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News Link • Economy - Economics USA

Bank Of America Is Becoming A "Counterparty Risk" Like Bear And Lehman


I mentioned earlier this month that I expected banks to keep their hedges on for the rest of this month so that they could show the minimum amount of exposure possible on their quarter end statements.  With the crisis increasing and spreading, this hasn't changed.  So there will continue to be no profit taking from banks on their hedges until at least October.  If anything, as the crisis is expanding to more financial institutions both in Europe and here, we will likely see banks adding to their hedges.

Yesterday's downgrade of BAC was potentially problematic for credit markets.  I am less concerned about the holding company downgrade.  Downgrading the bank to A2 from Aa3 could become problematic.  That is the entity most derivative counterparties will face.  A2 is still fine, but I suspect many counterparties will be having meetings over the next few days to discuss how comfortable they are facing BAC as a derivative counterparty.  It might be wrong, and unnecessary, but it is something that will be occurring.  BAC should be doing everything in their power to address this potential risk immediately.

The risk of ratings downgrades to a bank is twofold.  On a basic level, it may reduce the flows they see as counterparties prefer to trade with higher rated entities for their derivative trades.  That is manageable.  The bigger, and far more problematic issue, will be if firms cut their lines to that bank.  This would cause banks to unwind or assign existing trades, or to buy protection on the downgraded banks to "hedge their hedge".  Protection buying would drive their spread higher (if this was all exchange traded, it wouldn't be an issue).  Unwinds could force the bank to raise some cash.  Most hedge funds will have one way collateral agreements with banks, so that on any positive mark to market, they are posting collateral to the bank, which the bank can typically use "rehypothecate".  Hedge funds will unwind or assign profitable trades, which will force the bank to return collateral to the hedge fund.  It is a subtle, but painful, way for a bank to experience a run.  It happened with Bear and with Lehman. 


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