Are you wearing a neck brace yet? With all the volatility in the financial markets as of late, I just had to ask the question. It seems recently that not a week goes by where equities are not either screaming higher or lower, or often both in the same week. If I’m not incorrect, last week was a 10% bottom-to-top in the S&P futures alone. For most, that’s a good year. The question of recession is also a regular on again off again topic de jour. I find it close to laughable that most headline investment firms handicap the odds of such an occurrence on an ongoing basis by assigning ever changing probabilities to a recessionary outcome, as if it were some type of linear mathematical calculation. And these odds often change in the same week! Whoever said Wall Street is not in very good part entertainment, no?
Of course a key issue of the moment certainly inspiring more than a fair amount of volatility is goings on in the European financial and sovereign debt sectors. Very serious business, yet financial assets move meaningfully based on the words of those perhaps least qualified in financial market and long cycle economic analysis – politicians. Talk about irony, does it get any better than this?
I usually hate to initiate a discussion where I don’t at the very least have some type of fundamental opinion or at minimally a set of fundamental road markers. But when it comes to the subject of derivatives, I’m lost, and the important issue of the moment is so is everyone else. I won’t waste your time as the key point, as had been the case for two decades now, is lack of disclosure not only domestically, but globally also. As investors respond to headline Euro bank bailout announcements virtually by the day, the real focal point of discussion comes back to individual country sovereign debt soundness as in Euro land, a banking crisis for all intents and purposes is a sovereign debt crisis.
Early on when Greece was finally identified as a locus of concern, many a Euro country initially cajoled their banks into buying Greek debt. The residential real estate fiasco in Spain is largely attributable to the fact that politicos encouraged Spanish banks to lend to immigrants without credit histories. Although the “union” of the financial sector and politicians in the US is all too real, in Europe, in many senses the banks have been used more overtly clearly for political purposes. Lastly, although there is no cross border fiscal policy mandate in the land of the Euro, there is an incredibly high level of cross border financial asset holdings among the Euro financial sector. Hence the reality of the contagion problem of the moment.
But the issue I see missing from the broader discussion is the potential for unintended consequences coming from the opaque derivatives world. Again, I have no hard and fast conclusions, but rather questions about magnitude and global exposure of and to the European financial sector. Why? Just take a look at the four largest derivatives holders inside the US banking system as brought to us by one of the very few factual and quantitative derivatives data sources stateside – the OCC.
The folks you see above account for the bulk of US banking system derivatives exposure. And these are their charts after a 10% run in the market through Monday of this week. Anyone even tangentially watching did not need me to post their charts. You know what has been happening. Yes, we know lending is not happening. Yes, we know trading has been driving a lot of reported results and it has been a tough few months. Yes, we know bad debts lurk under the cover of non-mark to market on their books. And yes, we know the economy is slowing which is not exactly a wild positive for the banks. But most of this has all been true for years with the economic slowing recent. So why the plunge this year in sympathy with Euro financial sector deterioration? Is it in any way related to the clearly heightened risk in the Euro sector as a counter party to derivatives held by the above? We hear a ton about direct Euro financial sector exposure to PIIGS sovereign debt. What about the large French and German bank’s derivatives exposure? After all, the three French banks BNP, Credit Agricole and Societe Generale have assets that exceed the combined total of JPM, BAC and C. This is just France. And so their derivatives exposure is inconsequential relative to their smaller US brethren?
The fact is that no one has any hard data on US or European bank derivatives exposure or individual counter party exposure. But what we do know, although just a glimpse, is as follows. At the end of 2008, US banks (and it’s really the four key provocateurs above) were exposed to 0 trillion of notional derivatives contracts. By the second quarter of this year, that number is up just shy of 25% to 9.4 trillion. As usual, the bulk of that exposure is interest rate contracts. The funny thing is, though, US bank lending in aggregate from year end 2008 is down substantially.
Of course this begs the question, if US bank loans are down not quite 15% from their peak in 2008, why are interest rate related derivatives contracts up 25% over the same period of time? Clearly this is not related to hedging interest rate risk in the lending process. And as we know, the shadow banking system has for all intents and purposes imploded over this same period, so again this growth has not been driven by credit expansion activities.
The counter party issue looms very large as today the banks tell us they have offset 90% of their derivatives risk exposure to said and unnamed counter parties. It’s called bilaternal netting in the reporting documents. This number has barely been higher and is a good 5% above where we stood in 2008. Can we fairly say co-dependency, so to speak, has never been higher? We can.
If anything, this very simplistic graph screams that counter party exposure is a key issue when looking at the interlinkages between the US and Euro financial sector. It’s only in the semi-annual bank for international settlements report that we get a glimpse of macro magnitude, but zero information in terms of specifics about individual institutions. Euro area derivatives exposure in many instances is second only to that of the US.
Finally, a very simple relative comparison. Although I fully acknowledge notional exposure can be light years away from net or cash exposure, the current holdings of the banks whose stocks have been limping badly as of late account for notional exposure 16x’s greater than the value of US GDP.
So, just where does all of this leave us? Unfortunately the correct answer is “with questions”. We’ve recently seen what happened with Dexia and the issue of bank nationalization. I’d venture to say most investors didn’t even know who Dexia was until a few weeks ago.
As mentioned, banking is a bit different in Europe than in the US. The political “action” linkage is closer, although not much in the very large picture if you think about the history of Fannie and Freddie as an example. I think it’s very fair to say that a banking crisis is a sovereign debt crisis in Euro land, although you will not hear that on TV. We’re watching US and Euro bank credit ratings being dropped almost by the day. You remember the same credit ratings that underpin bank derivatives collateral. We’re seeing the same downgrades in many a sovereign peripheral Euro country for now, but it will not be long until the core is affected. This all begs the question, just what is the risk of a derivatives problem based either on individual counter party solvency or the credit ratings that underpin collateral for contracts? For now, the vote of the markets as per the charts of the large US banks is far from encouraging. Without trying to look for negativity as the true reality of derivatives risk simply cannot be analyzed, beware ghosts in the machine. Do our current circumstances make the case that the opaque derivatives world is begging for the transparent light of day? If not now, then when? When it’s too late? I only wish I knew.
