Derivatives Datapoint of the Day

Here’s a little table I put together with numbers from the OCC — page 9 of this pdf. Using second-quarter numbers for each year, I looked at the total nominal derivatives exposure of end users — the people for whom derivatives are meant to exist — and for dealers.

The results are pretty startling: while end-users have pared their derivatives exposure to a seven-year low, dealers have increased theirs to yet another all-time high. And as the OCC notes, when we say “dealers”, we really mean four banks in particular: JP Morgan Chase (JPM), Goldman Sachs (GS), Bank of America (BAC), and Citibank (C).

Oh, and did I mention? The amounts here are in trillions.

Year	End Users	Dealers	Ratio
2003	2.6	62.4	24.0
2004	2.5	76.9	30.8
2005	2.5	96.2	38.5
2006	2.6	110.1	42.3
2007	2.6	138.1	53.1
2008	2.8	163.9	58.5
2009	2.4	187.6	78.2

What has happened in recent years that derivatives dealers now need $78 in nominal derivatives exposure for every $1 in end-user exposure? When Adair Turner talks about “profitable activities so unlikely to have a social benefit, direct or indirect, that [banks] should voluntarily walk away from them”, this is surely a prime example of what he has in mind.

When the OCC tells us that total derivative notionals are now above $200 trillion, we can’t really help but go blank: the number is so many orders of magnitude divorced from any conceivable reality that it’s almost impossible to work out what it could possibly mean. But clearly that kind of exposure wasn’t necessary a few years ago. So why is it now?

Comments

[MattZN:]

Please, for gods sakes at least use the netting figures and not the notional amounts. Let me give you a hint: Authors who use notional amounts instead of netting figures throw up a big red flag called "I don't know what the hell I'm talking about". Notional amounts are completely irrelevant.

-Matt

Sep 28 01:42 PM

[Roger Knights:]

"Notional amounts are completely irrelevant."

To risk exposure, maybe. But that's not what Felix was talking about.

And Karl Denninger (I think it was him) has argued recently that increasing notional exposure increases systemic risk, because if one major participant goes bankrupt, the market for all derivatives seizes up and all participants are impacted. This, I think, is what Felix is worried about.

Sep 28 02:17 PM

[Bruce Vande...:]

Derivative defenders are quick to claim "notional amounts are completely irrelevant". Felix's question was: Why the hundreds of Trillions exposure now? People like Matt might wish to answer his question rather than sidestepping and pontificating.

Remember the AIGFP CDS derivative debacle? Major systemic risk, necessitating $100's of billion in taxpayer bailouts. Why are TBTF institutions so heavily into this market? Taxpayers deserve an answer.

I don't know the answer. Felix doesn't apparently. If Matt knows he is not telling and can't understand why you would even ask. Draw your own conclusions.

Sep 28 05:07 PM

[Kinabalu:]

Derivative exposure is made much more important by the recent ruling in the Lehman bankruptcy that throws out a material provision of the ISDA master agreement.

www.financeasia.com/ar...

The International Swaps and Derivatives Association master agreement governing most derivatives transactions says that a counterparty does not need to make payments if the other party suffers an event of default and, needless to say, bankruptcy is classed as such an event.

The court ruling would prevent the solvent counterparty from avoiding its out of the money obligation to an insolvent counterparty. This could significantly increase the potential obligations of a major derivative holder.

Sep 28 05:22 PM

[SecretaryNo...:]

The Elephant In The Room
www.financialsense.com...

J.P. Morgan’s derivatives book cannot be ‘hedged’.

As per their call reports filed with the Comptroller of the Currency’s Office, we know J.P. Morgan’s derivatives book grew by a cancerous 12 Trillion from June 07 to Sept. 07. The OCC’s Quarterly Derivatives Report serves as the public’s only peek into the opaque and murky world of derivatives-flim-flamm...

Flim Flammery is the understatement of the century. In fact, dealer notionals have EXPLODED parabolic-ally in recent years while END USER demand has been static and virtually non-existent.

Sep 28 05:27 PM

[Kinabalu:]

Notional amounts are highly irrelevant to risk exposure of an individual company OR to systemic risk. This is because for certain types of derivatives the actual risk may be 1-2% of the notional amount (fixed rate/floating rate swaps) while for other derivatives the actual exposure may be as much as 60-70% of the notional amount (the protection side of certain Credit Default Swaps). The types of derivatives are much more important than the notional amounts. Anyone who argues that increasing notional exposure increases systemic risk is missing the point.


On Sep 28 02:17 PM Roger Knights wrote:

> "Notional amounts are completely irrelevant."
>
> To risk exposure, maybe. But that's not what Felix was talking about.
>
>
> And Karl Denninger (I think it was him) has argued recently that
> increasing notional exposure increases systemic risk, because if
> one major participant goes bankrupt, the market for all derivatives
> seizes up and all participants are impacted. This, I think, is what
> Felix is worried about.

Sep 28 05:39 PM

[a fat panda:]

Whether it is "netting or notional", it is the concentration of risk that is worrisome. This is what Buffett said in 2002, "Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others... Linkage, when it suddenly surfaces, can trigger serious systemic problems."

What should also be worrisome is that the banks involved haven't managed risk well in the past. Citibank is a ward of the state. BofA isn't far behind. GS while being smart enough to buy CDSs was foolish enough to buy them from AIGFP.

Sep 29 03:00 AM

[Moon Kil Woong:]

With or without losses the risk exposure exists and often must be hedged. If there is counterparty risk or other associated risk lumped into the cost aside from the zero sum derivative bets made by the origional participants then no actual loss has to occur to incur some percentage of the notional value to be lost before settlement.

If this is a quandary for you, it is for most of us including people who bought or sold derivatives only to find out they need derivatives to hedge their derivatives or to set aside some percentage of the notional amount to account for potential defaults. It's like buying insurance and needing to buy insurance to insure yourself in case your insurer goes broke. Most of the derivatives market is totally out of control and unregulated and most people fear, if it is regulated their massive losses will be uncovered.

Thus they all put their heads in the sand and hope it goes away as they write more derivatives to cover their bad derivatives. In fact, just like all ponzi schemes, it never ends until it ends badly.

Sep 29 04:40 AM

[Anthony Har...:]

Taking a hint from the OCC report our team at boombustblog.com conducted a research on the health of derivatives of one of the biggest players in the market – JP Morgan. Considering JPM’s gross market exposure, its value of gross derivative receivables (at fair value) stood at $1.8 trillion as of 2Q09 (almost 19 times its tangible equity), while fair value of gross derivative payables stood at $1.7 trillion. Now since accounting standards allow banks to net offsetting contracts under FIN 39, net fair value appearing in JPM’s balance sheet stood at $164.7 billion or 1.74 times its shareholders’ equity. This implies that JPM has swapped a net $1.6 trillion of market risk for $1.6 trillion of counterparty risk. Even if one is legally allowed to account for this netting via GAAP and FASB standard accounting principles, a realistic, granular look at the quality of their net exposure should cause a shudder. Of the total derivative receivables exposure, 35.4% were rated BBB (the threshold for junk ratings) and below which is enough to wipe off 23.6% of the bank’s tangible equity in the event things move significantly south. This is an exposure that a large bank like JPM (and by extension the US and its taxpayers) can’t afford to assume under the current tilting market conditions. Can JPM’s operations truly justify the capital needed to prudently sustain the risk that they take? The quality of JPM’s derivative exposure is even worse than Bear Stearn’s and Lehman‘s derivative portfolio just prior to their fall. Total net derivative exposure rated BBB and below for JPMorgan currently stands at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers!!
boombustblog.com/index...

Sep 30 12:20 PM