"Marvel At The Derivative On Its Derivatives That Credit Suisse Wrote To Itself "

From DealBreaker:

Financial news is very serious business and you should probably fret more than you do about the economy and the banksters and the muppets and the homeowners and so forth. Some things, though, are best viewed as purely aesthetic triumphs, and your reaction should just be an appreciative whistle. This starts slow but stick with it, it gets wonderful:

Our results are impacted by the risk of counterparty defaults and the potential for changes in counterparty credit spreads related to our derivative trading activities. In 1Q12, we entered into the 2011 Partner Asset Facility transaction (PAF2 transaction) to hedge the counterparty credit risk of a referenced portfolio of derivatives and their credit spread volatility. The hedge covers approximately USD 12 billion notional amount of expected positive exposure from our counterparties, and is addressed in three layers: (i) first loss (USD 0.5 billion), (ii) mezzanine (USD 0.8 billion) and (iii) senior (USD 11 billion). The first loss element is retained by us and actively managed through normal credit procedures. The mezzanine layer was hedged by transferring the risk of default and counterparty credit spread movements to eligible employees in the form of PAF2 awards, as part of their deferred compensation granted in the annual compensation process.

We have purchased protection on the senior layer to hedge against the potential for future counterparty credit spread volatility. This was executed through a CDS, accounted for at fair value, with a third-party entity. We also have a credit support facility with this entity that requires us to provide funding to it in certain circumstances. Under the facility, we may be required to fund payments or costs related to amounts due by the entity under the CDS, and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us. The credit support facility is accounted for on an accrual basis. The transaction overall is a four-year transaction, but can be extended to nine years. We have the right to terminate the third-party transaction for certain reasons, including certain regulatory developments.

Oh man, if I could write like that. If I could do that*! It’s from Credit Suisse’s quarterly financials released today and it is magic. The first paragraph is about their PAF2 facility, which we’ve talked about it before, in which Credit Suisse bankers get paid in the form of their own counterparty credit exposure. If you lived in a world of pure economic decisionmaking you’d probably be like “yeah, that’s great, eat their own cooking, align incentives, blah blah blah.” I mean, I did.

But the second paragraph! I am not a doctor so I’ve probably got it wrong, but here is how I read it:

(1) CS (the bank, not its bankers) still has ~90% of senior credit risk on that thing (in addition to ~4% of first-loss risk which it manages using “normal credit procedures”).

(2) It is, shall we say, a creepy risk: it is the credit risk on the “expected positive exposure” on some derivatives trades. That is, CS is currently in-the-money, or otherwise expects to end up in the money, on a bunch of trades, and those exposures are not collateralized by its counterparties, and it doesn’t expect the in-the-moneyness to dissipate. This is not “someone owes us $11bn and we hope they’ll pay it back”; this is “a lot of someones owe us an uncertain amount of money but it might be $11bn and if so we hope they pay it back.”...MORE