Investment Bank Counterparty Risks are Probably Modest

I’ve seen a number of articles recently about what dangers the investment banks face from counterparty risk.  Counterparty risk is what happens when an investment bank enters into a derivative transaction with another party (the counterparty), and when the investment bank ends up on the winning side of the trade, the counterparty is unable to make good on the necessary payments to the investment bank.

Think about history here for a moment.  Investment banks do take losses.  We saw that in the past week.  But almost all of that came from their own risk-taking, not from counterparties.  Now think about hedge funds that have gone bust.  What was the final trigger event?  The investment banks moving to foreclose when there was still enough margin to do so.  (LTCM, Granite, Amaranth, Neiderhoffer (how many times?) and more… the investment banks are very good at protecting their own hides.)

I have a few concerns about counterparty risk, but they aren’t big.  I worry more about mispricing within derivative books.  The risks that no natural counterparty wants to bear must be held by a speculator, who gets a bit of a bargain for taking down the risk.   Speculators are usually not thickly capitalized, so the investment banks, while grateful that they got the toxic waste off their books, watches the margin of solvency like a hawk, and more so for larger players.

The record of the investment banks of cutting off leverage to the impaired is pretty good.  There is some modest reason for concern here, but I think the investment banks have more potent means of shooting themselves in the foot.