Warren Buffett has called them “financial weapons of mass destruction.”
And before my Dad passed away in 1997, he called them “a gambling casino empire that has taken over the world’s largest banks.”
In the United States alone, their total face value is more than $71 trillion, or over double the size of the great U.S. debt monster I told you about last week. Including those held overseas, the grand total easily exceeds $100 trillion. And yet …
VERY LITTLE IS KNOWN ABOUT THEM!
When you mention their official name — “derivatives” — most people’s eyes glaze over.
And when you try to discover some basic facts, you run into a virtual information black-out on the subject.
What are they? Essentially — bets.
For example …
I bet you that, in the next 50 days, the 13-week Treasury-bill rate is going to go up at a faster clip than the yield on 20-year Treasury bonds. You take my bet. We cut a deal. We write up a unique, customized contract involving $1 billion in Treasury securities. And we sit back to see who wins.
Or …
I bet you that, in the next 15 days, the Thai baht is going to plunge against the Indian rupiah more quickly than the Swiss franc is going to rise against the Japanese yen.
You don’t take the bet, but someone else does. Again, a deal is cut. A customized contract is negotiated and signed. Everybody’s happy.
Multiply this by thousands of financial institutions, hedge funds and pension funds … hundreds of instruments … countless permutations and situations … and it all adds up to the $71 trillion in commitments on the books of U.S. banks as of December 31, 2003.
Does this mean that the entire $71 trillion is at risk? No.
That figure actually overstates the dollar risk inasmuch as many of the derivatives are dual transactions like the examples I just gave you.
You buy one instrument, while you sell another; and the two instruments are similar in some way. So instead of simply betting on the market going up or down, you’re often betting just on the DIFFERENCE or “spread” between one market and the other.
But no one knows exactly who owns what. So …
NO ONE KNOWS WHAT
THE RISKS REALLY ARE …
… and therein lies the heart of the problem!
A few years ago, I got a phone call from an official at the Office of the Comptroller of the Currency (the OCC).
“We’re doing a major study on derivatives,” he said. “And I’m having a hard time finding any meaningful data on them. But we’ve seen your work on the subject and we’d like to know what your source is.”
For a moment, I was perplexed. Then I laughed. “Our source? That’s funny. Our source is the OCC — your office. In fact, just the other day, I called your office to try to find out more about YOUR sources.”
It reminded me of an experience I had when I was a teenager growing up in Piracicaba, a mid-sized city in the state of São Paulo, Brazil.
I was acting as an amateur interpreter for two foreign visitors who needed information on who was selling and buying local real estate properties. But despite many long searches at city hall and many interviews with city officials, they came up empty-handed.
So eventually, with an eye toward getting a lot more interpreting business, I shared my own opinion on this subject: “Just listen to all the gossip of all the old men and women in every neighborhood of town and you’ll learn pretty much everything you need to know.”
They frowned, saying they didn’t have the time.
Yet that’s essentially the same problem banking regulators face today when it comes to tracking down who owns precisely what in the massive, amorphous market for derivatives.
OVER-THE-COUNTER MADNESS
The main reason we know so little about derivatives is because the overwhelming majority are traded over the counter — not on regulated exchanges. In other words, each item can be created, structured, negotiated, and traded directly between each buyer and seller.
You can’t simply go to an exchange — like the NYSE or the CBT — and ask for volume or price data on each security or commodity. Instead, you’d virtually have to go to every single institution or investor and get them to give you a full accounting of exactly what they’re holding at any given moment.
Since each contract is customizable … since new contracts and new strategies are being created every day … and since the players are shifting their chips on the table with every roll … it is simply impossible for anyone to keep track of in any meaningful manner.
Catching every word of gossip in every neighborhood of Piracicaba would have been a far easier task.
SHOCKING FACTS
Since my conversation with the OCC, they’ve actually done a lot of good work on this. They’ve discovered that the hub of the worldwide derivatives market is a very limited number of large American banks. So that’s the government’s primary source for the regular quarterly updates the OCC provides on derivatives.
Ironically, this could be one of the most critical factors in changing your financial life in the years ahead … and yet most “experts” don’t even know the information exists.
Where is it? Simple …
Go to http://www.occ.treas.gov/ftp/deriv/dq403.pdf
Read the first couple of pages on screen.
Then come back to this e-mail so I can explain to you the key facts:
Fact #1: “The notional amount of derivatives in insured commercial bank portfolios increased by $3.9 trillion in the fourth quarter, to $71.1 trillion.”
This is the source of the $71 trillion figure I gave you at the outset.
PROBLEM: No matter how you slice it, it’s huge. Also bear in mind that these are separate from, and in addition to, the $34.4 trillion in U.S. debts I told you about in my “Martin on Monday” last time.
The difference is that, unlike standard debts, the risk in derivatives obligations cannot be measured by the total face value or “notional amount” of the contracts. (More on the risks in a moment).
Fact #2: “Eighty-seven percent of the notional amount of derivative positions was comprised of interest rate contracts …”
In other words, nearly $9 out of $10 of the derivatives are connected, in some fashion, to the ups and downs in various interest rates.
PROBLEM: If too many players are betting on certain interest rates staying where they are or going up only gradually … and those rates spike higher unexpectedly … guess what!
The consequences could be chaotic.
When something similar happened just a few years ago (the Long Term Capital Management disaster), it shook the world to its core. When something similar happened just a few years ago (the Long Term Capital Management disaster), it shook the world to its core. (For details, see my 2003 book, Crash Profits.)
Fact #3. “Holdings of derivatives continue to be concentrated in the largest banks. Seven commercial banks account for 96 percent of the total notional amount of derivatives in the commercial banking system, with more than 99 percent held by the top 25 banks.”
Uh-oh. This is not healthy. And these are the same folks that tell us “diversification of risk” is so important?!
Sure each individual bank tries to do its best to stay diversified (I hope). But the SYSTEM as a whole is anything but!
Almost any historian, any political scientist, and certainly any economist will tell you that too much power and risk concentrated in too few hands is a serious threat to society. And they’re right.
Fact #4. “Over-the-counter (OTC) and exchange-traded contracts comprised 90 percent and 10 percent, respectively, of the notional holdings as of the fourth quarter of 2003.”
Why do they keep 90% outside the auspices of exchanges?
According to the OCC, these “tend to be more popular with banks and bank customers because they can be tailored to meet firm-specific risk management needs.”
But that takes us to …
Fact #5. “… OTC contracts expose participants to greater credit risk and tend to be less liquid than exchange-traded contracts, which are standardized and fungible.”
In other words …
==> If you’re a big banker, and the other guy (the “counterparty”) is about to default on a trade, it’s up to YOU to take protective action, largely WITHOUT the help of exchange officials.
==> If they do default, it’s your fault. You’re the one who was responsible for the due diligence. You’re the one who was supposed to keep track of the “credit risk.”
==> If “protective action” means getting the heck out of the deal in a big hurry, good luck!
==> It’s like the difference between selling a share of stock and a piece of land. Your stock is the same as everyone else’s. Its value is easy to determine; the value of your land is not. You have to get it appraised and then find a buyer who wants that particular parcel in that particular location.
Bottom line: Unloading losing positions isn’t easy in normal times … it could be even harder in abnormal times … and it will be next to impossible if the counterparty is close to conking out on the deal.
Fact #6. “Long-term contracts (i.e., with maturities of five or more years) increased by $730 billion, to $13.8 trillion. Longer-term contracts present valuable customer service and revenue opportunities. They also pose greater risk management challenges, as longer tenor contracts are generally more difficult to hedge and result in greater counterparty credit risk.”
Whenever you ask big bankers about derivatives, their pat response is: “Don’t worry. We’re hedging our risk.”
Maybe so. But there are two problems with this defense. First, as the OCC tells us in fact #6 above, $13.8 trillion of the derivatives is tied up in long-term contracts which are more difficult to hedge against.
Second, the largest derivatives players are over-exposed to the CREDIT risk associated with their derivatives positions.
I’m not even talking about how much they could lose on the investments themselves. I’m referring to their risk exposure in the event of defaults by their trading partners.
THE SEVEN BIGGEST PLAYERS
Do you still have the OCC’s report up on your screen? If so, scroll down to page 10. (See the page numbers in the lower left of your screen? It should say “10 of 27.”)
At the top of your screen, you should now have a bar graph, with the bold headline …
“Percentage of Credit Exposure to Risk Based Capital”
If you do, you’re in the right place to personally witness one of the most shocking phenomena of our time.
Go to the bottom of the page.
You’ll see a table.
It lists seven big banks.
In the right hand column, labeled “03Q4” — fourth quarter of last year — you’ll see some numbers. Starting from the bottom of the list, here’s what the numbers mean:
Banc One. For every dollar of capital (adjusted for some risk factors), the bank was assuming 58.7 cents in credit risk associated with its derivatives positions. That’s a heck of a lot to risk over and beyond the normal risks of taking deposits and making loans or investments, don’t you think?
Hold your answer.
Bank of New York is taking 77.6 cents in risk per dollar of capital. Oops.
Wachovia? Similar risk — 80.6 cents on the dollar.
But wait. It gets worse, much worse …
The OCC says the B of A is at nearly two-two-two.
Want me to spell it out? OK. The U.S. Office of the Comptroller of the Currency is reporting that the Bank of America is risking nearly $2.22 for every dollar of its capital. More than DOUBLE its capital.
What about Citibank? $2.67 in risk per dollar of capital.
HSBS Bank USA? $2.88!
And here comes the most shocking shocker of all … JP Morgan Chase. For every single dollar of risk-based capital, this one giant derivatives player is taking on a risk of $8.44.
I’m sure these banks will tell you that the OCC’s formula is misleading or inaccurate in various ways … and I’m sure there’s some truth to their arguments.
But will they give us all the data to back up their comments? Will they show us exactly how far off the formula is? No.
Suppose the true risk is only half or even one quarter of what this figure implies. Is that going to help OCC officials sleep nights?
I don’t think so.
They have a big problem. So do we. Just pray that there are no major surprises — in the markets, in the Middle East, or in some yet-unnamed corner of the globe.
Then prepare for the worst by following the very same recommendations I have been insisting upon for so many months.
Specifically, the unloading of even a small fraction of interest rate derivatives could drive bond prices down — and interest rates up — a lot more quickly than most people now dream possible.
Get your money to safety. Stick with short term. Reduce your debt. Avoid risk.
What about exchange-traded funds (ETFs), options, other such instruments? Aren’t they derivatives, too? Yes. And someday, there may be questions raised about the viability of those markets as well. But not now.
Unlike the over-the-counter derivatives I’ve been telling you about today, these are under the auspices of closely regulated exchanges; and those exchanges are both strong and tough with all participants.
My view: The exposure you have with these exchange-traded derivatives is strictly the loss you can incur when the investment itself goes the wrong way. You need not worry about the other guy skipping town. At least not in the foreseeable future.
In any case, if you play in these markets, be sure to use strictly the money you can afford to risk.
Good luck and God bless!
Martin
Martin D. Weiss, Ph.D.
Editor, Safe Money Report
Chairman, Weiss Ratings, Inc.
