The European sovereign debt crisis has any number of knock-on effects to the financial markets, but one we are interested in is the uncollateralized exposure on swaps.
Sovereign exposure is coming back to roost. Market sources estimate that derivatives houses have some Euro 10 to 15 billion of uncollateralized swaps and swaptions exposure to Italy, primarily long dated, . Italy either has one-way CSAs and doesn’t have to post collateral on the exposures or can give their own debt as collateral. Talk about wrong way risk!
We wonder what kind of reserves the banks have taken on this exposure? Most have probably hedged, to one degree or another, with sovereign CDS, pushing those spreads out in the process and perpetuating the “savage circle”. And could a negotiated sovereign “restructuring” that doesn’t trigger a default yet includes cramming down swap obligations make the CDS insurance value moot anyway?
In Finadium’s March 2011 report “Central Credit Counterparties, Margin and the Challenge of Collateral Management” we wrote,
“Depending on their power to negotiate terms on their ISDA CSAs, many end clients do not currently need to collateralize their OTC derivatives. Some are able to include very high threshold amounts, posting margin only when cumulative theoretical initial margin plus variation margin exceeds a threshold. Many simply do not have to collateralize at all including sovereign and quasi-sovereign counterparts. The irony of regulators legislating CCP collateralization yet those same governments bypassing having to pay themselves is not lost on some.” Ironic indeed.
The ISDA 2010 Margin Survey noted that as of the end of 2009 (the most recent date released) only 25% of exposure to sovereigns and supranational agencies were collateralized.