Every quarter the OCC comes out with a Quarterly Report on Bank Derivative Activities. This contains a wealth of information, including the GPFV (Gross Positive Fair Value) and GNFV (Gross Negative Fair Value) of both Total Derivatives and Credit Derivatives for all Banks and Trading Companies combined. Not surprisingly, the GPFV always exceeds the GNFV: even less surprising, the size of the difference has a -90% correlation with the S&P 500.
Here is a chart (click to enlarge), displaying the dollar difference between the GPFV and GNFV of Credit Derivatives for all banks vs the S&P 500:
When Credit Default Swaps first appeared on the scene, we were told that their presence would stabilize the financial system. They were an integral part of the great moderation. In addition to stabilizing the system, they conferred great benefits of price discovery and transparency on the credit markets.
However, a simple glance at the chart shows the direct negative correlation – the greater the amount of Credit Derivatives, or more accurately, the greater the profit on these WMDs claimed by our savvy investment banks, the lower the S&P 500 index plummeted. But these banks somehow were in trouble at the very time their profits as shown maxed out.
As the profits claimed by the big banks decreased, the S&P 500 obediently rose back toward more comfortable and prosperous levels. And the banks were restored to health. Sadly, during the second quarter, European sovereign and bank creditworthiness became an issue, the difference between GPFV and GNFV stopped declining, and the S&P 500 tanked. It is with joy that I hear concerns that the banks are getting reduced trading profits. Trading profits include these WMDs. And the less profit of this type that the banks make, the higher the S&P 500 goes.
It is possible to argue that the cause and effect relationship is invalid, and the extreme negative correlation arises from outside causes which affect both Credit Derivatives and the S&P 500 equally.
A Simple Suggestion
This chart displays the results of a great experiment – one in which theoretical benefits were so great that it became necessary to exempt these instruments of salvation from any regulation of any kind. Unfortunately that experiment went awry, and the Great Wizards at the heart of the financial system wound up doing a fairly good impression of the Sorcerer's Apprentice.
Here's the suggestion – why not stabilize the banks by increasing capital requirements, and put them out of the Derivative's business? Entirely. If Derivatives are needed, it is as insurance. Insurance regulation is well understood: it involves capital adequacy on the part of the issuer, and an insurable interest on the part of the buyer. And at one time Banks were barred from the insurance field.
Disclosure: No position in any investment bank