EUROPEAN GHOSTS IN BANKING MACHINE RETURN TO SPOOK INVESTORS / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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OCTOBER 2, 2011, 5:29 P.M. ET.

European Ghosts in Banking Machine Return to Spook Investors .

By DAVID REILLY


When it comes to banks, what you don't know can definitely hurt.

That's a hard-learned crisis lesson and helps explain, in part, why big U.S. banks have taken such a pounding of late. As Europe wobbles, investors in firms like J.P. Morgan Chase, Citigroup, Goldman Sachs, Bank of America and Morgan Stanley, are again trying desperately to figure out their euro-zone risks. Morgan Stanley, in particular, suffered for this reason Friday.


A big problem for investors is varied, sparse or confusing disclosure about derivatives exposures—even after the financial crisis showed that the inter-connectedness of firms is often as big a threat as their size. Indeed, in just the U.S., the five big banks account for 96% of $332 trillion in face value, or notional, derivatives held by leading firms.


Granted, executives offered some detail on European exposures when reporting second-quarter results, saying they were manageable. But investors were often given net, not gross, exposures, and can't tell how exposed the banks' massive derivatives portfolios may be to big European banks through counterparty risk.


Even bankers acknowledge shortcomings. In a recent speech, Citigroup CEO Vikram Pandit noted derivatives "remain too opaque." He added, "Lack of transparency inhibits market discipline, obscures risk and leaves nasty surprises buried in the system."


If only Citi walked Mr. Pandit's talk. During the bank's second-quarter call, analyst Mike Mayo of Credit Agricole asked about the bank's exposure to troubled European countries. "What is the gross number and what's the difference between the gross and the net?" Citi CFO John Gerspach replied: "I don't think that the gross number is relevant."


But it is. As Morgan Stanley found Friday, confusion over gross and net exposures can spook investors. The difference is usually due to cash and collateral held against loans as well as derivatives used as hedges. Yet investors often don't know how big the hedges are—an important point since hedges often aren't perfect— or who the counterparty is.

Divining counterparty risk, and concentrations of it, is tough and disclosures vary. Morgan Stanley gives a country breakdown of derivatives exposures. J.P. Morgan doesn't do that, but does give a derivatives breakdown based on region. In its second-quarter filing J.P. Morgan said it had net derivatives assets with exposure to Europe, the Middle East and Africa of $35 billion.


But there is no similar geographic breakdown for the firm's gross derivatives assets of nearly $1.4 trillion. If a counterparty fails, gross figures may prove more important for investors. "The asset can disappear and you're left with the liability," explains Credit Suisse accounting analyst David Zion.


Plus, during periods of extreme market turmoil a problem with a counterparty's counterparty—something almost impossible to measure—can come to haunt even banks that have chosen their trading partners well.


Given the difficulty in gauging which banks hold what risks, investors are often choosing to simply sell bank stocks.


That leaves banks with a choice as third-quarter reporting season approaches: provide more and better information about derivatives and European exposures, or continue to get tarred with the euro-fear brush.
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