Beware the Current Bull Market in Derivatives 24 comments
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The Dow is near 10,000 again. The business press is full of stories about the resurgence in mergers, IPOs and even so-called blank check companies.
There’s one statistic, however, that should give investors pause: the growth in the total dollar value of derivative contracts at the top too-big-to-fail banks in the United States.
In the second quarter of this year, the notional value of derivatives contracts at JPMorgan Chase (JPM), Goldman Sachs (GS), Bank of America (BAC) and Citigroup (C) increased by $1.92 trillion, to $191 trillion. Shockingly, Citi is responsible for most of that gain from the end of the first quarter.
Overall, the total dollar value of outstanding derivatives transactions at the top 25 U.S. commercial banks was $203 trillion, according to the Office of the Comptroller of the Currency, meaning that the nation’s four biggest banks account for 94 percent of the industry’s total exposure to derivatives.
Now the concentration of derivatives at a handful of banks isn’t new. It’s even to be expected, bank regulators say.
The OCC, in its quarterly derivatives report, routinely notes that the Big Four “have the resources needed to be able to operate this business in a safe and sound manner.”
In other words, the biggest banks are best suited to handle all these derivatives contracts because they’ve been doing it for so long.
But it’s this regulatory logic that has helped enshrine the too-big-to-fail doctrine. A handful of financial institutions are deemed more indispensable than others because they are too interconnected to fail. It’s the large concentration of derivative contracts at a troubled bank like Citigroup that made a big bailout necessary.
So it’s particularly disturbing to find that the total dollar value of outstanding derivatives at Citi rose by $2.3 trillion, to $31.9 trillion in the second quarter. By contrast, the notional value of derivatives transactions at JPMorgan Chase — the leader in this category — fell by $1.2 trillion, to $79.9 trillion.
It’s hard to fathom how a bank that has yet to prove it can stand on its own two feet without huge amounts of federal support should be adding to its potential derivatives exposure.
That’s especially so with Citi losing $238 million in trading revenue because of derivatives in the second quarter. Citi managed that feat even as the nation’s 25 top commercial banks took in $5.1 billion in derivatives trading revenue in the same time period, according to the OCC.
This is why, of all the proposals for reforming the financial system, the Obama administration’s plan to require that the vast majority of derivatives be traded on well-capitalized exchanges is the most important.
The president’s team needs to keep the pressure on Congress to enact a measure that will ensure there’s a way for a trading partner to get paid on a derivatives contract, even if the bank on the other side of that transaction fails.
And if anyone doubts the need for regulating derivatives and making it easier to unwind a troubled too-big-to-fail bank, Citi should provide all the evidence that’s needed.
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Today, after the open, we saw the bottom fall out and, for no perceptible reason, they closed only marginally lower.
Are Ben and friends keeping those printing presses burning the midnight oil?
It seems to be that 80-90 point drops are acceptable. Would you agree to this theory? I think most investors are fully aware that our economy is running on thin air or fumes.
What began as a simple means of hedging the price of corn has become a global market that trades trillions of dollars per day. The interactions and correlations between markets that were once considered separate are today closely connected,with price shocks rippling from one market to another. The development of computer systems has been the single most important "enzyme" without which it would simply not have been possible for markets to grow.
Ironically, it is now the inability of computer systems for risk management to keep pace with the markets that is holding back further development. The IT systems landscape within most investment banks is now highly complex with many different systems interacting in ways that are difficult for a human being to understand. Armies of software specialists and consultants maintain fragile systems; "if it ain't broke don't fix it" being the mantra of many. But a nest of vipers lies hidden, a tangled web of fragmented and fragile interconnections that means trading firms are vulnerable to substantial losses due to potential system failures. Operational risk within IT systems has the potential to bring about collapse of the entire firm. The time has come for many banks to face up to this problem and tackle it at the grass roots level. Instead of adding more and more patches onto existing systems, radical investment is needed to clean up and bring a structured, well architected systems landscape into being.
Let's hope President Obama can get a well-regulated derivatives exchange set up. Greenspan has already admitted he was flat out wrong in his Panglossian assessment of the OTC derivatives markets.
We don't need to oversee their managements, give them taxpayer dollars to cover their operational losses, or even regulate how they operate.
The solution is simple. If you run a bad business, you fail. If you commit fraud or other financial crimes, you go to prison.
By putting them above the law, we have opened a deadly pandoras box that will sink our country.
The people at the top seem too ignorant to understand the severity of the problem, and their solution of recapitalizing bad businesses will blow up in everyones faces.
Short-term Interest rates remain low and the market is "inflating" back to normal valuation levels while the CPI remains very tame. The next leg for the economic recovery will see increased employment.
The lesson learned from the derivatives fiasco is that this should not be used as the Wall Street casino. But, responsible hedging to lock in profit margins limiting business risk continues to be needed. And, those who can afford to shoulder the risk can make a prudent bet against the price decline the business hedger tries to avoid. These contracts should not exceed the actual commodity or currency hedge supporting the underlying contract. This is where regulation is needed and is being better enforced with additional rules being put in place.
THE FED, SEC, EXTERNAL AUDITORS AND BANK EXAMINERS
ALL STILL LOOK THE OTHER WAY. WHY IS IT THAT THE FED BUYS THE BAD BETS AND THE BANKS KEEP THE GOOD BETS
AND SHOW SUPER EARNINGS FROM WHICH TO PAY BIG BONUSES. WE ARE DOOMED.
Please tell this humble amateur economy watcher that this was a typo. I've been warning anyone who would listen, for months now, that it is the major too-big-to-fail, 'creative accounting procedure' banks that will be this country's fiscal downfall. This brief article only highlights my deep concern for the Fed>Gov't>Banks money laundering fiasco.
Do you suppose it will all come to a head as commercial and
industrial real estate derivatives explode over the coming months?
Where does this all end? Am I overreacting? Who's in charge?
When will we see the first major bank go down and how hard will
it go down, and most importantly, what will the ripple effects be on
our economy then? I take no comfort in the fact that big banks have
been in this business for a long time, for that seems to be the
overriding problem. I guess it's a wait and see situation....isn't it?
If, as a society, we hadn't been acting like village idiots, we wouldn't be in this mess. Most Americans have fallen far short of the eternal vigilance that is freedom's requirement.
Granted, we have been the target of an incredible barrage of deceit and propaganda. But that's where the eternal vigilance comes in. The sad truth is that in the U.S. the vigilant have gotten far more anger than gratitude. People didn't want to hear anything that conflicted with their corporate-media disneyland understanding of the world. I'm sure many of you had this experience.
We blew it. Time to learn our lessons, rebuild, and see if we can do a better job living up to the values we pay lip service to.
On Oct 01 09:02 PM rennert wrote:
> Plant your own food. Get plenty of canned food also. Hunker down
> and keep your loved ones save. There was a guy on TV who suggested
> some day Americans mite be tired of being treated like the Village
> Idiots while the Elite lives like the King of France. He suggested
> be prepared and buy a farm out in wide open land. I do not know if
> that would really work for me since I never killed a chicken before
> I mite starve than anyway.
We might start with Bush, Cheney, and co.: torture; starting wars aggression; wiretapping the American public; signing statements; etc. I can think of no better way to discourage future abuse, and to begin to redeem America's international image, which is in the gutter right now.
But if we prosecute all guilty of fraud, how far would we have to go? The mortgage and related industries were riddled through with fraud from top to bottom.
I'd settle for hammering the big fish, and putting into place reasonable safeguards to prevent further abuse.
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