How US Banks Are Lying About Their European Exposure; Or How Bilateral Netting Ends With A Bang, Not A Whimper

Tyler Durden's picture

A little over a month ago, Zero Hedge started an avalanche in the financial sector, and an unprecedented defense thereof by the "independent" financial media and conflicted sell side, by being simply the messenger in pointing out that the gross exposure of one Morgan Stanley to the French banking sector is $39 billion. The firestorm of protests, which naturally focused on the messenger, and not the message, attempted to refute the claims that Morgan Stanley (and many others) are overexposed to Europe (both banks and countries) by stating that gross is not net, and that when one nets out "hedges" the real exposure is far, far lower. The logic is that bilateral netting, as the principle behind this argument is called, should always work - no matter the market, and that counterparty risk, especially when it comes to hedges, should always be ignored because banks will always honor their own derivative exposure. Obviously that this failed massively when AIG had to be bailed out, to preserve precisely the tortured and failed logic of bilateral netting was completely ignored, after all things will never get that bad again, right? Well, wrong. Because the argument here is precisely what the exposure is when the chain of netting breaks, when one or more counterparties go under (such as MF Global for example, which filed bankruptcy precisely due to its hedged (?) European exposure - luckily MF was not in the business of writing CDS on European banks or else all hell would be breaking loose right now). So little by little the story was forgotten: after all when everyone says gross is not net, contrary to what history shows us all too often, everyone must be right. Today it is time to refresh this story, as none other than Bloomberg pulls the scab right off and while confirming our observations, also goes further: yes, banks are not only massively exposed to Europe, but they are in essence misrepresenting this exposure to the public by a factor of well over ten!

Bloomberg begins with some simple math: the concept that is seemingly most disturbing to the status quo, not only in Europe, but now in the US as well.

Guarantees provided by U.S. lenders on government, bank and corporate debt in those countries rose by $80.7 billion to $518 billion, according to the Bank for International Settlements. Almost all of those are credit-default swaps, said two people familiar with the numbers, accounting for two-thirds of the total related to the five nations, BIS data show.


The payout risks are higher than what JPMorgan Chase & Co. (JPM), Morgan Stanley and Goldman Sachs Group Inc. (GS), the leading CDS underwriters in the U.S., report. The banks say their net positions are smaller because they purchase swaps to offset ones they’re selling to other companies.

So far so good: after all this is the same argument that not only the banks themselves, but CNBC, sell side analysts and everyone else conflicted enough to trump myth over reality has used in the past month and a half. Alas, the argument stops there, because there is a very critical second part to the argument, one which however is voiced not by a fringe blog but by a member of the, gasp, status quo itself:

With banks on both sides of the Atlantic using derivatives to hedge, potential losses aren’t being reduced, said Frederick Cannon, director of research at New York-based investment bank Keefe, Bruyette & Woods Inc.


Risk isn’t going to evaporate through these trades,” Cannon said. “The big problem with all these gross exposures is counterparty risk. When the CDS is triggered due to default, will those counterparties be standing? If everybody is buying from each other, who’s ultimately going to pay for the losses?”

Reread the bolded text enough times until you have enough information to debunk the next time clueless advocates of Morgan Stanley and other banks scramble to say that the banks are hedged, hedged, hedged. No. THEY ARE NOT. And as the AIG debacle demonstrated, once the chain of bilateral netting breaks, whether due to the default of one AIG, one Dexia, one French or Italian bank, or whoever, absent an immediately government bailout and nationalization, which has one purpose and one purpose alone: to onboard the protection written to the nationalizing government, then GROSS BECOMES NET! This also means that should things in Europe take a turn for the worst, Morgan Stanley's $39 billion in gross exposure really is.. $39 billion in gross exposure, as we have been claiming since September 22.

For those still confused here is Bloomberg with more:

Similar hedging strategies almost failed in 2008 when American International Group Inc. couldn’t pay insurance on mortgage debt. While banks that sold protection on European sovereign debt have so far bet the right way, a plan announced yesterday by Greek Prime Minister George Papandreou to hold a referendum on the latest bailout package sent markets reeling and cast doubt on the ability of his country to avert default.

Which explains why the banks are if not lying, then taking advantage of a gullible public to misrepresent their exposure by as much as a factor of ten!

Five banks -- JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C) -- write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.

Well naturally the banks will represent a far lower and far more manageable number than the one which is sure to inspire nothing short of panic. We wonder: was MF Global's $6 billion in Italian exposure part of this net exposure? Does this mean that America's top banks, sans MF, have just, don't laugh, $39 billion in exposure?

So let's go back to the math to see what the real exposure is:

The CDS holdings of U.S. banks are almost three times as much as their $181 billion in direct lending to the five countries at the end of June, according to the most recent data available from BIS. Adding CDS raises the total risk to $767 billion, a 20 percent increase over six months, the data show. BIS doesn’t report which firms sold how much, or to whom. A credit-default swap is a contract that requires one party to pay another for the face value of a bond if the issuer defaults.

Shhh, don't tell anyone, but not only is the total gross exposure many, many times than what the banks have represented, but inf act US banks have been aggressively selling protection in the first half of 2011!

And here is where the lies get downright surreal:

While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.

In theory, if a bank owns $50 billion of Greek bonds and has sold $50 billion of credit protection on that debt to clients while buying $90 billion of CDS from others, its net exposure would be $10 billion. This is how some banks tried to protect themselves from subprime mortgages before the 2008 crisis. Goldman Sachs and other firms had purchased protection from New York-based insurer AIG, allowing them to subtract the CDS on their books from their reported subprime holdings.

Yet what happened next is a vivid memory to all:

When prices of mortgage securities started falling in 2008, AIG was required to post more collateral to its CDS counterparties. It ran out of cash doing so, and the U.S. government took over the company. If AIG had collapsed, what the banks saw as a hedge of their mortgage portfolios would have disappeared, leading to tens of billions of dollars in losses.


“We could have an AIG moment in Europe,” said Peter Tchir, founder of TF Market Advisors, a New York-based research firm that focuses on European credit markets. “Let’s say Greece defaults, causing runs on other periphery debt that would trigger collateral requirements from the sellers of CDS, and one or more cannot meet the margin calls. There might be AIGs hiding out there.”

Also, recalling AIG, the way most banks protect against this contingency, is to buy CDS on the counterparty itself, thereby layering netting concerns on netting concerns, and pushing even more net exposure onto the strongest credit in the link:

Banks also buy CDS on their counterparties to hedge against the risk of trading partners going bust, Duffie said. To ensure those claims are paid, the banks may be turning to institutions deemed systemically important, such as JPMorgan, according to Duffie. The bank, the largest in the U.S. by assets, accounts for a quarter of all credit derivatives outstanding in the U.S. banking system, according to OCC data.


Goldman Sachs said it had hedged itself against the collapse of AIG by buying CDS on the firm. Company documents later released by Congress showed that some of that protection was purchased from Lehman Brothers Holdings Inc. and Citigroup, firms that collapsed or were bailed out during the crisis.

However, had AIG failed, and had the full "bilateral netting" chain been broken, not only would Goldman not receive a single penny on the CDS it had bought on AIG, the firm itself would be insolvent in hours. And here is where the global bailout of the financial system stepped in: to prevent the entire chain of tens of trillions in gross CDS exposure becoming net. But that is the topic of a different post...

As for this one, the only reason why US banks represent net as the only exposure that is relevant, stems from one simple assumption:

U.S. banks are probably betting that the European Union will also rescue its lenders, said Daniel Alpert, managing partner at Westwood Capital LLC, a New York investment bank.


“There’s a firewall for the U.S. banks when it comes to this CDS risk,” Alpert said. “That’s the EU banks being bailed out by their governments.”

Sound familiar? That's right - this is the logic that MF Global used to not only layer massive "hedged" European risk, but, as latest reports demonstrate, to steal from its accounts to fund short-term liquidity shortfalls.

Where does that leave US banks, and our old favorite, Morgan Stanley?

Hedging and other ways of netting help banks report lower exposures than the full risk they might face. Morgan Stanley said last month that its net exposure in the third quarter to the debt of Spain’s government, banks and companies was $499 million. The Federal Financial Institutions Examination Council, an interagency body that collects data for U.S. bank regulators and disallows some of the netting, said the New York-based firm’s exposure in Spain was $25 billion in the second quarter.


The net figure for Italy was $1.8 billion, Morgan Stanley said, compared with $11 billion reported by the federal data- collection body.


Ruth Porat, 53, Morgan Stanley’s chief financial officer, said during a call with investors after the earnings report last month that the data compiled by regulators didn’t take into account short positions, offsetting trades or collateral collected from trading partners.


“It’s the firms that don’t post collateral because they’re seen as more creditworthy that pose the counterparty risk,” said Tchir. “Those could be insurance companies, mid-size European banks. If some of those fail to pay when the CDS is triggered, then the U.S. banks could be left holding the bag.”

And when they do end up holding the bag, the number in question will be not the $46 billion represented, but the far larger triple digit one pointed out above. Which is why keep a very, very close eye on the Italian bond spread, because if Italy falls, Europe falls, and with it fall not only all the largely undercapitalized French banks (all of them), but the US banks that have not tens, but hundreds of billions of gross CDS exposure facing them, which at that point will be perfectly unhedged as all their transatlantic counterparties will be in the same boat as MF Global.

And the only thing we will hear on CNBC then is how nobody, nobody, could have possibly foreseen this happening...

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
eureka's picture

Next to fall - US/DC/CIA/WALL STREET mafia-ponzi...

Motorhead's picture

Indeed.  Not if, but when.

LawsofPhysics's picture

I agree, but do not underestimate an intelligent, desperate, thug with a modern arsenal at his disposal.  Got physical, know your neighbors?  You better.

Don Birnam's picture

"...banks will always honor their own derivative exposure."

I.e., the Fed: Banker, Honorer, and Printer of last resort.

redpill's picture


I'll sell you a million dollar life insurance policy for $5 a month.  What a bargain!


Looks great on paper but here's the thing: I don't actually have a million dollars.  So you better not die :)


Pladizow's picture

And this is a surprise to who?!?!

Smithovsky's picture

Bloomberg, welcome to the fringe.  Would you like some coffee?  

JW n FL's picture



Bloomberg Thugs!


Celebrate the Fraud!

Celebrate the Criminality!!

Just like New York's Finest DO!


NYPD Fake Drug Charges for Arrest Quotas

Eight officers from the New York Police Department are facing trial for allegedly fabricating drug charges to make their arrest quotas


FBI arrest NYPD Officers for gun running and smuggling cigarettes into New York.

Who Do the White Shirt Police Report to at Occupy Wall Street Protests?

Financial Giants Put New York City Cops On Their Payroll

If you’re a Wall Street behemoth, there are endless opportunities to privatize profits and socialize losses beyond collecting trillions of dollars in bailouts from taxpayers.  One of the ingenious methods that has remained below the public’s radar was started by the Rudy Giuliani administration in New York City in 1998.  It’s called the Paid Detail Unit and it allows the New York Stock Exchange and Wall Street corporations, including those repeatedly charged with crimes, to order up a flank of New York’s finest with the ease of dialing the deli for a pastrami on rye.

The corporations pay an average of $37 an hour (no medical, no pension benefit, no overtime pay) for a member of the NYPD, with gun, handcuffs and the ability to arrest.  The officer is indemnified by the taxpayer, not the corporation.

New York City gets a 10 percent administrative fee on top of the $37 per hour paid to the police.  The City’s 2011 budget called for $1,184,000 in Paid Detail fees, meaning private corporations were paying  wages of $11.8 million to police participating in the Paid Detail Unit.  The program has more than doubled in revenue to the city since 2002.

The taxpayer has paid for the training of the rent-a-cop, his uniform and gun, and will pick up the legal tab for lawsuits stemming from the police personnel following illegal instructions from its corporate master.  Lawsuits have already sprung up from the program.

 See how breaking the Law effects business men.



CClarity's picture

Also, recalling AIG, the way most banks protect against this contingency, is to buy CDS on the counterparty itself, thereby layering netting concerns on netting concerns, and pushing even more net exposure onto the strongest credit in the link:

Ala, Germany holding up the rest of Eurozone.  

And our solution to debt saturation is with more debt. 

Truly, the magical thinking of trying to outlast this rumbling approaching storm is not working.

NewThor's picture

Euro Markets down 5-6% tidal waves outflows beginning?

ZerOhead's picture

Bernanke apparently.

My guess is that as CEO of Bankster Inc. , rather than see his boys take an obviously forthcoming big dirt nap on this, he is more likely than ever to backstop the European sovereign/bankster crisis early while trying his level best to keep his fingerprints off it.

And fortunately for GS Morgan and friends... that one time audit that showed up $16.1 trillion reasons NOT to trust the Fed is now over.

$2T or so of very quietly arranged currency 'swaps' to the Chinese Central Bank to lend on to Europe should be enough to kick this Europroblem down the road for a couple of more years without creating so much as a ripple in the markets.

Stupid idea huh?

NewThor's picture

I wouldn't be surprised to see Bernanke have the balls to flat out announce QE3 tomorrow.

vocational tainee's picture

Oh, why is it ,that I can only spend as much ,as is in my posession?..

jekyll island's picture

Because you don't have a printer like Big Ben

gmj's picture

Why don't you sign up for 50 new credit cards, max them out, and then buy CDSes on yourself? 

Hard1's picture

Nothing to worry, US banks main counterparty are banks from France, a AAA rated CDO squared country.

knukles's picture

Well, I'm hedged, what with all the CDS's on my books (carried at cost) from Bear Stearns, Lehman and MF Global.  What could go wrong?

knukles's picture

Whaddya mean that because I bought my CDS's on Lehman from Lehman they're no good anymore?  ISDA didn't say anything about that.  Quit picking on me.  What the Bear STearns one from Bear and MF Globals from themselves too?  What is this, a fraud?

slewie the pi-rat's picture

bilateral banksterism, BiCheZ!

Deadpool's picture

or you better get 17,000 paying customers.

TruthHunter's picture

I'll sell you a million dollar life insurance policy for $5 a month.  What a bargain!

 Looks great on paper but here's the thing: I don't actually have a million dollars.  So you better not die :)


If this weren't a kleptocracy, wouldn't the Insurance Regulators step in and say CDS are our turf this crap isn't legal?

So,  give back $5, pay a fine and maybe do some jail time.

El Viejo's picture

Didn't congress have to have a special meeting to explain to those geniuses just how CDS work?

"When the people lead the leaders will follow." Some real genius said.

Kayman's picture

No reserve Insurance policies.  What's not to like ?  Premiums are today's income.  Losses are "go fuck yourself".

Ned Zeppelin's picture

Tell that joke to Brooksley Born.

peekcrackers's picture


You can insure your bunk insurance  from me for 1 million for $2.50   and I'll sell it to some guy in Iceland as a money fundfor $20.00 a month and take out Put Ops against it.

mccoyspace's picture

But that isn't fraud because your a "sophisticated investor" who would be aware of risks.
And how could it be fraud if everybody does it?


peekcrackers's picture

Hey let me add in a some of these Prime un-real estate ops I mean real estate markets ,, they are booming  in Detroit , ya appraised value  $68.00 ops I mean 680k.. great deal.. dont worry we will do CDS and sell it off to Bank in Canada they will throw it in to a pention hedge... all good!

Oh regional Indian's picture

This thread above, with your line of thinking peek, is exactly how it DOES work. An eighth grader could understand it.

Insurance, one of THE biggest scams pulled on general humanity. Scum sucker business. Death, Fear business.

Most banks have strong insurance ties. Lying is in their DNA. Money for nothing. 

It all makes sense to me anyway. See Buffet....Banks and Insurance companies. 

And recently, what has the world of finance been dominated by? 

Writing policies on Money Bets.




Toroidal Vortices and Stillness

peekcrackers's picture

Thanks  Oh regional

I am glad I stoped at grade 3 .

Yup a smiple little scam of  fancy words like "Insurance" to sell SHIT with nothing to back it up but a huge mess of suits finger pointig at each other.

RafterManFMJ's picture



And if he dies, how's he to know you don't have the cash? You, sir, are brilliant! Although I fear you may in fact be a bankster by the way you think.

Ahmeexnal's picture

No need to worry.  Just as Japan raised the limits on "dangerous levels of radiation exposure" so will the banks proclaim that their exposure to toxic assets will be within reasonable levels.

That's one of the fist lessons on Kick the can 101.

DosZap's picture

Just as Japan raised the limits on "dangerous levels of radiation exposure"

Yeah,now their Importing RADIOACTIVE cars...............

Going to a Japanese dealer?, carry a Geiger counter.

GeezerGeek's picture

Shop at night. Don't buy a car that glows in the dark.

RafterManFMJ's picture



a car that glows in the dark

No Sir! That's not a defect, that's a feature! Normally we charge extra for that eerie green glow, but I can see you are a man of distinciton, and I really need to sell two more cars this week...tell you what I'm gonna go...

UP Forester's picture, when you go down a dirt road, you don't have to worry about the tubes breaking on your neon under-lights!

TheFourthStooge-ing's picture

Cop: What you got in the trunk?

J. Frank Parnell: Ohhhh ... you don't want to look in there


legal eagle's picture

Come on now!  Banks misleading and misrepresenting?  Say it aint so Charlie.

A local real estate lawyer just sent me some mortgage assignments Bank of America submitted in a foreclosure case - from a make believe pretend trust that doesnt exist to one that does.  They will try anything.

Stop playing their game!

Mitzibitzi's picture

They'll dig out the biological and chemical weapons before they deign to fight you on the streets. There are too many of you and you're too well armed. Too many of you are veterans who know how to use those arms not just effectively but tactically and strategically. A straight up fight would degenerate into a decades long guerrilla campaign and TPTB know VERY well by now how well those turn out.

Going NBCR on the domestic population will engender a lot of outrage from the rest of the world, though, so it'll be essential that we get properly fucked by the same means at the same time, sadly. Welcome to the apocalypse.

fnord88's picture

Why would NBCR cause outrage? It was the terrorists. Cause they hate our freedoms. Although Chavez has lots of oil. So maybe it will be the commies. They hate our freedoms too.

RafterManFMJ's picture

Going NBCR on the domestic population will engender a lot of outrage from the rest of the world, though, so it'll be essential that we get properly fucked by the same means at the same time, sadly. Welcome to the apocalypse.


You could not be more mistaken; the rest of the world will laugh themselves into convulsions if the US imbecile mass gets gassed.  

disabledvet's picture

Who could that be I wonder?

gojam's picture

Maestrom pulling everything and everyone down !


PS, Maestrom is a cool word isn't it ?

Popo's picture

LOL.   It's   "M A E L S T R O M".

You're an idiot.

gojam's picture

Typo. dickhead.

I don't mind being corrected. but you go to far to assume i'm an idiot and by assuming you show yourself up.

I'm at the end of a long day.

Popo's picture

LOL at your excuse too.

The same "typo" TWICE in a two-sentence post?  



legal eagle's picture

Liked it better before you edited your post.