Banks seek to slash Italy swaps portfolio

In Morgan Stanley’s fourth-quarter results a footnote made rivals sit up and take note: the US bank reduced its net exposure to Italy by a whopping 69% in late 2011, from US$4.9bn to US$1.5bn.

The way Morgan Stanley pulled this off was arguably as significant as the end-result. Other banks have been forced to slash government bond portfolios or buy credit default swaps to shield themselves against Southern European countries. In contrast, Ruth Porat, Morgan Stanley’s CFO, explained during an investor call on January 19 that the bank began to restructure certain derivatives positions with Italy in December.

These trades settled in January, leading to the material reduction in the bank’s net exposure to Italy and to the rest of peripheral Europe. Altogether, the deals slashed the bank’s exposure to peripheral European countries from US$6.4bn to US$2.3bn, excluding unfunded commitments, Porat said.

“It’s a huge number, and it shows just how big the [sovereign derivatives] exposures in the industry are”

Rival dealers admit that Morgan Stanley has killed two birds with one stone. Beyond the immediate boon of cutting its peripheral exposure, the US bank has removed a sizeable chunk of its sovereign swaps trades, which have become a major headache for all dealers under the new Basel III regulatory regime.

“It’s a huge number, and it shows just how big the [sovereign derivatives] exposures in the industry are that Morgan Stanley can get that kind of relief, and just how painful the widening of sovereign CDS has been for banks,” said one person who looks after sovereign clients for a major bank.

Legacy derivatives trades with sovereigns have become extremely expensive for banks over the past few years. In a hangover from the days when sovereigns were considered risk-free, most national treasuries are not required to post collateral when out of the money on a swap, but receive cash from their dealer when they are in the money.

Under Basel III, the funding, counterparty credit and capital charges of these collateral agreements have become material for dealers, particularly when they are owed money on the swaps. The widening of European sovereign CDS, which have quadrupled in many cases over the past year, has only compounded this problem for dealers.

The Italian problem

Italy’s legacy derivatives portfolio – estimated at €20bn–€30bn – dwarfs that of all other sovereigns in terms of size, and has consequently become an industry bugbear. The derivatives causing the most pain for banks are a series of long-dated interest rate swaps, which essentially push Italy’s debt payments further into the future.

Many dealers have tried to persuade Italy to post collateral or restructure the trades, thereby reducing their credit and funding costs. The problem is that Italy has an incentive not to post collateral or unwind these positions. Doing so would require Italy to stump up a large amount of cash, and that in turn would be likely to mean issuing more debt.

Instead, the Italian Treasury may believe that it is better off digging in its heels and waiting for the swaps to roll off its books.

“We have talked to Italy and there is no happy ending to this story. Italy has a significant derivatives portfolio, and collateralising it would have a material impact on the public accounting. Italy has difficulty raising €5bn in a bond auction, and this funding would be more than that,” said the global head of rates at a major dealer.

Morgan Stanley leads the way

Exactly how Morgan Stanley managed to reduce its exposure so dramatically has left rivals scratching their heads. Two senior traders at separate banks believed that Morgan Stanley had exercised a provision in its collateral agreement with Italy that allowed it to unwind a trade if its mark-to-market breached a certain level.

Traders said this most likely related to a legacy interest rate swap, which Italy had used to lock in rates for 30 years at about 4%–5% on around €3bn–€4bn of debt. With 30-year swap rates now more like 2.5%, Italy would be significantly underwater on the trade, and would therefore have to pay up as much as €2bn to unwind it, the traders estimated.

A major unwind or restructuring would also explain volatility at the long end of the euro swaps curve late last year, they added. Morgan Stanley and the Italian Treasury declined to comment.

Other dealers scanning their swaps contracts for similar provisions may be out of luck: break clauses are extremely rare in collateral agreements with sovereigns, although one senior trader said Credit Suisse had enforced a similar clause with Italy in November. Credit Suisse declined to comment.

If there wasn’t a break clause, Morgan Stanley might have been able to persuade Italy to re-coupon the trade in a way that would reduce its exposure – an avenue that other dealers are most likely also investigating. However, it is debatable whether Italy would agree to do this, because this would bring forward its debt payments.