Custom Search

THE SKEPTIC: Banks’ Exotic Fear

Last Update: 6/19/2008 11:09:24 AM

By Arindam Nag
A DOW JONES NEWSWIRES COLUMN

In a few weeks investors in some European banks will have to brace themselves to
hear about two different potential sources of losses: basis risk and credit value
adjustments.

It sounds exotic, but simply put, basis risk occurs when a hedge goes wrong,
i.e., when the price of an investment in a financial instrument - such as an
index, made to protect against losses in another investment - moves in an adverse
direction.

If you own an underlying asset, say subprime or AA-rated mortgages, the best way
to hedge against a decline in value is to short an index. But what if the index
goes up? Then you are caught in a situation where you own protection that has
cost you more than what’s now available in the market place.

Accounting standards dictate that the value of any protection - you assume it’s
equivalent to an asset - has to be marked to market. And as the U.S. investment
banks unveil their results, these hedge-related losses are looking conspicuous.

Goldman Sachs reported roughly $500 million in losses related to its
leveraged-finance positions. For Lehman Brothers the big shift in the underlying
assets and their corresponding derivative positions played a significant role in
its $2.9 billion worth of losses.

Indeed, basis risk isn’t really an unknown entity. Goldman Sachs CFO David Viniar
highlighted the basis risk associated with Alt-A mortgages during the bank’s
March conference call. Alt-A doesn’t have a corresponding index so you have to
mix and match several indexes for your hedges. Some work, some don’t.

But in the latest quarter, potential losses related to basis risk or hedges have
reared their ugly head. Since the end of the first quarter, the spreads on the
high-yield Series 9 iTraxx Crossover index have gone down from 577 basis points
to 483 basis points. That’s because the rescue of Bear Stearns and various
central banks’ move to boost liquidity helped boost sentiment.

Interestingly, the ABX indexes have gone down, reflecting housing prices in the
U.S. Banks are unlikely to lose money here. But then this could be offset by
exposure to monoline insurers like Ambac and MBIA that have been downgraded. This
could force banks to make further provisions.

The latter is called credit value adjustment, or CVA. If the value of a
collateralized debt obligation declines, logically the value of a credit default
swap - i.e., protection - rises. But because the ratings of the monolines have
been downgraded that protection holds less value and banks have to make
provisions.

The fair value of UBS’ monoline-related CDS stands at roughly EUR9 billion. For
Royal Bank of Scotland it’s EUR6.2 billion and for Deutsche Bank it’s EUR3.8
billion.

On basis risk, if one reads across from Goldman’s leveraged finance-related
losses, Credit Suisse, with nearly CHF21 billion in exposure, could face losses
here, as could Barclays, with over GBP7 billion, and Deutsche Bank, with EUR33
billion. Losses will differ, though, depending on what proportions each bank are
hedged.

Indeed, so far European banks haven’t been very clear on the exact nature of
hedges. And investors have paid more attention to the value of underlying assets
than to hedge losses.

But if hedge losses linked to basis risk and CVA become conspicuous in the
second-quarter results investors will demand more transparency in this respect as
well.

(Arindam Nag, a Senior Writer for Dow Jones Newswires, has covered business and
finance for 16 years in Asia, Europe and the United States. He can be reached at
+44 207-842-9289 or by email: arindam.nag@dowjones.com)

TALK BACK: We invite readers to send us comments on this or other financial news
topics. Please email us at TalkbackEurope@dowjones.com. Readers should include
their full names, work or home addresses and telephone numbers for verification
purposes. We reserve the right to edit and publish your comments along with your
name; we reserve the right not to publish reader comments.

(END) Dow Jones Newswires

June 19, 2008 11:09 ET (15:09 GMT)

Possibly Related Posts:

• US debt clock runs out of digits —- BBCNews
• US to buy stake in banks; first since Depression
• A Great 2008-2009 Depression
• the fear is still there - doubt it will be gone by monday.
• Quote by Thomas Jefferson “If a Central Bank is ever created in America- Through Inflation and Deflation the “Bankers” will Rob The Americans”

Comments