Deutsche Bank Limits Credit Swaps Adding to Bank Risk (Update2)

By Jody Shenn


Sept. 17 (Bloomberg) -- Deutsche Bank AG is taking steps to slow credit-default swap trades that expose it to the risk of failure among Wall Street firms, according to three investors told of the policy.

Germany's largest bank is requiring risk managers to approve trades where the company takes over an investor's contract with another dealer, said the people, who declined to be identified because they do business with Deutsche Bank. Signing off on so- called novations can take an hour, deterring investors from the trades with the Frankfurt-based institution, they said.

Financial companies are seeking to limit exposure to competitors after Lehman Brothers Holdings Inc. went bankrupt and the government rescued American International Group Inc., sparking concern that other dealers may fail. Credit-default swaps on Goldman Sachs Group Inc. and Morgan Stanley surged to a record today, as their shares fell the most in at least a decade.

``Counterparties are being judicious in their actions at this point, given what's happened,'' said J.J. McKoan, who oversees about $65 billion as director of global credit at AllianceBernstein Holding LP in New York. ``Few are willing to take on new risk positions.''

Credit-default swaps are financial instruments that are used to speculate on a company's ability to repay debt. The agreements between so-called counterparties trade over-the-counter, leaving each side exposed to the risk that their partner will fail to pay its obligations. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

`Heightened Sensitivity'

If a holder is concerned about the dealer on the other end of the trade, he can find a second dealer to take over the contract, known as a novation. Ted Meyer, a spokesman in New York for Deutsche Bank, declined to comment.

Several financial companies have made similar changes since last week, said Thomas Priore, the chief executive officer of Institutional Credit Partners LLC, a New York-based fixed-income advisory and investment firm that manages $13 billion. He declined to name the other firms.

``There's heightened sensitivity around novations and that's pretty consistent across the Street,'' said Priore. ``There's so much fear about the systemic issues engulfing the market that you can't really blame your counterparts for dotting every `I' and crossing every `T'.''

The price of insuring against defaults by securities firms and banks jumped today as investors retreated from all but the safest government debt. Yields on three-month Treasury bills dropped as much as 67 basis points to 0.0203 percent, the lowest since World War II.

Costs Surge

Sellers of credit-default swaps on Morgan Stanley demanded as much as 21 percentage points upfront and 5 percentage points a year today to protect the company's bonds for five years, according to broker Phoenix Partners Group. That means it would cost $2.1 million initially and $500,000 a year to protect $10 million in bonds. Contracts on Goldman climbed as much as 265 basis points to 685 basis points.

Greater difficulty and costs in doing novations may be driving investors to try to hedge against counterparty defaults with swaps on securities firms and banks, helping push their debt protection costs wider, Brian Yelvington, a strategist at New York-based bond research firm CreditSights Inc., said.

``It probably is exacerbating the situation,'' Yelvington said in a telephone interview. ``It's kind of a house of cards, though: Who do you hedge with, with respect to counterparty exposure?''

Bigger Losses

At the beginning of 2007, before the losses on securities created from subprime mortgages contaminated financial markets, contracts on Goldman and Morgan Stanley traded below 20 basis points. The companies are based in New York. Goldman fell $18.51, or 14 percent, to $114.50 in New York Stock Exchange composite trading. Morgan Stanley dropped $6.95, or 24 percent, to $21.75.

``As we reported yesterday, Morgan Stanley has a strong capital and liquidity position, as evidenced by nearly $180 billion in liquidity,'' Morgan Stanley spokesman Mark Lake said. Michael DuVally, a spokesman for Goldman, declined to comment.

Money-market rates jumped this week as lending between banks seized up. The London interbank offered rate, or Libor, that banks charge each for three-month loans rose the most since 1999, to 3.06 percent, the British Bankers' Association said.

Hedge funds are assessing their exposure to banks after the collapse of New York-based Lehman, one of the 10 largest providers of credit-default swaps, ICP's Priore said.

``There's now been bigger losses in the fund community from the dealers than there has been among the dealers from the funds,'' said Doug Dachille, chief executive officer of First Principles Capital Management in New York, which oversees $7 billion in fixed-income investments.