MARKET OBSERVATIONS

BANK DERIVATIVES EXPOSURE: UPDATE 1Q 2000

MARKET OBSERVATIONS - 6/8

Of course a senior economist at an institutional shop was quoted as saying the increase in debt was "not worrisome as long as consumers are fully employed and enjoy strong income growth.  They will be able to pay back these higher rates of debt".  Of course this was the same economist that cheered the fact that employment supposedly fell off a cliff and wages were moderating in the unemployment report just four days earlier.  Whatever fits the moment.  Standard and Poors issued a comment that they "expect higher interest rates to eventually have an effect on consumer credit".  We're waiting.

The Mark Of The Beast...The credit and money supply Beast, that is.  In celebration of the April consumer credit report, what better a time to report on Bank Derivatives activities in 1Q 2000?  As you know, we continue to report on quarterly money center bank derivative activity for what we believe is a good reason.  Are we facing a derivatives led financial meltdown?  Will the increased use of derivatives as supposed risk hedges ruin mankind as we know it?  How do we know.  What we do know is that the increased proliferation of derivatives is directly related to increased leverage in the financial system.  More consumer credit.  More corporate debt.  More financial market leverage.  The Mark of the Beast is glimpsed in the derivatives complex.  It's a confirmation that leverage is alive and well, and growing by the quarter.

As you know, estimates of total notional derivatives outstanding in the US financial system is at best a guess.  Lax disclosure regulations cloak the ability to intelligently assess system wide risk.  Corporations are immune from disclosure.  Hedge funds are exempt.  The only place where we can catch a glimpse of exposure is in the US banking system.  And even then, it will not be found in 10K's, 10Q's, annual reports, company press releases, and certainly not from the Wall Street analytical community.  It can only be found in bank regulatory filings.  After all, who reads that stuff when everything today's investor needs to know is on TV?

Despite higher interest rates, credit inside and outside of the US banking system continues to grow at a significant pace.  Resultantly, use of derivatives as a theoretical risk reduction mechanism continues to grow almost in lockstep.  Consumer credit grew at an annualized rate of 10.3% in the first quarter.  The total notional amount of derivatives in the commercial banking system grew 8.1% (or $2.8 trillion) in the first quarter of 2000.  Interest rate derivatives exposure (futures, forwards, swaps and options), the primary vehicles associated with financial leverage, grew 8.6% (or $2.4 trillion), accounting for 86% of total derivatives growth in the banking system.  Have a look at the following chart for a little retrospective of the growth in the notional value of derivatives held "off the balance sheet" by the US commercial banking system in the last decade.  Clearly the trend mirrors the growth in consumer, corporate and governmental financial leverage over the comparable time period:

(Very quickly, notional values are not actual cash values.  The premise of derivatives transactions is that a small amount of real cash can be used to gain exposure to a large amount of notional dollars.  Hence the leverage.  The movement in the notional values ultimately determines the profit or loss of the underlying derivative contract.)

These Are A Few Of Our Favorite Things...Let's get to the data.  When looking at banking system derivatives exposure, we focus primarily on the top seven banks in the country.  Why?  They account for over 95% of the total notional value of derivatives in the entire US banking system.  (The top 25 banks account for over 99%).  Here's a broad overview:

(in $ Billions):

Clearly, interest rate contracts dominate the derivatives activity of the commercial banking system in the US.  These guys are not out there buying puts and calls against Dell.  (Only Dell's corporate finance department does that.)  What is more interesting is that by far the large majority of derivatives holdings are what are termed "OTC contracts".  As you would imagine, OTC implies no listed exchange for the derivatives that are created.  The big players in the commercial banking system "create" these contracts to fit the specific risk management requirements of their customers.  God forbid these need to be sold or liquidated in a fashion other than orderly.  Unlike the OTC stock market where market makers simply do not pick up the phone in a bad or illiquid market, for the OTC derivatives players, there is no phone.  Analogously, who's the alternative buyer for a perfectly tailored suit?

As you know, the greater financial market subsets have come to rely on the Fed to provide liquidity at the first sign of any real trouble.  We believe that the importance in at least acknowledging the derivatives exposure of the money center banks (to say nothing of the hidden exposure in the greater financial market as a whole) is that these vehicles have never really been tested in a period of discontinuity.  We have come close, but junior fire marshal Greenspan has always turned the liquidity spigot on full blast as the flames have gotten a bit too close.  For what is known about the true situation at LTCM a few years back, the supposed mathematical certainty that underpins the construction of most derivative contracts can potentially come unglued in a real world situation.  Clearly no model can anticipate every eventuality.  Unfortunately the words "it wasn't supposed to work this way" doesn't warm the hearts of a counterparty which has accepted the risk of the "other side of the trade".

Nothing Ventured, Nothing Gained?...The comptroller of the currency kindly provides numbers on what they believe is derivatives credit exposure relative to risk based capital of the individual banks.  As you may know, risk based capital is a broader measure than pure equity for the banks.  For Chase, Morgan, Citi and B of A, the numbers look a bit unsettling:

For JP Morgan, this is serious business.  From the numbers in the regulatory report, one derivatives accident at Morgan appears as though it will certainly be its last.  Chase simply isn't too far behind.  With this kind of exposure at these major institutions and remembering that interest rate contracts are the bulk of activities, is it any wonder why Greenspan has completely telegraphed every interest rate hike over the past few years?

We have wondered over the past year how the derivatives market seems to have been so "quiet" in the face of 150 basis points of rate increase.  Shouldn't someone have been on the wrong side of the derivatives trade at least once in the past 18 months?  You'll be happy to know that "official" derivatives losses are running quite low.  Past due contracts remain at nominal levels.  Unfortunately, regulatory guidelines only mandate that banks report past due contracts.  Completely lacking in the report is an assessment of the magnitude of "restructured" contracts,  contracts rewritten as loans, and those accounted for on a non-accrual basis.  Oh well, you know how it is with banks.  How can you trust the books of an industry that can take non-performing loans and reclassify them as assets for sale?  After all, just who do you expect to ask the hard questions?  The folks on CNBC?      

Big Biz...The first quarter of each year usually marks a period of fairly significant derivatives activity for the Big Seven banking powerhouses.  After all, the players need to re-up their risk bets.  Here's a look at what trading was worth to these derivatives addicts in the first quarter of this year: 

Once again, Chase and Morgan are standouts in the meaning of derivatives activities to overall results.  With this kind of exposure, why aren't Wall Street analysts focusing on and discussing derivatives related exposure and revenues in their so called "security analysis" work?  Just because the banks won't directly break these numbers out in their quarterly reports does not mean they are not meaningful.  Although the regulatory reports on derivatives do not come out until two months after the close of the quarter simply does not mean it's "old news".  Quite the opposite.

The demand for interest rate derivatives is clearly a function of the levels of money and credit existing in the system at any point in time.  The numbers grow larger and larger with each passing quarter.  Given the anecdotes we have that financial discontinuity can become a potential reality (LTCM, the experience of the Asian countries in 1997, etc.), even if the chances are small, shouldn't full quarterly disclosure in 10Q's be mandatory?  And not just for financial institutions?  The SEC and the FASB have made feeble attempts to implement something along these lines a number of times.  In each instance, the corporate "lobby" was able to derail the proposals.  In the meantime, Wall Street seems unconcerned with what it knows exists, but can't directly measure.  Up until the moment the Titanic hit the iceberg, it was the world's only certifiably unsinkable ship.

Don't Let Me Hear You Say Life's Taking You Nowhere...As a last note, just for fun, let's have a quick peek at derivatives on the books linked directly to gold.  In celebration of the minor price pop in the most hated/useless asset as of late, here are the numbers:

There are really only three players.  It's the guys with broader international exposure.  Unless we're doing the math wrong, $79.6 billion in notional value of gold derivatives is equal to 8,510 "notional" tons of gold at $290 per ounce.  Although we are not experts in gold derivatives by any stretch of the imagination, this exposure seems easily capable of being able to move the price of the underlying commodity.  In fact, more than capable.

Closer To Home...The markets have been meandering for the past few days.  Of course pockets of speculation heat up and cool down day by day.  The biotechs, the semi's, a few of the Net "chosen".  Last night the ECB raised rates in Euroland by 50 basis points.  In sharp contrast to the telegraph approach used by our own timid central bank, the ECB actually surprised a good many expecting a less forceful move.  Only 2 of 36 interviewed analysts predicted a 50 basis point move.  The ECB is concerned with inflation, plain and simple, and are determined to let it be known.  As you know, if it weren't for Fed governor Meyer at the last FOMC meeting, Greenspan would still be flipping quarters up in the air.  The Euro markets and currency took notice of the action.  In sharp contrast here at home, Greenspan's well publicized actions are usually met with a "we knew that" rally.  

That Time Of The Month...We have a PPI headache.  Although the logical portion of our brain tells us tomorrow's PPI number should be anything but friendly to the financial markets, nothing will surprise us.  The intuitive side of our cerebral peanut worries about adjusted numbers.  It's simply far too convenient that within a one week time period, all economic stats are coming up roses for the economic slowdown bulls.  Unemployment supposedly imploding.  Productivity at a seven year high.  Wage gains moderating at best.  Jobless claims higher than expected.  Far too convenient.  Know what we mean?

To us, it appears as though we have begun the "final quarter" of the Big Game.  It's the charts versus the spin.  Or, as chartist extraordinaire Tim has so wisely opined, "it's Fibonnaci versus Machiavelli":

Until next Tuesday, arreviderci.

Copyright 2000, ContraryInvestor.com