Is Goldman Tempting the Interest Rate Black Swan with 1,056% Risk Exposure?

Last week Zero Hedge posted the most recent (Q4 2008) report from the Office of the Comptroller of the Currency, which among other things, discussed the $9.2 billion bank trading loss in cash and derivatives in Q4. That itself was not news to anyone who follows the major commercial banks' operations, however should make for an interesting contrast when the OCC reports Q1 results, especially in the context of the plausible scenario that AIG may have contributed for massive derivative profits, especially for the big banks.

Now focusing on the other things side of the equation, there were several charts in the OCC report that caught my eye. The first relevant item is the insane propagation of derivative contracts over the past 10 years, not merely CDS, which those foaming in the mouth claim is the sign of the beast.

A little background: the OCC has five categories of derivative products: 1) interest rate , 2) foreign exchange, 3) equities, 4) commodities and, of course, 5) credit default swaps. And, yes, while CDS have grown as holdings by commercial banks from $144 billion in 1998 to $15.9 trillion in 2008, it is not this that is of interest. More notable, while the total derivatives basket has grown at an astounding rate, from $33 trillion to over $200 trillion over the same period, it is the interest rate (specifically swaps but also futures and forwards) category that is the biggest culprit here: growing from $24.8 trillion to $164.4 trillion! This represents over 80% of the total underlying derivative notional currently in existence according to the OCC (and about 10x Obama's optimistic projections for U.S. GDP).

click to enlarge

Focusing a little more on the Interest Rate derivative category, the two critical subcategories here are the Interest Rate swaps maturing in under a year, and the IR swaps with a 1-to-5 year duration.

So what are interest rate swaps: in their simplest definition, they are merely contracts exchanging a stream of interest payments for another party's stream of cash flows. Interest rate swaps are often used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. The underlying key variable is, as the name implies, the interest rate, which derives from the Fed's policy decisions and subsequent spillovers into monetary markets. As interest rates fluctuate substantially less than corporate (and even sovereign) credit risk, and, one may argue, have better predictive visibility, the notional outstanding is so staggering. Specifically (and this is an oversimplification) to generate profits on a, i.e., 0.25% move in rates, the notional outstanding has to be a huge amount.

In a hypothetical example, imaginary company PIMROCK may purchase $100 billion in 30 year treasuries at price X after having a strong gut feeling interest rates may decline (or anticipate an administration pursuing outright Quantitative Easing, meaning open market purchases of Treasuries as they are printed by and through the government itself - for those confused by this circular process, please... you are not alone...).

Now this is a cash purchase, and can only be executed by those that have $100 billion in cash lying around (either from investors or via repos lent conveniently by this very same administration). If you are a consumer bank, and find all your cash recently disappeared, after paying the last ever cash bonuses you could sneak by before getting stuck with 95% stock bonuses with 100 year cliff vesting, you can replicate this using interest rate derivatives, where you can use your lovely toxic assets (which are prudently marked at par, thus giving you full collateral marginability) and purchase interest rate futures and swaps, replicating this exact formulation however without single dollar exchanging hands.

This is, of course a simplistic example, and I recommend reading up on literature discussing the finer nuances of IR swaps and futures. But the mechanics of the transaction are not all that critical. What, however, is, is the amount of capital a bank pledges in order to execute these IR swaps. Now, conventional wisdom is that Interest Rate swaps are low volatility, low risk instruments. Well, amusingly when AIG CDS was trading at 15 bps over LIBOR, people were saying the same about Credit Default Swaps.

And this is where a chart in the OCC report really sticks out: one which talks about Total Credit Exposure (TCE) to Risk Based Capital (RBC).

But first a brief definition of TCE for the wonkish: TCE is the sum of Net Current Credit Exposure (NCCE) and Potential Future Exposure (PFE). For a portfolio of derivative contracts, NCCE is the gross positive fair value of contracts less the dollar amount of netting benefits. On any individual contract, current credit exposure (CCE) is the fair value of the contract if positive, and zero when the fair value is negative or zero. NCCE is also the net amount owed to (from) banks if all contracts were immediately liquidated. As for PFE, Potential Future Exposure is an estimate of what the current credit exposure (CCE) could be over time, based upon a supervisory formula in the agencies’ risk-based capital rules. PFE is generally determined by multiplying the notional amount of the contract by a credit conversion factor that is based upon the underlying market factor (e.g., interest rates, commodity prices, equity prices, etc.) and the contract’s remaining maturity. However, the risk-based capital rules permit banks to adjust the formulaic PFE measure by the “net to gross ratio,” which proxies the risk-reduction benefits attributable to a valid bilateral netting contract.

In a simplified nutshell, TCE is total max pain in case the proverbial feces hit the fan. Now, as the metric is a ratio to Risk Based Capital (which is simply the sum of recently infamous Tier 1 and Tier 2 capital), the higher the metric, the scarier things may get, as in another "highly improbable" 6 sigma day, when the impossible becomes mundane, banks may have to demonstrate "they are good" for their collateral. In very much the same way Basel I required banks to have capital ratios of 4% for Tier 1 and 8% for Tier 2, the RBC is a cushion that could take the first loss chunk on that elusive feces-hitting-fan day.

The OCC discloses the TCE/RBC ratio for the top five banks, and one name in particular jumps out.

Yep, Goldman Sachs (GS)... Looks like Blankfein's minions went from a TCE/RBC ratio of 4% to 1,056% in the span of one quarter! In fact, Goldman is so enamored with Interest Rate Swaps that it has almost the same notional outstanding as Bank of America (BAC), and more than Citigroup (C).

The thing to note, is that unlike both Citi and BofA, which actually are real consumer banks with a depositor base, Goldman is a consumer bank only in name (when is the last time you deposited your cash in a Goldman retail branch?). Consequently, BOA and C have total assets of $1.5 trillion and $1.2 trillion, both more than 10x the assets of GS, which is at $162 billion (and this excludes the incremental assets at the Bank Holding Company level for both BOA and C).

Has Goldman, in its pursuit to catch up with the imaginary PIMROCK decided to chew off a little more than its assets would allow? 1,056% more in fact? Or, alternatively, has the company bet a little too much in its bet that it can easily anticipate interest rate moves?

As pointed out, over $160 trillion in Interest Rate contracts exist currently. What the credit crunch taught us is that the risk management of credit derivatives was woefully inadequate in a time when credit was flowing freely and the system was nice and liquid. After the bubble burst, certain entities (wink wink AIG) ended up having to commit capital to a sizable amount, more than half at times, of the total notional of derivatives the company had underwritten - a scenario previously never thought possible. And the massive reduction in global CDS notional outstanding over the past year and a half (from over $60 trillion to under $30 trillion today) has been a direct result of financial companies realizing they did not provision well enough for the "black swan" day, and thus rushing to unwind as much of these ticking time bombs as they could.

In the meantime, the interest rate black swan is growing. Do not misunderstand us: Zero Hedge has no idea what, if any, a black swan in Interest Rates may be. It is - by definition - an unexpected, unpredictable, outlier, aka fat-tail, event. Its prediction would immediately render it a grey swan at best, if not beige. However, instead of focusing so much on CDS as the financial system bogeyman, is it not time to look at some of these other derivative instruments that may soon plague the Basel I/II and whatever other risk consortia appear in the future.

At $200 trillion in total derivatives, and $160+ trillion plus concentrated in Interest Rates, a fat tail event here, whether due to a paradigm shift in US monetary policy (that whole thing about Greenspan focusing on inflation instead of deflation now might raise a few eyebrows), or something totally different, even partial needs to satisfy these contracts will result in staggering and unmanageable repercussions to the global economy (tangentially, is it even physically possible to print $200 trillion in one year?)

Of course, as everything is smooth sailing in IR Swaps for now, I doubt anyone will even think about potential issues in this space... until it is too late.

Comments

[wobatus:]

What dreck. BTW, the answer is no.

Mar 31 04:53 PM

[Tricky:]

Why worry? If they lose, we'll all pick up the tab. If they win, they keep it all. What's not to love?

Mar 31 05:20 PM

[market ace:]

Since Dodd and Frank have still not even learned how to spell derivative, let alone have a clue about what they are and what they mean in the scheme of bringing down the world's financial systems, you think we may have something to worry about here?

Dodd thinks it is great that AIG is so smart that they can even swap interest rates and make money at it - well maybe it's taxpayer money that their earning doing it, but they still have plenty of money to contribute to his election campaign so where's the problem here? Besides he has those smart, unknown, guys in Treasury writing his legislation for him and surely they would not let Wall Street lose more billions and further cheat the taxpayers - would they?

Then there is the brilliant Frank who think interest rate swaps must be great because the Fed is always swapping one rate for another and anything Bernanke does must be good so why shouldn't the big banks do it? Gee and that Goldman bunch "accepting" those backhanded taxpayer bailouts through AIG, but poised again to make those high leveraged returns with our tax dollars is just what the world needs. They must still have that brilliant Paulson advising them on how to leverage their investments so nothing could possibly go wrong. Maybe he better call them and get some larger campaign contributions for blessing them and their great investing strategies.

With finacnial geniuses (well at least at lining their own pockets) like this leading congress, and the Obama Geithner team feeding trillions to their Wall Street masters, we should feel well protected and yet some people say we should be worried just because "great" firms like Goldman are primed to lose up to a 1000% of their capital. What are taxpayers for if not to cover these losses and save the banking industry so they can loan us the money to pay our increased taxes?

Mar 31 05:58 PM

[MuzzaDuzza:]

Tyler, nobody will have to print $200 trillion! That's the nominal amount of interest rate swaps, not the payable amount (ie: the interest component) - I'd guess that's around $6 trillion - still large enough to do damage.

A Black Swan event could unfold if interest rates soared rapidly - eg: back to the 15%+ levels of the 1970's (or higher). Then the payable component of the IRS market could grow to $25 trillion - $50 trillion in the space of a year or so. A typical scenario here would be would be banks, corporates or hedge funds exchanging variable rate commitments for fixed rate ones with the major international banks who issue IRS'. If interest rates increased rapidly these companies would have to pay the large issuing banks that extra $20+ trillion over the period of the increase (payments are normally quarterly). So the major issuers (Deutsche, UBS, C, BOA etc) are likely to benefit while smaller players get killed. Not sure where GS stand (issuers or buyers).

Another possible black swan is exchange rate volatility. I can't remember the exact figures, but when I researched this 6 months or so ago something like 30-40% of all IRS' globally, involve multiple currencies. The parties would normally hedge that risk, but a massive increase in exchange rate volatility would be sure to create havoc, and is certainly conceivable over the next year or so.

Mar 31 07:11 PM

[MuzzaDuzza:]

OOPS! - I've just spotted the obvious flaw in my earlier comment. The point about the big issuing banks benefiting may have made sense a few years ago, before the current crisis, but a $20 trillion black swan coming along now (or any time in the next year or three) would be sure to mean a rapid escalation of defaults in payments to these big players. They would quickly bail out of their commitments to supply fixed rate loans (for example) to their counter-parties, and the flow-on effect of that would likely throw the whole financial system into chaos.

A few years back only the safest banks and top-rated corporates could get access to IRS' - now they've been sold to hedge funds, and smaller/riskier corporates with an added risk premium on the rates.

So a black swan event wouldn't be a $200 trillion dollar one, but it could still be a devastating death-blow to the financial system. But hey, IRS' are soooo safe: "as safe as houses", as they say!

Mar 31 07:33 PM

[einstein p ...:]

The new hundred dollar bill is going to have a picture of Alfred E. Newman with the motto, "What, me worry?"

Mar 31 08:58 PM

[HipHoption:]

One thing to note is that almost ALL over-the-counter derivative contracts require both the posting of initial margin, and subsequent collateral calls against the mark-to-market of the position. If a bank, has a derivative trade (let's say an IRS) on with Fraggle Rock Capital, and you are in the money by $1mln, then sure as shootin' FR Capital has posted well over $1mln collateral to the bank. That way, if the Black Swan occurs, and the value of the swap goes to $2.5mln quickly before the new margin call is answered, the bank is only exposed to $1.5mln in additional credit risk - not the full $2.5mln. Credit risk and margin is closely watched for good reason. The points you make above are good ones, but the banks are not at risk for the full amount you allude to above.

Mar 31 11:48 PM

[mike melley:]

Isn't it ironic the banks that were lined up with their hands out for TARP money. Can't pay it back fast enough. You don't think it's because they don't want to be forced to disclose how the monies were spent. They probably figured it was buissness as usual, with all the loopholes they could line their own pockets with more taxpayer money and knowone would notice.

Apr 01 03:46 AM

[Christopher...:]

First, good analysis. Only quibble is that the non-CDS exposure in OTC is essentially a forward market that tracks the cash basis. The size of the outstanding positions IS an issue, but only because many dealers are rotting from the inside out due to CDS. CDS is a sophisticated form of criminal financial fraud, IMHO.

GS has always been among the most highly leveraged Wall Street firms. In fact, as of year-end 2008, GS and MS had higher stress scores, including the OTC book, than almost any of the money center banks other than C.

Here are the Stress Index scores for the top banks as published by the IRA Bank Monitor. When MS and MS finish migrating their institutional business "in the bank," these stress scores will probably go higher. The Stress Index is based on 1995 = 1. The maximum score is 100, which is two orders of magnitude above the industry stress average. -- Chris

Industry 1.77
JPM 1.3
BAC 1.61
WFC 1.47
C 21.6
GS 20.6
MS 20.43

Apr 01 07:33 AM