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Recently, I was reading a blog that noted that Jim Rogers was shorting JPMorgan (NYSE:JPM) because it had the largest derivative exposure on the street. Jim has always been the smartest guy around - so that made me wonder what this derivative situation really was and how it might affect the other banks.

As it turns out, there is actually a report on derivatives held by the top 25 banks written by no less than the comptroller of the currency - so much for the “we didn’t know anything was going on” quotes from Greenspan. (See - OCC’s Quarterly Report on Bank Trading and Derivatives Activities Third Quarter 2008 - Comptroller of the Currency - Administrator of National Banks).

To start at the beginning, derivatives for these 25 banks only totaled $5 Trillion as of 1990. However, by mid-2008 that number had hit $175 Trillion!! And - this does not include the derivatives carried by foreign banks and other fiduciary institutions (like AIG which was rumored to have $20 Trillion in derivatives on their books alone). This is a staggering number on its face but even more unbelievable when it is revealed that 93% of this figure is owned by just three banks alone: Citgroup (NYSE:C), Bank Of America (NYSE:BAC) and JPMorgan (JPM).

What does this mean to these individual banks and why is Jim Rogers concerned about JPM?

  • JPM has $87.7 Trillion in derivatives and only $1.77 Trillion in equity
  • BAC has $38.7 Trillion in derivatives and only $1.36 Trillion in equity
  • C has $35.6 Trillion in derivatives and only $1.20 Trillion in equity

According to Warren Buffetderivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal” (Berkshire-Hathaway annual report 2002).

Given the amount of leverage between the derivative books and the equity bases, a fairly small hit to the derivatives could wipe out most of the equity of these banks. Under normal circumstances, there probably would not be great risk if this book of business trades within anticipated norms - but these are not normal times. Huge moves in mortgages, commodities, bonds, and international markets make norms look almost - well - nominal.

Additionally, the derivatives are not the only problems these three particular banks have to deal with these days. Goldman Sachs Research just put out a report reviewing the carrying values these banks have for various categories of business (net of their reserves). Goldman concluded that even with cheaper funding and more leverage, these banks have assets marked at” high levels” relative to value. I think that’s being kind.

Mortgages

Commercial

Consumer

Home Equity

Construction

Mortgages

Loans

JPM

85%

97%

98%

92%

BAC

93%

94%

96%

88%

C

94%

100%

96%

88%

Despite all the talk of “stress testing” of the home mortgage books of business for the big three, we have yet to see these figures and therefore don’t know the true condition of this business. Are the reserves of 6-7% at C and BAC or the 15% at JPM really adequate? I’m willing to bet they’re not over-reserved.

George Soros has just announced that he sees commercial real estate values falling by 30% (others have said 50%). In the face of this kind of potential drop, are the 2-4% reserves really adequate for their commercial mortgages?

Meredith Whitney has just written a piece noting a coming $2.7 Trillion credit line implosion in the credit card market with huge negative implications for most card holders and attending increases in the level of defaults. (See here.) Credit card defaults are already at 7.5% and growing almost hourly. And, this does not include the auto and boat loans that are also in the tank with the highest default rates in history. Again, are the reserve levels of 8-12% really adequate in the face of the consumer credit declines that appear to be growing much worse?

After looking at these numbers, it is amazing to hear these bankers talk seriously about returning the TARP money. I would think the real concern is whether the TARP money they already have is actually going to be enough.

Even more surprising is the huge recent move in their stock prices in the face of this virtual “perfect storm.” While these price moves have come off very low levels, that’s always true of pre-bankruptcy rallies. If these banks get nationalized and go through a pre-packaged bankruptcy of any kind, it can be assumed that their stock prices will be much closer to zero than where they are today.

Don’t forget: “Just because you’re paranoid - doesn’t necessarily mean you’re wrong.”

Given the $163 Trillion of derivatives and the lack of sufficient reserves these banks seem to be carrying, I think we have good reason to be paranoid. It remains to be seen - if we are wrong.

In the spirit of full disclosure, this writer holds a modest short position in JPM - more out of respect for Jim Rogers than any stalwart personal courage.

Source: Derivatives: Just One Reason to Short the Banks