As far as I can see, all the hoopla about Treasury issuance is little more than a carny's trick of distraction. Make people believe that the only way money comes into the world is through convoluted processes, and maybe they'll overlook the fact that all of it in the end boils down to using a printer or computer. Ask R. Mugabe about the utter lack of difficulty of bringing quadrillions of new money into being.

The banks (central and otherwise) have been playing a game of kick-the-can all along. I don't understand how their game is up until the common people get involved and reject fiat; it is in the interest of all of the fakers to just keep on faking, and as long as we keep treating their money seriously, then they will remain on top.

Again, thanks for your post.

mikla's picture

But I'd love to have an elaboration of your comment: "For various reasons, you can't even print this amount of money (though central banks everywhere will try)."

Short version:  It's complicated, but it's similar to the current argument of "inflation or deflation?"  Smart people can disagree (there are legitimate arguments on both sides), but in the short term, at least one of them will be wrong.

I'm in the camp believing in short-term deflation, followed by hyper-inflationary sovereign default (worldwide).

In short:  Central banks will inflate when that's to their advantage, and deflate when that's to their advantage.  They are currently attempting to inflate (at absolutely astounding rates) with some level of success (but not great success).

I assert that this is temporary because you can only "inflate your balance sheet" as long as you can service your debt.  The US Treasury can borrow infinite money as long as they pay 0% interest.  However, after borrowing infinite money, as soon as the interest rate goes to 1% (which it eventually will), then your "monthly minimum payment" on your credit card becomes more money than your GDP that month.  In that case, you're screwed (you can't pay your monthly minimum, and everything stops immediately -- ala Iceland).

But, what if I just print that money?  The current system doesn't work that way:  The US Treasury issues a bond, which must pay interest, to trigger the "manufacture" of more money.  The US Government *cannot* print more money without putting the US taxpayer on the hook -- hence the debt service issue.  So, the US Treasury can't create more money for "free".

But, the Fed can just print more money for "free"?  Yes, they can, but they can't give it to the US Treasury without the US Treasury issuing a bond (again, putting the US taxpayer on the hook, triggering the debt service issue).  The problem is that the Fed can't just pay the US Treasury's bills directly (although they are trying, by buying all the US Treasury auctions in 2009).

Further, even though the Fed is trying to de-value dollars as much as it can today (indeed, most central banks are trying to de-value their currencies), it realizes that currently, people will actually *use* dollars for stuff.  There's a point at which people will just call "bullsh*t", and not take dollars anymore.  The Fed knows this -- and the Fed won't let that happen (they will have just killed themselves, because they have no purpose in life except to control the monopoly called the "dollar").  So, while the Fed buys everything in the US Treasury auctions, even knowing it will never be paid back by the US taxpayer (it's mathematically impossible), the Fed will stop doing that the moment it realizes that the next bond purchase will make the dollar worth zero.  The Fed will try to save itself by permitting the US Government to have a failed auction, and to even to sovereign default.

So, when the Fed sees that the dollar is about to be worth *nothing* because they've printed too much, they will back-off and restrict dollar supply, so they can continue to control the dollar monopoly.  (Otherwise, the dollar monopoly won't be worth anything any more, because nobody will accept them for any purpose -- thereby making the Fed "dead", ala hyperinflationary currency collapse.)

The excitement comes as we all watch the Fed dance up-to-the-brink of the cliff, but then back away from the edge.  Can they back away from the edge in time?

I'm saying "yes" in the short term (we'll see a deflationary depression), but then everything will go to sh*t and it won't matter (dollars will be worthless because the old system will be gone in a hyperinflationary collapse).

But, this is speculating on "brinkmanship", and we don't see the end of the Roman Empire very often.  There are actually meetings being held about how to bring it down -- and you and I are not in the room (there are quite a few options for how to trigger the end-game). 

On the bright side, Planet Earth has never before seen Central Banks like they exist today, and their suicide is very exciting to watch...


andrew123's picture

This view sounds a lot like Karl Denninger's.   Assuming you are correct, how would you protect ourself?  Gold, bullets, land?  Are you really talking about apocalypse?

mikla's picture

<snip>,   Assuming you are correct, how would you protect ourself?  Gold, bullets, land?  Are you really talking about apocalypse?

Big question, and I'll take that as an honest question, so I'll attempt an honest answer.  To not hide the point, I'll try to be short:

Denial, Anger, Bargaining, Depression, Acceptance.

No, I'm not trying to be cute.  People are asking, "please give me an option that has no consequences", but it doesn't exist.  Governments, pensions, and welfare states all over the world are broke and there's nothing you can do about it.  Life is unfair.  But, you never expected life to be fair, did you?

On the "positive" side (yes, really), children today are born into servitude and debt.  After this economic correction, that will no longer be true (that's good).  If you're Christian, you're generally not supposed to fear the Apocolypse - it's an upheaval, and no fun, but (in theory) we're all waiting for what's on the other side.

It's the same for this:  Societies will change structurally, the extended family and local communities will become *much* more important, an actual *value*-based production will be a much bigger part of everyone's lives.

Before this correction, 30% (then 40%) of the US GDP was based on fiancial transactions and Wall Street.  I'm a HUGE believer in the capital markets -- we need them -- but 30%-40% of GDP from paper-pushers that don't know what they are doing is absolutely insane.  Rather, ditch diggers create societal value, while many of these paper pushers were merely leverage arsonists that did what they could do to hurt society (e.g., establishing ponzi schemes).

Yes, we'll re-form international finance, national cultures (it's already started, read Steven Keen - Economist in Australia), and what comes out will be much greater happiness for future generations (for real).  If you want the positive, that's the most responsible thing we can do for our kids and grandkids.

But, it won't be fun for us.  And, the recently retired Baby Boomers are screwed: They were lied to, they were betrayed, and to a large extent their political behavior created this problem themselves.

None of us are in control anymore.

ThreeTrees's picture

So, when the Fed sees that the dollar is about to be worth *nothing* because they've printed too much, they will back-off and restrict dollar supply, so they can continue to control the dollar monopoly.

Ok, so the two mechanisms of which I'm aware that the Fed can use to shrink the supply of dollars are 1) Reverse Repos and 2) Hike the interest rate.

We know the reverse repos haven't worked (why would banks want to buy back their worthless junk?) and the interest rate can't immediately decrease the amount of money in circulation but instead restrict the flow of new money entering the system.  I suppose there's currency confiscation but I don't even think that's on the radar yet.

What am I missing?