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.