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 Magic of Vanishing Bank Capital

A recent study by Scott Strah, Jennifer Hynes and Sanders Shaffer at the Federal Reserve Bank of Boston looks back at the financial crisis of 2008 - 2009 and examines how hard the crisis hit the capital position of major United States financial institutions.

The banking system requires a level of capital that is sufficient to preserve its stability.  Without this capital, the system will implode, something that very nearly came to pass during the crisis of 2008.  For those of my readers that are only vaguely familiar with the concept of bank capital, it is defined as "the difference between the value of a bank's assets and its liabilities.".  A bank's capital is basically the buffer of both cash and safe assets that banks possess and can access to protect creditors in case the bank's assets are liquidated.  In most cases, these funds are a mixture of equity (common and preferred shares) and debt that banks hold to support their ongoing business and to support the risks involved in the banking sector (and, as we all saw in 2008, there are plenty of risks in banking!).  You will often see the term "tier one capital"; this refers to the bank's most secure capital and this capital cannot be redeemed at the option of the holder (i.e. the shareholder in the case of equity) with core tier one capital being a subset of capital that is the most secure capital.  Banking system capital is measured against the value of the risky assets that a given bank holds.  Under the new Basel III rules, banks must have  a minimum ratio of 7 percent core tier one capital on its risk-weighted assets (i.e. its loan portfolio), up from a measly 2.5 percent under Basel II.  The phase-in period for the new enhanced capital rules will occur over several years with the entire implementation taking place in 2019.  In case you are interested, here is a link to an interesting video that explains Basel III in its entirety:

BASEL3 ENG 2013 from MultiMediaStudioBrussels on Vimeo.

Now, let's go back to the Fed's analysis of what happened to the banking system during the latest financial crisis and look at how quickly America's largest financial institutions saw their capital ratios decline or completely disappear.  The authors examined 26 financial institutions including domestic banks (bank holding companies or BHCs), domestic thrifts and domestic broker-dealers with total assets in excess of $100 billion.

Here is a chart showing the findings of this study noting that the figures in red represent the maximum erosion of both Tier I capital and common equity over the period from the first quarter of 2007 to the second quarter of 2012:

A total of eight institutions (31 percent of the total) had Tier I Common Capital ratio erosion levels of 450 basis points or more, twelve institutions had capital erosion levels in excess of 300 basis points and 13 institutions (half of the total) had capital erosion levels in excess of 200 basis points.  Of the banks that had capital erosion levels in excess of 5 percent, there were four that had erosion of more than 7 percent including National City Corp, Merrill Lynch, Countrywide Financial and Washington Mutual.  What is even more stunning is that six of the seven banks that were acquired by other banks during the crisis had four or fewer quarters of capital depletion before they failed.  In the case of Lehman Brothers and Bear Stearns, they had just two quarters of capital depletion before Lehman failed and Bear Stearns was acquired by JPMorgan Chase.  In the case of Lehman, the authors' calculations do not show the entirety of the capital depletion problem since it failed so rapidly.

What is even more frightening is that, without massive government intervention, the losses could have been far worse had the Washington and the Fed not stepped in to backstop the losses.  We might not be so lucky during the next crisis given that the federal debt level is now just over 81 percent higher than it was at the beginning of 2008 making it difficult for Washington to intervene.  Without the intervention of Washington in 2008 and 2009, many of America's banks would have found themselves in far worse shape, particularly since with Washington's assistance, they were able to push their credit-related losses further into the future when the banking system once again became profitable.  

As we can see from this study, the proposed capital increases under Basel III will provide some protection for the banking system, however, as you can see from the chart above, even a 7 percent capital ratio can be depleted very, very easily and very, very quickly.  Despite what we are being led to believe, our current banking system is still very fragile even under the new and supposedly improved, stiffer regulatory environment. 

How Could Canada's Bursting Real Estate Bubble Affect All Canadians?

Recently, Bloomberg published a news item on Canada's banking system and its relationship with the country's real estate market.  While I'm not prone to quote from the mainstream media since it is my preference to post directly from the source material, in this case, the source material is not available to the general public since it was obtained by Bloomberg under the freedom-of-information law.

In a document obtained by Bloomberg, Valasios Melessanakis, manager of policy development at the Office of the Superintendent of Financial Institutions (OSFI) wrote that Canada's past history of bank failures related to real estate lending and sharp drops in housing prices could happen again.  Mr. Melessanakis writes that:

"Canada is not immune.  Just because nothing happened in Canada in 2008 (a U.S.-centred crisis), does not mean that Canada is not vulnerable to a housing correction now....The market may break because the fundamentals are not sound (i.e. an overvaluation of homes)...".

For those of you that are not aware, OSFI is "...the regulator and supervisor of federally regulated deposit-taking institutions, insurance companies and federally regulated private pension plans."  It is a federal agency that supervises and regulates 431 banks and insurers as well as 1396 federally registered private pension plans with total assets of $4.245 trillion as of March 31, 2011.  OFSI has recently been empowered as the overseer of the Canada Mortgage and Housing Corp. (CMHC) and has proposed new rules that will make mortgages a safer investment for banks.  The most stringent new recommendation coming from OSFI is that mortgagers must re-qualify for their mortgages every time they renew or refinance as shown in this quote from OSFI's most recent draft proposal:

"The LTV ratio (loan-to-value) should be re-calculated at renewal, each refinancing, and whenever deemed prudent, given changes to a borrower’s risk profile or delinquency status, using an appropriate valuation/appraisal methodology."

This issue could become critical if the current high real estate prices drop or if interest rates rise.  Should real estate valuations drop and many home owners find that their tiny bit of "skin in the game" (i.e. equity) is gone and they are underwater, the situation could flood the market with for sale properties, pushing prices down very painfully.

As well, OSFI is suggesting the following:

"With respect to the borrower’s down payment for both insured and uninsured mortgages, FRFIs should make reasonable efforts to determine if it is sourced from the borrower’s own resources or savings. Where part or all of the down payment is gifted to a borrower, it should be accompanied by a letter from those providing the gift ensuring no recourse. Incentive and rebate payments (i.e., “cash back”) should not be considered part of the down payment."

This is going to impact some of Canada's banks since at least some of them have a record of offering a "cash back" program for consumers availing themselves of mortgages.

Back to Mr. Melessanakis.  He also notes that home equity lines of credit have 

"...contributed significantly to growing overall household debt...This is not sustainable...".

How is this going to impact most Canadians, particularly those that have been prudent by either saving their money or paying down their mortgage?  The OSFI is very concerned about the health of Canada's banking system if the housing market follows that of the United States.  While many of Canada's banks are well capitalized compared to their international counterparts, those of us who have taken the time and made the eye-glazing-over attempt to read through the opacity that passes for a bank annual report know that much is hidden from public view.  The examples of the failures of both the Northland Bank (NBC) and the Canadian Commercial Bank (CCB) from the mid-1980's should give Canadians pause to ponder the repercussions of a bank failure, particularly a major bank failure.

As an aside, I have first hand experience with a bank collapse.  I was "fortunate" enough to be a customer of both banks when they failed in 1985.  I can quite clearly recall the closing of the Northland Bank over the weekend and actually making it up to the executive floor on the first business day after they closed their doors, asking to speak to the President of the bank.  I didn't get a chance for obvious reasons!

The NBC and CCB were relatively small, western-based banks with assets of $1.4 billion and $2.7 billion respectively; fortunately for taxpayers, this was only three-quarters of a percent of Canada's total banking assets.  As western-based banks, their investments were heavily concentrated in the western provinces in oil, gas and real estate loans.  The early 1980s were tough on the west; first there was the National Energy Program which was followed in quick order by a rather severe drop in the price of oil; the combination pretty much killed the oil industry.  Interest rates were at or just below their all-time peak with mortgages in excess of 16 percent.  Calgary's real estate market plunged; I can recall some houses plunging by more than one third in value over a two year period.  Many homeowners that had bought real estate during the heady days of the late 1970s and early 1980s found themselves owning more mortgage than house and, until the laws changed, a large number of these people simply sold their homes to "dollar dealers" who would buy your house for a buck, rent it out to unsuspecting tenants, collect the rent and never make a single mortgage payment until the bank finally foreclosed and turfed the temporary inhabitants.  This was the business environment that killed both the Northland and Canadian Commercial banks, the first Canadian banks to fail since the Home Bank failed in 1923.  Both the NBC and the CCB saw the quality of their loan portfolios follow Western Canada's economy into the toilet.  This situation could well be a predictive precursor of what could happen nationally.

How did this impact the banks' customers?  Mortgages were transferred to another major bank so those with loans saw little change.  The only thing that saved depositors' bacon was the backstop of the Canadian Deposit Insurance Corporation or CDIC which insured depositors funds up to $60,000.  CDIC is a government-backed insurance plan for bank deposits, allowing depositors to retrieve their funds if a given bank or trust should fail.   Interestingly, it took CDIC until the fall of 1991 to wind-up operations for the Northland Bank.  In my personal case, my deposits were settled within two months.  

Let's look a little more deeply at CDIC, Canada's bank deposit insurer of last resort.  Here is a chart from CDIC's most recent annual report for 2011:

Notice that CDIC has $2.208 billion in cash and investments and $1.1 billion in provisions for insurance losses.  They also have the ability to borrow an additional $17 billion from the Federal Government.  While all of this may seem like a lot, in fact, it would cover only a tiny fraction of the $604 billion that Canadians have on deposit at the 85 banks and other financial institutions that are members of CDIC.  For example, Canada's smallest "big five" bank in terms of deposits, the Canadian Imperial Bank of Commerce or CIBC, manages $116.6 billion on behalf of personal depositors and an additional $134.7 billion on behalf of businesses and governments (not all of which may be covered by CDIC).  You can see quite quickly that if one of Canada's larger banks failed, the CDIC would quite quickly require a massive taxpayer-funded bailout since their cash would quickly disappear.  

As an aside (and yet further proof of the concern out there), here is an interesting quote from the CDIC annual report expressing the same concerns as the OSFI:

"The largest risk to CDIC’s membership (i.e. banks and other financial institutions) remains the possibility of a significant and prolonged decline in Canadian real estate prices. Higher interest rates and mortgage servicing costs for borrowers could also translate into credit quality issues in CDIC’s membership."

CDIC also notes that there is an increased risk that their insurance powers will be inadequate to support its insurance risks should a financial institution fail.

Let's go back to the credit provisions and mortgage side of CIBC's portfolio.    Provisions for all types of consumer credit losses in 2011 were actually down $181 million from the previous year to $762 million.  While total domestic mortgages of all types reached $260 billion, up from $249 billion in the previous year, the loan loss ratio dropped to only 0.48 percent, down from 0.56 percent in 2010 and 0.70 percent in 2009 which, in light of the current real estate market euphoria, would seem to be heading in the wrong direction but it could just be me.

Looking at the much bigger mortgage picture, total Canadian mortgages tallied at approximately $1 trillion in 2010, half of which was insured by the Canada Mortgage and Housing Corporation or CMHC (also known as the Canadian taxpayer) as shown on this pie chart:

The Federal Government who, by law, must back CMHC's insured mortgage loans, has had to increase the limit of the total value of mortgages that the CMHC can insure from $350 billion in 2007 to $450 billion in 2008 and its current level of $600 billion, more than Canada's entire federal net debt.  Can we say "bubble"?

From all of this, you can quite quickly see how a decline in the value of Canada's housing markets could impact all of us, those who have been prudent and paid down the value of their mortgage as well as those who have actually managed to cobble together some savings.  If, as the OSFI fears, a major Canadian bank failed, CDIC might find themselves begging Ottawa to cover the deposits that they cannot.  Additionally, CMHC might find themselves prostrate at the knees of both Steve and Jim begging for more.  Either way, I think that we all know who pays in the end.