The collapse of Bear Stearns and Lehman Brothers and the struggles of AIG have brought a gravity and urgency to counterparty risk and its sidekick, collateral management. Just as people tend not to think about insurance until they have an accident, collateral management -- the tracking and managing of the collateral that backs loans and credit-related derivatives -- was a relatively ho-hum middle-office function until the subprime crisis.
But as credit-related instruments become riskier, the underlying collateral becomes more important. And, "If you've got collateral out there and all of a sudden the collateral itself becomes questionable -- the liquidity of it or the pricing of it -- you could be asked to substitute [other] collateral or put up significantly higher amounts of collateral," points out Paul Migliore, CEO of consultancy Citisoft.
A collateral damage case in point is AIG, a major seller of credit default swaps (derivative contracts that act as insurance against risk that a credit instrument, such as a mortgage-backed security, will default). Many of AIG's CDSs served as insurance against collateralized debt obligations (CDOs), contracts based on complex packages of debt that can include subprime mortgages. Buyers of these CDSs have the right to demand collateral from AIG if the securities being insured by the swaps decline in value or if AIG's own corporate-debt rating is lowered. According to The Wall Street Journal, AIG has been hammered with collateral calls: In August and October 2007, Goldman Sachs asked the insurer to post a total of $4.5 billion in collateral on CDSs; AIG posted less than $2 billion. In November and December of that year five more trading partners requested collateral from AIG. In August 2008, as AIG's share price was plummeting, it had to post $16.5 billion in total collateral on swaps. The following month, AIG's credit ratings were cut, and on Sept. 16 the Treasury Department bailed out AIG with an $85 billion loan.
Since the credit crisis came to a full boil, investment firms have become much more attuned to counterparty risk, especially big players in the CDS market, which has a notional value of $60 trillion, according to Migliore. "A big challenge is that firms have taken collateral for granted instead of actively managing it," he says.
Although one might expect buy-side firms to manage collateral on a regular basis, "Firms were doing it weekly or, more likely, monthly, or whenever a broker-dealer made a margin call," Migliore continues. Now, however, firms are looking to value derivatives and collateral for their portfolios on a daily basis, he adds.
Some buy-side firms are investing in collateral management software that keeps track of collateral agreement terms and conditions, and maintains an audit trail of collateral movements. And custodian banks, including J. P. Morgan and BNY Mellon, which manage collateral as a service for others, report that their customers are asking for real-time views of exposures and collateral, so the firms are beefing up their technology platforms to answer this demand. "Being able to operate in a real-time environment so that [the borrower and the lender] can assess at any point in time that counterparty exposure and the underlying securities and transactions that define that counterparty exposure is a fundamental theme in the marketplace right now," says Kelly Mathieson, managing director, global clearance and collateral management executive, treasury and securities services, J. P. Morgan.
Meanwhile, the overall scope of collateral for derivatives contracts has grown. "The number of credit support annex collateral agreements that parties have executed with one another has grown, according to ISDA, more than 100 percent over the last few years," relates Tim Lind, managing director of strategic planning at Omgeo. "The value of collateral in the marketplace to offset derivatives exposure exceeds $2 trillion."
Heightening buy-side firms' collateral concerns is the fact that they've become more highly leveraged. "We've seen a dramatic shift in the way buy-side firms manage money," says Lind. "That dramatic shift comes with the use of derivatives -- both exchange-traded and over-the-counter -- securities lending programs and other types of transactions that create leverage, ... which in turn creates long-term counterparty and credit exposure. The risk of that leverage is constantly mitigated through pledging and accepting collateral."
For broker-dealers such as Credit Suisse, Goldman Sachs and Citigroup, the cumbersome, manual process of collateral and margin calls -- an uneven mix of e-mails, phone calls and faxes -- adds to the collateral management challenge. As such, 15 large broker-dealers are working to automate pieces of the collateral management process and plan to roll out an automated messaging system for margin calls in the first quarter of 2009 (see related sidebar).