It's Not Just Banks That Are Too Big To Fail

"Following the financial crisis, worries about failures in over-the-counter (OTC) derivatives trading causing destabilizing runs and market crashes have led regulators to force most OTC trades to be cleared through central counterparties (CCPs). CCPs act like clearing banks, taking on their own books the risk of the seller defaulting. Sellers clearing OTC trades through a CCP can (in theory) default on payment without risking the entire system unravelling.

But this creates a problem. What happens if a CCP fails? Of course, the way CCP-cleared OTC trades are structured should minimize this risk. CCPs require sellers to post initial margin in the form of cash or government bonds to cover expected volatility during the lifetime of the trade, and they also require posting of variation margin in cash to cover daily price movements. As everything is fully margined in liquid safe assets, there should in theory be no shortfalls and no defaults.

But…..cash margin requirements don’t necessarily make the system safer. Firms with largely illiquid balance sheets, such as large insurance companies, can have difficulty raising the cash to meet large increases in variation margin. The principal cause of the failure of AIG in 2008 was cash margin calls on OTC credit default swaps that it was unable to meet. And this brings me back to the question – what happens if a CCP fails?"

http://www.forbes.com/sites/francescoppola/2014/04/30/its-not-just-banks-that-are-too-big-to-fail/

The $5 trillion dilemma facing banking regulators

"During the financial crisis, everybody became familiar with the idea that a bank could be “too interconnected to fail”. The problem arises from the way that derivatives tend to accumulate: if you have a certain position with a certain counterparty, and you want to unwind that position, then you can try to negotiate with your original counterparty — but they might not be particularly inclined to give you the best price. So instead you enter into an offsetting position with a different counterparty. You now have two derivatives positions, rather than one. The profits on one should offset any losses on the other — but your counterparty risk has doubled. As a result, total counterparty risk only ever goes up, and when a bank like Lehman Brothers fails, the entire financial system gets put at risk."

"All of which means that as we move to a system of central clearinghouses, a new systemic risk is emerging: “fire sale risk” is the term of art. If a market becomes stressed, and the clearinghouses raise their margin requirements, then the consequences can be huge. In the bond market, the death spiral is all too well known: a sovereign starts looking risky, the margin on its bonds is hiked, which in turn triggers a sell-off in that country’s bonds, which makes them seem even riskier, which triggers another margin hike, and so on."

http://blogs.reuters.com/felix-salmon/2013/12/03/the-5-trillion-dilemma-facing-banking-regulators/

JPMorgan Chase and the London Whale: Understanding the Hedge That Wasn’t

Gdyby ktoś chciał sobie przypomnieć za co JP Morgan dostał teraz prawie miliard dolarów kary.

"The London Whale is a trader by the name of Bruno Iksil, who earned his nickname by betting huge sums of money in the derivatives markets from his home base in London. As one hedge fund manager recently quipped, “Bernanke is to Treasuries what the London Whale is to derivatives.” But to point out that the London Whale jumped the shark with these trades would be an understatement (he is now expected to leave the bank).

Let’s digest what we know thus far about the trade. Iksil had three discrete components to his trading strategy, which I will call packages A, B, and C as follows:

(A) JPM purchased credit default swaps (CDS) on high-yield bonds in which JPM would make money if high-yield bonds went down.
(B) JPM wrote substantial amounts of CDX.NA.IG.9, which is a basket of CDS on investment-grade bonds from 121 different issuers.
(C) JPM bought CDS on investment-grade bonds."

http://blogs.cfainstitute.org/investor/2012/05/17/jpmorgan-chase-and-the-london-whale-understanding-the-hedge-that-wasnt/

Deutsche Bank Did Some Accounting Stuff

"I used to work in a business that, among other things, helped clients get financing against securities. One thing that you learn quickly in that business, and then spend the rest of your career trying to forget, is that the simplest way to get financing against securities is to sell them. You’ve got $100 of stock and want to borrow $80 of cash against it? Just sell the stock, now you have $100, you’re welcome. "

"In the no-balance-sheet transactions, Deutsche Bank received the collateral, sold it and used the cash to make the loan. By selling the collateral — government bonds, in the deals reviewed by Bloomberg News — Deutsche Bank created an obligation to return the securities, allowing it to net to essentially zero its assets and liabilities, the documents show. … Deutsche Bank was able to sell the collateral because it didn’t have to return the bonds under the terms of the agreement. Instead, the borrower agreed that Deutsche Bank could return the “cheapest-to-deliver” equivalent in the event of default, the documents show."

http://dealbreaker.com/2013/07/deutsche-bank-did-some-accounting-stuff/