COUNTERPARTY RISK: A shrinking pool

FacadeBank credit rating downgrades are becoming a familiar sight. The importance of Latin America to Spain’s largest banks should cause fund managers to reassess counterparty risk. Nick Fitzpatrick reports. Spanish bank credit ratings were downgraded twice already this year as a result of the eurozone crisis. Fund managers in Latin America – where some Spanish banks have been building their investment banking businesses as well as their retail franchises – need to know if this has consequences for them. The Spanish bank Santander is a big over-the-counter (OTC) derivatives player, meaning fund managers could have counterparty exposure to it through these transactions. Exposure to Spanish banks’ bonds may occur when they are  posted as collateral with fund managers in activities such as securities lending. Therefore, the downgrades will have triggered a need for investment managers to address their counterparty risk because many funds will expect banks which act as OTC derivatives counterparties to have at least a single-A credit status. Similarly, concerns will exist about collateral quality where bank bonds are used, as in collateral management linked to securities lending. A bank downgrade could lead to a compliance issue by invalidating a fund or mandate. Counterparty risk has been a major topic since the beginning of the financial crisis in 2008. When Lehman Brothers collapsed, many professional investors found themselves in complicated counterparty arrangements with the defunct bank. The counterparty panic that followed revealed that investors did not always know with which financial institutions they were in counterparty arrangements because of the complexity of OTC financial instruments. Some of these instruments involved long chains of counterparties. Downgrading of bank credit ratings has led to a shrinking pool of A-rated banks eligible to act as counterparties in the OTC derivatives market, or whose bonds are acceptable as collateral. In June, Spain said its banks could need up to €62 billion ($80.8 bilion) of bailout money over three years. The independent auditors did not produce figures for individual banks but Spanish officials reportedly insisted that the three biggest lenders – Santander, BBVA and Caixabank – would not need public capital. But just a few days later Moody’s, a credit ratings agency, cut the credit ratings of 28 Spanish banks, saying the weakening finances of Spain’s government made it more difficult for the country to support its lenders. The agency also said the banks were vulnerable to losses from Spain’s burst real estate bubble. Santander and BBVA retained investment-grade status, despite the downgrade, but at least a dozen others were lowered to junk status. Santander had its long-term debt rating cut to Baa2 from A3. BBVA went from A3 to Baa3. The ratings agency had already lowered 16 Spanish banks’ credit ratings in May. Santander and BBVA view Latin America as important zones for expansion. The weakness in their home market means that for these two banks certain Latin American countries have become important bases of “support and strength”, according to a recent research noted by Velhon Partners (see box). The total market value of Santander’s OTC derivatives business was €7.38 billion in 2011, with 14% of this business in Latin America. The zone contributed 51% of the group’s profits in 2011. The group says it has a “leadership position” in Brazil, Mexico, Chile and Argentina through 6,046 branches. It was the geographical diversification of its profits that helped Santander retain its investment-grade credit rating from Moody’s. It is not only Spanish banks that have seen downgrades this year, but large global banks too, whose reach into the OTC derivatives markets and use in collateral management is much deeper than Spain’s banks. Collateralisation
Collateral management, such as that used in securities lending, is increasingly a factor in the OTC derivatives market, too. There has been a growing trend for collateralisation in the OTC market place to control credit exposures to counterparties on each side of a swaps contract. A bank’s bonds may be used even though the bank issuer itself is not involved in the OTC transaction. It’s the same situation in securities lending. Following a downgrade, what should a fund manager do to manage counterparty risk? “A downgrade that you have an interest in can impact in a number of ways,” says Ted Leveroni, executive director of derivatives strategy at Omgeo, a post-trade service provider. If a counterparty’s credit rating falls while they are in an OTC derivatives contract, it makes them more risky as a guarantor of payments should they be on the losing side of a contract, so the fund manager might expect there to be more frequent collateral calls, even if the collateral used is a safe asset, such as US Treasuries. In terms of collateral management in an activity like securities lending, Leveroni says that where a downgraded bank’s bonds are posted as collateral by a counterparty, fund managers may demand larger “hair cuts”. The hair cut is the percentage by which the collateral receiver will devalue the collateral value from the real market value as a safety mechanism. Or in both cases fund managers may simply require more collateral or seek to relax counterparty rules. Ultimately, collateral may simply become ineligible and have to be replaced, which Leveroni says is operationally complex. Providers of trade-related systems, such as Omgeo, and custodian banks that provide securities services, have found a fertile environment in the financial crisis for marketing automated collateral management systems.  These scan collateral positions and raise red flags when risk is heightened. Interest rate derivatives have been a key driver of recent OTC deals. The gross market value of interest rate derivatives between financial institutions at the end of December 2011 was $11.93 trillion, according to Bank of International Settlement figures. Hedge fund involvement in the OTC market is illustrated with the use of credit default swaps (CDS). At the same time, hedge funds in the G10 countries and Switzerland had a net $254.5 billion notional amount outstanding of CDS written on financial firms. ©2012 funds europe

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