Understanding Counter Party Risk

As we write this, CNBC is reporting that Lehman Brothers, Inc. (LEH) has a notional amount of outstanding OTC positions of nearly $800 billion.  Since Lehman is going into bankruptcy, what does that mean for the rest of the financial markets?Each of these trades has a counter party, an institution that is expecting to pay off or get paid according to the terms of the agreement.

Explaining Counter Parties

Let us start with an example that everyone can understand.  Suppose that you occasionally make a  football bet (completely illegal) with an online sports betting service or a local provider of such services.  Since you are a recreational player, your normal unit is $100, an amount less than tickets to a local sports event.  If you lose, you have to sacrifice some fun.  If you win, you can have more fun.  Either way it is not a life-changing event.

Let us further suppose that you have a friend who is a rabid fan of some team with uncertain potential.  Your friend wants to bet on the game.  He does not have a place to bet, and he wants to bet with you.  Let us suppose that he offers a bet of $1000 and is willing to lay 3 1/2 points.

Since you can “lay off” this action with your dependable source while giving only 2 points, you take the bet.  If you lose to your friend, you collect from the other party.  If you win from your friend, you collect from your source.  If the result if the game is your friend’s team winning by 3, you collect on both bets, making $2000.  If you win from the friend and lose to your illegal source, you pay the “juice” and lose $100, your normal risk amount.  You decide to bet with your friend and lay off the action, locking in a low-risk position with considerable upside.

The risk in this totally illegal maneuver relates to the counter parties.  Let us suppose that your friend’s team loses big.  You need to collect from him to pay off the other side.  Finally, let us suppose that you later learn that your friend has made ten such bets, and you are standing in line to collect.  Meanwhile, your obligations are instantly collectible.

This is the risk of “trading” without any legal guarantee.

Guaranteeing Counter Parties

In financial markets there is a process for guaranteeing the counter party.  If there were not, trading liquidity would be destroyed.  Let us consider the trading of options on an exchange.

On the day of the 1987 crash, options traders were guaranteed by firms that “cleared” their trades.  The clearing firms were further guaranteed by the Options Clearing Corporation.  These guarantees were the fundamental basis of the system.

In 1987 trades were reconciled at the end of the day.  A trader in the pit made a trade, perhaps buying an index put at $12, 100 times.  The trader watched the market move lower, and later sold the put for $20.  On a theoretical basis, the trader had locked in $8 on the trade, 100 times for a gain of $80,000.

A trader might make many such trades during the day, keeping the overall position in balance and locking in profits.

Let us further suppose that the market sold off even further, as was actually the case during the 1987 crash.  Suppose that our hypothetical put reached a price of $50.  Our hero now has a $38 exposure, 100 times, on his supposedly locked-in profit.  That is a loss of $380,000 instead of a win of $80,000 if the other side says “don’t know” to the trade.  These were career-changing trades for options traders on the day of the Crash.

The problem?  In 1987 many traders, some of whom had losses exceeding their own capital, were playing with the money of their clearing firm.  They went “all in.”  At the end of the day, some traders simply dropped their trading cards on the floor, never reporting the trades.  A few left for O’Hare, leading to the term “airport play” where the trader leaves the clearing corporation on the hook.

This can no longer happen, since hand-held devices provide instant updates to clearing firms, allowing for immediate intervention.

In 1987 the system was preserved.  In one case Continental Bank stepped in with additional funds for a subsidiary clearing firm, First Options, to satisfy the losing trades.  The system survived and improved, but it required intervention with more capital.

The Current Situation

With the background examples in mind, one can more readily understand the real significance of the current crisis.  Lehman has many positions with many counter parties.  This afternoon there was a special meeting for Lehman counter parties.  The objective of the meeting was to “net out” offsetting positions, reducing the aggregate notional amount.

There is no overall guarantor for these trades.  The parties acted with the expectation that the other side was creditworthy, would continue in business, and would honor any losses.  To the extent that these trades were insured, the risk was transferred to the insurers.

We now (seem) to know two things:

  1. The federal government refused to step in as it did in the Bear Stearns situation, assuming the risk for questionable assets;
  2. Lehman was unable to access the expanded Fed lending facilities, since the firm did not have enough qualifying assets;
  3. Private institutions are stepping in to provide capital to guarantee the trades.  The amount of $50 billion has been reported.

What it Means?

The key question is the actual size of the risk what role government agencies will play.

We have three observations:

  1. The notional amounts exaggerate the problem.  Investors should understand that the true losses are actually net amounts of winning and losing trades.  It is bad news, but no one yet knows just how bad.
  2. The system is being tested.  There is pervasive criticism of the SEC, the Treasury, and the Fed.  The past decisions of these institutions will be evaluated by historians.   The question for investors is how they will deal with the crisis tomorrow.
  3. Pundits have underestimated the commitment and resourcefulness of government.  The leaders now in power have inherited some difficult positions.  The Fed, the Treasury, and even the Congress have created new policies and facilities that no one even imagined fourteen months ago.  This creativity will now be tested again.

There will be plenty of time for opinions on past decisions.  Investors should instead look ahead.  It is a continuing story, and tomorrow’s trading will provide important information on the ability of government and leaders of financial companies to deal with a crisis.

Originally published at A Dash of Insight and reproduced here with the author’s permission.

One Response to "Understanding Counter Party Risk"

  1. Takeo Hoshi
    Takeo Hoshi   September 15, 2008 at 1:23 pm

    Jeff,A very nice piece. Indeed we are observing a great “test.”Bloomberg reports: (http://www.bloomberg.com/apps/news?pid=20601087&sid=a..jTipsuKCw&refer=home)Banks and brokers yesterday opened trading desks to enter into derivatives transactions that would offset trades with Lehman in case the firm filed for bankruptcy before midnight. The International Swaps and Derivatives Association said the “netting trading session” began at 2 p.m. and continued until at least 6 p.m. New York time. The trades would have been canceled had Lehman not filed for bankruptcy.I understand Lehman filed for bankruptcy this morning, not before the midnight of Sunday. Are these “netting” trades still good?