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...

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Zero Govt's picture

we got the definition of fraud now, it's the prosecution of fraud we're all awaiting to hurry the fuk up

Things that go bump's picture

No one is getting prosecuted for this.  When everything has gone in the shitter we are going to have to hunt down the perpretrators like the pigs they are and administer rough justice of our own, if we want it.  

LFMayor's picture

hopefully the Kiss Army will administer that justice.   We're millions strong!

LFMayor's picture

Oh I'm with you brother, the freikorps are the only justice that we're going to see. Until that's up and rolling it's the same game with your choice of two candidates and two parties to lay your VOTE on. 

I was referring to your avatar, and "The Kiss Army", which was a marketing meme that they used (don't know if you were there or not... I remember it though).  The "millions strong" was from the song "crazy nights". 

Kassandra's picture

Insanity...down the rabbit hole again.

Zero Govt's picture

insanity is an institution called Govt puts the parasites and criminals at the top of the food chain ..all the madness we see about us is an effect of that rotten, inept and delusional institution

Ruffcut's picture

Don't give cnbs more terms like bilateral nettings. I pinky swear I'll shit all over this if they spew those words, in the coming days.

How many terms for bullshit can we come up with anyway.

Jay Gould Esq.'s picture

"How many terms for bullshit can we come up with anyway."

"Liesman;" "Beckie;" "Griffeth;" "bank-skank;" "Pisani;" "Power Lunch;" "actionable network," &c.

UP Forester's picture

My fave is that dipshit Simon what's-his-fuck.  But then again, I guess all the networks figure that if they spout all their BS with an accent like Lady Di, the plebes will buy it hooker, limey and stinker....

maxw3st's picture

"...who’s ultimately going to pay for the losses?”

I have been asking that question for some time in regards to the Greek debt. I believe it may have something to do with why a "credit event" is being so carefully avoided. I doubt there is capital to back the outstanding CDS currently trading against Euro debt.

iDealMeat's picture

Precisely..    + a quad in derivatives to you..  Everything is insolvent..

ToddGak's picture

When it all goes bad, the US Gov't will step in again to backstop the banks.  The Fed will soak up as much US Debt as necessary to get cash into the hands of the banks.  They are too big to fail.

AE911Truth's picture

"...who’s ultimately going to pay for the losses?”

When the SHTF the CDS sellers will claim

bank guy in Brussels's picture

Hilarious even though catastrophic in its implications ... for example, this quote from above, on how Goldman bought hedges against the AIG debacle ... from Lehman Brothers!

« 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. »

disabledvet's picture

As if Dexia was any different. Why else put American taxpayers on the hook? Peekaboo...I see you!

canuck's picture

It doesn't really surprise me that that surprises you seeing your handle...

Thepnr's picture

The fan has now stopped turning, shit has overwhelmed it!

Uchtdorf's picture

That happened with my laptop once...uh, the fan thing, not the stink thing, that is.

Vergeltung's picture

excellent new take on an older cliche. well played sir!


lolmao500's picture

“The big problem with all these gross exposures is counterparty risk. When the CDS is triggered due to default, will those counterparties be standing?


Mercury's picture

In addition to counterparty risk we must now (as of this weekend) add reality acknowledgement risk: when some ISDA Determinations Committee rules that a default isn't officially a default....and therefore your hedge is no longer a hedge.

Withdrawn Sanction's picture

ISDA = International Self-Dealing Association.

It's not a loss if we (the bankers who wrote this crap and collected premiums and bonuses for doing so) say it isn't.

Unfortunately, the ISDA determination does not stop the underlying instruments from falling further, as the MF case shows.  Indeed, the result is even more margin/collateral calls.  One way or another, by fire or by wind, this entire house of cards is coming down.

It will not be end of THE world, just then end of THIS (overleveraged, overextended, unproductive) world.  Good riddance.

reader2010's picture

The Greatest Depression with the Chinese characteristics is down the road. Warz bitChez!

lolmao500's picture

Latest Italian spread : 442 points.

But it's closed for now. So no doom till it reopens.

Note to self's picture

Holy shit - SOME people must have pissed their pants looking at a 450 bps close.  Oh wait - that would be all of us.

Rainman's picture

.....if..... it reopens

spinone's picture

If that happens forget it all.

scatterbrains's picture

whew! Did BAC push it's CDS on the back of the tax payers just in time or what ? Bitch looks like it could blow any minute.

disabledvet's picture

And there's the crux of the matter. I never argue with the logic, numbers or veracity of ZH and this is why. "these things have a way of cropping up." I would only say two thing: I think the counter argument that bank bailouts (European banks are too big to nationalize-you must agree to that) truly does "ring fence" the catastrophic condition. The second and my argument is far simpler: we'll kill them if they "do that to US." any arguments on my counter?

chet's picture

It's like nearing the end of a game of Jenga. Which sticks can still be safely removed and which are integral? Was it MF Global?  Greece?  Some French Bank?

NewThor's picture

Netflix? Bank of America? Credit Default Swaps?

midgetrannyporn's picture

Color me surprised. </sarcasm>

FutureShock's picture

Yeah well Benny and Timmy know, and the ink is orderd for the IMF. Won't be american debt it will be theirs, we will just get the inflation. Huge gains will be a comming soon. You know what happens when soon is over.

riley martini's picture

USA  Banks lying so it aint so this isn't China. HFT Cadian lost $1,800,000,000 on the MF fraud . Tyler can you do a piece on the holders of MF stock and the bonds they sold last week?

clones2's picture

Will someone please explain this part... If the banks WROTE protection via CDS, and the CDS wont be paid out... dont they just collect that premium?

clones2's picture

I did miss this part... "

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"

Just trying to figure out some of the math on this....

francis_the_wonder_hamster's picture

"dont they just collect that premium?"

They have already collected the premiums and paid them out in bonuses.  All that's left is the liability.......although, theoretically, they have reserved against the payout.

Withdrawn Sanction's picture

theoretically, they have reserved against the payout.

And there's the rub: How does one know? In the first place, the derivatives transactions are off-balance sheet. In the second, the AIG escapade shows there were no reserves....but even if there were, the third killer is the orders of magnitude are all wrong.

Until the banks can show credible evidence and independently verified data on netting, I will take their obfuscations as just so much self-serving BS. Netting my ass...

If one counterparty can bring this whole thing down (and I believe it can), this whole edifice is so fragile Im at a loss for an apt metaphor, though sand castles at high tide springs to mind...

francis_the_wonder_hamster's picture

Indeed, and we are left to wonder, once again, why we didn't get a central clearing platform for OTC derivatives?  Simply amazing that Dodd-Frank failed to address this.....well, maybe not if one begins to understand just how rigged the game is.

I'm not much of one for metaphors, but I'm thinking of some sort of cheerleader pyramid.....but then again, my thoughts too often stray towards cheerleaders.

Mark123's picture

Zero Hedge is the best at ferreting out these skeletons in the closet!!


So the real hedge for the banksters is that governments (by robbing from their citizens) will always bail out the big banks - and all this fancy CDS financial engineering type stuff is just a smoke screen so they can pretend that their rape and pillage business model is quite reasonable and for the good of us all.


Praise Jesus....those banks are such a blessing to us all!

tony bonn's picture

huge kudos to zh for articulating this subject. unregulated derivatives markets are irreducibly complex systems which cannot be modeled with simple constructs. in essence, the media fucktards want to use (so to speak) arithmetic where differential equations are required and are thus impelled to make a plethora of simplifying assumptions to make their elementary school tools work.

fuck the main stream media.


DosZap's picture

tony bonn,


Sad part is most folks authorized to sell them, do not even know WHAT they are.

giddy's picture

Ummm... okay... modeling derivatives is complex... but the notion that you reap what you sow is pretty simple... in fact by overly complicating what should be simple arithmatic and pretending that its possible to hedge all human activity is so full of hubris and vanity that its way beyond merely offensive.  And -- the point of all this crap is not to save mankind or make civilization a better place -- but to enrich a bunch of fuckwads that believe they're the "best and brightest".  Look at history.  Wash, rinse, repeat.  Greed is the basis of its own distruction.      

spartan117's picture



Jim Sinclair has been saying this for what, 5 years now?  Nothing new.  No way to make good on all those CDS out there.

ReallySparky's picture

OT: Tin Foil Hat On... Was pondering last night the MF bankruptcy and lack of balance sheet details, what if the crap (derivatives), BAC moved into the bank against the FDIC wishes had anything to do with the immenent bankruptcy of MF Global.  Sure would be like a Goldmanite to soak the taxpayers again, with the Fed's blessing of course.

TimmyM's picture

Last collateral standing-PMs

MsCreant's picture

On the rise as you speak.

PulauHantu29's picture

Oh Sweet Jesus, I was afraid you were going to bring this "exposure" thing up again.....