Derivatives: A Banking Time Bomb Waiting to Go Off

I’ve been warning about the Trillion Dollar Ticking Time Bomb of derivatives for months now. As a brief recap, let’s consider the following:

1. The current notional value of derivatives on US commercial banks’ balance sheets is $203 trillion.
2. 97% of these ($196 trillion) sit on FIVE banks’ balance sheets (more on this shortly)
3. If even 1% of this $203 trillion is “at risk” … you’re talking about $2 TRILLION in at risk bets made in the derivatives market
4. If 10% of that 1% end badly, you’re talking about $200 billion in losses

Total equity at the five banks is $737 billion. So, if you assume that only 1% of derivatives are “at risk” (odds are it’s more) and 10% of that at risk money is lost, you’ve wiped out nearly 1/3 of the banks’ equity.

If 2% of derivatives are “at risk” and 10% of those bets go bad, you’ve wiped out $400 billion or nearly half of the banks’ equity.

If 4% of derivatives are “at risk” and 10% of those bets go bad, you’ve wiped out all of their equity and they go to zero.

Remember, I’m only accounting for derivatives here. I’m not even including on balance sheet risks, mortgage backed securities, and all the other junk floating around.

Suffice to say derivatives are a huge time bomb waiting to go off.

And what could trigger them?

Interest rates.

Of the $200+ trillion in derivatives on US banks’ balance sheets, 85% are based on interest rates.

For this reason, I cannot take any of the Fed’s mumblings about raising interest rates seriously at all. Remember, most if not all of the bailout money has gone to US banks in order to help them raise capital. So why would the Fed make a move that could potentially destroy these firms’ equity (essentially undoing all of its previous efforts)?

However, at this point, the Fed may not have a choice.

As I showed yesterday, the bond market is demanding higher yields from US debt. Put another way, US debt holders are unwilling to continue funding our profligate spending without getting paid more to do it. I can’t say I blame them, since the prospect of collecting a 3% yield to own a currency that’s lost 15% in the last six months isn’t too appealing.

But if yields rise this could blow up the derivatives market (remember 85% of derivatives are related to interest rates). So the question remains: which banks are sitting in the derivatives mine field?

I want to be clear here. The above chart may not be as bad as it looks. Remember, not all notional value of derivatives are at risk. For instance, only 1% of the above numbers might actually be real money at risk.

The issue however, is that no one knows how much money is at risk here. No one. But consider:

• The derivatives market is totally unregulated
• The nightmare that has occurred due to instruments that were allegedly regulated (mortgage backed securities, etc.)…
• Every attempt to increase transparency or accounting standards at the banks has been met with threats of financial Armageddon…

It’s very difficult not to be freaked out by the above numbers. Personally, I sure hope that less than 0.0001% of that stuff is “at risk.” I hope bankers were more careful with interest-rate based derivatives than they were with mortgage-backed securities.

I hope, but I doubt it.

Comments

[Michael Clark:]

Of course the Fed is not going to raise interest rates. But is the Fed going to stop buying TBonds that no one else wants, keeping yields down? Can it afford to dod this for ever?

Oct 29 12:06 PM

[Michael Clark:]

By the way, great article, Graham.

Oct 29 12:11 PM

[Mayascribe:]

Good comment, Michael. I'd like to see two more columns that include % of market cap, and % of the last two quarters revenue.

Sans: Still a good chart. Makes me more comfortable about owning Wells, less comfortable about JPM. Wish their was some sort of earnings power ratio.

Oct 29 12:15 PM

[Jasper M:]

"For this reason, I cannot take any of the Fed’s mumblings about raising interest rates seriously at all."

The Fed will not raise interest rates . . . but the markets will!
The Fed does not lead - it Follows.
Look at a long term chart of Overnight funds rates (set by Fed fiat) and the yield on T-Bills (set by the market).

Oct 29 02:41 PM

[Graham and ...:]

$203 trillion of derivatives. How many times larger is this than the U.S. economy?

Oct 29 05:00 PM

[Mill Rat:]

Yesterday, on Seeking Alpha, Reggie Middleton published a much more detailed analysis of this same topic (the topic of banks holding derivatives). It was titled: "The Next Step in the Bank Implosion Crisis."

seekingalpha.com/artic...

Oct 29 05:48 PM

[TeresaE:]

"I hope, but I doubt it."

That pretty much sums up the entire past 3 years for me. It started with a Business Law class that led to research that led to my being forced - kicking and screaming - to see the face hiding behind the curtain of MSM, Wall St and government propaganda.

When reminded of facts such as these, my hope wavers.

Especially when I look at things I have "hoped" for over the past 3 years. I hoped the auto companies could convince the unions that they slaughtered their own customers and figure out a way to stay in business, I hoped that McCain wouldn't win the nomination and the Obama wouldn't either, I hoped that the lame duck in office wouldn't bow to industry pressure (even though all history pointed the other way), I hoped the 2005 bankruptcy & financial laws wouldn't destroy the middle class's credit, I hoped my holdings wouldn't tank, I hoped Bank of America would value payments over financials, I have hoped for a lot.

And they all ended with my hope not being fulfilled.

Let us all hope that this time is different.

Nice article

Oct 30 09:36 AM

[CPA/CGFM/AU...:]

You are absolutely correct. And my hopes are have given way to despair. It will implode.

Oct 30 09:41 AM

[CPA/CGFM/AU...:]

You are absolutely correct. And my hopes have given way to despair. It will implode.

Oct 30 10:00 AM