market ace

One Easy CDS Fix

Why is everyone only talking about CDS's when the derivative market in interest rate swaps dwarfs it about 10-1 and giant problems will arise here when interest rates rise.

Until the third quarter of last year, the banks' losses in derivatives were almost entirely confined to credit default swaps — bets on failing companies and sinking investments.

But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.

Now, with potential new losses in interest rate derivatives, this problem has the potential to cause a collapse in a whopping 82 percent of the derivatives market.

Thus, considering this far larger volume, any threat to interest rate derivatives could be far more serious than anything we've seen so far.

Today U.S. banks alone control $200.4 trillion in derivatives; and it's precisely in this dangerous sector of IRS's that the megabanks dominate the most.
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According to the Office of the Comptroller of Currency's Q4 2008 report, America's top five commercial banks control 96 percent of the industry's total derivatives, while the top 25 control 99.78 percent. In other words, for every $100 dollar of derivatives, the big banks have $99.78 ... while the rest of the nation's 7,000-plus banking institutions control a meager 22 cents!3 This is a massively dangerous concentration of risk.

The large banks are exposed to the danger that buyers will vanish, markets will suddenly become illiquid, and they'll be unable to unload their positions without accepting wipe-out losses. The large banks are exposed to the danger that, with exploding federal deficits and new fears of inflation, interest rates will suddenly surge, delivering a whole new round of even bigger losses in the months ahead.

Worst of all, the five biggest banks are exposed to breathtaking default risk — the danger that their trading partners could fail to make good on their gambling debts, transforming even the best winning trades into some of the worst losers.

Here's a chart on these risks, updated to reflect the new data just released on Friday for the year-end 2008,

Bank of America's total credit exposure to derivatives was 179 percent of its risk-based capital;

Citibank's was 278 percent;

JPMorgan Chase's, 382 percent

HSBC America's, 550 percent, and

Goldman Sachs' total credit exposure at year-end was 1,056 percent, or over ten times more than its capital.

Get ready for some big fireworks in the banking industry that even Bernanke's giant printing press cannot possibly handle and all of the proposed accounting changes cannot mask or cure this massive problem..