The Multi-Trillion Dollar Vulnerability of America's Banking Sector

While the global stock market, particularly the American stock market, seems to be on an endless upward trajectory, there is a little discussed aspect of the business sector that could bring the global economy to its knees as you will see in this posting.

Let's open this posting with a definition:

"A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage."

Derivatives can be traded over-the-counter (OTC) or on an exhange with OTC derivatives comprising the majority of derivatives that currently exist.  These OTC derivatives are unregulated and have a far greater risk for the counterparty (i.e. one of the two parties that participates in the derivative transaction) than exchange traded derivatives.

Derivatives started out as a means for international traders to ensure that the exchange rate for internationally traded goods were balanced.  As is typical in the financial sector, the use of these contracts has mushroomed into the speculative world and are often characterized by very high levels of leverage and risk.

Here are some common types of derivatives:

1.) Futures Contracts - an agreement between two parties for the sale of an asset at an agreed upon price.  Futures contracts can be used to hedge against risk and can also be used to speculate on the future price of a commodity/stock etcetera.   Futures contracts are standardized so they can be traded on a futures exchange.  

2.) Forward Contracts - a customized contract between two parties to buy or sell an asset at a specific price on a future date.   Forward contracts can be used for both hedging and speculation. Since forward contracts are not standardized (i.e. commodity type, amount and delivery date can vary), they are traded as an over-the counter instrument.  As noted above, forward contracts are riskier than futures contracts since defaults can occur when a counterparty fails.  These contracts are often used by corporations to hedge currency and interest rate risks. 

3.) Swaps - a contract between two parities agreeing to trade loan terms.  

4.) Options - an agreement to buy or sell a security from one party to another at a predetermined future date.  In contrast to a futures contract, the buyer or seller is not obligated to complete the transaction if they do not wish to do so.  Options can be short, long, puts or calls.

5.) Credit Derivative - an agreement to sell a loan from one party to another at a discounted price.

6.) Mortgage-backed Securities - similar to other types of derivatives with mortgages as the underlying asset.

Let's look at the world of derivatives from the viewpoint of the Office of the Comptroller of Currency.  In its latest quarterly report, we find the following exposure to derivatives (in billions of dollars):

At a total of $188.3 trillion, the notional value of derivatives is roughly 9.7 times as large as the entire U.S. economy (using Q3 2017 GDP of $19.501 trillion) with interest rate derivatives making up 75 percent of the total.  You can also see that the total notional value of derivatives in the banking sector has grown by 6.1 percent on a year-over-year basis with interest rate derivatives rising by $8.251 trillion over the year.  If we exclude the 22.4 percent drop in the value of credit derivatives over the year, since Q3 2016, the notional value of derivatives has risen by $13.336 trillion or 68.4 percent of the U.S. economy.

With the background on the types of derivatives, here is a breakdown in the value of four main types of derivative contracts outstanding in the third quarter of 2017 (in billions of dollars):

The four largest banks with the most derivative activity hold 90.2 percent of all banking sector derivatives, totalling $169.8 trillion dollars.  The largest 25 banks in the United States hold basically 100 percent of all derivative contracts as shown on this table:

Here is a graph showing how the notional value of derivatives have changed since 2000:

While down from its peak of $249 trillion in the second quarter of 2011, the value of derivatives has mushroomed since the first quarter of 2000 when the notional amount of derivatives in U.S. commercial bank portfolios was a rather measly $37.6 trillion.

What is the potential downside of all of this "paper"?  The 2017 edition of the Financial Stability Report from the Office of Financial Research outlines the vulnerability posed by derivatives, particularly in the case of a failing financial firm.  The report notes that, historically, there have been problems resolving nonbank financial firms' over-the-counter (OTC) derivatives positions through bankruptcy.  Under current law, there is a significant risk that a run will take place on a bankrupt firm's derivatives counterparties, a situation that occurred when Lehman Brothers Holdings Inc. filed for bankruptcy in September 2008.  Counterparties terminated most of Lehman's 6000 plus derivative contracts (which accounted for only 5 percent of the global derivative markets) resulting in losses on its derivatives portfolio, magnifying the impact of Lehman's failure on the American banking system.

Here is a graphic showing the notional value of derivatives held by the United States global systemically important banks (G-SIB) and their banking subsidiaries to the end of 2016:

       

The authors of the report note that finding assignees for the over-the counter derivatives portfolios held by larger United States global systemically important banks could be difficult since there are very few potential buyers at that level.  If a derivatives portfolio is "out of the money", selling the failed bank's portfolio might be impossible at any price, causing a cascade of issues for the banking sector. 

  

As we can see from this posting, there is a very significant potential risk to the global economy related to the extremely large derivatives positions held by America's largest banks.  Should an unexpected shock like 2007 - 2008 roil the markets again, the systemically important banks in the United States and around the globe could find themselves holding paper that is nearly worthless.  If one party (i.e. counterparty) to a derivative contract fails, the impact can cascade through the financial system, a repetition of what happened as the contagion spread during beginning of the Great Recession.  

Apparently, when it comes to the U.S. banking sector, some lessons are never learned.

Derivatives - The Economy's Achille's Heel?

The same sector of the economy that created the Great Recession is back in full force, creating what could be the world's next financial crisis through their use of single product, derivatives.

While most of us have heard of derivatives, let's start this posting with a look at what derivatives are.  From Investopedia, here is the definition of a derivative:

"A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage."

The most common types of derivatives are forwards, futures, options and swaps.  A forward contract is a customized contract that takes place between two parties where settlement takes place on a specific date in the future at a price that is agreed upon the day that the contract is written.  Futures are exchange-traded contracts to buy or sell financial instruments or physical commodities for a future delivery at an agreed upon price in a future month.  Derivatives are contracts that are often used to hedge risk, however, they can be used by investors to speculate.  For example, a Canadian or European oil company that sells its oil in U.S. dollars may wish to protect itself against changes in the exchange rate between their currency and the U.S. dollar. To hedge against this risk, the oil company could buy currency futures, a type of derivative, that locks in a specific exchange rate for the future sale of their product.  Derivatives can help to transfer risks from parties that are risk adverse to parties that are risk-oriented.  In their simplest form, derivatives are a bet on the future and as long as the bank that has them on its books is on the winning side of the bet, everything is great.    The U.S. banking system is the world's largest user of derivatives, a product that unlike shares in a corporation represents nothing, as you will see in this posting.

According to the most recent quarterly report from the Office of the Comptroller of the Currency (OCC), a total of 1427 insured U.S. commercial banks and savings associations reported derivatives activities at the end of the first quarter of 2015.  The use of derivatives by the American banking system is dominated by the four largest commercial banks which represent 91.3 percent of the total nominal value of derivatives issued.  By far, the largest volume of derivative contracts are related to interest rates followed by foreign exchange and credit derivative products as shown on this table:

A whopping 78.9 percent of all derivatives held by the banking system are interest rate contracts followed by foreign exchange derivatives at 15.1 percent and credit derivatives at 4.3 percent.  

Here is a graph showing what has happened to the volume of derivatives  since 2000:

Here is a bar graph showing how the types of derivative contracts have changed since 2003:

In the fourth quarter of 2014, there were $157.728 trillion worth of interest rate derivatives.  While this is down from the third quarter of 2014, it is up $103.198 trillion or 122.08 percent from a decade earlier.

Now, let's look at the notional value of derivative contracts held by the top 25 banks:

The top four derivative holders include JPMorgan Chase, Citibank, Goldman Sachs and Bank of America which hold a combined total of $202.649 trillion worth of derivatives.  Total assets held by these four banks is $14.156 trillion as shown on this table:

In other words, the four "too big to fail" banks have exposure to derivatives that is more than 14 times the total value of their assets.

Should we worry about what seems like a completely abstract concept?  According to a recent statement by Thomas Hoenig, Vice Chairman at the Federal Deposit Insurance Corporation, the largest United States banks have an average tangible equity capital ratio (aka leverage ratio or the funds available to absorb loss against the total balance sheet and some off-balance sheet assets) of 4.97 percent.  This means that each dollar of bank assets is funded with 95 cents of borrowed money.  Mr. Hoenig goes on to note that:

"The Global Capital Index illustrates how financial resiliency is still sorely lacking.  The sector of the financial industry with the greatest concentration of assets is the least well capitalized. Plainly put, it operates with the largest amount of borrowed, or as we say, leveraged funding, and thus it is the least well prepared to absorb loss. Yet the primary measure of capital – the risk weighted measure  -- makes the largest firms appear relatively more stable than they really are. The reality is that with too little owner equity funding individual firms, the industry as a whole also is undercapitalized and should one firm fail, the industry continues to be vulnerable to contagion and systemic crisis. It follows that the lack of adequate tangible capital remains among the greatest impediments to successful bankruptcy and resolution."

As shown in this letter to shareholders from JPMorgan Chairman Jamie Dimon, even he admits that there will be another financial crisis:

"Some things never change — there will be another crisis, and its impact will be felt by the financial markets.  The trigger to the next crisis will not be the same as the trigger to the last one – but there will be another crisis. Triggering events could be geopolitical (the 1973 Middle East crisis), a recession where the Fed rapidly increases interest rates (the 1980-1982 recession , a commodities price collapse (oil in the late 1980s), the commercial real estate crisis (in the early 1990s), the Asian crisis (in 1997), so-called “bubbles” (the 2000 Internet bubble and the 2008 mortgage/housing bubble) etc.  While the past crises had different roots (you could spend a lot of time arguing the degree to which geopolitical, economic or purely financial factors caused each crisis), they generally had a strong effect across the financial markets." (my bold)

Only time will tell us whether the massive value of derivatives sitting on the balance sheets of the "too big to fail" banks will prove to be the Achilles heel of the banking system and whether a wrong bet has the power to bring the economy to its knees as it did in 2008.

The Global Derivatives Market - The Next Implosion?

I recently took a wander through the website for the Bank for International Settlements or BIS and found one very interesting chart that I'd like to share.

First, I'd like to give you a bit of background information on BIS and then I'd like to give you a quick explanation about derivatives so that we can put the data that you will see in the chart into perspective.

In its own words, here's what BIS is and what it does:

"The mission of the Bank for International Settlements (BIS) is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks.

The BIS pursues its mission by promoting discussion and facilitating collaboration among central banks, supporting dialogue with other authorities that are responsible for promoting financial stability, acting as a prime counter-party for central banks in their financial transactions and serving as an agent or trustee in connection with international financial operations

As its customers are central banks and international organisations, the BIS does not accept deposits from, or provide financial services to, private individuals or corporate entities. The BIS strongly advises caution against fraudulent schemes." 

Basically, BIS is the banker of all bankers.  It is the penultimate central bank, coordinating the efforts of its 58 member banks.  BIS has two goals: first, to regulate capital adequacy for banks and second, to make bank's reserve requirements transparent to ensure that the risk of bank runs is minimized.  Editorially speaking, I'd say that BIS must have been sitting on its hands during the Great Recession and during the recent implosion of many of the banks in the Eurozone.

On to part two.  What is a derivative?  Here is the definition from Investopedia:

"A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage." 

For those of you that have some knowledge of how stock exchanges work, you are aware that you do not physically have to hold a company share in your account to "own" that share, bond or commodity.  You can "own" it by holding a futures contract, an option to buy or sell, a swap or a forward contract.  As such, these instruments can be used to deflect risk on such things as future declines in price, future changes in exchange rate or even future changes in weather that could impact the price of a commodity.  Basically, you name it, and the minds controlling Wall Street have found a way to monetize it through the creation of a derivative.  

Basically, derivatives are just "something that is based on another source", that is, it is something created from something else.  In our increasingly "paper economy", it is creating something made of "paper" from something that originally had value.  If you want to know just how dangerous these paper fabrications are to the economy, you need to think back only 4 short years ago when the global financial crisis began.  In large part, the near implosion of the world's economy was caused, in part, by the creative proliferation of derivative products that were tied to United States residential mortgages.

Back to BIS.  Here is the chart from their latest Semiannual OTC Derivatives Statistics to the end of December 2011 in billions of dollars, remembering that only 13 of the 58 member countries are reporting their statistics:

All tallied, BIS reports that there were $647.762 trillion worth of derivative contracts globally at the end of December 2011.  Of all of the over-the-counter derivatives, interest rate contracts are by far the largest when measured in terms of dollar value.  In interest rate swaps, two parties agree to exchange (or swap) interest rate cash flows with the ultimate goal of preventing exposure to fluctuating interest rates or to allow the parties to gain access to a lower interest rate.  Clear as mud, right?  At the end of 2011, there were $504.098 trillion worth of interest rate contracts and, of these, $402.611 trillion were interest rate swaps.

Let's quickly put these numbers into perspective with this graph from the World Bank:

That's right.  The GDP for the entire world was $63.257 trillion in 2010.  That means that, according to BIS statistics, the world's entire stock of derivatives was 10 times the size of the world's GDP.  What is even worse is that some experts, including Paul Wilmott, estimate that the notional value of the world's derivatives markets is closer to $1.2 quadrillion or nearly twice what BIS statistics tell us.

As I noted above, interest rate swaps are the largest component of the world's derivative market.  When interest rates rise, one of the parties will be on the right side of the trade and the other will find themselves on the losing side as is the case with all derivatives.  With the size of the interest rate swap market exceeding the size of the world's GDP by many times, the fallout could be very, very ugly particularly when one considers how ugly it got when the much smaller credit default swap market collapsed in 2008 - 2009.  There are always winners and there are always losers on any trade; unfortunately, this time, we could all find ourselves on the losing side.