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Banks that act as trustees on collateralized loan obligations must have strong credit ratings, and the threat of downgrades has many of them too close to the line for comfort.
March 16 -
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March 22 -
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March 15
"The collateral call is coming! The collateral call is coming!"
It's popular in some circles to predict doom when it comes to banks' positions in derivatives. The fear is another round of downgrades by the ratings agencies — one of which is looming — will prompt counterparties to demand that banks post additional collateral because they would be deemed riskier partners.
Though the fear is legitimate, banks are more ready to withstand the shock than many might think, observers say.
Why? Banks are monitoring their swaps and other derivatives closely at least for now, the experts say. They learned from the financial crisis and are prepared to post additional collateral should their credit ratings be downgraded. Meanwhile they have been reducing exposures as part of a broader downsizing of their balance sheets, and they have greatly increased their liquidity.
"The banks have been reviewing their portfolios in light of possible downgrades, but that is not a new process," said Marc A. Horwitz, a partner at DLA Piper in Chicago. "It started when Enron went into bankruptcy and shook up the market. Banks began looking at downgrade triggers then and seeing what the implications were. As times improved, the focus shifted away from that, but these reviews picked up again after the credit crisis of 2008."
Last month, Moody's announced it had placed the long-term ratings of Bank of America (BAC), Citigroup (NYSE: C), Goldman Sachs Group (GS), JPMorgan Chase & Co. (JPM), Morgan Stanley (MS) and Royal Bank of Canada under review as part of a larger review of 17 international firms. At the time, Moody's said the review was prompted by more fragile funding conditions, wider credit spreads, increased regulatory burdens and tougher operating conditions.
The threat revived memories of collateral calls on credit default swaps. In 2008, American International Group (AIG) was left scrambling for liquidity when downgrades triggered massive collateral calls, prompting the government to increase its bailout funds to meet those commitments.
Officials at the six banks targeted by Moody's declined to comment or did not return calls. However, in yearend filings, each included passages detailing how much additional collateral it would have needed to post had the credit rating agencies downgraded it.
Citigroup, for instance, said in its annual report with the Securities and Exchange Commission that it had posted $21 billion of collateral already and a single-notch downgrade would require it to post an additional $3.1 billion.
The other companies said that a single-notch downgrade would require them to post an additional $1 billion to $3 billion of collateral.
Analysts say those are small amounts not worth worrying over.
"If they get downgraded a notch or two, maybe they have to pledge $5 billion or so in collateral, which sounds like an awful lot, but it isn't on a $2 trillion balance sheet with $300 billion of unencumbered securities," said David Konrad, an analyst at Keefe, Bruyette & Woods. "Obviously, it is not something they want to do, but it is nothing that would cause a capital or liquidity crisis."
Marty Mosby, an analyst with Guggenheim Partners, made a similar comparison as Konrad's.
"No," he said. "I'm not worried about it."
The collateral calls are almost always a part of the agreement, experts say. Whenever one of the counterparties has a lower rating, the other party can demand additional collateral. There are ways around it, of course. Banks could find other third-party guarantors for the transactions or even find ways to unload the positions, derivative experts say.
"The banks might be potentially looking for alternatives. They may not want to tie up cash as collateral just as their credit rating is taking a hit. They might want to deploy their cash on other things," said Joel S. Telpner, a partner at Jones Day. "Depending on the underlying financials of the swap, a more highly rated bank might be happy to take on the position, too."
Most analysts were skeptical of the company's dumping positions in response to the threat of looming calls for additional collateral, particularly given their apparent manageable size.
The more pressing issue for large banks and their derivatives business is the changing regulatory environment, including compliance with the Dodd-Frank Act and the capital requirements of Basel III, observers said.
"The biggest driver is the changes to risk-weighted assets," Konrad said. "But structured derivatives are an important business for them, and I do not see them changing that."
The companies are trying to lessen their derivatives holdings, others said.
"Many of the banks have felt that it makes sense to lighten up their balance sheets in general," said Peter Shapiro, managing director of Swap Financial, a independent swap advisor in South Orange, N.J. "They've been going through a process of quietly reducing exposures."
