MARKET OBSERVATIONS

UPDATE:  BANK DERIVATIVES EXPOSURE

MARKET OBSERVATIONS - 2/3

Update Time...In fact, quite timely, really.  Surely with the volatility in the bond market these days, it's high time we checked in on those wacky money center banks and their highly flammable derivatives exposure.  All sarcasm aside, the reason we continue to update you each quarter on these numbers is that derivatives are part of "what's different this time".  In 1990, the total notional value of derivatives outstanding "off" the balance sheet of the commercial banking system in the U.S. was $6.2 trillion.  As of 3Q 1999 (the latest numbers released), the value has skyrocketed to over $35 trillion.  Needless to say, the number is quite significant.  See what we mean?

Let's get one thing straight, one must draw a clear distinction between notional values and actual dollar values.  The whole premise of derivatives transactions is that a few real dollars can be spent to control a large amount of notional dollars.  Hence the leverage.  What has been untested up until this point is an illiquid or discontinuous market environment here in the U.S.  (We do have precedent on a lesser scale in the Asian countries pre their 1997 crash.)  Every time it has appeared as though we may be headed for trouble here at home, the Fed has stood at the ready, liquidity fire hose in hand.  Given the size of the derivatives markets today, the reality is that the strong possibility exists that we may someday find ourselves in a situation that is "too big" for even the invincible Fed to handle.  Don't get us wrong.  We're not hoping for something like this.  In fact it's our worst nightmare.  Seriously.  It could spell a real implosion in financial markets here at home an globally.  Nonetheless, you see glimpses of possibility and anecdotes found in the current market.  Undoubtedly this morning's "gap up" in the thirty year bond was the result of some heavy short squeezing, clearly exacerbated by the leverage inherent in derivatives overlay.  Despite the manipulative and well-timed Treasury sound bites of shortening bond maturity issuance in the future, volatility in the price of the 30 year over the last four weeks can be described as nothing short of dramatic.  Certainly a number of "players" in the bond cash and derivatives markets have been hurt badly.  We're sure you heard the rumor this morning (responsible for the short term 150 plunge/buying opportunity in the Dow) that "somebody" was in trouble and the Fed fire truck had been called to douse the flames.  (As we're sure you know by now, implosions like that of LTCM are actually bullish as the G team stands at the ready to spray massive amounts of liquidity in all directions.  Unfortunately, we're only sort of kidding.)

Enough of the optimistic, lighthearted banter.  A second, and equally important, reason we continue to focus in on derivatives is that these instruments have become so widespread in use that derivatives themselves can have a significant impact on price volatility in the cash markets that underpin the very values on which the derivatives contracts are based.  The last point regarding the derivatives markets that truly gives us pause is how little is spoken about them on Wall Street (despite every major trading firm heavily relying on their use).  The striking characteristic of derivatives use is the sheer lack of mandated disclosure.  There isn't even an attempt at some type of simplified analysis.  Every time the SEC/FASB seems near requiring that firm's account for their derivatives activities in their SEC statements, the proposal mysteriously seems to be scuttled at the last minute.  Every time.  It's like the great mystery of the margin requirement.  Just don't bring it up and it will go away.  If you simply ignore it, it's not there.  After all, it's a new era.  Certain things just aren't discussed.

Up tick In The Update...3Q 1999 saw an 8.2% rise in the notional value of derivatives in commercial bank portfolios.  It's a $2.7 trillion notional value increase.  Believe us, it's one of the bigger quarterly increases in some time.  Since most money center bank derivative dealings center around interest rate and foreign exchange contracts, is the up tick really that much of a mystery?  Of course it's not.  The bond market clearly was misbehaving as was the Yen/Dollar cross and the Euro/Everything Else cross.  As we've harped on too many times, derivatives give many of the big players a sense of "comfort" that they have indeed hedged their investment/interest rate/forex risk away in having the money centers construct "special" derivatives contracts specifically for them.  Again, these contracts are untested in a true liquidity crunch or (God forbid) discontinuous market environment.  Discontinuity is just not a part of mathematical models.

Let's get right to the numbers:

(In $Billions)

A few quick comments.  The "Seven Sisters" listed above account for 95% of all outstanding derivatives in the US commercial banking system.  The top 25 banks make it 99%.  Citibank is a bit of an anomaly in that FOREX contracts make up a big part of overall derivative activity relative to their brethren.  As you would expect, this is so given the global nature of Citibank operations.  For the group, interest rate driven derivatives make up the bulk of activity.  In case you have not heard us describe it before, OTC contracts are specialized vehicles customized to client requirements.  There is no specialist or ready market in which to "lay off" the trade in case liquidity for one party of interest becomes an issue.  Question:  How do you get out of an OTC derivatives contract that is going against you when there is no buyer for your side of the trade?  Answer: Simple.  Hedge with more derivatives, of course.  See what we mean and why growth in use of derivatives can feed upon itself?  (Try not to think about it, you'll feel much better.)

Let's Pull The Curtain Back A Bit Further...Are you ready? (No, this isn't some Cisco commercial.)  You can plainly see the notional value of derivatives holdings relative to total assets of the top seven bank holders listed above.  Forget equity, as these are total assets.  The office of the comptroller of the currency kindly breaks out actual derivatives credit exposure to total risk based capital for these firms in the following table:

Do you think JP Morgan really has their heart in this one or are derivatives really just a hobby?  Forget credit risk in lending and risk taken on in their other trading activities, JPM has 9x's their risk based capital on the line in their derivatives book alone!!!!!  Simple Question:  How come we never see Wall Street analysts report on these readily available and public numbers?  Maybe it's just because they do not want to risk confusing Maria.  After all, she might mistake these things for price targets.

What's It Worth?...You would think that for this kind of exposure, derivatives creation and trading would be super significant to these institutions.  Have a look at trading revenue as a percentage of gross revenue for these top banks in 3Q of 1999:

Clearly for JP Morgan it's a relatively big deal, but for everyone else you have to wonder why accepting this risk justifies the additional increment to revenues.  For some, it's pocket change.

There you have it.  Another quarter under the belt for the Derivatives Report card.  As we have said many a time, the more money and credit we have created in the entire US financial system, the demand for derivatives increases.  The more volatility in the financial markets, the more the demand for derivatives increases.  It truly is different this time.  Maybe financial derivatives will remain peaceful and quiet for decades to come, but so far they have only really been tested in the halls of academia or in computer models.  We have not experienced a financial market crisis in this country throughout this decade of explosive derivatives growth.  We may have come close with LTCM, but that experience was contained as around the toxic area an isolation perimeter of credit and liquidity was quickly and efficiently constructed.  What is untested is coincident failures on the part of multiple institutions.  Let's hope that day never arrives.  These numbers say it won't result in a graceful resolution.         

Rubinesque...Bob Rubin's Wednesday night comments from his speech at the  London School of Economics were simply swept under the rug.  After all, Bezos' comments promising to focus on profits (with what, a pair of binoculars?), while the recent quarterly loss was enough to choke a horse, were eminently more important.  We only saw Rubin's comments posted on Bloomberg.  No CNBC coverage.  After all, the comments were pointedly cautious in nature.  Believe us, we are not focusing on one-liners taken out of context.  Rubin was seriously questioning the widespread belief in the "new paradigm".  Rubin said that "since returning to New York, I have been struck by the pervading assumption that all will always be well in the financial markets".  He commented that "investors would do well to consider increasing risks."  He went on to say that, "The idea that the new technologies can erase business cycles is a myth.  New technologies are of profound importance, but they are not the first new technologies of significance.  Autos, electricity, railroads, and medicine led earlier productivity booms and none of them, separately or together, produced one-way prosperity."  Is Bob really conveying the message that "investors are on their own" right here?  His buddy Easy Al simply won't be able to stop the bursting of the dike at some point?  We only have ourselves to blame for investing based on a delusionary "new era" premise?  Sure sounds that way.  That's OK, Jeff Bezos will be there to save us, right?  Now we feel a whole lot better.

Calibrate, Calibrate, Dance To The Music...Our friend TH once again graces the page with his well done chart work that simply puts the current market into calibrated perspective.  The choice is simple, folks.  You can listen to 300 years of capitalist financial history in our fair country, or you can listen to a circus barker like Bezos.  Just where do you want to place the bet with your family assets?  (In the way of full disclosure and in case you hadn't guessed, we're with TH all the way.)

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