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active management of CVA risk.

      The above approach to counterparty risk started to change around 2005 as accounting standards developed the concept of “fair value” through IAS 39 (“Financial Instruments: Recognition and Measurement”) and FAS 157 (“Financial Accounting Standard 157: Fair Value Measurement”). This required derivatives to be held at their fair value associated with the concept of “exit price”,defined as:

      The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

      This implied that CVA was a requirement since the price of a derivative should be adjusted to reflect the value at which another market participant would price in the underlying counterparty risk. FAS 157 accounting standards (applicable to US banks, for example) were more prescriptive, requiring:

      A fair value measurement should include a risk premium reflecting the amount market participants would demand because of the risk (uncertainty) in the cashflows.

      This suggests that credit spreads, and not historical default probabilities, should be used when computing CVA. Furthermore, FAS 157 states:

      The reporting entity shall consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value.

      This suggests that a party’s own credit risk should also be considered as part of the exit price. This is generally known as debt value adjustment (DVA).

      None of the aforementioned focus on counterparty risk seen in regulation, market practice or accounting rules prevented what happened in 2007. Banks made dramatic errors in their assessment of counterparty risk (e.g. monoline insurers, discussed below), undertook regulatory arbitrage to limit their regulatory capital requirements, were selective about reporting CVA in financial statements and did not routinely hedge CVA risk. These aspects contributed to a major financial crisis.

      2.2 The crisis

      Between 2004 and 2006, US interest rates rose significantly, triggering a slowdown in the US housing market. Many homeowners, who had barely been able to afford their mortgage payments when interest rates were low, began to default on their mortgages. Default rates on subprime loans (made to those with poor or no credit history) hit record levels. US households had also become increasingly in debt, with the ratio of debt to disposable personal income rising. Many other countries (although not all) had ended up in a similar situation. Years of poor underwriting standards and cheap debt were about to start a global financial crisis for which derivatives and counterparty risk would be effective catalysts.

      Many of the now toxic US subprime loans were held by US retail banks and mortgage providers such as Fannie Mae and Freddie Mac. However, the market had been allowed to spread due to the fact that the underlying mortgages had been packaged up into complex structures (using financial engineering techniques), such as mortgage-backed securities (MBSs), which had been given good credit ratings from the ratings agencies. As a result, the underlying mortgages ending up being held by institutions that did not originate them, such as investment banks and even institutional investors outside the US. In mid-2007, a credit crisis began, caused primarily by the systematic mispricing of US mortgages and MBSs. Whilst this caused excessive volatility in the credit markets, it was not believed to be a severe financial crisis – for example, the stock market did not react particularly badly. The crisis, however, did not go away.

      In July 2007, Bear Stearns informed investors that they would get very little of their money back from two hedge funds due to losses in subprime mortgages. In August 2007, BNP Paribas told investors that they would be unable to take money out of two funds because the underlying assets could not be valued due to “a complete evaporation of liquidity in the market.” Basically, this meant that the assets could not be sold at any reasonable price. In September 2007, Northern Rock (a British bank) sought emergency funding from the Bank of England as a “lender of last resort.” This prompted the first run on a bank1 for more than a century. Northern Rock, in 2008, would be taken into state ownership to save depositors and borrowers.

      By the end of 2007, some insurance companies, known as “monolines”, were in serious trouble. Monolines provided insurance to banks on mortgage and other related debt through contracts that were essentially derivatives. The triple-A ratings of monolines had meant that banks were not concerned with a potential monoline default, despite the obvious misnomer that a monoline insurance company appeared to represent. Banks’ willingness to ignore the counterparty risk had led them to build up large monoline exposures without the ability to receive collateral, at least as long as monolines maintained strong credit ratings. However, monolines were now reporting large losses and making it clear that any downgrading of their credit ratings may trigger collateral calls that they would not be able to make. Such downgrades began in December 2007 and banks were forced to take losses totalling billions of dollars due to the massive counterparty risk they now faced. This was a particularly bad form of counterparty risk, known as wrong-way risk, where the exposure to a counterparty and their default probability were inextricably linked.

      In March 2008, Bear Stearns was purchased by JP Morgan Chase for just $2 a share, assisted by a loan of tens of billions of dollars from the Federal Reserve, who were essentially taking $30 billion of losses from the worst Bear Stearns assets to push through the sale. This represented a bailout via the US taxpayer of sorts. In early September 2008, mortgage lenders Fannie Mae and Freddie Mac, who combined accounted for more than half the outstanding US mortgages, were placed into conservatorship (a sort of short-term nationalisation) by the US Treasury.

      In September 2008 the unthinkable happened when Lehman Brothers, a global investment bank and the fourth largest investment bank in the US, with a century-long tradition, filed for Chapter 11 bankruptcy protection (the largest in history). The bankruptcy of Lehman Brothers had not been anticipated with all major ratings agencies (Moody’s, Standard & Poor’s, and Fitch) all giving at least a single-A rating right up to the point of Lehman’s failure and the credit derivative market not indicating an impended default.

      Saving Lehman Brothers would have cost the US taxpayer and exasperated moral hazard problems since a bailout would not punish their excessive risk taking. However, a Lehman default was not an especially pleasant prospect either. Firstly, there was estimated to be around $400 billion of credit default swap (CDS) insurance written on Lehman Brothers that would trigger massive pay-outs on the underlying CDS contracts; and yet the opacity of the OTC derivatives market meant that it was not clear who actually transacted most of this. Another counterparty might then have had financial problems due to suffering large losses because of providing CDS protection on Lehman. Secondly, Lehman Brothers had around a million derivatives trades with around 8,000 different counterparties that all needed to be unwound, a process that would take years and lead to many legal proceedings. Most counterparties probably never considered that their counterparty risk to Lehman Brothers was a particular issue; nor did they realise that the failure of counterparty risk mitigation methods such as collateral and special purpose vehicles (SPVs) would lead to legal problems.

      On the same day as Lehman Brothers failed, Bank of America agreed a $50 billion rescue of Merrill Lynch. Soon after the remaining two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks. Whilst this would subject them to more strict regulation, it allowed full access to the Federal Reserve’s lending facilities and prevented a worse fate. In case September 2008 was not exciting enough, the US government provided American International Group (AIG) with loans of up to $85 billion in exchange for a four-fifths stake in AIG.2 Had AIG been allowed to fail, their derivative counterparties (the major banks) would have experienced significant losses. AIG was “too big to fail”.

      By now, trillions of dollars had simply vanished from the financial markets and therefore the global economy. Whilst this was related to the mispricing of mortgage risk, it was also significantly driven by the recognition of counterparty risk. On October 6, the Dow Jones Industrial Average dropped more than 700 points and fell below 10,000 for the first time in four years. The systemic shockwaves arising from the failure of the US banking giants led to the Troubled

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