Derivatives: Just One Reason to Short the Banks

Recently, I was reading a blog that noted that Jim Rogers was shorting JPMorgan (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 (C), Bank Of America (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 Buffet “derivatives 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.

Comments

[cholmley:]

Pathetic ignorance.

It is not the gross value of the derivatives book but the net positions between counterparties that is relevant, do you know what these are, do you have any idea whatsoever what these are?

In any trading book there are billions of notional outstanding that can net down to almost zero with most trades being between a handful, yes five or less, counterparties.

A big market-making bank is actually likely to have a far smaller net exposure than a small one like say, oh Lehman or Bear Stearns.

If that is your reason for being short get out of your position.

Mar 30 05:45 AM

[punditobserver:]

One of the key indictors of a bottom is the recycling of bad news in the absence of continuing bad news.

This article is a recycle of articles that came out last quarter.

Mar 30 07:46 AM

[jsudds:]

They will recycle the bad news so all the big institutions have time to build there long positions! Just hang on and buy more on the dips.

Mar 30 08:43 AM

[Ishortyou:]

Derivatives are just contracts, you can make bets on those contracts and pay a fee to participate on them, but it does not mean that you are liable for the whole value of the contract, is kind of like the future derivatives trading, but more generic, so its difficult to find out what those contracts hold and what are the bets from the counterparties, unless of course their is transparency, banks have made bets on mortgage related derivatives with deposistors money, when the housing market slump so those bets and the counterparties on the loosing (banks) and insurers (CDS) side had to pay, because those contracts are high risk, high levered the loses are hugh!

Mar 30 08:56 AM

[Uninitiated:]

New to this-
What is the average life cycle of a derivatives portfolio

Mar 30 09:52 AM

[vodop09798:]

Hey Folks,
THEY'RE BACK!!! Short interest on Citi is over 18%. They're out to kill another bank and force another dip with their misrepresentations and insinuations. Don't listen to them.

Mar 30 11:25 AM

[User 368248:]

If and when the so-called 'toxic assets' are sold to private interests with government guarantees, the market will establish what this paper is really worth; I suspect it won't be much. Those institutions which have held unrealistic amounts of these will be caught with their pants down.
Were it not for the innocent among us, I woudn't care at all.

Mar 30 12:16 PM

[Gtarras:]

what a hogwash piece.

Mar 30 12:57 PM

[Allan Frain:]

Will the goverment insure JPM cover their short position in Gold owed the Longs the same way they covered AIG CDSs owed to GS ? I don't see a representative of the Gold Longs running the Treasury and sitting in on bailout policy. This could guide a bet on JPM.

Mar 30 01:02 PM

[NickH:]

This is a useless, hysterical article and I can't figure out how it got published. It is a bald faced attempt to "talk your book" and scare us all to death thinking we are stupid and don't know that these entities balance their books with long and short positions. Which editor okayed publishing of this piece? Must have been after a 2 Martini lunch.

Mar 30 02:02 PM

[PainfullyAware:]

If "Derivatives" were not that detrimental the Federal Reserve Would Not Be The "Lender OF Last Resort".

This Graph shows the shut down of interbank lending.

Series: BORROW, Total Borrowings of Depository Institutions from the Federal Reserve
research.stlouisfed.or...

The Banks Are Still Afraid Of "Toxic Assets" taking down their neighbors - Opacity Has Curtailed Interbank Lending.

Until this "Monster" is confronted and dealt with the "Crumbling" will continue.

Mar 30 02:11 PM

[GtownMetal:]

C has $35.6 Trillion in derivatives and only $1.20 Trillion in equity, if 3.4% of their derivatives default it totally wipes out their $1.2 Trillion in equity. Is that a chance any of you would take in this market?

Mar 31 01:53 AM

[Marcap:]

I think the question should really be: What happens if 10% or more of C's derivatives default (a very likely possibility)? What would that do? What about a 20% default? or even a 30%? I think the answer is a simple one. If C falls, a lot of other financial institutions, companies and perhaps even governments will fall with it.

On Mar 31 01:53 AM GtownMetal wrote:

> C has $35.6 Trillion in derivatives and only $1.20 Trillion in equity,
> if 3.4% of their derivatives default it totally wipes out their $1.2
> Trillion in equity. Is that a chance any of you would take in this
> market?

Mar 31 11:48 AM

[Owen:]

Where did you get your figures? According to their latest quarterly reports, each of the three banks you mention has less than $200 billion in equity - that's $0.2 trillion, not $1+ trillion as you mention.

They may have over a trillion each in total assets, but that number is meaningless for this discussion. Most of these assets are segregated regulated funds in client accounts, so the banks have no access to these funds for paying off derivative losses.

Apr 01 05:57 AM

[monday1929:]

Can we all assume you are being sarcastic about the "balanced banks" holdings?


On Mar 30 05:08 AM balabanovj wrote:

> Derivatives come in many forms. For Marc to say that these are huge
> liabilities to the banks carrying them, without knowing the balance
> of derivative that they hold is pure ignorance. If the derivatives
> are well spread, there is no reason for worry, and I doubt the portfolios
> of BAC or even C are anything but balanced.
>
> JBB

Apr 01 08:57 AM

[monday1929:]

Yes, after riding them down from$40.00 to one dollar, why not bet that a fascist system keeps Citi/JPM/BAC and the other walking dead walking a bit more. Their shares are just lottery tickets now- and always were. The Elites should be proud of what they wrought.


On Mar 31 01:53 AM GtownMetal wrote:

> C has $35.6 Trillion in derivatives and only $1.20 Trillion in equity,
> if 3.4% of their derivatives default it totally wipes out their $1.2
> Trillion in equity. Is that a chance any of you would take in this
> market?

Apr 01 09:01 AM

[monday1929:]

If everything were "balanced", then there would be no chance of profit. It is amazing that , at this late date, one still must read those defending one Quadrillion in derivatives as "harmless". Even Greenspan admitted he got that all wrong. Your ignorance assures a few more months of profitable trading. I will be buying from you at the bottom (S&P 200) when you finally "see the light". See you then.


On Mar 30 02:02 PM NickH wrote:

> This is a useless, hysterical article and I can't figure out how
> it got published. It is a bald faced attempt to "talk your book"
> and scare us all to death thinking we are stupid and don't know that
> these entities balance their books with long and short positions.
> Which editor okayed publishing of this piece? Must have been after
> a 2 Martini lunch.

Apr 01 09:05 AM

[Kinabalu:]

No, that's not what the question should be! For a simple example, if all C's derivative are fixed/floating swaps (this is probably the single biggest type of derivative they do hold) it would be highly unlikely that their exposure at any one time would be more than 2% of the notional value of any swap. The entities swap book would have been built up over an extended period of time. Accordingly a large number (say, 2% of the total swap book) would only result from a spectacularly wrong succession of bets on the direction of interest rates over several years.

The proper question is the one posed in the first comment under this article by Babanovj: What are the amounts of the different types of derivatives on the books of the institution? If the derivative book is concentrated in fixed/floating swaps, the notional value is a very poor indicator of risk. If the notional amount is on the providing protection side of a CDS it's much riskier. Fixed/floating swaps are by far the biggest part of the derivative business, so throwing total derivative numbers around is very misleading.


On Mar 31 11:48 AM Marcap wrote:

> I think the question should really be: What happens if 10% or more
> of C's derivatives default (a very likely possibility)? What would
> that do? What about a 20% default? or even a 30%? I think the answer
> is a simple one. If C falls, a lot of other financial institutions,
> companies and perhaps even governments will fall with it.
>
> On Mar 31 01:53 AM GtownMetal wrote:

Apr 01 06:49 PM

[Kinabalu:]

BofA and C are dealers. They can make money on the spread. I don't know what their position is on taking risk in this area is, but I have bought fixed/floating swaps from both of them depending on who had the best price when I was buying. They would take either the fixed or floating side.


On Apr 01 08:57 AM monday1929 wrote:

> Can we all assume you are being sarcastic about the "balanced banks"
> holdings?

Apr 01 06:59 PM

[Marc Liu:]

You are right - the figures I called "equity" should have been called "assets."

I got the figures from the Report by the Comptroller of the Currency on Derivatives but picked up the wrong heading for the figures. Note the paragraph below for the JPM website.



JPMorgan Chase & Co. (NYSE: JPM) is a leading global financial services firm with assets of $1.6 trillion and operations in more than 60 countries.
On Apr 01 05:57 AM Owen wrote:

> Where did you get your figures? According to their latest quarterly
> reports, each of the three banks you mention has less than $200 billion
> in equity - that's $0.2 trillion, not $1+ trillion as you mention.
>
>
> They may have over a trillion each in total assets, but that number
> is meaningless for this discussion. Most of these assets are segregated
> regulated funds in client accounts, so the banks have no access to
> these funds for paying off derivative losses.

Apr 01 09:22 PM