How Much Do Banks Use Credit Derivatives to Hedge Loans?

Abstract

Before the credit crisis that started in mid-2007, it was generally believed by top regulators that credit derivatives make banks sounder. In this paper, we investigate the validity of this view. We examine the use of credit derivatives by US bank holding companies with assets in excess of one billion dollars from 1999 to 2005. Using the Federal Reserve Bank of Chicago Bank Holding Company Database, we find that in 2005 the gross notional amount of credit derivatives held by banks exceeds the amount of loans on their books. Only 23 large banks out of 395 use credit derivatives and most of their derivatives positions are held for dealer activities rather than for hedging of loans. The net notional amount of credit derivatives used for hedging of loans in 2005 represents less than 2% of the total notional amount of credit derivatives held by banks and less than 2% of their loans. We conclude that the use of credit derivatives by banks to hedge loans is limited because of adverse selection and moral hazard problems and because of the inability of banks to use hedge accounting when hedging with credit derivatives. Our evidence raises important questions about the extent to which the use of credit derivatives makes banks sounder.

Appendices

Appendix I

Table 6

Table 6 Variable names and definitions. Variables used in study. Data items are from the FR Y-9C (Consolidated Financial Statements for Bank Holding Companies) filings with the Federal Reserve System for fiscal year-ends 1999 to 2003

Appendix II

Summary of banks’ disclosures about the use credit derivatives. Information is from year-end selected 10-K filings and annual reports for fiscal year-ends 2001 to 2005. In some cases, information is from 1999 year-end financial statements.

2.1 Amsouth

Amsouth reports using credit default swaps (CDS) to buy credit protection at year-end 2001 (notional amount of $85 million) on the BHC database. We are unable to find information in the 10-K filing or annual report for year-end 1999. The bank does not report using credit derivatives at year-ends 2002–2005. Amsouth merged with Regions Bank in 2006.

2.2 Bank of America (BOA)

In BOA’s annual report and 10-K filing for fiscal year-end 2002, the following information is disclosed: The Global Corporate and Investment Bank Sector of BOA is responsible for managing loan and portfolio counterparty risk. The group uses risk mitigation techniques including credit default swaps (CDS). In footnote (1) of Table VIII (page 62), BOA discloses using credit derivatives to provide credit protection (single name CDS, basket CDS, and CLOs) for loan counterparties in the amounts of $16.7 billion and $14.5 billion at year-end 2002 and 2001, respectively. The 2005 10-K shows that the bank has utilized credit exposure of $320 billion, for which it purchased a net amount of credit protection of $14 billion. Interestingly, as part of its credit portfolio activities, the bank records selling $1.67 billion notional amount of index CDS “to reflect a short-term positive view of the credit markets.” The bank also points out that CDS bought to hedge the credit portfolio do not qualify for hedge accounting “despite being effective economic hedges.” The total notional amount of credit derivatives reported for 2005 is $2,017 billion, which is four times what it was in the previous year. The bank states that “the increase in credit derivatives notional amounts reflects structured basket transactions and customer-driven activity.”

2.3 Bank of New York (BONY)

BONY discloses using credit derivatives in the footnotes under the “Credit risk management” section in its 2002–2005 10-K filing. The bank also uses total return swaps (CDS) to provide credit enhancements to its commercial paper securitization program. The fair value of the company’s credit derivatives that are held for trading purposes were $7 million in assets and $3 million in liabilities at year-end 2002 ($8 and $3 million, respectively at year-end 2001). The fair value of credit derivatives for trading purposes at year-end 2005 was $1 million for assets and $7 million for liabilities and for 2004 it was $2 million for assets and $6 million for liabilities. The notional amount of BONY’s credit derivatives outstanding at year-end was $1,818 million and $1,636 million for 2002 and 2001, respectively. In 2005 BONY was the beneficiary of $1,099 million and the guarantor of $370 million in credit derivatives which was down a little from $1,184 million and $440 million, respectively from 2004.

2.4 Bank One

Bank One primarily uses CDS and short bond positions as protection against the deterioration of credit quality on commercial loans and loan commitments. The change in the fair value of credit derivatives is included in trading results in the bank’s corporate financial statements, “while any credit assessment change in the identified commercial credit exposure is reflected as a change in the allocated credit reserves.” At year-end 2002, the notional amount of credit derivatives “economically hedging” commercial credit exposure equaled $7.3 billion and related trading revenue was $42 million. Bank One merged with JP Morgan Chase in 2004.

2.5 Cathay Bancorp

Cathay only reported using credit derivatives in 1999. On the BHC database, $20 million was reported for credit derivatives in which the bank was guarantor (i.e., sold credit risk protection). In the footnotes of the bank’s 1999 10-K filing, the bank disclosed a commercial commitment issued by the bank to guarantee the credit performance of $20 million of corporate debt. There is no additional disclosure of credit derivative use in the following years.

2.6 Charter One Financial

Charter One reports using credit derivatives in 1999, 2000, and 2001 on the BHC database. We are unable to find any information on the use of credit derivatives by Charter One in the financial statements for these fiscal-year ends. Charter One merged with Citizens Bank in 2004 and there was no reported use of credit derivatives in 2004 or 2005 by Citizens.

2.7 Chase Manhattan

Chase is in the sample in 1999. In 2000, the bank became part of JP Morgan Chase. According the BHC database, the bank was a net seller of credit protection in 1999. We are unable to find information on the use of credit derivatives by Chase in its 10-K filing for fiscal year-end 1999.

2.8 Citigroup

Citigroup reported large notional amounts of credit derivatives on the BHC database. In its 2003 10-K filings, Citigroup reports its total notional amount of credit derivatives for year-ends 2003 and 2002. In the bank’s discussion of “credit risk mitigation,” the bank discloses using credit derivatives to hedge portions of the credit risk in its loan portfolio. At year-ends 2003 and 2002, $11.1 billion and $9.6 billion of credit risk exposure was hedged through the use of credit derivatives and other risk mitigating techniques. By 2004, the amount of exposure hedged increased to $27.3 billion. A substantial fraction of the credit risk exposure hedged is for loans rated AAA/AA/A. For instance, in 2004, 48% of the credit risk exposure hedge has that rating. In contrast, while 15% of the loans have a rating of BB/B, only 8% of the hedged exposure has that rating. Credit derivatives also are used for trading purposes. In 2005, $40.7 billion of credit exposure was hedged. Almost half of the hedged exposure had a rating of AAA/AA/A. The total corporate credit portfolio of Citigroup had outstanding loans of $185 billion and unfunded lending commitments of $332 billion. Consequently, 7.88% of the total exposure was hedged. Citibank provides guarantees to customers in the form of CDS, total return swaps, and other written options. Citigroup also uses credit derivatives to create synthetic collateralized debt obligations.

2.9 Commerce Bancorp

Commerce is a seller of credit risk protection for all years in the sample and never a buyer of credit risk protection. The bank uses CDS to diversify its loan portfolio by assuming credit exposure from different borrowers or industries without actually extending credit in the form of a loan.

2.10 Community Banks

Community Banks only reports using credit derivatives for fiscal year-end 2003 on the BHC database. At year-end 2003, the bank is a buyer of credit risk protection. The notional amount of this protection is $7 million. We are unable to find information on the use of credit derivatives by Community Banks in its 10-K filing for fiscal year-end 2003, 2004, or 2005

2.11 Countrywide Financial

In the 2005 10-K, Countrywide states it uses credit default swaps for use in risk management primarily of commercial mortgage loans. The company receives credit protection and pays a fixed fee or premium. It also discloses that it used the credit default swaps to manage credit spread risk associated with interest rate lock commitments.

2.12 First Bancorp

First Bancorp is only in the sample as a user of credit derivatives in 1999. At year-end 1999, the bank was net buyer of credit protection ($460.12 million bought and $1.88 million sold) according to the BHC database. We are unable to find information on the use of credit derivatives by First Bancorp in its 10-K filing for fiscal year-end 1999.

2.13 First South Bancorp

First South Bancorp is only in the sample as a user of credit derivatives in 2003. At year-end 2003, the bank was a seller of credit protection (notional amount of $25 million) according to the BHC database. We are unable to find information on the use of credit derivatives by First South in its 10-K filing for fiscal year-end 2003.

2.14 First Tennessee National Corp

First Tennessee is always a seller of credit protection and never a buyer of credit protection. The bank uses CDS in a synthetic collateralized loan obligation (CLO) structure.

2.15 FleetBoston Financial

FleetBoston uses credit derivatives to hedge domestic credit risk ($24 million notional amount) and international credit risk of variable loans ($392 million notional amount). The bank also uses CDS to provide direct credit support to commercial paper conduits. FleetBoston discloses entering into offsetting credit derivatives with third parties. Credit derivatives also are used in trading activities. Credit derivatives are entered into to satisfy customers’ investment and risk management needs. The majority of the credit derivatives in the trading portfolio consists of offsetting or back-to-back positions. FleetBoston merged with Bank of America in 2003.

2.16 JPMorgan Chase

The bank discusses the use of credit derivatives in a number of places in its 10-K filings. It has the most extensive discussion of credit derivatives of all the sample banks. On page 52 of its 2002 filing, JPMorgan discloses the use of these instruments in the “Credit derivatives” section. The bank discloses that the marking-to-market treatment of these hedges provide some natural offset. Gains of $127 million in 2002 related to credit derivatives used to hedge the firm’s credit exposures were included in trading revenue. JPMorgan reports credit derivatives use related to its asset portfolio and dealer/client activity. The notional amount of protection bought was $34 billion and $158 billion, respectively, for the portfolio management and dealer/client activity. The notional amount of protection sold was $495 billion and $172 billion, respectively, for the portfolio management and dealer/client activity. The total sum of all these positions ($366 billion) is reported under “Derivatives contracts” section. Credit derivatives use also is disclosed in “Credit portfolio” section of the 2002 financial statements. The notional amount reported ($33 billion) equals the net credit protection bought and reported on page 52 and discussed above. The bank notes that these derivatives do not qualify for hedge accounting. The amount of credit portfolio hedging does not change much over time. In 2005, the bank has a total wholesale credit exposure of $553 billion. The notional amount of credit derivatives hedges is $29 billion. The bank has $98 billion of exposure to credits with non-investment grade ratings. For these credits, its hedging through credit derivatives is for $2 billion, or less than 2%. The total notional amount of credit derivatives reported by JP Morgan Chase in 2005 is $2,241 billion.

2.17 Johnson International

Johnson International is a buyer of credit risk protection only in 2001 according to the BHC database. The notional amount of the credit protection is $10.24 million. We are not able to find disclosures about the bank’s use of credit derivatives in its financial statements.

2.18 KeyCorp

KeyCorp was buyer of credit risk protection in years 1999 to 2001 and 2003. It only sold credit risk protection in 2000 and 2001. The bank did not use credit derivatives in 2002. We are unable to find quantitative information on the use of credit derivatives by KeyCorp in its 10-K filing for fiscal year-ends 1999–2001, and 2003–2005. In the 10-K for 2005, KeyCorp states that “Actions taken to manage the loan portfolio could entail the use of derivatives to buy or sell credit protection” but does not report having undertaken such actions.

2.19 Mellon Financial

Mellon uses credit derivatives in 2001 and 2003 but not in 2002. In both of these years (2001 and 2003), the bank is only a buyer of credit risk protection ($552.19 million and $612.44 million, respectively). Mellon discloses using CDS to hedge the credit risk associated with commercial lending activities. These hedges do not qualify as hedges for accounting purposes. The bank disclosed a net trading loss of $4 million in 2003 related to its use of CDS. The notional amount of CDS outstanding at fiscal year-end 2003 is reported in “other products” of the table in the bank’s footnote on derivative instruments used for trading and risk management purposes. In 2004 and 2005 Mellon reports CDS for trading purposes at $694 million and $598 million respectively.

2.20 Metlife

In 2004 and 2005, Metlife reports using credit default swaps to hedge risks. In particular, in 2005, the firm reports “[C]redit default swaps are used by the Company to hedge against credit-related changes in the value of its investments and to diversify its credit risk exposure in certain portfolios.” The company also reports that credit default swaps are used in replication synthetic asset transactions (RSAT) to synthetically create investments that are either more expensive to acquire or otherwise unavailable in cash markets. The company reports writing credit default swaps for $593 million and a total notional amount of 5,882 million in 2005, this is a little lower than that reported in the BHC database. In 2004 the total notional amount of credit default swaps was $1,897 million and $615 million in 2003.

2.21 Midwest Banc Holdings

Midwest Banc Holdings is in the sample as a user of credit derivatives in 2002. At year-end, the notional amount of credit derivatives was $50 million. This amount represents two CDSs in which the bank sold credit risk protection. The credit ratings of the CDSs were Aa2/AA and Aa1/AAA. The bank receives a quarterly fee of 1.25% of the notional amount and 1% of the notional amount for entering into the swap. There is no further reporting on derivatives use in 2004 and 2005.

2.22 National City

National City reports using credit derivatives in 1999, 2000, 2001, and 2003. In all years, the bank was a net buyer of credit risk protection. In its 2001 annual report, the bank discusses other derivatives as a group but we are unable to find any direct information on credit derivatives use in the 2001 and 2003 financial statements. Also, in 2004 and 2005 National does not report the use of any credit derivatives to hedge credit risk.

2.23 Northern Trust

Northern Trust is a buyer of credit protection in all years that the bank is a user of credit derivatives according to the BHC database. The financial statements appear to disclose information about these instruments under “other derivatives.” In their 2005 10-K Northern Trust states that it enters into credit default swaps with counterparties when the counterparty agrees to assume the underlying credit exposure of the a specific Northern Trust commercial loan or commitment. Credit default swaps are recorded under risk management derivative instruments but are not designated as hedges. Credit default swaps are not listed under client-related or trading derivative instruments. In 2004 and 2005, Northern reports minimal use of CDS with a fair value of $600k and $500k in these years, respectively.

2.24 PNC Financial Services Group

PNC Bank uses credit default swaps to hedge credit risk associated with commercial lending activities. The bank discloses that the net realized income in connection with the CDS for 2002 is not significant. The bank also discloses in its filing statements that CDS are used to lower required regulatory capital associated with commercial lending activities (2000 10-K). The bank continues to use credit default swaps to hedge commercial lending in 2004 and 2005 with a net loss of $4.4 million in 2004 and a minimal gain in 2005. PNC also reports a notional amount of credit derivatives of $359 million in 2004 which grows to $1,353 million in 2005.

2.25 Provident

Provident is a user of credit derivatives from 2001 to 2003. For all of these years, the bank is a buyer of credit risk protection. The bank discloses using credit risk transfer arrangements to transfer over 97.5% of the credit risk on an auto lease portfolio. Provident discloses that the use of credit derivatives allows the bank to lower its concentration in auto leasing while reducing its regulatory capital requirements. Provident merged with National City in 2004.

2.26 Summit Bancorp

Summit was a user of credit derivatives in 2000. At year-end 2000, the bank reports buying $9.83 million in credit risk protection according to the BHC database. We are unable to find any further disclosure about credit derivatives use in Summit’s financial statements.

2.27 Suntrust

Suntrust buys and sells credit risk protection to customers and dealers using CDS. The notional amounts of these CDS referenced in the “trading activities” footnotes in the 2002 annual report ($180 and $150 million for 2002 and 2001, respectively) correspond to the notional amounts of credit protection sold in the BHC database for these years. Suntrust also sold credit risk protection in 2003. The bank bought credit risk protection in 2001 and 2003. In 2001, the bank was net seller of credit protection. In 2003, the bank was a net buyer of credit risk protection. In 2004 and 2005 Suntrust was a seller of credit protection of $664.2 and $757 million respectively.

2.28 U.S. Bancorp

U.S. Bancorp uses credit derivatives in its trading activities according to the bank’s financial statements. The bank buys and sells credit protection to customers and dealers using CDS. These credit derivatives are accounted for as trading assets and any gain or loss in market value is recorded in bank’s trading income. The notional amounts of credit derivatives are not reported in tables listing derivatives used for risk management purposes.

2.29 First Union and Wachovia

First Union is in the sample as a user of credit derivatives in 1999 and 2000. In 2001, First Union merges with Wachovia Bank. The merged bank is called Wachovia Corporation. Wachovia Corporation is a user of credit derivatives from 2001 to 2005. Though the 2005 10-K states that Wachovia uses credit derivatives to hedge loans, no specifics are given except to state that these hedges do not qualify for hedge accounting.

2.30 Wells Fargo

Wells Fargo discloses the use of CDS in Note 26 (Derivative Financial Instruments) of its 2002 annual report (pages 104 to 106). The bank uses CDS for trading and “customer accommodations.” In the footnote to the table, the Wells Fargo states that it bought $2.2 billion in credit protection and sold $2.5 billion (which correspond to the numbers on the BHC database). In 2004 and 2005 Wells Fargo reports total notional amount of credit swaps of $5,443 and $5,454, respectively. However, there is no discussion of hedging credit risk with credit derivatives. The bank discusses credit derivatives under guarantees and notes that the protection purchases are offsets (defined by the bank as use of the same reference obligation and maturity) to the contracts in which the bank is providing credit protection to a counterparty.

Appendix III

Table 7

Table 7 Pearson correlations of selected explanatory variables. Pearson correlation coefficients for selected explanatory variables used in the probit regressions for year-end 2005. The sample includes all bank holding companies which filed report FR Y-9C (Consolidated Financial Statements for Bank Holding Companies) with the Federal Reserve System with total assets (book value) equal to or greater than one billion dollars. Data are obtained from Federal Reserve Bank of Chicago Bank Holding Companies Database. KA is the total equity capital ratio. LNTA equals the natural logarithm of total assets. NETINCTA equals net income scaled by total assets. NETINTA equals net interest margin scaled by total assets. L_CITOT equals the ratio of US C&I loans to total loans. L_UCITOT equals the ratio of US C&I loans scaled by total loans. L_RETOT equals the ratio of loans secured by real estate to total loans. L_AGTOT equals the ratio of agricultural loans scaled by total loans. L_TOTCONTTOT equals the ratio of total consumer loans to total loans. FOREIGN is an indicator variable equal to one if a bank originates foreign-denominated loans and zero otherwise. SEC is an indicator variable equal to one if a bank is engages in securitization activity and zero otherwise. SAL is an indicator variable equal to one if a bank is engages in loan sales and zero otherwise. TOTDEPA equals total deposits scaled by total assets. LIQA equals total liquid assets scaled by total assets. NPA equals non-performing assets scaled by total assets