Good news, bad news on derivatives

    U.S. banks' exposure to potential derivatives losses drops 10% in the first quarter - but remains a scary-looking $1.42 trillion.

    By Colin Barr

    The ever-present derivatives threat for big banks eased a bit in the first quarter.

    U.S. banks' exposure to possible derivatives losses dropped by 10% during the quarter as interest rates stabilized and offsetting contracts were canceled out, according to a report Friday from the Office of the Comptroller of the Currency.

    Despite this progress, some think derivatives continue to pose a considerable threat to banks' health.

    Derivatives are contracts tied to the value of other securities, such as stocks, bonds or currencies. Ill-timed bets in certain derivatives have been blamed for accelerating the financial crisis that shook the markets last fall.

    The OCC said the banks' total credit exposure -- reflecting banks' possible losses were their trading partners to default -- was $1.42 trillion at the end of the first quarter. That's up 9% from a year ago.

    The banks with the greatest derivatives exposure at the end of the first quarter were JPMorgan Chase (JPM, Fortune 500), with $462 billion, Citigroup (C, Fortune 500), with $264 billion, Bank of America (BAC, Fortune 500), with $213 billion, and Goldman Sachs (GS, Fortune 500), with $206 billion, the OCC said.

    Skeptics of the derivatives market have noted that this level of exposure is still higher than the banks' capital reserves against future losses. What's more, it's difficult to properly assess derivatives risks since little public data is available.

    "Credit exposure is an important number to watch," structured finance consultant Janet Tavakoli wrote in a note this week, but "more disclosure is needed by all members of the banking system."

    By its own admission, the OCC report is incomplete, as "there are a number of other providers of derivatives products whose activity is not reflected" in the numbers.

    The news comes amid wrangling in Washington over the shape of derivatives regulation. Derivatives, particularly credit default swaps (CDS), have come under scrutiny for their role in the collapse of AIG (AIG, Fortune 500).

    The insurer had massive exposure to credit default swaps, which allow traders to speculate on whether a bond issuer will default. AIG sold protection on hundreds of billions of dollars of debt without reserving to pay for potential claims or defend itself against collateral calls by trading partners.

    AIG has since received some $180 billion in taxpayer assistance, some of which was promptly funneled to banks -- notably Goldman Sachs -- that had purchased swaps from AIG.

    The spectacle only added to bailout rage in Congress, where some legislators have called for the use of certain derivatives to be sharply restricted. Even some financial experts think a crackdown on derivatives is warranted.

    Billionaire investor George Soros this month called credit default swaps "toxic" and suggested they should be abolished, according to Reuters.

    An Obama administration proposal released this month stops short of that but would subject all over-the-counter derivatives, such as interest rate swaps and credit default swaps, to federal regulation. As part of the plan, there would be capital, margin and disclosure requirements for dealers.

    But as worrisome as potential derivatives losses are, the first quarter data show current losses are muted.

    Banks wrote off $218 million in derivatives receivables as uncollectible in the first quarter, the OCC said -- well above the levels during the credit bubble but down substantially from the fourth quarter's record of $847 million.