Derivatives: A Disaster Lurking Just Below the Surface?

Four banks, trillions of Dollars in exposure, one huge risk...

DERIVATIVES are like the "meat and meat by-products" of the financial markets, writes Eric Fry for the Daily Reckoning.

They look, smell and taste just like regular securities, but almost no one understands why we need them in the first place. After all, what's wrong with actual meat? Or to re-phrase the question: Is Spam really an advancement over ham?

More importantly, can we trust the derivatives markets? Or might they be toxic? Might they subject the financial markets to devastating side effects?

No one really knows...and since lab rats refuse to eat them, we must assess the risks of derivatives by relying on suppositions, theories and conjecture. Therefore, as a public service, your California editor will offer a few suppositions, theories and conjectures about the rapidly expanding derivatives markets.

The worldwide marketplace of financial derivatives is enormous. No one disputes that fact. But the potential destructive impact of these arcane, opaque securities is very much in dispute.

The apologists for financial derivatives usually say something like, "Sure, the derivatives markets are huge on a gross basis, but relatively small on a net basis." According to this logic, a bank that purchased $1 trillion worth of Spanish interest rate swaps from one-party, but also sold $1 trillion worth of Spanish interest rate swaps to another party, has zero "net exposure."

Mathematically, that statement is correct. Realistically, it is a delusion. If the financial markets should hit a pothole or two, that "zero net exposure" has the potential to behave a lot more like the $2 trillion of gross exposure. How could that happen? Very simple. One or more of the parties to these enormous transactions would have to renege on its obligations, thereby triggering a domino effect. Very simple...and not difficult to imagine.

In fact, we've already seen the trailer for this horror film. The bankruptcy of Lehman Brothers in 2008 was not only the demise of a prestigious investment bank, it was also the demise of a major counterparty to numerous derivatives contracts. Without Lehman, billions of Dollars' worth of "zero net exposure" suddenly became billions of Dollars of plain, old exposure — i.e., unhedged risk.

But that's when the US Treasury stepped into the path of the falling dominoes with trillions of Dollars of newly printed cash and government guarantees. As a result, the dominoes did not merely stop falling, but Wall Street banks were also able to take their fallen dominoes to the Fed and trade them for cash. Pretty nifty, no?

But what happens next time? Will the US government's power of credit and collusion be sufficient to prevent a disaster in the derivatives markets?

No one knows — least of all the folks who are sitting atop this big, steaming pile of risk exposure. Here's a bit of background...

In the derivatives markets, the term, "net exposure," conveys a sense of certainty and reliability — a sense of finely calibrated balance. In fact, "net exposure" more closely resembles the image of two drunks leaning against one another. The net balance between the two drunks is the only pertinent risk factor, the apologists argue. As long as the two drunks are leaning towards one another, the two of them can toss back as many tequila shots as they wish. On a "net basis," they behave as if they are completely sober.

But what if one of the drunks should keel over backwards, instead of merely leaning toward his fellow drunk? "That won't happen," comes the practiced response from the derivatives industry. "That won't happen. Don't worry about it. The four largest banks operating in the derivatives markets maintain very manageable levels of net exposure."

This writer is not convinced. He suspects these levels of net exposure are only manageable...until they aren't. Furthermore, these exposures are growing rapidly. Since 2000, the notional value of US derivatives outstanding has multiplied ten times faster than world GDP. At last count, American banks had conjured more than $200 trillion of financial derivatives into existence, according to the Options Clearing Corporation — a staggering sum that is equal to roughly three times world GDP!

Even scarier, this mind-blowingly enormous pile of risk is highly concentrated inside the finance industry. A mere four banks hold 94% of all derivatives contracts outstanding. JP Morgan's exposure, alone, is larger than the entire world's GDP...while the gross exposures of Bank of America, Citigroup and Goldman Sachs do not trail very far behind.

The story becomes even more frightening when you take a closer look at what these "little derivatives are made of." Snakes and snails and puppy dog tails would be an improvement.

"In its 2011 annual report," reports James Grant, editor of Grant's Interest Rate Observer, "J.P. Morgan Chase & Co. discloses that the great bulk of the bank's [derivatives]...are classified as 'level 2' assets, i.e., they are valued, in part, by analogy."

JP Morgan's derivatives book is not unique. A whopping 97% of all derivatives trade "over-the-counter" where illiquidity and opacity are the norm. In other words, they do not trade on a public exchange where buyers and sellers continuously exchange cash for securities, thereby establishing real-world, real-time values for the securities they trade.

Let's summarize:

1. Gross US derivatives exposure is more than three times world GDP.
2. Four banks hold nearly all of this risk. (And by the way, each of these four banks received billions of Dollars from the Federal Reserve and Treasury four years ago to ensure their survival).
3. Almost none of these securities trade on a transparent, public exchange. Therefore, they are valued, as Jim Grant says, "by analogy."

What could possibly go wrong?

To begin answering that question, let's take a closer peek at JP Morgan's exposure — specifically, the calculation of its "Derivative Receivables" relative to its tangible equity capital (TEC).

"Derivative Receivables" represents the money other folks owe to J.P. Morgan, based on the current pricing of the derivatives on JP Morgan's books. These are Morgan's "winning bets" in other words. But as every gambler knows, a winning bet is not automatically a moneymaker. You must also collect the bet from the loser. Thus, the "Receivables" line item on the balance sheet represents uncollected bets.

So, what would happen if a couple of the losers didn't pay...just like Lehman Bros. didn't pay its bets a few years ago? Would that be a problem? In a word: yes.

Obviously, the size of the problem would depend upon the size of the reneged bet or bets. So just for kicks, let's imagine that almost everyone made good on their bets with J.P. Morgan. Let's say that 19 out of 20 repaid their bets, while only one out of 20 refused to answer his phone.

If something like that occurred, Morgan would be short roughly $90 billion — a shortfall that would completely wipe out Morgan's tangible equity capital. In other words, just one deadbeat gambler out of 20 could imperil the bank's very existence. Morgan would be insolvent...at least until the Treasury and the Fed flew in their "financial medevac" choppers to airdrop billions of Dollars onto the disaster scene.

We aren't saying a disaster is likely to strike. We are merely saying that it is not unimaginable.

And here's the really crazy thing; there aren't even 20 gamblers in the derivatives markets to diversify the risks, there are only four that matter — all four of whom are also "the House." In other words, because only four big banks hold 94% of the derivatives, they all owe money to each other in virtually incalculable ways.

Yes, they can each count the actual receivables and payables, but they still cannot quantify the "what ifs" that could ensue if one piece of this multi-trillion daisy-chain breaks down. "The high concentration of derivatives among the top four players," warns Reggie Middleton of the Boombustblog, "strongly suggest that they may be subject to extreme levels of counterparty risk towards each other. JPM is the largest player in derivative markets accounting for approximately 40% of total notional value of derivatives in US. JPM's notional value of derivatives as of March 31, 2009 stood at 39.0 times its total assets and 959 times its tangible equity."

These spectacularly large data points concern us. Enormous, opaque and illiquid risk exposure is rarely a good thing.

That said, we would quickly add that we have no axe to grind with JPMorgan...or any of the other big banks. Maybe they are great banks in every way, maybe they aren't. We have no idea. We are all about hating the sins, not the sinners. And we are concerned about the sizeable risks that linger just beneath the surface of the world's financial markets.

Any fool can see that the four big derivatives banks should be dialing back their exposures before the next credit crisis, rather than necessitating the next mega-bailout. But Fed Chairman Bernanke is no fool. He's got enough education and advanced degrees to understand that two drunks leaning against one another are actually "net sober."

We aren't that smart...and probably never will be.

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