December 22, 2024

Fair Game: What Investors Don’t Know About Europe

That’s what Timothy F. Geithner, the Treasury secretary, told Congress last week, trying to allay concerns that American banks might be hurt by the escalating crisis in Europe.

Investors have heard such assurances before, and they have learned to take them with a barrel of salt. Remember how the subprime crisis was going to be “contained”?

As the situation in Europe deteriorates, our own financial institutions are coming under growing scrutiny from investors. American banks have made loans to European ones. Some have also written credit insurance on the debt of European institutions and troubled nations like Greece. So if a default were to occur, some banks here would be on the hook.

Last week, officials at Morgan Stanley worked overtime trying to calm investors about the bank’s exposure to Europe. The company had $39 billion in exposure to French banks at the end of last year, not counting hedges and collateral. (Some analysts argue that the amount today is far lower, and at the end of the week, Morgan Stanley appeared to have relieved investor fears.)

Whatever the case, American banks have been writing more credit insurance lately. As of the end of June, some 34 federally insured commercial banks had sold a total of $7.5 trillion of credit protection, on a notional basis, according to the Comptroller of the Currency. That was up 2.3 percent from the end of March.

To be sure, these figures represent the total amount of insurance written and do not reflect other offsetting trades that bring down these banks’ actual exposure significantly.

For investors, the challenges in trying to assess the true exposures are real. Many of the risks in these institutions are maddeningly hard to plumb, and open to a range of interpretations. The fact is, investors must deal with significant gaps in the data when trying to analyze a bank’s exposure to credit default swaps. Even the people who set accounting rules disagree on how these risks should be documented in company financial statements.

A recent report by the Bank for International Settlements noted: “Valuations for many products will differ across institutions, especially for complex derivatives which may not trade on a regular basis. In such cases, two counterparties may submit differing valuations for valid reasons.”

Investors, therefore, have to trust that the institutions are being appropriately rigorous.

To compute the fair value of derivatives contracts, financial institutions estimate the present value of the future cash flows associated with the contract. On this part, everyone agrees.

But there are two subsequent steps in the valuation exercise that can produce wide variations on an identical exposure. First is the manner in which an institution offsets its winning and losing derivatives trades to come up with a so-called net exposure. Accounting rule makers disagree about the right way to approach this process.

Standard setters in the United States allow an institution to survey all the contracts it has with a trading partner and compute exposure as the difference between winning trades and losing ones.

International standard setters have taken a different view. They have concluded that investors are better served by knowing the gross figures of all of an institution’s trades, both the profitable ones and the money losers. Those favoring this approach say it gives investors more information and greater insight into the risks on the books, like how concentrated the bank’s bets are.

A recent report from the Bank for International Settlements illustrates how different the exposures can be, depending on which approach is used. Posing three hypothetical examples, the report noted that while the gross values of various derivatives totaled $41, the same trades dropped to $17 after netting, as is allowed in the United States.

THE second area where investors must rely on institutions to do the right thing involves the collateral that has been supplied to secure derivatives contracts. Banks reduce their exposure to a possible loss by the amount of collateral they have collected from a trading partner.

But is the collateral solid? Is the bank valuing it properly? Can it be located quickly? This, again, is a gray area.

The B.I.S., in its most recent quarterly review, highlighted these challenges. It said that gleaning information about collateral was difficult, and that arriving at a proper valuation was, too.

Further problems arise when it comes time to pay off a bet in a bankruptcy and close out one of these trades. At such a moment, liquidating collateral can put pressure on other positions carried by an institution, the B.I.S. noted. It is unclear whether institutions’ portfolio and collateral valuations reflect this reality.

Some investors who have been worrying about potential losses associated with European banks may have taken comfort in the results of financial stress tests conducted earlier this year by the Committee of European Banking Supervisors. Of the 91 top European banks tested — accounting for 65 percent of bank assets — only seven failed the toughest measures.

But, as an August report by Dun Bradstreet pointed out, these tests were not as stringent as they might have been. They only assessed the risks posed by deteriorating assets in banks’ trading accounts. The tests did not measure those assets carried in the so-called held-to-maturity accounts.

“In order to give a more adequate picture of European financial sector risk beyond the short term,” Dun Bradstreet said, “we believe the hold-to-maturity bonds should have been included in the stress tests.” There is clearly a great deal that investors do not know about exposures to Europe, notwithstanding the assurances from Mr. Geithner and others. Three years ago, investors were ignorant of the risks in faulty mortgage securities. If we’ve learned anything from that episode, it’s that what you don’t know can, in fact, hurt you.

Article source: http://feeds.nytimes.com/click.phdo?i=9b1b79f44f9066654b87443fc873b02d

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