Commercial Bank Derivatives - A Disaster Waiting to Happen
>> Thursday, October 22, 2009 –
Credit Growth,
Depression,
Derivatives,
Economic Analysis,
Inflation,
Inflation Forecast,
Recession,
U.S Debt
The Global stock markets, commodity markets and many other asset classes have gone up significantly since the lows of March 2009. But these asset classes might still not be in a bubble stage. However, the global optimism is surely in a bubble stage. Its a bear market for negative and more realistic opinions which is generally avoided or countered with sharp criticism these days.
However, the fact is that the biggest financial crisis that was beginning to unfold has just been postponed for a future date. The Governments and financial institutions are doing their best to make the crisis look even worse when it comes back in a much bigger way.
In this article, I would primairly be discussing the commercial bank derivatives, which is just getting bigger with time and it has the potential to cripple the entire financial system.
The notional amount of total derivatives among the Commercial Banks in U.S. has increased from $95.6 trillion in December 2005 to $190.0 trillion as on June 2009. The chart below gives the details of the same.
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Commercial Bank Derivatives
Table Source: FDIC
The table above gives the segmentation of the derivatives contract among futures and forward contract, option contracts and swaps.
The current financial crisis took a serious shape from October 2007 when the Federal Reserve cut rates for the first time. So, even when the world was going through one of the worst economic and financial downturns, the derivatives market went up by 27% to $190 trillion from $150 trillion as on December 2007.
One of the functions of economic recession is that it cleans the system of its excesses. However, the unique feature of this recession is that it has laid a solid foundation for a depression and a big financial collpase. The above example is just one of the reasons for saying so.
The interest rate swaps form a major portion of the composition of the commercial bank derivatives.
Composition of Commercial Bank Derivatives
Chart Source: FDIC
As evident from the chart above, 91% of the derivative contract is in interest rate swaps. It might be interesting to study the reason for the high concentration of derivatives in the interest rate swaps. Certain evidences suggest that it might help in artificially supporting bond markets. However, that is still subject to further study and conclusive evidences.
Another interesting statistic about Commercial Bank Derivatives is that it is only for the big players in the market.
Concentration of Commercial Bank Derivatives
Source: FDIC
It must be noted here that the amounts do not represent either the net market position or the credit exposure of banks’ derivative activities. They represent the gross value of all contracts written. Spot foreign exchange contracts of $1,395 billion for the seven largest participants and $85 billion for all others are not included.
The purpose of holding derivatives is also a key factor to look into. There is no doubt that most of it would be held just for trading.
In this respect, I would like to add that the only thing the banks have done with the bailout funds is to trade and speculate. Thus, there is no great reason to cheer when these banks come out with decent profit numbers. One really needs to work hard and be very dumb to be in losses even after getting billions of Dollars of free money.
Major Factors Affecting Earnings (Q2 09 vs. Q2 08)
Source:FDIC
It is clear from the chart above that it is increase in non interest income which has primairly lead to rise in banks earnings. The core banking business is still struggling as evident from the increase in loan loss provision.
As mentioned earlier, the primary purpose of holding derivatives is trading. The chart below confirms the same. Around 99% of the Derivatives have been held for trading.
Purpose of Commercial Bank Derivatives
Source:FDIC
The Derivatives held by Commercial Banks in the U.S. is already over ten times the size of the U.S. economy. This figure is just getting bigger and there has been no effort to put a tab on the same. There is no doubt that it is a big disaster waiting to happen. No one would exactly know the time frame, one day the entire financial system would collapse because of these derivatives. What one saw after the Lehmann collapse can be considered to be just the trailer.
As the above chart showed, it is a exciting game for the big players. But when it will collapse, the effect will be felt even by those who have not heard the word Derivatives.
So, apart from the big derivatives bomb, apart from record high deficits any country ever had in the history of capitalism, apart from rising unemployment and apart from purchasing power vainshing from the massive expected inflation, everything is fine with the world economy.
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Recent Articles:
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Oct. 21 (Bloomberg) -- The House Agriculture Committee approved legislation regulating over-the-counter derivatives after adopting a provision that may speed agreement on regulation of the $592trillion industry.
bills in the House would set new margin and trading requirements for swaps dealers and “major swap participants.” Sponsors of the measure say that would apply the rules to the biggest users of derivatives, including hedge funds, AIG and mortgage-finance companies Fannie Mae and Freddie Mac.
http://www.bloomberg.com/apps/news?pid=20601103&sid=aMxy9IQDJ2tA
And here is the history and Frontline video story on how a Band of Brothers refused to consider regulating derivates back in the 90's in Time Magazines headline story The Committee To Save The World. We can thank Alan G.
http://thewrightinvestmenteducation.blogspot.com/
Thanks much for these useful likns and information...It would be great if some regulation does come in this industry...
Its just too big and counter party risk is big...times like Lehmann when no one trust one another are fatal for such a big industry...
Some regulations and more of a control of the size of the industry would certainly help...
Both Warren Buffet and George Soros, the hedge fund billionaire, have said there should be a prohibition on so-called "naked" trading in credit default swaps - or that only those holding the debt of a company or institution should be able to take out insurance against that debt.
This one simple decession would shrink the CDS market by many trillions of dollars, since something like 90% of the market in recent years has taken the form of pure speculation, according to industry statistics.
The USA and UK have become the financial capitals of the world since the slow death of manufacturing. We seem to be locked into creating more and more financial products and derivatives to speculate with and sell to the world under a "investment" or "risk mitigation" label.
The U.S. has about half of the world’s $600 trillion over-the-counter derivatives market, which he said “played a central role” in the financial crisis.
The world needs food, clean water and electrical power but do we really do not need all these derivates if tax-payers must bail-out losses? No.
For sure the burden on the bailouts falls on the tax payer in one way or the other...
There is an urgent need to change a lot of things in the financial system...This will be good for US in the long run and also good for the rest of the world...
u mentioned about food and water...I think pure water for drinking and other purpose is a big challenge for India and China and also for the rest of the world...I particulrly mentioned India and China because of their growth rates, population and hence their need for water...
Lets see when these issues get addressed...
Yes, in my view, to much Yankee Ingenuity went into Wall Street and Internet.com applications of questionable importance to the world. Due to our Enviornment Clean Up movement starting in the 70's we have advanced polution control equipment. We have advanced Oil and gas and water drilling skills. We have the worlds leading deepwater oil drilling companies and equipment. We've been masters of water treatment and purification and sewage treatment plants for decades. We've been masters of farming for 100 years.
But with all the attention going to getting rich quick on Wall Street or Starting your own dot.com company combined with America's declining manufacturing sector fewer and fewer American youth seek careers in these other fields. We seem to have fewer and fewer amonts of capital flowing into these sectors. Our own infrastructure is in decay...yet Casinos are on the rise. A bad sign. And only as a result of the declining dollar (not government planning) has the world come to know John Deere Tractors and farming equipment and CAT jumbo construction equipment.
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