Fitch Report: Financial Companies Hold 99.7% of All Derivative Contracts

Fitch has released a comprehensive study on derivatives held by various corporations and has come out with some disturbing results: as Zero Hedge's recent disclosure of data from the Office of the Comptroller of the Currency confirmed, the bulk of the derivative risk is concentrated not merely in the "financial company" category (99.7%) but in a subset of just five companies, which account for an "overwhelming majority" of derivative assets and liabilities.

The companies in question (Total Notional Derivatives: Assets & Liabilities, $ in Trillions)

• JP Morgan (JPM):$81.7;
• Bank of America (BAC):$80.0;
• Citigroup (C):$31.5;
• Morgan Stanley (MS):$39.3, and of course
• Goldman Sachs (GS): $47.8 (this is an OCC estimate: Goldman has not disclosed notional amounts in their derivative book, only # of contracts);

If you want a preview of what the Basel III definition of "Too Big To Fail" will look like, the above five companies is a great place to start.

For those unfamiliar with the concept of derivatives, here is a good blurb provided in the Fitch report:

Companies use derivatives to manage risks related to interest rates, foreign currency exchange rates, equities, and commodity prices, as well as more obscure risks such as weather and longevity. According to the Bank of International Settlements, the notional amount of the global over-the-counter derivatives market was nearly $600 trillion at the end of December 2008. Furthermore, gross market value (the sum of gross derivative assets and gross derivative liabilities) stood at $33.9 trillion.

While improved disclosures and transparency are a good start to helping gauge the risks posed by these instruments, it is important for analysts and investors to take a fresh look at risk management practices, including the use of derivatives within that context.

The need for better disclosure on derivatives has been obvious since the implementation of Statement of Financial Accounting Standards (SFAS) 133, “Accounting for Derivative Instruments and Hedging Activities” (now Financial Accounting Standards Board [FASB] Accounting Standards Codification [ASC] 815). However, comprehensive derivatives disclosure did not become a U.S. GAAP requirement for most companies until March 2009 with the implementation of SFAS 161 (now ASC 815-10-50), “Disclosures about Derivative Instruments and Hedging Activities.”

For a more quantifiable overview of derivatives, we recommend the most recent quarterly report from the BIS, especially the data starting on page 28.

The key findings presented by the Fitch report are as follows:

• Not surprisingly, an overwhelming majority (approximately 80%) of the derivative assets and liabilities carried on the balance sheets of the companies reviewed were primarily concentrated in five financial services firms: JPMorgan Chase & Co. (JPMorgan); Bank of America Corp. (Bank of America); Goldman Sachs Group Inc. (Goldman Sachs); Citigroup, Inc. (Citigroup); and Morgan Stanley (Morgan Stanley).
• Fifty-eight percent of the companies reviewed disclosed the presence of credit riskrelated contingent features in their derivative positions. These contingent features generally require a company to post additional collateral or settle any outstanding derivative liability in the event of a downgrade of the company’s credit rating.
• The use of credit derivatives was limited to financial institutions, with 17 of these reporting such exposure.
• Proprietary derivatives trading by utilities and energy companies appear to be very limited, but most of the companies reviewed in both industries report the use of derivatives for hedging commodity risks.
• Generally, non-financial companies appear to use derivatives only for hedging specific risks.
  Derivative valuation is often model-based, making changes in significant valuation assumptions particularly important. Analysis would be enhanced if issuers provided additional disclosure on the sensitivity of their derivative valuations to major assumptions.

And some charts (click to enlarge) that indicate why the Big 5 as listed above will never be allowed to go under, as the unwind of the $300 trillion in derivatives that are intertwined within their balance sheets would be end of what was previously known as free and efficient markets.

And while the gross notional value is a useful metric, in terms of actual capital at risk, it is necessary to apply a netting to the gross. Conveniently, Fitch has done the calculation. No surprise: of the Big 5, almost all (except Morgan Stanley) have a net notional exposure of over $100 billion! How about them VaR apples?

The other notable conclusion is that while virtually all non-financial companies had participated in derivative designated as a hedging exposure, it was energy companies (83%) but mostly financials (97%) that used derivatives merely as a method to speculate on underlying assets. Yet a net notional speculative exposure of almost half a trillion is staggering: this represents roughly 5% of the US GDP, the bulk of it focused on interest rate exposure. As we have speculated, in the event of a interest-rate black swan event, the fall out from the implosion of this over $500 billion in speculative derivative exposure would be enough to make the Lehman fiasco seems like a walk in the park.

It is this potential risk that these BHCs' regulator, the Federal Reserve, should be trying to mitigate, not to enhance its risk regulatory powers even more, having proven that all it does it promote increasing speculation until such time that the house of cards inevitably comes tumbles down.

Comments

[The Hammer]

I guess we the taxpayers will have to bailout these smart guys again when a derivative convulsion hits.
How does this S$#! continue to fester?

2009 Jul 29 08:03 AM

[Angry Banker]

At least you actually acknowledged that the NET exposure was more relevant and even referenced the $100 billion figure (which is a mere fraction of the sensationalist $300 trillion figure you used to get the readers' attention). But still, throwing around $100 billion as the exposure makes it seem like the banks may actually end up paying this amount. But surely it must be acknowledged that this is a WORST CASE scenario, worse even than anybody's reasonable stress scenario.

As an example of the gross, net and actual impact of CDS, take a look at this nice little example courtesy of Wikipedia:

<quote> In September the bankruptcy of Lehman Brothers caused a total close to $400 billion to become payable to the buyers of CDS protection referenced against the insolvent bank. However the net amount that changed hands was around $7.2 billion. This difference is due to the process of 'netting'. Market participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them from their hedging positions. Dealers generally attempt to remain risk-neutral so their losses and gains after big events will on the whole offset each other. <unquote>

You see, the actual financial impact (at least as it related to CDS exposure) of even a significant triggering event was not unmanageable.

So why don't you quit your scare-mongering and stop writing these doom-and-gloom articles to support your hedge fund friends who are losing their shirts shorting the the financial sector?

2009 Jul 29 08:10 AM

[doubleguns]

Why are the bankers angry, we bailed you out. It is the unemployed that should be angry.

400 billion is a far cry from 300 trillion. I would think even an angry banker could do that math.


On Jul 29 08:10 AM Angry Banker wrote:

> At least you actually acknowledged that the NET exposure was more
> relevant and even referenced the $100 billion figure (which is a
> mere fraction of the sensationalist $300 trillion figure you used
> to get the readers' attention). But still, throwing around $100 billion
> as the exposure makes it seem like the banks may actually end up
> paying this amount. But surely it must be acknowledged that this
> is a WORST CASE scenario, worse even than anybody's reasonable stress
> scenario.
>
> As an example of the gross, net and actual impact of CDS, take a
> look at this nice little example courtesy of Wikipedia:
>
> <quote> In September the bankruptcy of Lehman Brothers caused a total
> close to $400 billion to become payable to the buyers of CDS protection
> referenced against the insolvent bank. However the net amount that
> changed hands was around $7.2 billion. This difference is due to
> the process of 'netting'. Market participants co-operated so that
> CDS sellers were allowed to deduct from their payouts the inbound
> funds due to them from their hedging positions. Dealers generally
> attempt to remain risk-neutral so their losses and gains after big
> events will on the whole offset each other. <unquote>
>
> You see, the actual financial impact (at least as it related to CDS
> exposure) of even a significant triggering event was not unmanageable.
>
>
> So why don't you quit your scare-mongering and stop writing these
> doom-and-gloom articles to support your hedge fund friends who are
> losing their shirts shorting the the financial sector?

2009 Jul 29 08:22 AM

[John Galt]

If I have a 100 Billion dollar bet on Red with Caesars Palace, and a 100 Billion dollar bet on Black with the Bellagio ( and there's no green 0 & 00), then yes, it isn't as bad as it "sounds".

BUT, what happens if I have to pay out my losing bet to the Bellagio with my winnings from Caesars Palace but Caesar's Palace goes out of business and doesn't pay me?

Being stuck paying out your losers but not collecting your winnings could destroy companies. That's why the former Goldman Sachs people in the government wanted to protect AIG so hard.

2009 Jul 29 08:45 AM

[Angry Banker]

Buddy, I'm willing to bet that I've paid a lot more taxes in my life than you have. I'm in this thing too. You didn't bail me out. And by the way, when the taxpayer earns back the TARP with a profit, people won't be whining so much ($79 billion already repaid to date).


On Jul 29 08:22 AM doubleguns wrote:

> Why are the bankers angry, we bailed you out. It is the unemployed
> that should be angry.
>
> 400 billion is a far cry from 300 trillion. I would think even an
> angry banker could do that math.

2009 Jul 29 09:05 AM

[Angry Banker]

You're right, but that risk only materializes if everybody goes bust. Which is why in the Lehman example, although the theoretical value at risk was $400B, the actual payouts were a fraction of that amount. (Even doubleguns could probably do the math on that)


On Jul 29 08:45 AM John Galt wrote:

> If I have a 100 Billion dollar bet on Red with Caesars Palace, and
> a 100 Billion dollar bet on Black with the Bellagio ( and there's
> no green 0 &amp; 00), then yes, it isn't as bad as it "sounds".<br/>
>
> BUT, what happens if I have to pay out my losing bet to the Bellagio
> with my winnings from Caesars Palace but Caesar's Palace goes out
> of business and doesn't pay me?
>
> Being stuck paying out your losers but not collecting your winnings
> could destroy companies. That's why the former Goldman Sachs people
> in the government wanted to protect AIG so hard.

2009 Jul 29 09:09 AM

[Swashbuckler]

"When the taxpayer earns back the TARP with a profit...." In your dreams.


On Jul 29 09:05 AM Angry Banker wrote:

> Buddy, I'm willing to bet that I've paid a lot more taxes in my life
> than you have. I'm in this thing too. You didn't bail me out. And
> by the way, when the taxpayer earns back the TARP with a profit,
> people won't be whining so much ($79 billion already repaid to date).
>

2009 Jul 29 09:18 AM

[John Galt]

But the theory is...

I win my bet at Caesars Palace
I lose my bet at the Bellagio

but Caesars goes bust for some reason and can't pay me my winnings...
So I can't pay off my losing bets to the Bellagio, and they go bust...
Then the Bellagio can't pay their bets at the Wynn...
Then the Wynn can't pay off their bets at MGM Grand

When you are talking about BETS in the billions and trillions of dollars and a financial system that is highly connected, just a couple companies going bust infect the entire system and set off a chain of dominos.

That's the theory anyway. Please understand that choosing Casinos as an example was 100% intentional.

The Oracle once warned people that derivatives were weapons of financal "mass destruction". They have the ability to destroy lives and cause pain without even firing a single shot. Is the pen mightier than the sword? Is the Derivatives contract mightier than both?



On Jul 29 09:09 AM Angry Banker wrote:

> You're right, but that risk only materializes if everybody goes bust.
> Which is why in the Lehman example, although the theoretical value
> at risk was $400B, the actual payouts were a fraction of that amount.
> (Even doubleguns could probably do the math on that)

2009 Jul 29 09:40 AM

[The Hammer]

The arrogant bankwhores are no different than the realtwhores. Both these thugs bankrupted our country.
The Hammer

2009 Jul 29 10:44 AM

[Pat C]

Angry Banker, come out of the closet let us know who you are.

2009 Jul 29 10:51 AM

[Heaven, Hell or Hoboken]

One of the potential ways to manage systemic risk related to OTC derivatives would be for the creation of a primary and secondary market, whereas transactions done by dealers with commercial hedgers can remain off-exchange and be done without margin with the subsequent dealer hedge executed in the secondary market on either a regulated exchange or off-exchange transaction requiring margin. This would mitigate the systemic risk while allowing commercial hedgers to still offset their physical risk position without having to divert erstwhile productive capital into non-productive activities such as margining. Some of the "fixes' being espoused by politicans, i.e., "clear (just about) everything on regulated exchanges, period" are downright scary. The above data shows that the systemic risk can be eliminated without such a dracanion and economically deleterious approach.

2009 Jul 29 11:03 AM

[nova]

Angry Banker wrote:
"Buddy, I'm willing to bet that I've paid a lot more taxes in my life than you have."

May be. But, how much money did you steal ruining America industrial, biotech, high-tech, etc., corporations? You SOB ruined the country!

2009 Jul 29 12:01 PM

[JSArbitrage]

That's the problem, isn't it? It's like saying systemic risk doesn't exist unless the system fails. It's a circular statement.

Every major financial institution did go bust ... they were put on Treasury/Fed life support. If the Treasury/Fed didn't intervene, there wouldn't be a major Wall Street firm left to debate whether that "risk" could "materialize."

On Jul 29 09:09 AM Angry Banker wrote:

> You're right, but that risk only materializes if everybody goes bust.

2009 Jul 29 12:17 PM

[Living4Dividends]

Tyler Durden - on ZeroHedge article you seem to be implying that a majority of the credit derivatives are betting AGAINST an interest rate rise. I seriously doubt this is the case.

I suppose that there can't be a net derivative exposure against interest rates rising, can there? For every derivative, someone bets say for interest rate rise and the counter party bets against. Therefore these are side bets.

The problem comes if one institution has a large net exposure to rates rising (or falling). should that scenario occur - the institution would be wiped out (actually the Fed would step in to cover the derivatives).

Does anyone know if any of the banks have a large net exposure??

2009 Jul 29 12:33 PM

[John Galt]

On Jul 29 12:33 PM Living4Dividends wrote:

> Does anyone know if any of the banks have a large net exposure??


The thing is, I don't think there are a whole lot of people ( even within the companies themselves) that know what they own. Isn't that scary? I mean, when you are talking about 81.7 Trillion dollars, who'se keeping tabs on all that? Isn't the CEO also supposed to be the chief risk manager as well? Do you think Jaime Dimon knows where each and every one of those bets are placed and for what?

I do think for the most part these companies are hedged ( as angry banker alluded to)... let's say a 10.3 trillion dollars bet that rates go up, and 10.1 trillion dollar bet that rates go down. They still have exposure but on a smaller but still big and unnecesary scale. That would mitigate a lot of that risk with the asumption that they will be paid out on winning bets. But if they are trying to collect through bankruptcy court, or they aren't paid... when you talk dollars on such a large scale...

All of these casinos... errrr banks, are making bets... errr derivatives contracts with each other. I really doubt many people even in the organizations themselves know what the bets are who they are with. That would be some pretty valueable information though.

2009 Jul 29 01:44 PM

[SisyphusStone]

Living4divi -

My guess is that the 'Banksters' know only too well that by the Fed allowing them to front-run it in the - thus risk-free - bond market, ensures that interest rates are kept down. In the foreseeable future I suspect it would only be as a result of a maverick political decision that would lead to rates being raised, thus their 'insurance'.

Don't be fooled by talk of big inflation soon, this is a MASSIVE deflationary event unfolding and in all probability it is only just warming up. Their capital is gone, eroded by a long-term low interest rate policy (this is also largely true of corporate America as a whole).

The US is now into negative returns in GDP for every dollar borrowed!

Finally, don't think Europe is in any better shape!

2009 Jul 29 02:22 PM

[Living4Dividends]

Thanks John - I see your point - the problem is not if interest rates rise or fall and someone has to pay off on the insurance policy, the problem is that the person paying off on the insurance policy will go bankrupt. Still, we know from recent history with AIG that the Fed would step in to cover the derivatives.

What's a Trillion among friends ??


On Jul 29 01:44 PM John Galt wrote:

> On Jul 29 12:33 PM Living4Dividends wrote:

2009 Jul 29 06:05 PM

[jhartz]

There will come a point where the ability to mortgage America's future will be taken out of the hands of the banksters and their confederates in government "service". When that happy day finally comes, a lot of criminals will be made to answer for the wholesale theft that is now being perpetrated on the American taxpayer.

You can only throw money down a rat hole for so long before intelligent people will put a stop to it. The problem I'm having is understanding why it hasn't been stopped already.

2009 Jul 29 08:45 PM

[Mark54]

This is the real risk and is the predecessor to a failure due to liquidity....

ABC financial has a 100b notional book of derivatives. Plain vanilla derivatives that have low price volatility. It has an A- rating and is posting 100mm in collateral because its positions are net underwater and all the ABC counterparties that are in the gain position want ABC to do something like escrow securities to minimize the risk of loss if ABC should go under. Now S&P downgrades the company to BBB+. With that action ABC now contractually has to post 200mm of collateral against the losses in the book. Keep in mind these are paper losses but it has to find 100mm more acceptable collateral.

Now lets assume these are exotic derivatives... 10%+ price moves in a day. So then in any one day ABC now may need to find 20mm (maybe more) to post.

Now lets assume they get downgraded again and the cycle continues.

The ratings based CSA grids are used mitigate loss in the event of a default but in tail events may actually increase the probability of a greater loss.... Chew on that Black Swan pate'

2009 Jul 29 10:20 PM

[Mark54]

just to be clear... there are "credit" risks even in non-credit related derivatives.

2009 Jul 29 10:29 PM