Five Firms Hold 80% of Derivatives Risk, Fitch Report Finds

First-quarter financials mark the first time comprehensive derivatives disclosure was mandated for all U.S. companies.

David M. Katz - CFO.com | US

July 24, 2009

Members of Congress probing threats to the global financial system — especially the threat of concentration of risk — will have a lot to ponder in newly mandated disclosures highlighted by a Fitch Ratings report issued last week. While derivatives use among U.S. companies is widespread, an "overwhelming majority of the exposure is concentrated among financial institutions," according to the rating agency's review of first-quarter financials.

Concentrated, in fact, among a mere handful of financial-services giants. About 80% of the derivative assets and liabilities carried on the balance sheets of 100 companies reviewed by Fitch were held by five banks: JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley. Those five banks also account for more than 96% of the companies' exposure to credit derivatives.

About 52% of the companies reviewed disclosed there were credit-risk-related contingent features in their derivative positions. Such features require a company to post collateral or settle outstanding derivative liabilities if there's a downgrade of the company's credit rating.

The Fitch analysts also found that just 22 companies disclosed the use of equity derivatives. Just six nonfinancial firms — IBM, General Motors, Verizon, Comcast, Textron, and PG&E — reported exposure to share-based derivatives.

For the report, the rating agency reviewed first-quarter 2009 filings of the companies, which come from a range of industries and represent almost $6.4 trillion in aggregate outstanding debt. The companies also recorded a total notional amount of derivative positions of more than $296 trillion.

Unlike the financial firms, which both use derivatives and issue them for profit, nonfinancial companies seem mostly to use derivatives just to hedge specific risks, according to Fitch. While "derivatives trading by utilities and energy companies appear to be very limited," for instance, "most of the companies reviewed in both industries report the use of derivatives for hedging commodity risks," the report found.

The first-quarter 2009 financial reports marked the first time comprehensive derivatives disclosure was mandated for all U.S. companies. "The need for better disclosure on derivatives has been obvious since the implementation of Statement of Financial Accounting Standards 133, Accounting for Derivative Instruments and Hedging Activities," according to the Fitch report. But comprehensive disclosure of derivatives wasn't part of U.S. generally accepted accounting principles for most companies until March, when the Financial Accounting Standards Board implemented SFAS 161, Disclosures about Derivative Instruments and Hedging Activities.

The latter standard is an attempt to simplify hedge accounting, perhaps the most notorious example of the complexity of U.S. financial reporting. More than 800 pages of rulemaking and guidance were needed to make sense of SFAS 133.

For its part, SFAS requires companies to improve their disclosures about how they account for and use derivatives, and how derivatives affect their balance sheets, income statements, and cash-flow statement.

"The new derivative disclosures are a welcome addition for analysts and investors, and they bring much-needed transparency to financial reporting," says Olu Sonola, a Fitch Ratings director. "The disclosures reveal plenty, but careful analysis and additional scrutiny must be applied."

In particular, users of financial statements need added information about the sensitivity of companies' derivative valuations to major assumptions, according to the ratings agency. Since risk analysts often base their derivative valuations on quantitative models, changes in significant valuation assumptions are particularly important, says Fitch.

The firm's analysts reported that perhaps "the most surprising information coming from our review of energy companies" was that Exxon Mobil — the biggest U.S. energy company — had no derivative exposure at the end of the first quarter. Instead, the company appears to rely on what's called natural hedges — countervailing trends within the corporation itself — to manage potential risks. The report cited Exxon's 2008 10-K:

"The corporation's size, strong capital structure, geographic diversity and the complementary nature of the upstream, downstream and chemical businesses reduce the corporation's enterprise-wide risk from changes in interest rates, currency rates and commodity prices. As a result, the corporation makes limited use of derivative instruments to mitigate the impact of such changes. The corporation does not engage in speculative derivative activities or derivative trading activities nor does it use derivatives with leveraged features."

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