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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lolmao500's picture


LoneCapitalist's picture

Who is going to be buying greek debt now that everyone knows theres no way to insure it?

Jim in MN's picture

I will just surmise that JPMonster has 'engineered' a way to keep the asset paying 'part' of the CDS on their books while 'imagining' the obligation to pay out 'doesn't really exist' or is 'somewhere else'.  Because, you know, the essence of doing God's work is magic, no?

There.  Whew.  No more nasty debts.  You know, everyone really should just default, because none of it is...what is that word?  

Oh right.  Real.  None of it is real.

kaiserhoff's picture

It's easy, Jim.  As Lloyd the great said of 2008, "We were hedged.  If the Fed hadn't stepped in, we would have exercised our claims against counter-parties."

You just leave out the "bankrupt" counter-parties and it sounds almost sane.

giddy's picture

No... the "essence of doing God's work" is humility and meekness.  Don't think this bunch of TBTF's has much of either quality.  Meekness is a derivative (using this word in a context unfamiliar to many) of the Greek (again -- timely, huh) word "paretes" (unsure of spelling -- sic the spell-police) which means "reined-in strength".  A much better visual than some pussy weakling inheriting the earth, huh?  Someone strong and determined to work for a greater good than his own personal gain -- that does resonate.  Don't think Lloyd makes the cut.

Mediocritas's picture

Another thing that pisses me off whenever people say "don't worry, net positions are small" is the complete failure to account for duration mismatch in "hedges", a complete lack of understanding that exotic derivatives are often bespoke, legally complex and can't be simply compared apples to apples. Netting using simple notional value of derivatives is simplistic at best and horribly misinformative at worst.

For example, I make a bet with you for a cool billion that pays out in one hit tomorrow. I make an opposing bet that also strikes tomorrow but pays a slightly larger sum at the cost of paying out in monthly payments over a year. I balance the risk of timing mismatch with the extra profit, pat myself on the back and call it net 0. Tomorrow comes, I lose my bet with you, but win the other one for a net profit. Sweet. Just one problem, I owe you a billion right now and I don't have a billion yet because the other position doesn't finish paying out for a year. Gross position has now become a big problem. Hey, if you just wait a year until my other position pays out, it's all good, so can you just wait a while? No? OK, someone want to spot me for a billion temporarily? Someone? Anyone?......Guys? Shit, er, OK, how about you take this asset from me, it's better than good for the cash. No? You want me to payup CASH NOW because you need it to pay off your own bets? Um, OK, yeah, just wait a sec while I panic and try to offload this asset for hard cash. Ah, fuck it, those bastards on the bid can see what's going on and they're killing me on the price, gonna have to take a haircut...hey can you settle for say 0.9B instead? No? Hey, hold the line while I make some calls....*presses speed dial 1 for Bernanke*, NEED LIQUIDITY!

Granted, a lot of progress was made to try to standardize CDS contracts to make them generically tradable, but under the hood there's still a lot of fine print to wade through in each contract regardless of what the ISDA may have to say regarding a credit event.

giddy's picture

Wow.  That example is impressive.  Imagine the possibilities of taking your enormous creativity and intelligence and doing something REALLY worthwhile.    

cranky-old-geezer's picture



So CDS purchased from American banks how Euro-banks end up transferring their losses to American taxpayers.

Euro-bank > American bank > Fed bailout > Fed > American taxpayers.

It's roughly $1.5 trillion now ...and rising.

centerline's picture

That's the way I read it.  We all know the shit storm will be backstopped at any cost.  US Taxpayer is going to be on the hook for another trillion soon enough.

Mediocritas's picture

Regarding CDS, it's impossible to know until after the event. Massive spaghetti mess of interconnected CDS producers and consumers. Don't know how the net position will play out once all resolved (might take decades to resolve if allowed to cascade uninterrupted).

Only thing I'm 100% sure about is that it will be impossible for all the dominoes to run without a massive liquidity injection from the world's central banks. ZH is completely correct that banks will find liquidity problems even though, net, they may be "fine". Injected liquidity will stay out there in the system for years causing the kind of spot inflations we've been seeing from the last liquidity injections of QE1 and 2.

Chances are, central banks will never recover it and they'll quietly forget about their legacy "assets" *cough* liabilities, leaving citizens of the world to pick up the bill via general inflation.

mccoyspace's picture

Or maybe from the Fed through the IMF in the form of a 'special assessment' -- you know, like from your condo board:

To all Tradewinds Owners Association members,

As you may be aware, the recent stormy weather has blown the roof off of the parking garage. Since the situation is quite serious and requires immediate action, the board is issuing a one-time assessment of $250,000 per member. We regret taking this action, but no one could have foreseen this coming. No one.

Timmay's picture

Just like I previously said, the DRONES are heading to Greece if the vote fails.

vegas's picture

No sweat, just let the CME clear everything. After all, they do such a bang-up job regulating and policing member FCM firms.

sbenard's picture

This feels like Lehman all over again more and more each day!

"History is a gallery of pictures in which there are few originals and many copies." - Alexis de Tocqueville

Belarus's picture

All definately good enough to get enough of a computer ramp into the close to send the DOW green!

catacl1sm's picture

MF Global = Mother Fucking Global (Ponzi Scheme).

Dick Darlington's picture

Great article Tyler!

docmac324's picture

Just get us to Friday close.  All will be forgot come Monday.

I am a Man I am Forty's picture

I could totally see MF Global being set up intentionally to take this fall.  To take the bad side of this trade, to take one for the team.  It is going to be interesting to see who was on the other side.  Anyway, they may have seriously screwed the pooch if they used clients money.  Infinite stupidity.

zebrasquid's picture

I predict within a couple of years Jamie Dimon's head will be kicked through the streets, like Mussolini's.

His bank has created the store of weapons that will bring civilization, as we know it, to an end.  All, while he just smiles that boyish smile of his...




tim73's picture

No wonder they grounded the space shuttle program and all the cool Mars programs. All the rocket scientists are at Wall Street netting derivatives.

Mediocritas's picture

When looking for AIGs in Europe, I'm looking at BNP Paribas and Deutsche Bank.

Also, when hearing banks say, "we've reduced our exposure to Greek debt", it does not mean they've sold Greek debt, rather it means they've purchased "protection" in the form of CDS. Protection which, as ZH points out, likely isn't worth the paper it's printed on.

Net zero, my ass. Besides, why in the fuck should we count on the honesty of participants to report their REAL net exposure anyway?Overlooking the massive complexity, indeed the probable impossibility of truly calculating a net position with accuracy, assuming it was simple, why the hell would anyone trust numbers being published? What possible incentive is there for banks to pronounce inconvenient truths in preference to comforting lies?

SheepDog-One's picture printing fake money out of thin air while solving no underlying fraud and criminalty...DIDNT work?? Has anyone called Helicopter Ben about this?

Mediocritas's picture

Hey, didn't you hear? When I swap my asset-backed securities to Uncle Ben in exchange for cash they get iced the way the Fed's infinite cash is iced so net value in the system hasn't increased and no money has been printed!

What's that? Ben paid full price for an "asset" that's worth only 10 cents on the dollar so that if marked to market, 90 cents of money printing just happened? (Because the Fed can't afford the loss, it simply ignores it, aka money printing).

Oh I can fix that. We'll just never mark it to market. Check it out, alchemy in progress. Move shit to the Fed's books and it becomes gold!

What's that? Qualitative differences matter? Assets on the Fed's books have maturities, are too illiquid to roll and can't be infinitely iced like cash can so mark to market HAS to happen at some point?

HEY LOOK, IT'S ELVIS!!! *runs*

Dr. Engali's picture

Looks like the HFT robots are taking control of the market.

BluPoint's picture

Mutually assured destruction.

hannah's picture













but they did have CDS exposure.....and that doesnt count.....hahahahahahahahaha!

knukles's picture

Talking about CNBS.  Early this a.m. checking out European markets, switching between BBG and CNBS World to see the prices, World has Joey the K on with that guy who used to be head of GSAM and Mikie Mayoontoast.  Instead of addressing WTF was going on globally, Joey asked everybody (who all looked a tidge uncomfortable) whether they should discuss "Too much vs too little Capitalism" or, "Whether executive compensation is too high or not."  Seriously.
I took a shit and felt better.

And people wonder why anybody the least bit aware are fucking cynics.

Dirt Rat's picture

"A cynic points to the reality others wish to ignore." --from The Devil's Dictionary by Ambrose Bierce

Ellesmere's picture

Excellent info...only on Zero Hedge

Great work guys

monopoly's picture

Tyler, Kudos to you and staff, again. My latest donation sent in today. A post advised that servers will be maxed out at some point. I agree. We need to keep the truth flowing all, donate when you can, no matter how little.

Amazing site.

Guess I will not be selling my physical anytime soon.

Miners holding well and with the DOW down 200, I am impressed.

the grateful unemployed's picture

reminds you of Long Term Capital, who bought Russian bonds, and hedged the currency exchange (from the same party essentially) and when one couldn't pay neither could the other. its a lot like running a casino with no money, you buy insurance in case anyone hits your mega-jackpot, and you reinvest your stream of income in a hotel and a golf course and then you buy an interest in the insurance company. ooops

mccoyspace's picture

You just keep expanding that equation in different ways and suddenly a divide by zero pops in and nukes the whole thing......

Eurodollar's picture

It becomes quite obvious that CDS as a tool has to be regulated much better. Or banned, no matter how much tighter the liquidity would get. At a very minimum: More collateral please. The bankers are playing by the rules. This one is all about the politicans. They have to learn to say NO to lobbyists, but I guess the going is quite tough when there is free booze, drugs, sluts and rocknroll.

prodigious_idea's picture

Not coincidental that Corzine was also a key figure in the Long Term Capital Management story.  If he ever gets another CEO position it'll be an obvious shorting play.

prophet's picture

Yes, the Gross = Net = 0 until someone fails and then it get interesting.  The netting has to take place before the failures. 

Vergeltung's picture

this was a great post. It really helped to get a grasp on the level of interconnectivty in these banks, and the whole "house of cards" aspect to their foundations.


scary stuff. thank you ZH. gotta love the free flow of accurate information!

Cone of Uncertainty's picture

Chain of netting bitches

GOSPLAN HERO's picture

noun \?bich\

Definition of BITCH


: the female of the dog or some other carnivorous mammals


a: a lewd or immoral woman b: a malicious, spiteful, or overbearing woman —sometimes used as a generalized term of abuse


: something that is extremely difficult, objectionable, or unpleasant


: complaint

See bitch defined for English-language learners »

See bitch defined for kids »

Examples of BITCH

That word is a bitch to spell.

Origin of BITCH

Middle English bicche, from Old English bicce
First Known Use: before 12th century

GOSPLAN HERO's picture

Uhh, are there many female dogs or lewd/immoral women on this site?

Is "bitch/bitches/bitchez" a term of endearment on ZH? 


Gief Gold Plox's picture

Being somewhat of a newcomer maybe I can attempt at an explanation. From what little I've been able to deduce unwritten comment posting guidelines are as follows;

1. Junk RoboTrader's comments immediately without reading.

2. Read the aforementioned comment, if you really must.

3. Junk MilionDollarNBonus' comments without second though.

4. Do not read the post. It's like masturbating with a cheese grinder. Slightly amusing, but mostly painful.

5. Posts ending with "Bitch, bitches, bitchesez" or any variation thereof are most of the time to be considered the very finest points of advice in the broken, no-connection-to-reality markets we enjoy today. Plus these comments at will.


...oh and got physical bitches!? (sorry couldn't resist)


RockyRacoon's picture

You've pretty much figgered it out.  Congrats.

NewThor's picture

Robotrader is the Cliff Claven of ZH.

Sure. Most at the bar give him a hard time,

but the audience loves him,

and the gang wouldn't be the same 

without him.


Flakmeister's picture

Me thinks CDS's will be going the way of the dodo....

One can only hope...

Mediocritas's picture

What we have here is another cold war, only instead of nations facing off, it's banks and the nukes are CDSs. This time around, instead of just two main players we have dozens of well armed participants facing off, nobody wants to disarm and Greece is playing whack-a-mole right next to the big red button.

I guess that also makes gold bugs cockroaches (survivors).

jack stephan's picture

Arent they leverage over 30 times more than a few years ago.  My math is shit but that would make it take the losses and put in against the credit leveraging and it multiplies.  This is going to never be shown or just in snippets.  If that.  Hmmmmmmm.

thursday0451's picture

This post is required reading for anyone who wants to talk to me about global finance. Maybe we should send it off to some prominent Econ professors?

topshelfstuff's picture

.....but, its been OK'd...remember this:


Intelligence Czar Can Waive SEC Rules

Now, the White House's top spymaster can cite national security to exempt businesses from reporting requirements

President George W. Bush has bestowed on his intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations. Notice of the development came in a brief entry in the Federal Register, dated May 5, 2006, that was opaque to the untrained eye.

The memo Bush signed on May 5, which was published seven days later in the Federal Register, had the unrevealing title "Assignment of Function Relating to Granting of Authority for Issuance of Certain Directives: Memorandum for the Director of National Intelligence." In the document, Bush addressed Negroponte, saying: "I hereby assign to you the function of the President under section 13(b)(3)(A) of the Securities Exchange Act of 1934, as amended."

A trip to the statute books showed that the amended version of the 1934 act states that "with respect to matters concerning the national security of the United States," the President or the head of an Executive Branch agency may exempt companies from certain critical legal obligations.
These obligations include keeping accurate
"books, records, and accounts"
maintaining "a system of internal accounting controls sufficient" to ensure the propriety of financial transactions and
the preparation of financial statements in compliance with "generally accepted accounting principles."

thursday0451's picture

I wonder how far the rabbit hole goes on the insanities this can lead to...

Calmyourself's picture

As i've said no law or contract CAN trigger this mess...