Bank Derivatives Exposure: Update 2Q 2000

Thirty Nine and Holding...Thirty nine trillion that is.  That's right, as we told you last Thursday, the 2Q '00 Bank Derivatives report has hit the street.  Well, in this case, the backstreet as we just never find mention of it in the popular financial press or the Wall Street analytical community.  We keep you updated with the highlights of this report quarterly as the derivatives complex is inextricably linked with the credit markets.  They are self reinforcing.  Although the report shows the total notional value of derivatives held by the US banking system at $ 39.3 trillion as of 2Q quarter end, there is simply no question in our mind that by now, banks have rolled over the big Four-O.  Is it really all downhill from here?  (Unless money and credit creation in the financial system slows, not a chance.)

Somebody Stop Me...This is a new economy.  Unfortunately one that has become dangerously dependent on credit.  It may appear like a brand new world, but it's really an age old trap.  Instead of depending on savings and rising incomes for capital formation and economic growth (the old fashioned method), the US economy and financial markets are now dependent on a steady supply of new credit to achieve acceptable nominal levels of growth.  Just last month it was reported that consumer debt grew twice as fast as spending.  With credit growing faster than the economy as a whole, and with a large amount of credit creation happening outside of the banking system, Greenspan's ability to slow the economy through monetary policy has been diminished relative to much of prior historical experience.  After all, credit traps are anomalies, aren't they?

Back to the matter at hand.  By their very nature, the use of derivatives in this new era allows credit creation to move well beyond what would be considered normal.  This is new territory for the US economy and financial system.  Never before in a US economic and financial market expansion have derivative contracts/securities played a significant role.  Never before has underlying exposure to the leverage inherent in these vehicles been experienced.  Never before has the system been so dependent on the proliferation of derivative hedge "promises" to underpin the risk inherent in accepting significant credit risk.  We're currently looking for the Fed to be publishing their quarterly Flow of Funds statement within days.  (Of course we'll let you in on all the little secrets.)  In the FOF report we get a glimpse of the amounts of credit/debt being created by the Financial sector of our economy.  Unquestionably, derivatives play a huge role in the perpetuation of the credit creation "mechanism" in the current environment.  We're simply astounded they receive about zero analytical attention.

The Current Picture...Total US banking system exposure to derivatives grew 4.5% in the second quarter of this year alone.  2Q 00 over 2Q 99 is a 20.7% growth figure in total notional exposure.  77% of total current exposure is caught up in interest rate contracts.  The following graph is just a little jaunt down memory lane:

The growth in derivatives outstanding conceptually tracks the growth in financial system leverage as a whole.  The importance of interest rate contracts cannot be overstated.  This may sound facetious, but the next time you lever to buy a new house or a new car (collectively speaking, of course), there is an interest rate derivative contract being written somewhere.  Although we rant and rave (and will continue to, thank you) about the Greenspan fan club spiking the money and credit supply punch bowl, the financial sector in this country clearly shares the honors.  The financial sector includes the banks, the non-bank financial companies, and the obliging brokerage outfits.  At the moment, the only clear picture we can get of derivatives usage within the greater financial sector is with the banks.  Thanks to our diligent regulators, no one else is obliged to fess up for now.  We've heard estimates that have put total system (brokers, hedge funds, other financial companies, etc.) usage of derivatives at over $100 trillion.  There's just no way at the current time to prove it.

The Big Four...And three of their closest friends.  We're looking at the largest banking behemoths in the US in the following tables.  These are the big boys.

The top seven banks in this country account for over 95 % of total derivatives exposure in the US banking system.  As with imbalances in other areas such mutual fund holdings of individual stocks, the top four banks in the country (Chase, JP Morgan, BofA and Citi) account for 89.4% of total banking system derivatives exposure.  The concentrated exposure is striking, if not chilling.  

As you can see, interest rate contracts account for the bulk of derivatives activities.  Citibank is a bit of a special case given it's global exposure.  FOREX (foreign exchange) contracts are near and dear to its risk management heart.  Many people tend to think of derivatives as puts, calls and futures.  The banks aren't betting on the stock market.  Far from it.  Interest rate contracts and credit derivatives are essential to their lending activities and those of their clients.  Their contribution to credit creation.  What time is it when you've hedged the bulk of your loan portfolio?  Time to make some more loans, of course.  You knucklehead.

Lastly, and quite important, is that the bulk of all derivatives exposure at the banks is OTC contract exposure as opposed to exchange listed.  OTC clearly means that these were specialized and individualized contracts tailored specifically to the counterparty.  By definition, there is no readily available market.  We've already seen in the experience of foreign countries how liquidity ran screaming for the exits in the listed derivatives market at simply the very first sign of trouble.  Just how do you think liquidity acts in the OTC market if it even hears a fear laden pin drop?  Let's put it this way, we sincerely hope we never get the chance to find out.  Our most near experience with something like this was LTCM.  But, that was a "controlled burn", not a Montana wildfire. 

What's The Risk In A Little Fun...Take a peek at the following table and we'll talk:  

Morgan and Chase aren't screwing around here.  This is serious and big exposure.  It's also very meaningful to their top lines.  As you may know, the measure of "risk based capital" in the banking world is much broader than the pure or absolute number that is equity.  (Although unfair, notional derivatives exposure divided by pure equity is 43x's at Chase and 54x's at Morgan.)  Seeing these numbers, is it really any wonder why the Fed's interest rate actions over the past few years have been so deliberate, so gradual, and so well telegraphed?  Of course it's not.  It's clear as a bell.

Deutsche Just Hate It When That Happens?...And here Deutsche Bank is rumored to be considering swallowing JPM.  Clearly "in play" JP Morgan is one big dog in the sand box of the derivative playground.  Given JPM's incredibly large exposure to derivatives and hardcore top line reliance on trading (see the following table), Deutsche better hope this doesn't turn into the quicksand box at some point.

The following table delineates the meaning of trading revenues to the top line of these derivatives junkies.  Once again, this is super important stuff to Morgan and Chase.  We've said this before, but for the life of us we just cannot figure out why Wall Street bank analysts routinely ignore derivatives activities of these institutions in their writings and ratings.  How can any decent research report on Morgan or Chase be written without a discussion on the meaning and risk of derivatives to both the top and bottom lines?             

There you have it.  These tables and graph are the highlights of banking system derivatives exposure as of about two months ago.  The one last comment we would make is that even this mandated disclosure is lacking and incomplete.  The OCC mandates a good number of disclosure items, but only requests past due contracts as a measure of risk.  It's sort of like a past due loan.  At what point does it become something else?  The official number of past due contracts is quite low.  Perceptually it looks great.  Given the wonders of creative accounting, what is not disclosed are derivative contracts that have been "restructured", have been rewritten as loans, and those accounted for on a "non-accrual" basis.  More ingenious banking lingo.  Now, tell us, what shell is the pea under?  Place your bets.  

Chillin Wit Shady G...We've caught our fearless Fed leader in too many a rap proclaiming that derivatives have helped "raise the standard of living" in the US and globally.  Possibly Greenspan means that mankind is supplying credit where no credit has ever been supplied before.  If derivatives usage is so wonderful, according to Greenspan, then why has the Fed fought tooth and nail to keep the facts a secret?  The Fed has ignored/turned down requests by the FASB for both disclosure and mark to market mandates.  The Fed has actively lobbied to keep the derivatives market unregulated.  This in spite of the fact that widespread and broad usage of derivatives barely has ten years of history in our and the global financial system.  Completely untested in any scenario that could even remotely be characterized as discontinuous.

Greenspan isn't stupid.  He knows that credit can only proliferate with the supposed safety valve underpinning of the derivatives market.  It's simply how the current game is played.  At this point, the financial markets and the real economy must have a steady diet of new credit to function.  It's a cycle that if interrupted significantly would cause the economy and the financial markets to come to a screeching halt.  In the greater "circle" of interrelationships we discussed last week, the continued expansion of the derivatives market tangentially underpins the US dollar and the stock market itself  vis-à-vis the credit creation mechanism in this country.  Will the real Shady G please stand up?  (We doubt it seriously - he's already had far too many chances and passed.)

At The Wire...After the close, it was announced that the Board's of Chase and JP Morgan "are talking" (about a potential merger).  Looking at the 2Q derivatives report, our humble and meek response is HOLY GOD!  These are clearly the two largest players in the derivatives market among the banks.  Put them together and the single entity alone would account for over 50% of all US banking system derivatives exposure.  The combined Chase/JPM would be exposed to over $20 trillion in notional derivatives securities/contracts.  (Once again an unfair comparison, but a notional value greater than the entire value of the US equity market.)  Remember, these are the two entities with outsized reliance on trading and the greatest derivatives credit exposure as a percentage of risk based capital.  We truly live in remarkable times.  We guess it is a new era after all.
 

Contrary Investor
http://www.contraryinvestor.com