Bank Derivatives Exposure
The OCC (office of the Comptroller of the Currency) is out with the 1Q 1999 Bank Derivatives Report. We thought we'd check in and see what the numbers look like. The report on derivatives employed by the major money center banks are one of the few glimpses we have in the current environment for seeing the extent of real exposure in what is most often an off balance sheet item (for many companies). As you may know, the FASB had originally issued guidelines late last year that were to become effective last month that would have required firms to report derivative positions used for hedging reasons on the balance sheet (as either assets or liabilities). Even more effective is that these instruments were to be recorded at "fair" value/supposed market value. In many cases, the change in position from quarter to quarter would have required an income statement flow. This would have enhanced the ability of the analyst community to determine how significant derivatives have become in terms of corporate profit enhancement, asset risk exposure, etc. Unfortunately, the FASB delayed implementation for another year due to the outcry of the corporate community.
Still lacking is data on hedge fund activity and other forms of private money management vehicles. Despite the apparent magnitude of what was a potential LTCM meltdown, regulators have found no reason to call for increased derivatives disclosure/regulation. In the banking community alone (the commercial banks) total notional derivatives exposure has risen from $6.2 trillion in 1990 to almost $33 trillion as of 1Q 1999. Quarterly trading revenue for the banks has grown from just under $1 billion four years ago to almost $3.6 billion in 1Q of this year.
Strangely enough, banks were one of the most vocal in their opposition to this mandate. Rationales ranged from lack of Y2K compliant reporting capabilities to the belief by the banks that this would incent firms to use derivatives for financial statement "window dressing". (Aren't some already doing this?) To be fair, some banks are really "trading operations" while others conduct business in a more old fashioned way - actually taking deposits and making loans. Their derivatives activities reflect this. Let's get to the numbers. At the moment, the top seven money center banks in this country account for 93% of the total notional value of derivatives outstanding in the US commercial banking system. Here's a snapshot of 1Q 1999:
(in $billions)
BANK
Total Assets
Total Derivatives (Notional)
% OTC Contracts
% Interest Rate Contracts
% Foreign Exchange Contracts
% Credit Exposure to Risk Based Capital
Chase
$ 291.5
$10,410
91.3 %
82.8 %
15.8 %
356.7 %
JP Morgan
184.3
8,358
83.3
81.3
13.8
850.9
Citibank
304.3
3,411
93.2
45.7
50.9
174.5
Nationsbank
317.3
2,638
75.4
94.5
2.5
83.6
Bankers Trust
98.9
2,522
93.2
69.4
26.9
425.6
B of A
250.7
1,824
90.2
62.4
36.3
86.7
First Chicago
68.9
1329
96.1
86.4
12.6
181.8
As can be seen, the total notional value of derivatives positions at the money centers dwarfs total assets at each institution. Clearly, notional values do not reflect real potential dollar value risk given the leveraged nature of the instruments themselves. A more realistic view of actual risk is represented by the column "% Credit Exposure to Risk Based Capital". Although these numbers seem quite staggering, it would truly be a global financial meltdown scenario for the derivatives to have this much of an ultimate impact on equity. Nonetheless, we believe the current derivatives exposure of these institutions does represent a clear and present danger due to the assumptions that ultimately underpin such exposure. We'll discuss this in a minute.
A few final comments on the bank positions. As can be seen, the vast majority of current derivative positions are OTC contracts. By nature, a good portion of these are non-standard or have been developed to suit the individual needs of a specific client. Given these characteristics, surely these instruments offer relatively limited liquidity and above average credit risk. As can be seen, the majority of the derivatives positions are interest rate or foreign exchange driven. The banks are not fooling around with equities or commodities. The heavy concentration in interest rate driven vehicles may go a ways in explaining why the bond market just can't seem to rally. When derivatives positions go against an institution/speculator, one method of hedge is to sell or short the cash market vehicle underlying the derivative itself. In this case bonds. This may also be another very strong reason why Greenspan has been so accommodative in monetary policy and quite timid in raising interest rates. He may just have no other choice. As we have mentioned before, we never see Wall Street analyst reports that discuss these "off balance sheet" items. It's as if they simply don't exist for the analytical community. Clearly, Wall Street will be forced to discuss this issue if the FASB ever gets around to mandating disclosure and inclusion in financial statements. (By that time it may already be a moot point if the financial markets don't hold together for another year.)
As we have said, data on total global derivatives positions is a question mark. Estimates put the notional value at close to $80 trillion U.S. dollars. These numbers simple dwarf the underlying real cash markets. In addition to interest rate and foreign exchange contracts, instruments such as puts, calls, futures, options on futures, etc. are a huge business. The leverage underlying the derivatives markets has been anecdotally apparent over the last few years. We have had singular incidents/accidents such as Victor Niederhoffer's (former Soros associate) firm going under a few years back caught in the first US "reaction" to the Asian meltdown by his writing of out of the money S&P puts. LTCM needs no comment. Greenspan saved the world from the evil, derivatives-crazed clutches of LTCM, but tacitly condones the money center bank exposure. Asia, Russia, Brazil, were all exacerbated by derivatives "unwinding" (or attempts to unwind). Does anyone remember "portfolio insurance" in the 1987 "buying opportunity"? Clearly Greenspan has witnessed the downside of leveraged derivatives exposure. How he can remain silent or appear unconcerned is beyond us. Possibly the animal is just to violent to be returned to the cage and Greenspan is just too scared to let the people know the animal is loose in the community.
We thought we'd spend the rest of the discussion focusing on what we believe are key assumptions implicit in derivatives usage and why these assumptions may ultimately offer a very false sense of security:
1. Derivatives usage assumes that markets are both liquid and efficient. (Maybe one could argue that any financial asset rests on this premise, but while a stock is a claim on real assets, a derivatives contract is a claim on a promise.) While most of the time markets are liquid, this is not always the case. (Trust us, "efficient" is a topic for an entire separate discussion.) It fact for derivatives, it is precisely the time of greatest potential risk that liquidity may dry up or prices display significant volatility. We have had direct examples of this in the recent emerging markets troubles over the last few years. Sectors of our own bond market virtually froze late last year. At the time of greatest crisis, liquidity quietly hid in the corner. Their was no one to "take the other side of the trade".
2. What is ultimately of greatest importance is the effect of derivative transactions on the cash markets. In today's world, the cash markets and the derivatives markets are inextricably bound at the hip. We believe most of the investing "public" has absolutely no idea of this important interrelationship. 1987 provided a front row seat as to how an overpopularized derivatives strategy can attempt to unwind with swift and incredible force directly effecting the cash markets. Unlike today, 1987 had nothing like the leverage we see in the financial system and markets of the modern world. The sheer size (financial exposure) of the derivatives markets of present seem to suggest that during a protracted liquidity seizure or significant multiple contract "failure to perform" event, a bailout may just not be in the realm of possibility. When derivatives markets experience a liquidity shortage, the only available "out" or hedge may be to undertake cash market alternative positions. The tail can not only wag the dog, but can pick it up and spin it in the air.
3. We feel derivatives assumed to hedge risk seductively entice market participants to assume "excess" risk. (Clearly "excess" is a term that can only be precisely defined in hindsight.) Simplistically, the origins of the derivatives markets really sprung from the need to insure against risk. After all, what is the purchase of a put held to expiration except an expensive short maturity term insurance policy? This origin of the derivatives market as a tool of risk avoidance has "evolved" into a lever of return enhancement in many of today's popular derivatives strategies. The combined use of leverage and derivatives (levered instruments in their own right) has made for a powerful and potentially quite explosive cocktail. LTCM apparently felt quite comfortable in the thought that it had hedged it's investment risks. So comfortable that the decision was made to significantly lever the total portfolio. Despite the rigorous risk simulations created by some of the brightest academic minds in quantitative analysis at LTCM, as a practical joke market reality decided to bend the rules a bit.
Almost by definition, the investment community in the entirety cannot be simultaneously hedged against market risk. The extent of leverage in and use of derivatives in today's financial markets is simply without precedent in U.S. and global history. Maybe these derivatives markets will continue to remain completely liquid and quite price efficient for years to come. Alternatively, this "paper world" is completely untested in a true secular bear market for financial assets. We have the funny feeling that most (former?) Asian, Russian and Brazilian market participants may not be quite as complacent regarding derivatives as most U.S. investors seem at the moment.
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