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 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

cause significant financial harm to its counterparty, which may have offsetting obli-
gations to third parties and depend on prompt payment. Indeed, most OTC deriva-
tives dealers hedge their contracts with offsetting contracts; thus, if they are owed
payments on one contract, they most likely owe similar amounts on an offsetting
contract, creating the potential for a series of losses or defaults. Since these contracts
numbered in the millions and allowed a party to have virtually unlimited leverage,
the possibility of sudden large and devastating losses in this market could pose a sig-
nificant danger to market participants and the financial system as a whole.
The Counterparty Risk Management Policy Group, led by former New York Fed
President E. Gerald Corrigan and consisting of the major securities firms, had
warned that a backlog in paperwork confirming derivatives trades and master agree-

ments exposed firms to risk should corporate defaults occur. With urging from
New York Fed President Timothy Geithner, by September ,  major market
participants had significantly reduced the backlog and had ended the practice of as-
signing trades to third parties without the prior consent of their counterparties. 
Large derivatives positions, and the resulting counterparty credit and operational
risks, were concentrated in a very few firms. Among U.S. bank holding companies,
the following institutions held enormous OTC derivatives positions as of June ,
: . trillion in notional amount for JP Morgan, . trillion for Bank of
America, . trillion for Citigroup, . trillion for Wachovia, and . trillion for
HSBC. Goldman Sachs and Morgan Stanley, which began to report their holdings
only after they became bank holding companies in , held . and . tril-
lion, respectively, in notional amount of OTC derivatives in the first quarter of
. In , the current and potential exposure to derivatives at the top five U.S.

bank holding companies was on average three times greater than the capital they had
on hand to meet regulatory requirements. The risk was even higher at the investment
banks. Goldman Sachs, just after it changed its charter, had derivatives exposure
more than  times capital. These concentrations of positions in the hands of the
largest bank holding companies and investment banks posed risks for the financial
system because of their interconnections with other financial institutions.
Broad classes of OTC derivatives markets showed stress in . By the summer
of , outstanding amounts of some types of derivatives had begun to decline
sharply. As we will see, over the course of the second half of , the OTC deriva-
tives market would undergo an unprecedented contraction, creating serious prob-
lems for hedging and price discovery.
The Fed was uneasy in part because derivatives counterparties had played an im-
portant role in the run on Bear Stearns. The novations by derivatives counterparties
to assign their positions away from Bear—and the rumored refusal by Goldman to
accept Bear as a derivatives counterparty—were still a fresh memory across Wall
Street. Chris Mewbourne, a portfolio manager at PIMCO, told the FCIC that the
ability to novate ceased to exist and this was a key event in the demise of Bear
Stearns. 
Credit derivatives in particular were a serious source of worry. Of greatest interest
were the sellers of credit default swaps: the monoline insurers and AIG, which back-