Banks keep investors in the dark on trillions of dollars of derivatives risk by only reporting net exposure.



Here is a net exposure example to show what I mean. Suppose I owe my sister Sue $250,000 and Uncle Ernie owes me $250,000. My net position would appear to be zero.



But what if uncle Ernie is bankrupt or simply will never pay the loan back for any reason. I cannot tell Sister Sue, "I am not paying you back, collect from Uncle Ernie".



Net position reporting only works if counterparty risk is zero. In my example counterparty risk from uncle Ernie is 100%. So what is the counterparty risk at JP Morgan, Bank of America, Citigroup, and Goldman Sachs on tens of trillions of derivatives contracts?



The answer is no one can possibly figure it out, on purpose, because banks are only required to disclose "net" exposure.



JPMorgan, Goldman Keep Risk in Dark



With that backdrop, please consider JPMorgan, Goldman Keep Italy Risk in Dark



JPMorgan Chase & Co. (JPM) and Goldman Sachs Group Inc. (GS), among the world’s biggest traders of credit derivatives, disclosed to shareholders that they have sold protection on more than $5 trillion of debt globally.



Just don’t ask them how much of that was issued by Greece, Italy, Ireland, Portugal and Spain, known as the GIIPS.



As concerns mount that those countries may not be creditworthy, investors are being kept in the dark about how much risk U.S. banks face from a default. Firms including Goldman Sachs and JPMorgan don’t provide a full picture of potential losses and gains in such a scenario, giving only net numbers or excluding some derivatives altogether.



‘Funded’ Exposure



Goldman Sachs discloses only what it calls “funded” exposure to GIIPS debt -- $4.16 billion before hedges and $2.46 billion after, as of Sept. 30. Those amounts exclude commitments or contingent payments, such as credit-default swaps, said Lucas van Praag, a spokesman for the bank.



JPMorgan said in its third-quarter SEC filing that more than 98 percent of the credit-default swaps the New York-based bank has written on GIIPS debt is balanced by CDS contracts purchased on the same bonds. The bank said its net exposure was no more than $1.5 billion, with a portion coming from debt and equity securities. The company didn’t disclose gross numbers or how much of the $1.5 billion came from swaps, leaving investors wondering whether the notional value of CDS sold could be as high as $150 billion or as low as zero.



Counterparty Clarity



“Their position is you don’t need to know the risks, which is why they’re giving you net numbers,” said Nomi Prins, a managing director at New York-based Goldman Sachs until she left in 2002 to become a writer. “Net is only as good as the counterparties on each side of the net -- that’s why it’s misleading in a fluid, dynamic market.”



Investors should want to know how much defaulted debt the banks could be forced to repay because of credit derivatives and how much they’d be in line to receive from other counterparties, Prins said. In addition, they should seek to find out who those counterparties are, she said.