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.
Smithovsky's picture

what did the unedited version say?

knukles's picture

Don't ask me, I wasn't listening.

NoClueSneaker's picture

... I red Mae's Storm ... and wonderd why would she pull everything down. Mrs. West used to make everything growing, for at least 40 yrs.

 " Jack, is there a pistol in your pocket, or you're just happy to see me ... ? "



Oh regional Indian's picture

It said, I think, that curiousity killed the Cat.


ljag's picture

To = go to hell


Too = too much beer


Two = 1&1=2 (two)


write that shit down.....ok?

Popo's picture

OMFG. The idiots are out in force today.  You sir, are also an uneducated idiot.   (Seriously, it's time for you to go back to work.  Those french fries don't cook themselves, you know.)






in addition; also; furthermore; moreover:  e.g.:  "young, clever, and rich too."

Maybe *you* should write that shit down..  Ok? 


Any more idiots want to step up to the plate?


Silver Dreamer's picture

Popo, his post wasn't directed towards you.

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

Popo's picture

Ah.  Thanks for clarifying that SD.  


My sincere and humble apologies to Ijag.   Indentations aren't so good on smartphones.   The fault is mine.   I thought it was a reply to my post.



rosiescenario's picture

"but you go to fa"....that would be 'too' far

Grinder74's picture

Typo[,] dickhead.

I don't mind being corrected[,] but you go to[o] far to assume [I]'m an idiot[. A]nd by assuming[,] you show yourself up.


Seven more typos aren't winning your argument too well.

matrix2012's picture

Overall this 'language correctness' section is the most entertaining part of this post... LOL
it's much more amusing to read than all the sinful stories of the banksters  :-)>....

El Viejo's picture

Must be a Dell Keyboard. I consistently make the same typo. It's maddening.

 There is a slight delay in the key type and Dell misses it consistently.

gojam's picture

Unfortunately, El Viejo I can't blame Dell.

Just tired.

trav7777's picture

When willl be a lot further into the future than you expect.

Last time they were imperiled, the government rushed to their rescue with trillions.

Calmyourself's picture

Much further, no law, no insurance contract, no firm will pull this scam down.  Hunger only hunger and if they can contain that, welcome to 1984 winston..

stocktivity's picture

Why do you think Benny and Obama (never mind Obama...he doesn't have a clue about this kind of shit) sent Timmy to Europe every other week to tell them to do something. Benny is scared shitless.

OpenEyes's picture

Banks are misrepresenting themselves to a gullible public?  By a factor of 10?  C'mon, really?  Banks wouldn't misrepresent the facts.  How could that possibly happen?  

junkyardjack's picture

Good thing they price all the illiquid securities that they hold themselves.  "Nope still looks good to me"

silverserfer's picture

"I hate numbers... there like to many of them.... UUUHHHHHHuhh

Uhhhuhhhhh Huhhhh huhhh" - Butthead

Mike Judge said it best.

DutchZeroPrinter's picture

As long as the printers are online, no probs for super Mario and Osama Ben Bernanke!

UP Forester's picture

Until they piss off enough people, devaluing monetary units and unilaterally dictating government actions.

Merry Christmas, ala Targoviste in 1989....

kung fu's picture

The PONZI scheme of FIAT REALITY begins and ends with the "ego", a false belief in separation from Source. The terror-filled shrieks of the guilty match step by step to the justl, angry, and innocent victims, whose raise up their pitchforks of retribution, seeking punishment of others. It's a childish game of personas, seeking and finding whatever "reality" their unexamined thoughts produce.

The ego is CLEVER, ie shell-game financial instruments are no diffent in essence than shell-game personas. Both conceal the LIE. Both are PIGS with lipstick.

The ego is a product of a world of conditioning, an ingrained bodily identification, a state of mind taught by those of the world, with all it's societal trappings: gifts (position, status, possessions) and anit-gifts (poverty, lonliness, isolation). Changing conditions, rich today---poor tomorrow, are NOT a true awareness of Self or Realilty.

The "self-concept", whose fabrication the world promotes, is the front man, caught in a dualistic reality; DECEIVER-VICTIM, US-THEM, RICH-POOR, etc. It simply shields the fantasy; we created all this, we are responsible. Defenses of the Ego, the false knowledge of the Tree of GOOD and EVIL, shield the mind from the Truth, and catches it in the web of duality.



donsluck's picture

Very good! Successful investers surf the waves of illusion, where remaining un-attached to the illusion is the key to it's mastery. In other words, pigs get fat and hogs get slaughtered.

luna_man's picture

Oh Boy...And doe's this mean we get to hunt them down, the way they did Saddam and Quaddfi?

luna_man's picture

Oh Boy...And doe's this mean we get to hunt them down, the way they did Saddam and Quaddfi?

crazyjsmith's picture

As the song goes...

Lie to me, I promise, I'll believe.

Lie to me, just don't leave. 


covert's picture

bend over grab the vaseline and gold, here it comes:


rufusbird's picture

No! No! Don't worry! It's all gonna work out! You'll see. They gonna let Jon Corzine do the math!

Note to self's picture

Greetings, this is margin calling.  Give me all your dough.

ReallySparky's picture

Tyler,  Clearly you are starting to change the world.  I for one will be donating today, knowing that very soon your servers will be blowing up when this sh*t hits the fan and the market liquidates.  Thank you for showing up everyday!

topcallingtroll's picture

Everyone please donate. Even ten or twenty bucks a year would be apprwciateds. Internet ads and click throughs are peanuts, and ZH doesnt suck the public tit like NPR and PBS.

nope-1004's picture

Tylers' servers won't crash, they'll probably be told to be "shut down" from the Federal Reserve Public Comment Advisory Board, headed by John Corzine, IMO.

LOL.  This freakin' gov't is such a joke.

Y'all gotta read this email I got today. 

VERY QUIETLY OBAMA'S CITIZENSHIP CASE REACHES THE SUPREME COURT AP - WASHINGTON D.C. - In a move certain to fuel the debate over Obama's qualifications for the presidency, the group "Americans for Freedom of Information" has Released copies of President Obama's college transcripts from Occidental College . Released today, the transcript school indicates that Obama, under the name Barry Soetoro, received financial aid as a foreign student from Indonesia as an undergraduate. The transcript was released by Occidental College in compliance with a court order in a suit brought by the group in the Superior Court of California. The transcript shows that Obama (Soetoro) applied for financial aid and was awarded a fellowship for foreign students from the Fulbright Foundation Scholarship program. To qualify, for the scholarship, a student must claim foreign citizenship. This document would seem to provide the smoking gun that many of Obama's detractors have been seeking. Along with the evidence that he was first born in Kenya and there is no record of him ever applying for US citizenship, this is looking pretty grim. The news has created a firestorm at the White House as the release casts increasing doubt about Obama's legitimacy and qualification to serve as President article titled, "Obama Eligibility Questioned," leading some to speculate that the story may overshadow economic issues on Obama's first official visit to the U.K. In a related matter, under growing pressure from several groups, Justice Antonin Scalia announced that the Supreme Court agreed on Tuesday to hear arguments concerning Obama's legal eligibility to serve as President in a case brought by Leo Donofrio of New Jersey . This lawsuit claims Obama's dual citizenship disqualified him from serving as president. Donofrio's case is just one of 18 suits brought by citizens demanding proof of Obama's citizenship or qualification to serve as president. Gary Kreep of the United States Justice Foundation has released the results of their investigation of Obama's campaign spending. This study estimates that Obama has spent upwards of $950,000 in campaign funds in the past year with eleven law firms in 12 states for legal resources to block disclosure of any of his personal records. Mr. Kreep indicated that the investigation is still ongoing but that the final report will be provided to the U.S. Attorney general, Eric Holder. Mr. Holder has refused to comment on the matter... LET OTHER FOLKS KNOW THIS NEWS, THE MEDIA WON'T !

Subject: RE: Issue of Passport? While I've little interest in getting in the middle of the Obama birth issue, Paul Hollrah over at FSM did so yesterday and believes the issue can be resolved by Obama answering one simple question: What passport did he use when he was shuttling between New York , Jakarta , and Karachi ? So how did a young man who arrived in New York in early June 1981, without the price of a hotel room in his pocket, suddenly come up with the price of a round-the-world trip just a month later? And once he was on a plane, shuttling between New York , Jakarta , and Karachi , what passport was he offering when he passed through Customs and Immigration? The American people not only deserve to have answers to these questions, they must have answers. It makes the debate over Obama's citizenship a rather short and simple one. Q: Did he travel to Pakistan in 1981, at age 20? A : Yes, by his own admission. Q: What passport did he travel under? A: There are only three possibilities. 1) He traveled with a U.S. .. Passport, 2) He traveled with a British passport, or 3) He traveled with an Indonesia passport. Q: Is it possible that Obama traveled with a U.S. Passport in 1981? A: No. It is not possible. Pakistan was on the U.S. State Department's "no travel" list in 1981. Conclusion: When Obama went to Pakistan in 1981 he was traveling either with a British passport or an Indonesian passport. If he were traveling with a British passport that would provide proof that he was born in Kenya on August 4, 1961, not in Hawaii as he claims. And if he were traveling with an Indonesian passport that would tend to prove that he relinquished whatever previous citizenship he held, British or American, prior to being adopted by his Indonesian step-father in 1967. Whatever the truth of the matter, the American people need to know how he managed to become a "natural born" American citizen between 1981 and 2008.. Given the destructive nature of his plans for America, as illustrated by his speech before Congress and the disastrous spending plan he has presented to Congress, the sooner we learn the truth of all this, the better.

craigh01's picture

The whole Occidental college thing is a hoax, you know that right?

knukles's picture

WTF,, everything else is make believe.

Withdrawn Sanction's picture

Which "whole Occidental college thing" is a hoax? That he went there? That they had to answer a subpoena? Citations, please?

GeezerGeek's picture

A little truth mixed with a little falsity makes for a great conspiracy tale. On the other hand, if the USA had a Constitution that anyone paid attention to, and if said Constitution required that presidents be 'natural born citizens', then Obama would not be president. Chester Arthur was the first illegitimate president on these grounds. Marco Rubio, the darling of the Republican party, does not qualify either. Nor Bobby Jindal, governor of Louisiana. For better or worse, only perhaps 1% (no, not the rich 1%) care what the Constitution says. Give it a rest. Obama will never be tossed out except by voters or term limits.

ToddGak's picture

Still, with this nonsense?  Really, we have much bigger problems to deal with.

JohnG's picture

Ten minutes in the shower, market up 120 pts.  W T F ?

Now, to read the article.

Dave Thomas's picture

Apparently Adam Smith's "Magic Hand" was at work, get back into the shower CNBC needs their floozies to get all crotch happy.

Piranhanoia's picture

They will sell more and more varied financial and sexual products before they are shut down. Just think how many smarter investors they would get if they hired nude anchor bimbos?   "Now someone is going to talk about creedit... what's that?"  Anyway, here's Poopi cuz I'm stuck to the leather seat,  Hi Poopi, nice thong!  .........

donsluck's picture

It's been done!

Maybe you could buy stock?

jcaz's picture

Good article-  yep, pretty tough to hedge yourself when the people your hedge is with are underwater themselves.....

americanspirit's picture

Absolutely nobody.

LawsofPhysics's picture

Simply put, insurance against bets on bets on bets on bets...


Now wonder paper is going to zero.  Got physical?

espirit's picture

Which of course has the ability to purchase whatever viable fiat will survive... if needed for trading.

Gene Parmesan's picture

The definition of fraud.