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US BANKING SYSTEM DERIVATIVES EXPOSURE
UPDATE: 3Q 2000

The Far Too Simple Beauty Of The Promises We've Made...We're still wiping the fresh ink of the 3Q 2000 US Banking System Derivatives Report from our fingers.  Quite timely in terms of what we see as the accelerating deterioration in the credit arena these days.  As you know, our stance has been for some time that the derivatives market has been the tranquilizer for the lending and credit risk acceptance community at large in the economic and financial expansion of the last half decade plus.  "Everything's fine, we're hedged".  We continue to report these numbers to you quarterly, at the risk of boring you to death, to keep you apprised of what seems to be the unspoken risk in the greater financial system.  Unspoken by the Fed.  Unspoken by the Treasury department.  Largely unspoken by bank regulators.  Relegated to the off balance sheet netherworld by the SEC.  Certainly unspoken by the Wall Street analytical community.  Much like our descriptions of the economy and equity markets being extremely dependent on the interlocking set of linkages between credit expansion, dollar strength, consumer spending, foreign capital flows to the US, etc., the derivatives markets in their global entirety are dependent on a web of promises and interlocking counter party risk.  A fragile daisy chain whose total strength can only be determined by the strength of the weakest link.  Unfortunately, given the virtual complete lack of formal disclosure, assessing default risk and the ramifications of that risk in any meaningful manner is next to impossible.

Suffice it to say that the notional value of derivative contracts being held by the US banking system warrant our attention and attempt at comment.  Despite the decline in stock market values and the slowing of the general economy, consumer credit expansion in the US continues unabated.  Just today consumer credit for October was reported at a 7% annualized growth rate.  It's approximately unchanged from September, but you may remember our last look at GDP growth was in the 2+% range.  On the corporate and commercial side of the equation, the tightening in expansion and credit standards is now well under way.  Many banks are currently reaping the negative rewards of less than stellar credit decisions sown years ago.  Summarily they are tightening standards for newly issued credit while hoping to contain the effects of their prior sins.  It was quite telling to hear Greenspan suggest lenders not become too restrictive in his speech a few days ago.  His comments tell us he is clearly worried about a credit crunch that drives the economy into recession.  Of course the obvious irony is that Greenspan himself has been a key provocateur in aiding and abetting the reckless credit expansion that is slowly but surely becoming his legacy, with or without his approval of that characterization.

The US banking system has become a key player in the growth of the global derivatives markets.  Let's lay out a few ground rules here.  First, notional values of derivative contracts we will show you are not actual cash values.  Derivatives are chiefly characterized by the leverage inherent in these vehicles.  Principals to a transaction may put up a cash "down payment" to theoretically protect against or control a certain notional amount of monetary exposure.  Only in a blackout default scenario (or more correctly a series of counter party defaults) should a notional value approach a cash obligation.  Nonetheless, although the facts will most likely never be revealed, this was a situation that was possibly being approached in the LTCM debacle of a few years back.  Secondly, it is really a very few banks in this country that represent the bulk of the exposure.  No worries, these just happen to be the largest banks in the country.  The top seven commercial banks in this country account for 95% of total banking system exposure.  And here you thought the S&P was top heavy.

In 3Q 2000, the notional amount of derivatives in insured commercial US banking system portfolios totaled $38.3 trillion, an actual decrease of $1 trillion from 2Q.  We'll comment on possible reasons for the decrease in a minute.  So you want perspective on that number?  Say no more:

As you can see in the chart, derivatives growth has mushroomed (along with credit expansion) in the US over the last decade.  Conceptually, growth in derivatives outstanding tracks the growth in US financial system leverage as a whole.  Also important in the chart is growth of interest rate contract vehicles.  We've told you before, the banks are not playing with equity linked derivatives here.  They've left that up to the corporate finance departments at the likes of Dell, Microsoft, Intel, etc.  It's the job of the banks to accommodate their clients in providing derivative vehicles that offset certain defined client-specific risks.  With interest rate contracts being the bulk of derivatives exposure at the banks, it can clearly be assumed that the client risk in need of offset relates to credit expansion activities.

Survey Says...Let's get to the company specific numbers, shall we?  As you know, we are looking at the leaders of the pack in terms of the largest US domiciled commercial banks:

The seven sisters here again account for 95% of total US banking system derivatives exposure.  The top four account for approximately 90%.  The word concentration may just be a bit too mild in describing the system specific exposure.  Or is that more aptly characterized as systematic risk?  Clearly from the table above you can see the importance of interest rate contracts in derivative portfolios.  Citibank is a bit of an exception as FOREX (foreign exchange) contracts are quite meaningful, as one would expect in such a global operation.  It is interesting to note (not shown in the table) that the notional level of both interest rate and Forex contracts fell in 3Q relative to 2Q, but the amount of "credit" derivatives actually rose a touch.

Quick turnoff on the road.  As you may know, many "funding companies" have sprung up over the last few years.  Non-regulated and many, if not all, shielded from disclosure.  Many of these entities are in the business of transforming water into wine.  Repackaging asset-backed and lower quality credits into vehicles suitable for money market funds.  Magic?  Hardly.  You have to look no further than "credit derivatives", letters of credit, credit guarantees, etc. to find the source of the sorcery.  We have the overwhelming sense that most of the American investing public has absolutely no idea what kind of repackaged questionable credit underpins their theoretically "safe" money market funds.  In the current environment, we would never put our own money in anything but a government paper specific money fund.  And we mean never.  Forget the yield differentials.  If you don't think money funds in existence today have the potential to "break the buck", we hope for your sake you are absolutely correct.  Rest stop over.

The last comment on the table above is that OTC contracts account for the bulk of exposure in the banking system.  By definition, OTC contracts are specialized and tailored specifically to a unique counter party client need.  There is no exchange to check a price quote.  There is no broker to call to request a market bid.  There is no readily available market for these contracts at all.  Have you ever heard the words, "you own it!"?  They may not be the three most dangerous words, but they have been know to stop human hearts in mid-beat during periods of liquidity starvation.  Just how do you think liquidity acts at the first sign of fear?  One only has to look at the current junk bond market to find out.  Answer:  Not well.

Big Biz...Derivatives have become quite meaningful to a good number of the "players club" among the big banks.  Have a look:

One simple question.  With derivatives trading revenues meaning so much to Chase, JP Morgan and Citibank, how come Wall Street analysts conveniently neglect to discuss this source of revenues in detail in their "reports"?  Instead of uttering the words, "great quarter guys" on quarterly conference calls, we humbly submit that bank "research" analysts may want to question bank management's on their derivatives book.  Of course under new SEC rule FD, that would probably stop the conference call dead in its tracks.

What's Life Without A Little Risk?...Maybe that question for the seven sisters should be "what's life without a little hidden risk?"  (Hidden from disclosure, that is.)  Hold on tight to your mouse and scroll forward:

Goin' To The Cha-a-a-pel...The table above is a nice little segue into our next topic of the moment, the Chase and JPM merger.  In this disclosure, Chase and JPM are telling you that they have taken on substantial shareholder equity risk in their derivatives activities.  We're no longer in the world of notional amounts in viewing the table above.  The rubber has hit the road with these numbers.  Once again, shouldn't the analytical community be all over this?

The merger of Chase and JP Morgan has incredible consequences if you ask us.  Together, this entity will account for close to 60% of total US banking system exposure to derivative vehicles.  Talk about concentrated systematic risk.  This possibly sets a new definition.  To be fair, potentially there will be some offset to derivative book risk in combining exposure of Chase and JPM.  To us, we have to believe that offset is conceivably quite small.  Although we cannot know for sure because of non-disclosure, to believe the offset is large assumes that the clients of these respective institutions are making completely opposite interest rate bets.  In this world of homogenous thinking and action, the probability of that actually being the case seems to us to be incredibly remote.  This will truly be an institution that will not be able to tolerate a derivatives accident, let alone a knee-scrap in terms of liquidity and fluidity of the generic derivatives market as a whole.  It's quite interesting to note that the $1 trillion drop in notional derivatives exposure of the banking system in 2Q versus 1Q is 70+% driven by a reduction in the JP Morgan book.  Could it be that Chase management got a look at the JPM book and after coming to with smelling salts demanded a bit of risk reduction prior to signing the marriage certificate?

Behind The Curtain...In spite of being able to gain a brief peak into the world of US banking system derivative activities, a clear assessment of default risk cannot be made.  Not only potential default risk, but more importantly, actual historical default experience.  In the wonderful world of creative accounting, there is no disclosure mandate for derivative contracts that have been "restructured", have been rewritten as loans, and those accounted for on a "non-accrual" basis.  Don't you just love bank accounting?  The only disclosure requirement to gauge risk is that of "past due" contracts.  As we have mentioned before, at what point does "past due" become something else?  In the derivatives world, the answer may be "quite early on".  It's a shame we have no way to really know.

You know and we know that the credit markets currently find themselves in a liquidity environment not seen for many moons.  Bond downgrade bombs are hitting the deck.  A few ships have already sunk.  Many are listing badly.  The following table will give you a feel for how the banks are participating in the "credit derivatives" market.  In this world, we're not talking about interest rate bets, but rather credit bets.  A different ball game completely.  To us, a potentially riskier ballpark.

We've already shared with you the yield on the Merrill high yield index at 14+% indicating extreme stress.  Spreads between Treasuries and most "everything else" in US bond land being very wide.  Very wide.  Corporate bonds performing badly.  Credit deterioration of major players like BofA, Wachovia, First Union, etc., being right out in the open for all to see.  With what seems a credit environment subject to stress we have not witnessed in possibly a decade, why does the following chart look like it does?

Are the players really that smart?  Or is accounting really that creative?  (Quite honestly, we do not know the real answer.  We would have bet as a matter of simple common sense that derivatives losses would have at least made a guest appearance by this point.)

It's My Party And I'll Cry If I Want To...Since so much of what happens in the derivatives world is hidden from view, we really cannot properly assess risk, or lack thereof.  In our minds, the greatest risk in the derivatives market is that of "counter party risk".  As we have discussed, the derivatives world is one almost solely devoted to the supposed hedging of risk.  Interest rate risk, credit risk, foreign exchange risk, etc.  Although the banks accommodate their customers in writing OTC contracts to satisfy the needs of unique clients, the banks simply do not sit back and accept whatever risk comes their way.  In turn, they try to hedge the risk they have accepted in accommodating client transactions in the broader derivatives market.  The game is one of trying to run a "neutral book" (neutral to market risk) to the greatest extent possible.  To do this, banks must enter into arrangements with third parties, who probably in turn try to hedge their own newfound exposure.  Here is the ultimate interdependency of risk.  The daisy chain if you will.  All it takes is one party to fail and the chain of interdependency is broken.  The ripple effect is the unintended consequence.  Conceivably a large scale default could cause a derivatives tsunami.  Lack of disclosure precludes any type of intelligent quantitative assessment of risk.  If the party in default is big enough, like LTCM most likely was, the financial party in the bigger sense may just be over to a much greater extent then ever thought possible.  One thing we can surmise is that the larger the derivatives world grows, the greater the statistical chance of a counter party default becomes.

Last comments.  We promise.  The Bank for International Settlements (BIS) in Basel Switzerland produces a semi-annual survey that puts the notional value of the global OTC derivatives market at $94 trillion as of June 2000.  Clearly from the above numbers, the US banking system accounts for over one third of this global exposure.  Moreover, global interest rate contracts outstanding are estimated at $64 trillion in notional amount.  The US banks are closer to 50% of this number.  Interestingly, the BIS describes the derivatives business conducted on global exchanges as "stagnating".  As with the US equity market, the real action in the global derivatives market is OTC.  Is all of this discussion on derivatives simply too ethereal?  We hope not.  We also hope this notion of ethereal risk is never crystallized, or better yet, monetized.  By the way, pleasant ethereal dreams.

The Forest...Volatility, the hallmark of a top and the characterization of the year 2000 in the financial markets, continues.  Whether it's a Greenspan speech (another one tomorrow-watch out!), a supreme court ruling, or just good old-fashioned earnings preannouncements, what's a trader or investor to do?  We'll, sometimes it doesn't hurt to step back and look at the bigger picture.  Thanks to Tim for the following:  

By now you are familiar with the NASDAQ ranges we have drawn. No mysteries.

We're getting a lot of earnings preannouncements out of the way.  Soon the bulk of these will be done.  The Fed meeting is on the 19th.  Plenty of spin-op.  Bludgeoned techs who preannounce are now being treated a bit less harshly than in the last few months.  Motorola today is an example.  Intel after the bell was not being destroyed in after hours trading.  Are traders and investors numbing to bad news?  The cash building up in funds may be thrown at the market before year end to reduce trauma.  After all, it's your money.  Offsetting this is our belief that there are a lot of stocks waiting to be sold at the opening bell of the new year.  Pushing further realizations of long term capital gains into 2001 has to be on the Christmas wish list of many investors.  Expect continued volatility.  Perhaps eye-popping volatility.