Banks brace for derivatives 'big bang'

Credit default swap dealers are cleaning up a dark corner of the derivatives market, but the risk of a blowup remains.

By Colin Barr, senior writer

NEW YORK (Fortune) -- One corner of the wild and wooly world of derivatives is about to get a little tamer -- and not a moment too soon for those who fret over the rising cost of bailouts.

The banks that handle the bulk of the trading in credit default swaps -- the unregulated contracts whose misuse helped AIG (AIG, Fortune 500) bring about its own demise -- are adopting new trading and settlement rules this week in a shift the industry has labeled the "big bang."

The changes will set new terms for credit default swaps traded on companies in North America, standardize payment schedules, or coupons, and eliminate clauses that would force CDS users to settle trades when a company does a limited restructuring under certain circumstances. Other shifts will streamline the process for settling the swaps in the event of default.

The moves should eventually make it easier for regulators to oversee the CDS market, whose rapid growth and limited transparency have long been a source of acute anxiety.

Treasury Secretary Tim Geithner has called for putting the market, currently an "over-the-counter" affair that consists of private contracts between traders, on the same footing as the markets for stocks and commodities, in which parties trade with a central counterparty or exchange.

The changes, which are due to take effect Wednesday, will push the market closer to that goal.

"Regulators and the industry have been working together for some time to strengthen the infrastructure," said Karel Engelen, global head of technology solutions at the International Swaps and Derivatives Association trade group. "This is the next step in the evolution toward a more standardized market."

Even so, it will be some time before the CDS market is all grown up. In the meantime, some observers are warning of the dangers of concentrated derivatives exposure in a banking sector already leaning on federal support.

Dealers are taking "an inordinate risk -- and exposing taxpayers to substantial risk as well," said Gary Kopff, a former McKinsey consultant who is now an expert witness in shareholder litigation involving subprime mortgages, collateral debt obligations and credit default swaps.

U.S. commercial banks' net current credit exposure -- a measure used by regulators to estimate possible losses on outstanding derivatives contracts -- more than doubled last year, to $800 billion, the Office of the Comptroller of the Currency said last month. Total credit exposure, which reflects how derivatives exposure could rise over time, hit $1.58 trillion - up 50% from 2007 levels and in line with the 2006 all-time high.

The nation's largest banks, many of which have received tens of billions of dollars of federal assistance over the past year, have the most exposure to these derivatives.

Four the top five commercial banks with the biggest U.S. derivatives dealings -- JPMorgan Chase (JPM, Fortune 500), Bank of America (BAC, Fortune 500), Citigroup (C, Fortune 500) and Britain's HSBC (HBC) -- lost money in the fourth quarter on their credit-related trading.

Goldman Sachs (GS, Fortune 500) was the only one in the top five that made money in the fourth quarter on its credit trading, the OCC said. Still, one of its units -- New York-based Goldman Sachs Bank -- lost $926 million on credit trading last year, according to reports filed with the Federal Financial Institutions Examination Council.

Goldman notes in its annual report filed earlier this year that the market for credit derivatives -- 98% of which are credit default swaps, going by OCC data -- is no picnic.

"The market for credit default swaps is relatively new, although very large, and it has proven to be extremely volatile and currently lacks a high degree of structure or transparency," Goldman said in the report.

'Lots of changes' but 'little visibility'

This week's changes set out to change that, however modestly. Engelen said there could be some hiccups as traders get used to the new regime, with "lots of changes taking place at once." But he said he expects little disruption.

Geithner said in congressional testimony last month that a regulatory overhaul must include federal oversight of unregulated over-the-counter derivatives such as credit default swaps. He called for CDS trading to move to so-called central clearing -- eliminating the fears that one party won't make good on its obligations.

Even in a centrally cleared market, however, it will be difficult for investors to track which firms end up holding the counterparty risks embedded in tradable derivatives. That's why Geithner wants to give regulators the authority to privately view firms' books and monitor traders' risk management.

"The days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers from losses must end," Geithner said in reference to AIG, the insurer that imploded last September and has since required more than $170 billion in taxpayer funds to stay afloat.

Not everyone is alarmed by the banks' derivatives exposure. Unlike AIG, banks are widely assumed to habitually hedge their trading books. It's also worth noting that the OCC's current exposure estimates don't reflect the collateral held by dealers -- a number that tends to run around 30%-40% of net exposure, the agency said.

Still, FBR Capital Markets analyst Steve Stelmach estimated in a report last month that the potential credit derivatives losses at two big dealers, Goldman and Morgan Stanley (MS, Fortune 500), stood at $568 million and $675 million, respectively.

Stelmach stressed that this level of losses is unlikely, but that "given the minimal disclosure" provided on counterparty exposure, there is "little visibility on any potential problems, and the market would likely receive little forewarning if losses were to develop."

Perhaps a bigger problem for the banks is that adding structure to the CDS market stands to squeeze their profits, Stelmach added. That's because it would make pricing more competitive at a time when many of their businesses are already under pressure.