Stress Tests Prove that Credit Default Swaps Still Pose a Huge Risk to the Economy

The stress tests reveal that credit default swaps and other credit derivatives still pose a huge risk to the economy.

The Financial Times today notes that:

US banks could be forced to hold more equity than initially expected after it emerged that "stress tests" organised by regulators take into account risks not commonly understood to be included in the assessment.

In addition to looking at potential losses on loans and securities, bank examiners are looking at so-called "counterparty risk" on derivative contracts - the chance that the party on the other end of a derivatives deal might default, depriving the bank of a payment that is due.

They want to be sure each bank has enough capital to cover this potential source of loss as well as its more traditional lending risks.

In the past regulators have focused on traditional lending risks that form the basis of bank capital requirements. The stress test provides a more rounded assessment of the amount of equity a bank needs in order to be considered well capitalised relative to the risks it is running.

This means banks that have incurred large counterparty risks in their trading books could be forced to hold more capital.

(references to "counterparty risks" usually mean that credit default swaps are involved).

And economist Martin Weiss notes (as summarized today by leading economist Nouriel Roubini in a discussion of the stress tests):

OCC [Office of the Comptroller of the Currency] data show that as of Q4, the total credit exposure with derivatives as % of risk-based capital was: 179% for Bank of America, 278% for Citibank, 382% for JPMorganChase; 1056% for GoldmanSachs. "Moreover, since JPM holds half of all the derivatives in the U.S. banking industry, JPMorgan is ground zero in the debt crisis."

In other words, contrary to what lobbyists in the credit default swap industry say, the risk of losses from CDS is still very real.